Franchise Finance is a crucial component of investing in a Franchise business. However, Franchising is one of three operating models, each with its own advantages and disadvantages. First is the Start‐up, which offers a very high risk/reward ratio (e.g., Mark Zuckerberg). The Start-up model makes sense for individuals with a unique solution to a significant business challenge and a high tolerance for risk. The second option is acquiring an existing business with a long track record to reduce your risk (Warren Buffett). Business acquisition is suitable for individuals with a lot of industry experience who want to invest in an existing operation with a strong track record. Finally, there’s Franchising, where you are joining a network of established individual businesses under the same Brand (Howard Schultz). Franchising is a good fit for individuals with varying levels of expertise who work well within structured and repeatable processes. Consequently, Franchising offers the lowest risk profile of the three alternatives. However, like many things in life, there are pros and cons to Franchising, and we will explore them here to help you determine if Franchising is right for you.

 What is Franchising?

Franchising is a business model where you open or acquire an existing business that operates under a Franchise Agreement (“FA”). Under your FA, you’ll pay the Franchisor an initial Franchise Fee, an ongoing Royalty (a percentage of future Sales), and a Marketing Fee (for national advertising). Top Franchises like Starbucks (14,825 locations), McDonald’s (13,154), and Taco Bell (6,588) operate thousands of locations in the US and globally. However, while each location is uniquely focused on operating effectively in its territory, they still depend on the Brand name to attract and retain customers using well‐defined processes. For certain entrepreneurs, this justifies the recurring expenses of the business model. Here are some of the pros and cons of Franchising.

Pros

1. Experienced business partner that wants you to succeed.

Franchising offers the opportunity to work with business partners invested in your success. However, while all Brands want their Franchisees to succeed, some haven’t realized that they are the problem. To that end, sites like Entrepreneur.com, Nerdwallet.com, and Forbes.com produce a Top Franchises List annually. These lists are a great way to connect with successful brands looking for talented entrepreneurs to join their system. Additionally, partnering with good Franchisors gives you access to their experience, knowledge, and resources. As a result, by hitching your financial “wagon” to theirs, you’re investing into the momentum they’ve built over time to drive consistent long‐term growth.

2. Work with a Proven Concept.

Some entrepreneurs like to experiment, but the problem with experiments is that they don’t always achieve consistent results. Instead, by going with a proven concept, like Franchises with 250 or more locations, you are shifting from experimentation into validation. The 250 stores threshold is a crucial indication that a brand has moved from local to regional success (multi‐state). Once a Brand reaches 250 locations, Conventional Franchise Lenders (non‐SBA) are more willing to lend to its Franchisees without government guarantees.

3. Defined Processes.

With Franchising, most of the processes are well defined, which is a significant advantage over Start‐ups. As a result, concepts with a long track record and numerous locations signal that their model and processes have been successful through various economic cycles. With Start‐ups, there isn’t a budget or operational process. You’re winging it, hoping you will sell enough to cover your expenses. As a Franchisee, your partner has completed the market research, and they know where to locate stores to achieve the desired result. Consequently, Franchisees have a better chance of matching the Sales (Average Unit Volume (“AUV”) and operating targets provided by the Brand. To that end, Franchisees tend to do well by following the plan, communicating with the Brand, and validating results with their peers.

4. Easier to obtain Financing from Banks and Investors.

For many new entrepreneurs, obtaining suitable financing is one of the critical drivers of business ownership (“getting off the plantation”). As you begin to consider financing options, you’ll quickly notice that securing Franchise financing is much easier than other Business loans. And that’s because Bankers like the Franchise model. The SBA Franchise Directory is a great place to find all the Franchises approved for SBA loans. Once you identify a Franchise that suits your requirements, all that remains is Franchisor approval, drafting a good Business Plan, and applying for financing.

Cons

1. Franchising is a marriage.

Partner selection is a crucial step in the process because divorcing a Franchisor is painful and expensive. No Franchise model is bulletproof, and like many other businesses, Franchises have and will fail. According to a 2019 article about top Franchises based on SBA default rates, Comfort Keepers, Christian Brothers Automotive, and Home Instead Senior Care are top performers. However, Noble Roman Pizza, Image Sun, and Wireless Toyz have not faired as well. There are many reasons a Franchise might fail, but most revolve around Franchisor missteps. According to recent articles, top Franchors like McDonald’s and Subway (24,798) have active disputes with Franchisees over fees, promotional pricing strategy, and territories, among other things. Needless to say, prospective entrepreneurs need to complete a rigorous due diligence process before selecting a partner.

2. Unproven model.

For most Conventional Franchise Lenders (non‐SBA), Franchises with less than 250 locations are not proven partners and tend to have above‐average risk. Consequently, it’s essential to select an established Brand before speaking to your local banker. On the other hand, SBA Lenders are not as focused on location count. They can provide debt to any Franchise in the SBA Franchise Directory as long as the borrower and opportunity meet their criteria.

3. Unwilling or unable to change with the market.

A good Franchise continually adapts to the market based on economic conditions. For example, the COVID‐19 pandemic re‐emphasized the importance of effective online ordering and contactless delivery. However, some Franchises failed to shift quickly and suffered for it once cities locked down. That said, you also want to avoid brands that move randomly from one fad to the next because that isn’t an ideal option either.

4. Recurring fees and costs.

Franchises face certain recurring charges that do not affect non‐Franchise businesses. Along with the Royalties and Marketing Fees mentioned above, most Brands also assess fees for renewing or transferring your Franchise Agreement. Additionally, Brands tend to actively update their image every ten years, which leads to remodeling costs for existing locations. Remodeling free‐standing locations can quickly run into six figures with only anecdotal data regarding long‐term improvements in profitability.

 Investing Involves Risk

Let’s face it, investing can be a double‐edged sword and the highs and lows go hand in hand. Therefore, you will need to plan adequately and focus on your due diligence on both the Franchisor and the industry served to succeed. Here are some of the keys to successful Franchise selection:

• Select an industry that you have experience with so it’s easier to understand the economics. To paraphrase a Warren Buffet quote, “invest in businesses that any idiot can run because sooner or later, some idiot will be running the place.”
• Profitability is essential, but you should also compare start‐up and recurring costs between Brands using their Franchise Disclosure Document (or “FDD”). For example, let’s assume Franchise#01 produces a 10% EBITDA margin or $200k while a different concept, Franchise#02, delivers a 12% EBITDA margin or $120k. Which one is better? Well, it depends. What if Franchise#01 requires $3MM to buy land and build a store and Franchise#02 costs $500k to build out a leased space. Alternatively, what if Franchise#01 operates from a small office space that doesn’t require a lot of foot traffic.
• Connect with both former and current Franchisees to get a better sense of the Franchisor. These conversations will help you figure out how the business works and the issues you can expect. You should also evaluate the Pending Litigation section of the FDD to understand any underlying issues between either the Franchisor and Franchisees or customers.
• Your Business Plan should also include a detailed Market Analysis and SWOT Analysis to give a better sense of the business opportunity.
• If the Franchisor is a public company, read the last three annual reports, paying close attention to the Business Risks section and Management’s Discussion and Analysis of results.

Conclusion

Franchising can be a great business option but it isn’t for everyone. It involves a good bit of research and preparation to select the right industry (e.g., Restaurant, Automotive, Healthcare) and the right Franchisor partner. You should be prepared to complete a thorough due diligence process to minimize the chance of failure. Nevertheless, you should start with a mindset focused on success and follow the plan!

Please feel free to contact us for additional information about Franchising, Business Plans, or Franchise Lending.