Do you feel like you are ready to become a small business owner? Does the idea of starting from scratch seem scary or intimidating? Then you might be an excellent candidate for the franchising process.
Franchising allows a business owner to pay an initial fee, along with ongoing royalties, to a home organization with a familiar brand to potential customers. In return for these payments, the right to use that franchise’s trademarks transfers to the company. Ongoing support from the franchisor and the right to use their system of doing business to sell products or services comes with the package.
Franchising is a buyer-beware market. Reputable franchisors conduct market research before selling new outlets, which means you can have a higher level of confidence that there is a demand for the product or service. Small business owners also receive a clearer picture of what the competition will be when they start operations. Not every opportunity follows these steps.
That’s why a complete look at the advantages and disadvantages of franchising is necessary before anyone decides to become a franchisee. These are the key points that will take you through the consideration process.
List of the Advantages of Franchising
1. Franchising gives a small business owner access to better talent.
Franchising provides a small business with more chances to find talented people to manage each location. It gives them an incentive to work hard because the entire organization becomes a possible promotion opportunity. The people who are the most qualified and work the hardest usually want to invest in a business operation that will provide them with a return instead of taking a salary as an employee.
That’s why franchising from an organizational standpoint creates an opportunity to find better talent that will expand the footprint of a brand. From a franchisee point of view, it is a way to get a jumpstart on the local hiring process.
2. Expansion capital is easier to option through franchising.
If your business is ready to start expanding, then franchising might be the opportunity to pursue. It is an excellent way to obtain expansion capital. Every franchisee must pay to purchase outlets in your chain. That means you get the chance to grow the number of locations without tapping into your own capital to do so. When this benefit is successful, then there is less of a need to request additional financing from investors, banks, or other lenders in the financial services industry.
3. Growth risks get minimized when taking the franchising approach.
The act of franchising generates high levels of financial returns for relatively little risk when it is successful. When you allow franchises, then you are putting relatively little money into adding a new location when compared to the idea of starting a company-owned outlet. A good business model will help your company earn significant royalties from sales at each authorized location. The returns you can earn from the small percentage can be significantly higher than what you would make when operating these outlets internally.
4. It gives businesses access to a proven system.
When an independent business decides to buy a franchise, then they are purchasing the years of experience that went into building that opportunity in the first place. It is a chance to access a specific brand and systems that have proven their effectiveness. Although the cost of this initial investment can be significant, you also know as a franchisee that there are fewer risks involved in a startup phase of your new company.
Most franchisors provide a series of best practices to follow so that you can achieve a grand opening while maximizing your investments.
5. Franchisees receive training and support while designing their new business.
Franchisors provide an initial level of training and support so that a new business owner can begin their company in the right way. Most franchising opportunities require investors to attend a training seminar that teaches the best practices developed by the organization over a two- to six-week period. Ongoing training at specific locations designed to broaden knowledge is often part of this process.
Franchisees receive help with interior design, their point of sale, and even the selection of a physical location to do business. The best franchisors always have someone available to contact when a problem or question arises. Many of them assign a liaison so that there is one specific person to reference is an issue starts creeping up.
6. Franchising allows a new business to benefit from instant name recognition.
Building a new brand in today’s world is not an easy task. It is an expensive, time-consuming process that does not have a guarantee of success as an outcome. Franchisees who receive approval to open a new location have this work already completed for them. That means their future customers are already familiar with the name of the company, and that gives them an idea of what to expect when the doors open for business.
You can think about this benefit in this way: if you were to start a new fast food restaurant, with customers recognize your name better, or would they want to step into a new McDonald’s location?
7. The structure of franchising allows small businesses to have more purchasing power.
The easiest way to increase profit margins for a small company is to reduce overhead costs. Franchising accomplishes this advantage by creating three unique opportunities for independent companies that purchase the right to branding and assistance.
- The franchisor will work with the small business owner to negotiate a beneficial lease or purchase real estate at an affordable price.
- These new locations get to work with other franchisees to create bulk-purchasing opportunities, which lowers the price of the raw materials needed to create products.
- Instead of paying a marketing agency to access local television, radio, and newspaper advertising, the franchisor uses the leverage of their brand name to create a national level campaign.
8. Franchising creates new networking opportunities for business owners.
Franchising creates partnerships and networking opportunities around the world. Everyone who puts money into this pot gains access to the entire pool of businesses that are making the same investment. That’s why most franchisors offer a yearly gathering so that everyone can share the ideas that are working and those that are not. These annual gatherings are also a way for the primary brand to offer information to everyone at the same time so that it is easier to avoid having a franchisee go rogue for some reason.
9. Franchisees get to be their own boss – to an extent.
When someone owns a franchise, then they are a small business owner. It can be rewarding to have the ability to call your own shots. At the very least, owners have the option to create a flexible schedule for themselves while having more autonomy over their careers. Some franchisors allow the owner to be off-site, assuming that a trained manager is in place to govern the location’s operations.
Even if there is a mandate for the owner to be on-site, franchisees still have a support system to which they can turn when there is a need for assistance or advice. You’re in business for yourself with this opportunity, but not necessarily by yourself.
10. Having access to more data means it is easier to track results.
Although franchisees must share a significant amount of financial data with their corporate office, a lot of information comes their way that wouldn’t be available otherwise. It is possible to benchmark the performance of a specific location with the rest of the franchising system because of this advantage. It is a significant benefit that can help to improve business profitability and the company’s overall financial performance.
11. It can be easier to secure financing for a franchise opportunity.
Financial institutions often see the risk of starting a franchise as being lower than what is associated with a new business opportunity. That means it can be easier to secure a small business loan during the start-up phase of your new organization as a franchisee. Banks and credit unions want to get their money back with some interest, so you are more likely to get the funds you need to get started when there is a proven business plan in place. Many franchisors can provide this to you as part of the initial fee, and then work with you to customize it to meet the needs of your lender.
List of the Disadvantages of Franchising
1. There is less control over the daily operations of each location.
Franchisors make money when they collect a percentage of sales as a royalty for allowing the use of branding and operating systems. Franchisees are independent business owners. Each one has a different goal that they want to pursue, and there can be times when these efforts conflict with what your company hopes to accomplish. You can’t tell people what to do in the circumstances the same way you could if they were a direct employee.
Anything that boosts sales without earning more profits will almost always create conflict in this relationship. Offering promotional coupons can create strong objections. There must be a balance between benefiting the franchisor add helping the franchisee.
2. It creates a weaker core community of expertise.
If your company wants to expand its location profile, then it is easier to hire managers than it is to find franchisees. Independent businesses have an incentive to profit from each other as a way to generate business. One of the most common outcomes from this disadvantage is called franchise freeriding.
Let’s say a franchisee decides to stop paying the advertising percentage of their royalties. The business owner believes that their company can still benefit from the brand recognition of the franchisor while other franchisees continue to pay. There must be proactive efforts to enforce the franchising contract to prevent this issue, but it is also an approach that can require significant time and money resources.
3. Innovation is harder to achieve when franchising.
When you come up with a new idea and you have several locations operating as franchisees, then you must negotiate with each one of them to accept the new product or service. You don’t have the option to put the new idea in place by yourself. That means there is a disincentive to invest in research and development, no matter what your industry happens to be.
This disadvantage also applies to franchisees. If one of the independent businesses under your umbrella comes up with a fantastic idea, then they must receive approval to pursue its implementation through the franchisor. That means there are time and financial considerations in that scenario to consider.
4. The startup costs for a franchise can be significant.
Most independent business owners discover that they need to find some level of financing so that they can become a franchisee in the first place. The franchising relationship requires an initial investment into the brand plus all of the conventional expenses of starting a company. Being a franchise doesn’t mean that you get to skip real estate costs, licensing, or labor expenses.
Owning a franchise can be lucrative, but it can take an extensive investment. If you want to start a McDonald’s, then the franchise fee is $45,000. Wendy’s wants a $40,000 franchise fee per restaurant, while Pizza Hut wants $25,000 and up to 9% of gross sales as service and advertising fees. Some franchisors even require specific building stipulations in the contract, like opening several locations within a specific time.
5. You need a high net worth to begin operating a franchise.
Most franchisors have a net worth stipulation in their contract. As a small business owner, you must prove that you have enough liquid assets to survive the first years of starting a franchise in opportunity. Many of the requirements involve a total that exceeds $1 million. If you work with Yum! to open a new Kentucky Fried Chicken or Taco Bell location, then your net worth must be at least $1.5 million, and some applicants must prove $2.5 million outside of their property assets.
You must also have a specific amount of liquid assets available to you at the time of application. This figure often ranges from $250,000 to $750,000, depending on the business being pursued and the brand recognition that’s available.
6. Ongoing fees can be high enough to put some business owners into bankruptcy.
When an independent business decides to become a franchisee, then there is more than the initial fee to pay to gain access to the franchisor’s branding. Ongoing royalties or service fees combine with advertising costs to take up to 10% of the gross sales that each location earns. Because the expectation for payment comes from the total amount of revenues instead of the net profits, some franchisees don’t earn enough to get out of the red with their budget. If this disadvantage occurs frequently, then it is a fast path towards bankruptcy.
Many franchisors have stipulations in their contracts that such an occurrence would qualify for a buyback of the location from the independent business at a significant discount. Almost all of the risk of starting a new company lies with the local owner, not the home organization, and that’s why this opportunity isn’t for everyone.
7. Less autonomy is available in the franchising relationship.
If you are the type of person who likes to march to the beat of your own drum, then a franchising opportunity might not be the best thing to pursue. These systems require you to run your operations as dictated by the franchising agreement. There is very little leeway for you to make decisions at a local level unless the contract allows you to do so. Even if you know a specific action could lead to fewer customer interactions, the franchisor can still dictate that you move forward with them anyway.
8. Franchising is a long-term agreement.
Franchisees must be prepared to be working with their franchisor for a long time if they pursue an opportunity in this field. The agreements that govern this business relationship are for a specific period, and the time expectations can be very lengthy. Most contracts require a 10-year arrangement, and it is not unusual to see 20-year expectations in some industries.
Even if the contract only requires a 5-year commitment, there is no legal way to get out of this arrangement if it turns out to be a detrimental decision. You’re stuck as a franchisee holding the losses while the home organization continues to earn royalties or expect advertising fees from you.
9. Numerous restrictions are in place for most franchisees.
Because a franchise is a predetermined brand, there are limited opportunities for creativity when a franchisee has the desire to explore, alter, or make additions to their independent business. The contract will dictate what locations are available for expansion, what products or services can be sold, and sometimes the vendors or suppliers that get used. Since all of the financial information from the business gets shared with the corporate office, there really isn’t a way to pursue an opportunity outside of what the franchisor dictates.
10. Franchisors don’t need to renew the agreement after it expires.
Another disadvantage of the franchising contract to consider is the fact that the franchisor is under no obligation to renew the agreement for another period. When the end date arrives, the independent business might find themselves forced to remove the branding that has served them over the past 5 to 20 years. That expense usually comes out of their own pocket, and it can sometimes be enough to put that location out of business.
Anyone concerned about this disadvantage should look at the length stipulations in the contract. If there is a guaranteed option to renew, then you won’t need to worry about this issue until you reach the final end date. Many agreements are structured so that you receive an initial 10-year period, with an automatic option to renew for another decade.
Franchising can be an excellent opportunity to start a successful business from the first day of operations. A significant amount of due diligence is necessary from both parties to ensure that this relationship is beneficial to everyone.
Franchisees should consider interviewing independent business owners with existing locations, examining the Uniform Franchise Offering Circular, and reviewing the audited financial statements that are available. Any earnings claims or sample unit income statements should receive a high level of scrutiny.
Franchisors want to see applicants who have significant financial resources so that the new location can draw without worrying about money during the first years of existence. Interviewing potential franchisees about their past business experiences can help them to find the right people to support the brand.
The advantages and disadvantages of franchising can be challenging to navigate at times. That’s why it is imperative to have legal representation during this process. Don’t be shy about asking questions.
Blog Post Author Credentials
Natalie Regoli, Esq. is the author of this post and the editor-in-chief of our blog. She received her B.A. in Economics from the University of Washington and her Masters in Law from The University of Texas School of Law. In addition to being a seasoned writer, Natalie has almost two decades of experience as a lawyer and banker. If you would like to contact Natalie, then go here to send her a message.