Franchises by the numbers

In short

A friend of mine once told me he was buying a franchise because the brand was famous and the risk looked small. He was half right, and the half he missed cost him a year of sleep. If you are thinking about a franchise, start by reading the Franchise Disclosure Document, which the seller must hand you at least fourteen days before you sign or pay. Look at Item 7, which lists the total money you will need to open the doors. Look at Item 19, which may show what other owners earn, and notice if it shows nothing at all. Add up every ongoing fee and turn each one into dollars a year, so you can see what comes off the top before you earn a cent. Then call several current and former owners from the list in Item 20 and ask them what they wish they had known. You are a careful person for reading this far, and careful people tend to make good owners.

The whole of it

What it is

I once watched a fellow open a sandwich shop under a big name. He said he was buying a recipe, a sign, and a way of doing things that already worked. That is a fair way to see it. A franchise is a contract. You pay a company, called the franchisor, for the right to use its name and its system. In return you agree to follow its rules, pay its fees, and run your own location as a separate business. You own the risk. The franchisor owns the brand.

The Federal Trade Commission has a rule that governs how franchises are sold. It is called the Franchise Rule, and it requires the seller to give you a disclosure document before you commit. That document is your best friend in this process. It is long and a bit dry, but it was built to protect people just like you.

How it works

If you are holding a franchise offer, you have probably noticed it comes with several kinds of money. There is the upfront franchise fee, paid when you sign. There is the cost to build out or equip your location. Then there are the fees that never stop, and those are the ones that surprise people.

Most franchisors charge a royalty. That is a percentage of your sales, paid every month or week, whether you made a profit or not. Many also charge a marketing fee, another percentage of sales that pays for national or regional advertising. Some add a technology fee, a training fee, or a fee when you renew. Each one may look small alone. Together they can be large.

Here is the part worth slowing down for. Royalties come off your sales, not your profit. Sales are the money that comes in the door. Profit is what is left after every cost. A shop can have healthy sales and still leave its owner thin, because the franchisor gets paid first.

The numbers, and where to find yours

Every franchise disclosure document has the same 23 sections, called Items, in the same order. That sameness is a gift. You can compare one brand to another line by line. I would read these first.

Item 5 shows the initial fee. Item 6 lists the other fees, including royalties and marketing. Item 7 gives a range for your total starting investment. Look at the low number and the high number, and plan your money around the high one. Item 19 is the financial performance section. It is optional, so some franchisors leave it blank. When it is there, read the fine print about which locations are included. Item 20 lists how many outlets opened, closed, or changed hands, along with contact details for current and former owners. Item 21 holds the franchisor's own financial statements.

Some of the figures you will need come from the law and change over time. A loan through the Small Business Administration, for example, has a maximum amount of the current figure, which the official source publishes each year and a guarantee percent of the current figure, which the official source publishes each year for many loans. You can check the current numbers at sba.gov. The FTC's page on the Franchise Rule, at ftc.gov, explains what the seller must disclose and when.

A worked example

Let me tell you about a woman named Marisol. She was thinking about a fitness studio franchise. She read the disclosure document at her kitchen table with a cup of coffee and a pencil.

Item 5 said the franchise fee was 40,000 dollars. Item 7 gave a total starting cost between 180,000 and 320,000 dollars. Item 6 said the royalty was 6 percent of sales and the marketing fee was 2 percent of sales. Item 19 showed average yearly sales of 400,000 dollars for studios open at least two years.

She did the math on paper so she could check it. Royalty: 400,000 times 0.06 equals 24,000 dollars a year. Marketing: 400,000 times 0.02 equals 8,000 dollars a year. Together those two fees come to 24,000 plus 8,000, which is 32,000 dollars a year. That is 8 percent of sales, gone before rent, wages, or her own pay.

Then she planned for the top of the range. She would need up to 320,000 dollars to open. If she borrowed 250,000 dollars at 9 percent simple interest, she would owe about 250,000 times 0.09, which equals 22,500 dollars in interest in the first year alone. Add that to the 32,000 in franchise fees, and she had 54,500 dollars a year to cover before paying a single coach.

Marisol did not quit. She did something wiser. She called five owners from Item 20, including two who had left the system. She asked how long it took them to break even. She asked what the sales figure really looked like in year one. Those calls told her more than the brochure did. She kept her pencil handy, and she kept her savings safe until the numbers made sense.

Where it goes wrong

I do not say this to scare you. I say it because I would want a friend to say it to me. The first trap is the sales figure that sounds grand but says nothing about profit. Ask what an owner keeps, not what an owner takes in. The second is planning your cash around the low end of Item 7. Openings run over. Plan for the high end, and add a cushion for slow months.

A third trap is skipping the phone calls. The franchisor will happily give you a list of its happiest owners. Item 20 also shows who left. Call them too. They are often the most honest people you will speak to, and they have no reason to flatter anyone.

Watch the contract terms as well. Look at how long the agreement lasts, what it costs to renew, and what happens if you want to sell or close. Some agreements limit where you can work if you leave. A franchise lawyer can read these terms with you before you sign, and that one fee may save you a great deal. It is money well spent.

One more thing. If a seller pushes you to sign fast, or will not let you take the document home, that is worth noticing. A good offer can wait for careful eyes. Slow down.

Questions to answer before you leave this page

Have I read every Item of the disclosure document, or only the ones that sounded good? Do I know my total starting cost at the high end of Item 7, and can I cover it with a cushion left over? Have I turned each royalty and fee into dollars a year, so I can see what leaves my pocket before I take home a dime? If Item 19 is blank, what does that tell me, and who can I ask instead? Have I spoken to at least five owners, including some who left? Do I understand what happens if I want to sell, renew, or walk away? Have I had a lawyer who knows franchise agreements read the contract? And when I picture an ordinary Tuesday in this business, six months in, does it look like a life I truly want?