Wilentz, Goldman & Spitzer, P.A.
Franchising in the United States is a more than $1 trillion per year business. Over 450,000 franchised businesses are in operation in the country and employ about 15 million people.¹ Thousands of franchisors in about 75 different industries offer franchise opportunities ranging from fast food to hotels, health clubs to cleaning services and numerous other business opportunities.² However, even though franchising is such a big part of the American economy, the question must be asked whether becoming a franchised business owner is always a good idea.
When people think of franchised businesses they generally think of the fast food chains or hotels of national scope, which engage in extensive national and local advertising, and have tremendous brand recognition. However, many franchise opportunities do not fall into this category. Rather, they represent smaller national franchise systems or regional or start up businesses in the process of expanding or developing a franchise network and gaining brand recognition. Not all of them succeed in this endeavor. Some franchise systems disappear; others hold on but with few franchisees, little to no advertising support and limited, if any, brand identity. Even among national franchise systems with high brand recognition, there are franchisors that over-saturate markets without regard to the prospects for revenue generation by franchisees and some administer better franchise systems with better franchisee relations than others.
Before signing onto a franchise system, incurring substantial franchise fees and start up costs, agreeing to pay royalties and advertising fees to the franchisor, and limiting one’s ability to engage in a substantially similar business even after the end of the franchise relationship, a prospective franchisee should carefully analyze what he or she is getting for the commitments that must be made.
Upon entering into a franchise relationship, among other things, the franchisee commits to paying the franchisor’s franchise fee, royalties and often advertising fees; building and equipping a facility to the franchisor’s specifications; undergoing and having key employees undergo training required by and at locations designated by the franchisor; conducting business in accordance with the franchisor’s system; selling products and using supplies approved by the franchisor; and signing a restrictive covenant that will prevent the franchisee and, perhaps, some key employees, from engaging in a competitive business if the franchise expires or is terminated.
In exchange for these commitments, a franchisee should expect the franchisor to provide a valuable business system and/or product with name recognition that will attract customers; to have the expertise to assist the franchisee in developing a successful business; to insist on quality controls and uniformity among its franchises; to engage in brand advertising on the national, regional and local levels; and to provide the franchisee with an environment that will enable the franchisee to derive sufficient revenue to be successful.
With franchise fees and build-out costs often in the hundreds of thousands of dollars or more, and combined royalties and advertising fees in the 8 - 12% range, it is important that prospective franchisees take a hard look at a franchise opportunity to make certain that it meets these expectations and justifies the financial outlay. Among the topics that a prospective franchise should address include those discussed here. Others will certainly arise in individual situations.
First, it is vital to consider whether the franchise has name recognition in the geographical area in which the franchise will be located or a business plan that indicates a reasonable likelihood that the franchisor will gain name recognition in that area within a reasonable period of time after the franchise is opened. Name recognition is a major attribute of a franchise system. It offers an identity and potential clientele to a new franchise the minute it opens for business. Many franchise systems have tremendous positive name recognition. However, for franchise systems where name recognition has not been developed, the prospective franchisee must carefully assess the likelihood that the franchisor can develop a recognizable brand name within a time frame that justifies the commitments in start up costs, royalty payments and, perhaps, advertising fees that must be made to the franchisor. Without name recognition, a hamburger and fries, a gym or a hotel, is just another hamburger and fries, gym or hotel.
A corollary to name recognition is brand advertising. Advertising creates brand recognition as it keeps the brand and/or the product in the minds of the consuming public in a favorable light. Without effective brand advertising, a franchise can be little different that a local business in the same product or service. Moreover, franchisees often pay fees to the franchisor for brand advertising and also pay royalties to be part of a franchise system. Those payments must provide an advantage if the franchise offering is to be worthwhile. It is therefore important to learn whether the franchisor currently engages in effective national, regional or local brand advertising or, if not, whether the franchisor has a business plan that will result in such advertising within a reasonable period of time after the franchise is opened for business. Many franchisors engage in extensive advertising at all levels, provide advertising assistance to franchisees and offer promotions that bring customers to their franchises. However, absent advertising at a level that well benefit the prospective franchisee, a significant advantage to being part of a franchise system is missing.
A franchisor’s business plan for brand advertising is particularly important in the case of a start-up or regionally expanding franchise system. Brand advertising can be expensive, especially in metropolitan areas. A start-up or regionally expanding franchisor may not have the resources to justify and enable it to incur the costs of significant advertising until it reaches a critical mass of franchisees nationally or in a new region. An early entry into a new franchise system needs to inquire carefully about the franchisor’s plans so that an assessment can be made as to the value of the advertising fees that may have to be paid and the likelihood that the franchise system will develop sufficient brand recognition in the area in which the franchise will be located to justify the start up costs, royalty fees and other expenditures that will be incurred.
Brand recognition and national/regional advertising are significant advantages of franchising over the opening of a local business. However, without a valuable product or business model, they may not be sufficient in themselves for a franchise to be successful. Before committing to the costs and ongoing fees of a franchise, a prospective franchisee needs to carefully assess whether the business model or product offered by the franchisor is of any value.
Likewise, consideration needs to be given to whether there is anything to the franchised business model or product that one cannot successfully duplicate oneself without the costs that will be incurred by being part of a franchise system. Who wants to pay royalties and incur other costs for something one can easily duplicate oneself? Here again, this is of particular significance in the case of a start-up or regionally expanding franchise system where brand recognition and brand advertising are not apt to be immediately available. If, in such a case, one could easily duplicate the franchise model, the costs and fees of being part of a franchise system may not be justifiable.
To survive and grow long term, a franchise system needs a good business system or product, brand recognition and effective advertising. But, it also needs skilled management at the franchisor level and a well administered franchise system. Whether the franchisor’s executives have expertise in the service or product field and in running a national or regional business must be considered. Whether the franchisor has a sufficient number of properly trained employees to train and advise franchisees and administer the franchise system is also important. Many franchisors have large administrative and/or field offices from which they administer their franchise systems, offer start up and other training and assistance to their franchisees and protect the value of their brands. However, there have been instances in which an entrepreneur successfully develops a product or business concept and decides to franchise it, but has no skill in managing an enterprise. Such franchise systems tend to be poorly run and have poor track records. Sometimes, franchise systems, particularly those that are start-ups or regionally expanding, are thinly staffed and, as a result, after the initial training process, franchisees are left adrift without support from the franchisor. Such franchises may provide little value for the franchisee in relation to the costs and fees that must be paid.
A franchisee’s success can also often depend on whether the franchisor maintains uniformity among its franchise outlets and consistent quality for the service/product being sold. Uniformity and service/product control are essential as they offer a customer who has used one franchised outlet confidence that he or she will have a similar experience when using another outlet of the same franchise system. Not all franchise systems are equal in their ability to maintain consistency and quality. Absent such consistency and quality, however, the franchisor’s brand may have little value or, over time, lose whatever value it at one time had.
The reason one opens a franchised business, of course, is to earn an income and/or profits. While brand recognition, advertising, a product or service that has value and a well operated franchise system are all important in enabling a franchisee to secure that income or profits, everything can be taken away if the franchisor can appoint additional franchisees that encroach on the market area needed by the franchise to be successful or can compete with the franchisee under the same or different brand names, for “large” or “national” accounts, at non-standard locations such as airports, arenas, hotels, etc., or for internet sales. A prospective franchisee needs to know what the franchisor’s rights, past history and plans are in these respects and assess what impact they will have on the franchisee’s business.
A prospective franchisee also needs to know what is hidden in the fine print in the franchisee agreements that will be signed. While all franchise agreements are different and each must be analyzed on its own, they all address termination; renewal and renewal fees; remodeling requirements when the franchisor changes its brand image or upon renewal; restrictions on the sale of the franchise to someone else; transfer fees; restrictive covenants barring the owners and key employees of the franchise from owning or working at a competitive type of business during or after the franchise relationship ends; limitations on the types of products or services that can be offered at the franchised location; restrictions on suppliers that can be used; requirements regarding lawsuits, arbitration and damages, etc. These types of contract terms and others can have a significant impact on the cost of operating the franchise, the value of the franchise business, the ability of the owner of the franchise to attract employees and the prospect of earning a living during and after the franchise relationship ends.
Franchising is a remarkable business format. It has enabled thousands of people to open businesses of their own. However, not all franchise systems are equal and not all are suitable for the business sophistication and risk tolerance of every potential franchisee. Before entering into a franchise relationship, it therefore behooves a prospective franchisee to raise probing questions on the topics mentioned here and others that may arise in individual situations. Clear, informative responses from the franchisor’s representatives should be expected. Vague answers or glib assurances should be looked at as red flags. While no franchisor can guarantee that a franchisee will be successful, before investing time and tens or hundreds of thousands of dollars, every effort should be made to make a reasoned evaluation whether the franchise opportunity offers a sufficient prospect of success that the investment in it is justified.
Marvin J. Brauth is a shareholder with Wilentz, Goldman & Spitzer, P.A., in Woodbridge, NJ. For over 30 years he has represented franchisees in the evaluation of franchise opportunities, review of franchise agreements, real estate purchase contracts and leases, buy-sell and other agreements and has handled disputes with franchisors, vendors, consumers and government agencies. Mr. Brauth can be reached at 732-855-8084 or firstname.lastname@example.org.
¹ U.S.Census Bureau, 2007 Economic Census