If you’re considering starting a business but are unsure about viable business ideas, buying into a franchise could be your answer.
A franchise provides a market-tested business model and a product that people already love. For the price of a negotiated royalty, you can buy into a thriving brand that not only gives you a platform to quickly grow a business but also provides the support you need to succeed.
However, while there are obvious benefits to leveraging a franchise model, it’s important to approach the process with due diligence and a well-thought-out plan. Just as buying into a great franchise can help you launch a growth-ready business, signing up for the wrong franchise can produce a world of pain and financial ruin.
To help you navigate the franchise purchase process, this article explains the key steps involved and important matters to consider when purchasing a franchise. We’ll provide a comprehensive overview of the process of buying a franchise, including how to find, assess, and secure funding for the right franchise.
What is a Franchise?
According to Investopedia, “a franchise is a type of license that grants a franchisee access to a franchisor’s proprietary business knowledge, processes, and trademarks thus allowing the franchisee to sell a product or service under the franchisor’s business name.” In short, it is a business model that provides the option to use the branding, processes, products and market dominance of an established brand in exchange for a fee.
The parties involved in the license are referred to as the franchisor (the original business owner) and the franchisee (the person buying into the franchise). The fee paid in order to access the franchise may include ongoing royalties, often ranging from 4.6% to 12.5% of yearly revenue, and a one-time license fee (an initial franchise fee).
What are the Types of Franchises?
There are different types of franchises depending on the type of business involved, benefits offered under the franchise, and the franchise model involved. Some of the common types of franchises include:
- Service franchises: Service franchises become well-known for the quality and novelty of the services they provide. They don’t offer a physical product. Home/office cleaning businesses, lawn care, and childcare/daycares are examples of service franchises.
- Product franchises: They are the opposite of product franchises. Here, you can buy into a franchise that is renowned for the physical products they sell and gain a license to distribute those products in a specific area. Examples are oil change businesses, machine and soda pop, dealerships and gas stations.
- Business-format franchises: In a business-format franchise, the franchisor offers a complete business system, including operating procedures, marketing strategies, and training programs. It’s a complete package meant to ensure the success of a specific business model. Examples of this franchise type include fast food and retail, gyms etc.
- Investment franchise: Investment franchises are characterized by large scale projects and immense capital outlay. They cover a sub-variety of franchises such as management franchises and master franchises. Hotel chains, large restaurant chains, and supermarket chains are examples of investment franchises.
- Conversion franchise: Finally, conversion franchises do exactly what the name implies: they convert independent businesses into a franchise that are currently within the same industry but under different brands.
It’s important to note that each type of franchise has its unique benefits and drawbacks. Whichever you choose will depend on several factors and their ultimate fit to your circumstances and goals. We’ll discuss these factors and how to evaluate them next.
How to Purchase a Franchise
Many people are surprised to find that buying into a franchise isn’t like purchasing any other business. With other businesses, your main concern is whether the business has good financials, a healthy cash flow and opportunities for growth.
But with a franchise, you’re also considering the terms of the franchise agreement (which governs your relationship with the franchisor), the applicable franchise fees, and the kind/quality of support you’ll receive from the franchisor. Apart from these, there are various other considerations to keep in mind such as how to secure financing and what a great exit plan should look like.
Here’s a step-by-step guide that can help as you work through the franchise purchase.
1. Preliminary Matters and Due Diligence
Understand that while buying a franchise offers a potentially great deal, it also has lots of drawbacks. A franchise brings with it an established brand, proven business model, ongoing training and support, and easier access to financing. But it can also require high initial investment, stifling ongoing royalty payments, limited autonomy, and a limited ability to exit.
Think about both sides of buying a franchise and ensure you have a balanced appreciation of the facts before diving in. You should also read through our article on the pros and cons of buying a franchise to learn more.
2. Decide your Preferred Role
Do you want to be an owner-operator or a passive investor in the franchise? Think about this early on, before you even begin to look at franchise opportunities.
An owner-operator essentially owns the business location but also works in there on a full-time or part-time basis. In this position, you could work as the manager or any other position you prefer. On the other hand, as a passive investor you don’t play any active role in the franchise. All you do is provide the funds, collect profits, and provide high-level oversight of the business. Shaquille O’Neal is a great example of a passive franchise investor, as the owner of multiple Papa John’s, Auntie Annie’s, Five Guys, 24-hour Fitness Centers, Car Washes, and Krispy Kreme franchises.
The role you pick will depend on your personal goals. But it will also depend on the franchise type, as some franchises will require more involvement than others.
3. Research the Right Type of Franchise
The next step is to research what type of franchise makes sense for you, keeping in mind the role you’d like to play. Here are some factors to consider:
- Your passions and interests
- Track record and sales
- How much support you’ll get
- Market growth / opportunities
- The right area
- Local competition
- Franchise fees
- Day-to-day operations and involvement
When you’ve done your research, assess what franchise opportunities meet your requirements. It’s important to be objective in this assessment as any red flags you overlook might spell trouble down the road.
4. Conduct a Financial Analysis
By this point you should have a tidy list of franchise opportunities that you’d like to review more closely. To ensure a manageable process, it’s best to have no more than five opportunities that you’re seriously considering.
Conduct a financial analysis of the top options be doing the following:
- Estimate or obtain information about the upfront costs
- Evaluate ongoing costs and the project your revenue per month
- Assess how much take home pay you need for you and your family to live the life that you want to live
- Project future growth potential in the short term (3 – 6 months) and long term (3 – 5 years)
5. Carefully Review your Franchise Agreement!
After identifying great franchise prospects, you should reach out to the franchisor to initiate discussions. As part of the discussion, you’ll be provided with two key documents: the Franchise Agreement and Franchise Disclosure Document.
The Franchise Agreement contains the terms on which the franchisor is willing to let you buy into the business. It will address matters such as the license fee and royalties to be paid, frequency of payment, and the rules for terminating the franchise.
On the other hand, the Franchise Disclosure Document is a legally mandated document that details exactly how the franchise will work. It provides comprehensive information about estimated costs, the roles of the parties and the operation of the franchise. Its purpose is to help you make an honest and informed decision about your proposed investment.
6. Speak to Current Franchise Owners
To ensure the documents and facts you’ve received align with reality, consider also speaking with current franchisees of the franchise you’re interested in. Learn from them how the franchise operates in practice, the challenges they’ve faced so far, and any hidden details you should know about the franchise. You should also receive a list of past owners in the Franchise Disclosure Document, so it may be worth it to reach out to them as well.
The information you receive here will be vital to helping you make a final decision on whether to invest in the franchise or not. This is also a great way to determine how the franchisor has been supporting their franchisees, since you can ask questions about this during your outreach.
7. Apply for Financing if Necessary
There are various options you can explore for financing, if it becomes necessary. Some of the avenues you can pursue include:
- Traditional business loan
- Lines of credit
Buying into a franchise can help you access financing easier, as banks are more willing to lend to a business backed by an established, risk-mitigated business model. But be careful about taking on debt. Remember that the business will be required to pay off that debt, so only take this on if you think the business can pay of the debt within the agreed term.
We’ve seen far too many franchisees driven into bankruptcy each year because they didn’t do the right financial analysis before entering into a franchise business. It’s always important to reach out to a professional, such as an experienced franchise lawyer, if you think you could use some help in making this very important assessment.
8. Training and Ongoing Relationship with the Franchisor
One of the key factors for the success of a franchise is access to training and support from the franchisor. If it looks like you won’t be getting this, then you should consider withdrawing.
Likewise, assess the franchisor to see if they’re someone you would have a good working relationship with. A good relationship will help the process flow smoother and potentially help you unlock even more benefits from the franchisor.
9. Planning an Exit vs. Building an Empire
Lastly, think about how you would like to end your journey with this franchise. Would you like to eventually sell the franchised business to a buyer or buy more franchises within the same brand on the way to building an empire?
There is no right or wrong answer, but is important to consider this right from the outset so that you have the legal rights you need in your franchise agreement to go either way.
Ultimately, there are many things to think about when choosing to buy into a franchise. This guide provides the information you need to reach a good understanding of the process and identify how best to proceed.
But you should keep in mind that obtaining help during the process can assure a more successful outcome. A franchise lawyer can help review and negotiate your franchise agreement before you make a hefty investment in one of these businesses. If you want more information, download our Ultimate Franchise Negotiation Package for franchisees looking to purchase a franchise business or get in touch with us today.