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Due diligence is key when investing in a franchise

on Friday, 04 September 2015. Posted in Finance

Franchising is an attractive route for people looking to start their own business but it pays to get the whole picture before parting with your money, says Willem van Lynden of Boost Capital

Due diligence is key when investing in a franchise

There’s no doubt franchising can be a great way to launch an enterprise. Tried and test formulas can give someone a head start in becoming their own boss and people tend to regard franchising as a safer business bet during less certain economic times.

But there are some things franchisors often fail to reveal to potential franchise owners before they sign on the dotted line. And would-be entrepreneurs often don’t realise what they should be asking ahead of committing capital to a franchise business concept. 

The turnover rate

It’s obvious why franchisors want to increase their franchise branches. Their brand grows in recognition, they increase their geographic reach, there are more initial franchise fees, as well as subsequent royalty payments and a share of future profits. They’ll tell prospective franchisees of the potential riches in store, plus possibilities for great business growth. But they could be less enthusiastic to disclose where pitfalls may lie or the business overall isn’t doing so well.

The turnover rate of a franchising business’s units is an important figure – in other words, the number of locations they close in any one year. According to the latest franchise data available from the British Franchise Association (bfa), one in ten franchise units in the UK underwent some change in 2013, whether changing franchisee, being bought back by the franchisor or going bust. More than a third of these closed down, with reasons varying from commercial failure, retirement of the business owner or ill health and domestic causes.

In essence, you want to figure out whether the franchise operation you’re considering buying into has a high rate of turnover and, if it does, why. Franchising isn’t regulated by law in the UK, unlike the US where rules require franchisors to disclose information such as turnover rates. In Britain, it’s a case of buyer beware. This means being responsible and doing lots of background research. Talk to other franchisees to get a realistic picture of the health of the whole organisation, both current business owners and those who’ve left. Ask demanding questions of the franchisor, find out turnover rates of rival franchising systems and always take the appropriate legal, accounting and professional financial advice before handing over any cash.

You may be better off alone

Perhaps you’ve always fancied running a hairdressing salon or a child-minding firm and you see there’s an existing franchise in the field of your choice. But, hold on a second. Is your money best placed buying into an established business set-up or would using capital for your own startup be a better move? After all, franchises don’t come cheap. The bfa puts a typical mean startup cost for a franchise in the hotel and catering sector at £142,000, one in retail at £88,000, and a unit in property services at £32,000. These are funds you’ll have to find from personal savings or a business loan. Given the effort to raise the money, do you want to spend it on someone else’s concept?

Most franchisees are attracted to the support system, contacts, expertise and experience that come from buying into a franchise model. That’s part of what you’re paying for. And franchises can be a cheaper way of getting started in business than an independent startup in some cases. But these systemised structures also demand a strong degree of uniformity, which takes some of the entrepreneurial zeal and autonomy out of the process.

A lot comes down to personality. If you’re likely to want to put your stamp on the business, make changes and be nimble in response to shifts in the market, a franchise system may not be the best option. Likewise, if you’re not great at being answerable to a more senior authority – you’re running your outlet but the franchisor ultimately still calls the shots – franchising may not be for you. But if yours is a corporate background where you’re accustomed to playing by the rules, it could be ideal.

Franchises might be on the fringes

Some franchise operations are made up entirely of franchised units, while others have a mix of company-owned and franchised outlets. McDonald’s, for example, runs 35% of it 1,200 UK restaurants directly, while the remaining 65% are franchises. But sometimes the opposite is true. A business may have a few franchises but the greater part of the operation is owned and run directly by the company. If this is the case and you’re one of a handful of franchised outlets, you might find yourself on the periphery of the enterprise, given little priority or support. Essentially, the big business is looking to balance ownership, control and profitability, and franchising may just be one element of a much bigger picture.

Explore this when you’re weighing up a franchise operation in the first place. Ask the franchisor what proportion of their entire organisation is made up of franchises. Check the franchise agreement to see what ongoing help is guaranteed. What are the lines of communication to the head office and will you have a named point of contact? What are the fees? Does the support you’re promised in return seem fair and good value?

There’s no policy to resolve disputes

Of course, it’s in franchisors’ interests for their franchisees to succeed but they may put the needs of the greater organisation ahead of the wants of the few. Disagreements between franchise owner and franchisor are almost inevitable so you want to be confident that formal processes are in place to ensure your voice is heard. Your franchise agreement should outline policies to address, adjudicate, and resolve upsets. Don’t forget you’re a cog in a larger machine, so without a proper system to address grievances you may end up frustrated, with your gripes ignored. Things may be hunky dory at the outset but storms do occur, and forewarned is definitely forearmed.

Finally, remember there’s no such thing as guaranteed business success. Franchising may bring greater support, buying power, and powerful branding, but franchises can fail. If you feel your life would be wrecked by such a set-back, you’re probably not cut out to run a company – franchised or independent. Business ownership involves risk. But a combination of well-judged risk and hard work can still reap some great rewards. 

Willem van Lynden is director of sales and marketing at Boost Capital, the provider of business funding solutions to growing SMEs.

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