Franchising: A primer

March 3, 2013

by Sarah Kulbatski, Director, JT Corporation

Franchising is a method of distributing products or services. At least two levels of people are involved in a franchise system: (1) the franchisor, who lends his trademark or trade name and a business system; and (2) the master franchisee and/or franchisee, who pays a royalty and often an initial fee for the right to do business under the franchisor’s name and system. Technically, the contract binding the two parties is the “franchise,” but that term is often used to mean the actual business that the franchisee operates.

The business model in franchising is different from the traditional business model. Within the framework of the traditional business model, a company uses its own human, technical, and financial resources to proceed with its development. It is the owner of the company who makes all the decisions with regards to the operation of the company.

In franchising, a person, the franchisor, uses the human, technical, and financial resources of a third party, the franchisee, to proceed with its development. Contrary to the traditional business model, even if a franchisee is qualified as an “independent entrepreneur,” the franchisee must operate its business according to the standards, procedures, and directives of a franchisor. Consequently, the franchisee is generally limited with respect to the decisions that it can make as concerns the operation of its business. On the other hand, it purchases a concept that has proven itself over time, thereby increasing the chances of success of its business.

 

WHAT SHOULD I CONSIDER BEFORE BUYING A FRANCHISE?

Among the points which we recommend for investigation are:

a.     the type of experience required in the franchised business;

b.     a complete understanding of the business;

c.     the hours and personal commitment necessary to run the business;

d.     who the franchisor is, what its track record has been, and the business experience of its officers and directors;

e.     how other franchisees in the same system are doing;

f.      how much it’s going to cost to get into the franchise;

g.     how much you’re going to pay for the continuing right to operate the business;

h.     if there are any products or services you must buy from the franchisor, and how and by whom they are supplied;

i.      the terms and conditions under which the franchise relationship can be terminated or renewed, and how many franchisees have left the system over the past few years;

j.     the financial condition of the franchisor and its system.

It should be pointed out that the tips that are the most important when evaluating one franchisor are not necessarily the same for every franchisor. Each file must be evaluated on its own merits. By working with a potential franchisee when researching information on a franchisor, you will discover which tips are the most important to verify.

 

WHY DUE DILIGENCE?

When purchasing a franchise, the objectives of this exercise are to learn about a franchisor and the operation of its franchise network as well as to minimize the risks of an investment of this nature. For a potential franchisee, the financial investment is very often an important amount. This reason in itself should be sufficient for a potential franchisee to undertake the due diligence of a franchisor.

In addition, the philosophy of a franchisor is another reason to undertake the due diligence of a franchisor. Indeed, franchisors, like people, have a philosophy with respect to the conduct of their business—on the role of a franchisee in a franchise network, on the responsibilities of a franchisee (employee, manager, business person), etc. This philosophy should conform to the philosophy and to the aspirations and expectations of a potential franchisee. It is a question of determining if both parties are compatible.

 

WHAT IS THE DISCLOSURE DOCUMENT?

Certain provinces in Canada have adopted specific laws on franchising. These laws provide that a franchisor must submit to a potential franchisee a “Disclosure Document,” and this at least fourteen (14) days before the signature by the franchisee of a contract with regard to the franchise or to the payment by the franchisee to the franchisor of an amount of money.

The Disclosure Document contains a great deal of information about the franchisor: its activities; its history; the management team which operates the franchise network on a daily basis; a list of existing franchisees as well as a list of those who have left a network (with phone numbers); certain important clauses of the franchise agreement; some contain detailed information about the financial operation of a franchise; the financial statements of a franchisor; legal procedures taken against a franchisor during the last five (5) years; and general information on the functioning of the franchise network of a franchisor.

There is a tremendous amount of information in this document which allows a potential franchisee to evaluate a franchisor. Therefore, if you are considering purchasing a franchise from a franchisor who offers franchises in one of the provinces that require disclosure compliance, you know that the franchisor has a Disclosure Document. We recommend you ask the franchisor for a copy.

 

IF I WANT TO BUY A FRANCHISE, WHAT SHOULD I DO TO GET STARTED?

You should contact the companies directly, and “shop wisely.”  “Shopping wisely” requires that you determine how much you can afford to invest and where to obtain financing.  Careful investigation prior to purchasing a franchise also necessitates understanding the Disclosure Document.  You need to examine what the franchise relationship entails. For instance, you need to inquire into the training and support provided, assistance in finding and developing a location, and the sources of inventory and supplies.  You should research the companies’ growth and prospects for future growth.  You should also seek advice from professionals and business people you respect.  By shopping wisely, you can make an informed decision on whether to purchase the franchise.

 

WHAT KIND OF INVESTMENT IS NECESSARY TO BUY A FRANCHISE?

Investment requirements differ tremendously. It all depends on the industry and the type of business. Total start-up costs can range from $20,000 or less, to over $1,000,000, depending on the franchise selected, and whether it is necessary to own or lease real estate to operate the business. Moreover, the initial franchise fee for most franchisors is between $10,000 and $30,000. Seventy percent of franchisors charge an initial franchise fee of $40,000 or less. The average investment, excluding real estate costs, is between $350,000 -$400,000. You must discuss the initial fees and opening costs with individual companies.

 

WOULD I MAKE A SUCCESSFUL FRANCHISEE?

A successful franchisee should be suited to the industry of which he or she is a part, suited to the particular franchise company, and suited to the franchise system generally. Important questions to ask yourself include: Am I suited to the industry physically and by experience, education, learning capacity, temperament, and financial ability? What type of work is most appealing to me? For example, do I enjoy working with food, mechanical things, people, real estate, books and recordings, sporting goods, etc.? Am I prepared to work hard and take financial risks? Do my advisors, family, and friends think I am adaptable and trainable? How do I react to controls? Am I a loner—resenting authority and restraints—or can I accept guidance and direction happily? If I prefer to act as a passive investor in the franchise, will the company accept this? How do I personally feel about the company’s image and products and services? The right answers to these types of questions help determine your potential success as a franchisee.

We recommend potential franchisees learn about the functioning of the franchise business model and undertake an examination of their own resources and expectations with respect to the purchase of a franchise beforehand. Further to this examination, a potential franchisee can more easily find the right franchise to purchase.

 

Sarah Kulbatski is director of JT Corporation, a company specializing in franchise consulting and risk management. For more information contact her via email at jtfranchising@me.com or visit www.jtfranchising.com

For more information on franchise opportunities in Canada, contact Gregory Evans at gevans@thebehargroup.com.