For the Franchisee

April 13, 2006

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A primary advantage of franchising is that you can reduce the risks associated with a new business by buying into an existing business that has established goodwill and a marketable reputation. While purchasing a franchise may often be a more expensive way to start a business, franchises can also provide a "blueprint" for business operations that's especially valuable if you don't have much experience in the type of business you want to start.

The conventional wisdom is that franchised businesses have a much greater likelihood of success than independently started firms. However, some recent studies have reached an opposite conclusion. It's probably safest to say that the jury is still out on this one.

Franchising is a form of capital financing, and franchisors may offer financing assistance in securing fixed assets and occasionally even working capital. For example, where real estate and building costs are high, the franchisor may be able to secure financing because of its creditworthiness or by use of a real estate limited partnership. The franchisor would then lease the property to the franchisee. A franchisor may also sign a guarantee or assume other contingent liability on loans or leases made directly between a third party and the franchisee. Less direct methods of financing assistance can take the form of the franchisor's subordination of certain claims to franchisee lenders or assistance in preparing loan packages for commercial lenders.

Did You Know?

A franchisor may provide benefits relating to advertising, research and development, economies of scale, quality assurance, and other important operating factors.

Nonetheless, while franchisors can assist in financing, you should be aware that startup costs with franchises may run from $25,000 to $500,000 or more, depending upon the particular franchise and the nature of the business. Professional service franchises, such as tax preparation, usually are significantly less expensive than, for instance, hotels or gas stations.

Warning

It is extremely unlikely that the franchisor will cover all initial costs for a franchise and you will almost certainly need to raise some capital on your own, besides the fees required by the franchisor. In fact, additional financing that would not be necessary in an independent startup is often required.

Franchise disclosures. The Federal Trade Commission (FTC) provides some protection against franchisor abuses by requiring certain disclosures at least 10 days prior to a franchisee's execution of a franchise agreement. The disclosure must include the names, addresses, and telephone numbers of other franchisees; an audited financial statement of the franchisor's business; background information on the officers of the franchisor; a statement of estimated costs for setting up and operating the franchise; and the respective responsibilities of the franchisee and the franchisor. If you don't get the disclosure or are uncomfortable with what it says, we recommend you delay signing any contracts until you are satisfied.

Franchise fees. The costs of franchising include a variety of fees and contributions typically required by the franchisor in exchange for the assistance and experience of the franchisor.

Usually an initial franchise fee or license fee will be required. The fee may be a lump sum or may be payable in installments. Interest varies and is often nonrefundable.

Other fees may be assessed for training costs (tuition, room, board, and transportation) and on-site startup assistance and promotions, advertising (2 percent to 8 percent of gross sales), periodic royalties (4 percent to 6 percent of gross sales), or fees. These fees are typically tied to a percentage of sales and payable weekly or monthly. Royalties usually represent the cost of using trade names and commercial symbols, as well as any trade secrets, patents, or other intellectual property rights, and advertising contributions (often payable monthly or weekly, based upon a percentage of sales). If bookkeeping is centralized, separate accounting and processing fees may be assessed.

Additional payments for equipment, supplies, property, and beginning inventory may be required. Note that "initial fees" do not generally include product inventory or equipment downpayments.

Warning

In addition to the monetary expenses associated with purchasing a franchise, remember that one of the unavoidable costs of franchising is the sacrifice you make in control and ownership of the business.

For more information on franchising, see our discussion of starting a new business under a franchise agreement.