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Should I Buy Into This Franchise?

Written by: Anthony Delyani

Published in the Portsmouth Herald (9/27/2020)

In this current environment of uncertainty, would-be entrepreneurs are no doubt reluctant to start a business from the ground up. One hedge against the uncertainty can be to become a franchisee in an established franchise system. An entrepreneur who chooses to go into business as a franchisee will immediately obtain benefits that can take years to develop in an independent business.  Those benefits include the right to use well-known names and logos; a business support system, which can include training, successful methods of doing business, and operations and employee manuals; and access to vendors for well-known products, sometimes with favorable pricing.

First-time business owners brim with questions and insecurities about how best to conduct a business.  Business owners all want to succeed; not all know how.  An established franchise system will require new franchisees to receive training in all aspects of the business, such as hiring employees, conducting day-to-day operations, and maintaining accurate records.  A franchisor profits more from a successful franchise then from a failure, so it has a strong ongoing interest in helping the franchisee to succeed. To protect its interests, the franchisor will require the franchisee to provide periodic (usually monthly) reports of its activities, particularly financial performance. Franchisees are also subject to spot checks to determine conformity with appearance and product quality guidelines. Franchisees that do not meet the franchisor’s performance standards risk having their franchise rights terminated.

Access to vendors for specific products is a key consideration for franchisees.  Many customers enter a franchise location precisely because of their familiarity with the type and quality of  products associated with the franchise. Only franchisees will be able to obtain and sell those specific products, and at lower prices than an independent would pay. Purchasing products as one of many franchisees creates economies of scale that enable vendors to provide their lowest per-unit prices.

In nearly all cases, a franchisee must pay an initial fee- often in the tens and sometimes in the hundreds of thousands of dollars- in order to join a franchise system.  Commonly, franchisees also pay a monthly royalty of a percentage of gross receipts.  Percentages vary, but 5% to 7% is common. Many systems also require franchisees to make periodic payments into local, regional, and/or national advertising pools.

Many franchisors require that a franchisee operate his or her franchise through a formal legal entity – usually a corporation or limited liability company – rather than as an individual. Historically, corporations were most common, but increasing certainty about the legal ramifications of conducting business as a limited  liability company and an increased public comfort level with them has made the limited liability company the most common choice in recent years. Each form of entity has its own legal and tax compliance requirements. A prospective franchisee should become familiar with those requirements in order to determine the best entity to form for the operation of the franchised business.

An initial question considered by too few prospective small business owners, whether or not of a franchised business, is how and when they hope to sell or otherwise disengage from the business. There are myriad possibilities, including selling to a partner, selling to employees, and gifting to children, to name a few. Divestiture for franchisees can be particularly difficult, with limited options, because franchisors generally reserve the right to approve a new owner. It is important for a franchisee to determine his or her time horizon, and his or her preferred succession plan. A franchisee should make that determination as early as possible – ideally at the outset - and remain mindful of it at all times.

Entrepreneurs should keep in mind that becoming a franchisee is simply one way of doing business.  Given the costs and continuous scrutiny, the benefits and burdens of franchise ownership should be weighed carefully against those of operating independently.

Tony is a director in McLane Middleton’s Corporate Department.  He can be reached in the firm’s Portsmouth office at (603) 334-6935 or [email protected].

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