Franchising – The Good, the Bad and the Ugly

Franchise Operations can make substantial earnings. (The Good)

Every hour in the United States a franchise is sold. Franchising has grown into a thriving and established business activity. Large corporations are using franchising as a means for diversification, while franchisees seek it as a competitive edge over other small businesses It is apparent that franchising has become a major force in the food industry. Not only are fast food restaurants franchised today but theme restaurants, catering operations and family style restaurants are being packaged and marketed to a seemingly inexhaustible market of anxious would-be restaurateurs even during recessionary economic times. Franchising is unique in that it probably is one of the few forms of business activity that by its very nature recreates itself by establishing new business units from within itself. The United States Department of Commerce has reported that over one-third of all retail sales are currently made through franchise stores. This growth is expected to continue.

Buying an existing Franchise opportunity (The Good & The Bad)

Owning a successful franchise in the foodservice industry can be a truly comforting feeling. You go to work, hang out your shingle, open your doors and the crowds come rushing in to purchase all of your world famous products. They pay top dollar for them and then go out singing the praises of your establishment and another 50 customers come in and start the cycle all over again. This goes on until you close for the day. Then you lock up and get ready to start the process all over again the next day. Right?

Wrong! This may be the stereotypical version of the way it’s supposed to be, but in many instances this example does not apply. The reality of the situation is exactly the opposite. Be aware that in some cases the candidates who pay fees to purchase a new franchise are really signing on for research and development of the concept at their own expense. These newer Franchisers often have not marketed their product sufficiently to know if it will work in all parts of the country or for that matter, the world. Instead, they use the money of their franchisees to further develop their concepts.

Knowing this, why open a company store in a new market area when the risk can be transferred onto an unsuspecting franchisee? I say “unsuspecting” because the profile of a prospective franchisee usually shows far less experience and exposure in the field than that of an experienced independent operator. And after all, isn’t that the reason a prospective franchisee, usually with little experience, buys a franchise? Be aware that not every franchise can be for you. Today, there are still dozens of fly-by-night franchise concepts that go in and out of business every year, taking many investors down with them in a flaming crash.

Starting a new Franchise. (The Good)

I was involved for many years with franchise operations and problems as a VP and CEO of franchise companies. I understand that franchising is a rapid and relatively low cost way to expand your business when compared to the money, people and time that otherwise would be required to build, open and operate a chain of company-owned stores.

Restaurant owners interested in successfully expanding their business enterprise may know that now is the time to expand but do not have the financial resources or the management personnel to build and operate a chain of company-owned stores. They should consider franchising. It can be an effective way to obtain capital to build stores and to obtain dedicated people to run those stores. Franchising has proven itself as a successful method to expand one’s business and gain national name recognition.

A successful franchise system starts with a successful prototype store. (The Good)

The franchised business must be profitable, have a name which can be registered as a trademark, and have business operating systems which can be taught to a new franchisee. A new franchiser must have sufficient capital to start a franchising program. Prior to selling or even offering to sell a franchise, a franchiser must prepare a comprehensive franchise agreement and register a franchise offering circular. The federal and state franchise laws regulate the pre-sale disclosure of information to prospective franchisees. A franchiser must understand the special ongoing franchise relationship, select qualified franchisees, and develop strong, long-term relationships with the franchisees.

The initial franchise fee is a one-time fee charged to new franchisees to secure the franchise, and it can range from $10,000 and up. The ongoing royalty fee is based upon a percentage of the gross sales of each franchise location. The franchise fee, royalty fees, and the sale of supplies to franchisees are typical ways by which a franchiser makes money. Though the amount of these fees ranges widely, a $25,000 franchise fee and a 6% royalty would be fairly typical. A franchiser can also provide a money savings for all stores, including its company-owned stores, through volume discounts from suppliers of equipment, inventory, services and advertising.

To undertake the legalities of a new franchise, you need a franchise lawyer and a restaurant consultant knowledgeable in franchising. Your franchise lawyer will write the franchise contract, draft and register the franchise offering circular, register the franchise sales people and advertisements, review the real estate leases, prepare any necessary corporate documents, and have the connections with all the business services necessary for you the fledgling franchiser to get started. The Restaurant Consultant can assist with operation manuals, training programs, advertising and public relations materials, franchise recruitment programs, business plans and communication programs which are required by your State’s franchising authority. This consultant can also assist in fine tuning your original operation into a smooth functioning multi-unit enterprise.

Franchisee problems (The Bad)

As franchising has flourished so have the problems between the operators and the franchiser. Over the years a host of franchisee advisory groups and franchise councils have been formed by franchisers to learn what franchisees want and need from the franchiser in order to grow and prosper. State and Federal regulations, enacted beginning at the end of the 1970’s, more tightly controlled franchising and tended to benefit the franchisee. The 1979 Federal Franchise Act reflects the modern tendencies at all levels of government for tighter control of what franchisers can say and do and with established procedures for the protection of franchisees regarding terminations, renewals, additional franchises and claims against the franchiser. Even so there are often serious drawbacks.

A real Franchisee Problem (The Ugly)

Here is a case in point – My company, GEC Consultants, Inc., was called in to help a franchisee of a small sized but well known 50’s burger concept. The client’s problem was diagnosed as not having enough of the proper items to make it in Chicago ‘s diner market. GEC suggested five new items that were then inserted into the operation and for twenty-two days, they sold incredibly well. The franchisee then made a fateful error. He didn’t inform the franchise Company of his intentions. This was a violation of his agreement. As a result, the Company threatened legal action if he did not remove these items. Subsequently, the items were removed. A short time later, the franchisee made a request to once again put these items back on his menu and permission was denied. Without the ability to alter the menu to help himself, the franchisee eventually was forced to give his unit back to the franchiser for very little compensation. The Company went ahead and began to operate this unit as its own. Shortly thereafter, a story appeared in an industry publication stating that this franchise was rolling out “new” menu items throughout all its stores and that their reception had been fantastic. These were basically GEC’s suggested menu changes.

Here was a case where operators were resourceful enough to see problems with the stability of their franchise vehicle, and found solutions to their problem but were restricted from using them, according to their franchise agreement, and they ended up solving a problem for the parent company unit-wide. When this happens, a franchisee almost never receives compensation nor any credit for aiding in the solution. They may even lose their franchise. It’s a no win proposition.

This case indicates that the Franchise Company had always known about the weaknesses in it’s menu. The fact that it was hurting their franchisees did not seem to bother the Company. Why should it? They let GEC’s client pay for the marketing research and development of the new recipes. After restricting the franchisee’s ability to use these new menu items successfully, they simply went in, picked up the pieces, and then did all the things they wouldn’t let him do. The outcome was extremely profitable for the franchiser.

Unfortunately, you can’t say the same for the poor franchisee. After paying good money to purchase what he felt was a fully developed concept, he got instead a weak sister idea. After the franchisee hired professionals to help rescue their sinking ship, the parent company hid all the life preservers from them. They rescued themselves and discarded their franchisee (our client) like some old tattered pair of pants. This hardly seems fair.

The morale of this story reads like something out of Business Law 101. Caveat Emptor let the buyer beware! When you go out shopping for franchises you had better bring along an expert or you may be buying nothing but trouble and paying your money to further the development of someone else’s company.