The Comprehensive Guide to Buying a Franchise for First-Time Buyers

Investing in a franchise is a significant financial commitment, particularly for those embarking on this journey for the first time. The decisions made during this process are critical and should commence with the careful selection of the right franchise opportunity.

Exploring Franchise Options

With over 3,000 franchisors in the U.S. and approximately 300 new brands emerging each year, the vast array of choices might appear overwhelming. However, by narrowing down your options based on the type of franchise, geographical availability, and brand strength, you can quickly reduce your choices to a manageable few. The Federal Trade Commission (“FTC”) recommends that franchise buyers first consult a lawyer before buying a franchise.

Making an Informed Decision

Choosing between two or three franchises can be challenging. Not all franchise systems are alike, and your success will depend significantly on the franchisor you select. Here are seven critical factors to consider when evaluating franchise opportunities:

1. Initial Investment

The initial investment required for different franchises can vary widely. For instance, opening a fitness center or restaurant might necessitate an investment of over $500,000 or even $1,000,000, while a mobile or home service franchise could cost less than $200,000.

How to Compare Initial Investments:

• Review Item 7 of the Franchise Disclosure Document (FDD): This section provides an estimate of the initial investment required.
• Understand that these figures are estimates: Actual costs may differ and we often find that Item 7 understates the true costs, particularly as to lease buildouts.  
• Pay attention to the “Additional Funds” line item: This is meant to cover expenses until the franchise becomes profitable and is a crucial factor in understanding the true financial commitment.  Note that it often takes many more months than identified in Item 7 to reach break-even and a lot of businesses do not break-even in the first year.

2. Royalties and Marketing Fees

Franchisees are typically required to pay ongoing royalties and marketing fees, usually a percentage of gross revenue, on a monthly basis. Some franchisors also charge minimum fees which can lead you to pay a higher percentage of gross revenue.  And many franchisors charge liquidated damages or lost future royalties if the franchise fails and closes prior to the expiration of the term.

How to Compare Royalties and Marketing Fees:

When evaluating different franchise opportunities, it is crucial to understand and compare the royalties and marketing fees as they will significantly impact your financial performance. Here are some steps to effectively compare these fees:

1. Review Item 6 of the FDD: The FDD provides detailed information about the fee structure in Item 6. This section outlines all ongoing fees, including royalties, marketing fees, and any other financial obligations.
2. Understand the Fee Structure: Be aware of any minimum payment requirements, how the fees are calculated, and any additional financial obligations. Here’s what to look for:
   •        Percentage Rates: Compare the percentage rates for royalties and marketing fees across different franchises. Even a small difference in percentage can significantly impact your profitability.
   •        Fixed Fees: Determine if there are any fixed fees and understand how they will affect your finances during periods of low revenue.
   •        Additional Contributions: Identify any additional required contributions to local advertising or cooperative advertising funds.
3. Analyze the Impact on Profitability: Consider creating financial projections based on different sales projections to see how the fees will impact your profitability in various situations.
4. Assess the Value Provided: Consider the value you receive in return for these fees. High royalties might be justified if the franchisor provides substantial support and marketing that significantly boosts your business or has a valuable trademark or novel concept.

By thoroughly understanding and comparing the royalties and marketing fees, you can make an informed decision that aligns with your financial goals and expectations.

3. Territory Rights

Franchises generally come with designated or protected territories. Some offer exclusive territories, preventing other franchisees from operating within your area, while others may restrict where you can market your services or products.

How to Compare Territory Rights:

• Review Item 12 of the FDD: This section outlines the territorial rights and restrictions.
• Check the franchise agreement: Look for what your territory will be composed of, whether it’s certain zip codes or a radius around the location you operate. 

4. Initial Term and Renewals

Franchise agreements specify an initial term and conditions for renewal. A longer initial term can provide stability but may also lock you into a potentially unprofitable situation.

How to Assess Terms and Renewals:

• Consider the length of the initial term: Evaluate whether the term aligns with your long-term business goals.  In particular, you typically want to line up the term of the franchise agreement with the term of a lease.
• Review renewal conditions: Ensure they are reasonable and provide flexibility for future planning.

5. Operational Restrictions and Support

Franchisees benefit from using the franchisor’s trademarks, business systems, and receiving operational support. However, franchisors may impose operational restrictions to maintain brand consistency.

How to Evaluate Support and Restrictions:

• Review Items 8 and 11 of the FDD: These sections detail the operational support and restrictions imposed by the franchisor.
• Speak with current and former franchisees: Gain insights into their experiences with the franchisor’s support and any operational challenges they faced.

6. System Size and Growth

The size of a franchise system and its growth trajectory can be indicative of its stability and potential for success. A larger system with many successful franchisees can offer more security, while a smaller, growing system might present unique opportunities if the franchisor has the resources to expand effectively. Be also wary of franchise systems growing quickly that cannot support their franchisees or franchise systems so small they have not built up any infrastructure.

How to Compare System Size and Growth:

• Review Item 20 of the FDD: This section includes data on franchise openings, closings, and projections, providing a snapshot of the system’s health and growth prospects.
• Discuss growth plans with the franchisor’s representative: Understand their vision and strategy for expansion.

7. Post-Termination Covenants

Franchise agreements often include post-termination covenants such as non-competition and non-solicitation clauses. These can significantly impact your future business endeavors after the termination of the franchise agreement.

How to Understand Post-Termination Covenants:

• Carefully review the termination provisions in the franchise agreement: Understand the restrictions on your ability to operate in the same industry or market after the franchise agreement ends.
• Be aware of any limitations: These can also affect your other businesses and you will want to ensure that any other business you operate does not fall within the non-compete and if one does you will need to specifically negotiate a carve-out from the non-compete in an addendum.

Conclusion: Conduct Thorough Due Diligence

When evaluating franchise opportunities, thorough due diligence is essential. This guide outlines the primary factors to consider, and the following steps are critical to making an informed decision:

1. Develop a Detailed Business Plan:
   •       Ensure the franchise aligns with your personal and financial goals.
   •       Outline your strategy for operation, growth, and profitability.
   •       Consider market analysis, competitive landscape, and whether you are a good fit for the franchise based on your prior experience and skills.
2. Consult with Legal and Financial Advisors:
   •        Have experts review the franchise agreement to understand all terms and conditions.
   •        Assess financial commitments, including initial investment, ongoing fees, and potential hidden costs.
   •        Understand your obligations and rights under the agreement to avoid future disputes or financial surprises.
3. Speak with Existing Franchisees:
   •        Gain practical insights into the daily operations of the franchise.
   •        Learn about the level of support and training provided by the franchisor.
   •        Ask about their experiences with profitability, challenges faced, and overall satisfaction.

By incorporating these steps into your evaluation process, you can make a decision that aligns with your goals and capabilities, setting a solid foundation for success as a franchisee. The key to a successful franchise investment is meticulous research, calling as many franchisees as possible and careful consideration of all factors involved, ensuring that you are fully prepared for the journey ahead. For more information on franchise law check the franchise law page of our website.