DO YOU REALLY KNOW WHAT YOU’RE IN FOR???
Do you consider yourself a foodie? Are you a great cook at home?? Or do you have a knack for spotting cool trends and can visualize yourself preparing dishes for others?? Have you ever dreamed of owning your own business? Perhaps a franchise? If you’ve answered yes to any of these questions, you might suspect that owning a franchise restaurant business would be a perfect fit for you considering your passion for food!
Most people venture into business, especially franchises because they feel that the industry suits them and that the specific franchise model of their choosing reflects their personal interests and passions. While owning a business might be a profitable way to persue what you love, it can be a nightmare if you’re not properly informed of the risks involved! Choosing to own and operate a franchise business should be considered in great detail before proceeding and requires a substantial amount of caution beforehand!!!
In this blog, I’ll outline for you a few very important suggestions if you’re considering a franchise business opportunity.
In a nutshell, a franchise is a clearly defined business arrangement. You are in a contractual agreement with franchise head office to pay them royalty fees and other fees in exchange for the rights to licence their business name and operating procedure and systems. What many people do not understand are many of the risks involved that are critical to understand BEFORE you enter into one of these agreements. I’ll highlight a few of these points below. Before I do so, I want to caution you to hire a lawyer who is familiar with franchise law to review any and all legal documents BEFORE you begin!
Personal Guarantee: In laymen’s terms; a personal guarantee is where you sign all major contracts where you are personally liable and cannot be protected by your limited liability corporation. You’ve agreed to remove this limited liability security and have declared yourself personally responsible. THIS IS EXTREMELY IMPORTANT TO UNDERSTAND!!!! In many franchise businesses, there are at least 3 contracts where they will try to get your personal guarantee: The franchise agreement, the lease agreement (if you are renting space or equipment), and a bank loan (if you require financing to start your business). It only takes one of these agreements to jeopardize you completely in the event that you have a disagreement with franchise head office. By signing a personal guarantee, you pledge all of your assets (savings, investments, home, cars, etc.) towards any losses, debts, or financial burdens caused while operating your franchise business. This means that if you’re late paying your royalties, aren’t able to pay your rent, or business isn’t sufficient enough to pay your bank loan, any one of these situations can put you in default and can jeopardize you financially. I cannot stress this enough!!! Even suffering financial losses as a result of your business not being successful does not release you from
Lastly, if and when you decide to sell your franchise business to another party, the franchise head office can (and often does) continue to keep your personal guarantee in place as added security on the new owners. In the event that the new party doesn’t commit to all of their financial obligations, you’ve essentially become another layer of security for them. Franchise head office doesn’t have to release you of your personal guarantee, and in some cases will try to negotiate a small fee (in the thousands of dollars) to be paid to them in exchange for the release.
If anything were to happen to the new owners of the franchise, where your personal guarantee is still in place, you share the responsibility of the financial burden. For example: Let’s say that the new owners were absent owners and the business suffered as a result. They were never there and all the franchise policies and procedures became diluted and the customer experience was poor. The image and brand of the franchise suffers and head office will at some point terminate the franchise agreement (after a series of default warning letters) in an effort to protect their brand. This action immediately jeopardizes their ability to pay their bank loan, the rent, and now the royalty fees which form part of the main franchise agreement. These losses (as well as future losses) all become part of legal claims that eventually get sorted out through the courts. By having your personal guarantee in place, you’re technically in default with the other parties even when you had no dealings in the business any longer!!!
You don’t have to sign a personal guarantee and you shouldn’t if it’s at all possible. Again, please consult the advise of a franchise lawyer for counsel in this regard.
Lease: Be sure that if you do need to sign a rental lease to obtain space to operate your business, I highly recommend that you only sign on as the sub-tenant and NOT the main tenant. The reason for this is in case you decide to leave your business or sell it, then the new owners will sign a new sub-lease agreement in place of yours. Otherwise, if you leave or sell the business and you’re on the main lease, it’s likely that the next owners will not sign for the main lease and only the sub lease, therefore keeping you responsible for paying the rent on the commercial space that you are no longer operating out of. If you sign the main lease agreement, you are responsible for the lease space for the term of the agreement (5, 10, 20 years), no matter who the sub tenant is, or if the space is vacant.
Equity: Equity in your franchise business is whatever the business is worth after you paid off all of your debts and liabilities. This figure isn’t always straight forward to calculate but it becomes important when you want to sell your business. Most businesses are valued by a multiplier of their annual profits. In the restaurant industry, this multiplier can be 3-7 times, and can be even higher for other businesses. This means that if a business earns $100,000 in profits at the end of the year, that a person is willing to pay 3 times its annual earnings, or $300,000 to purchase this business. Another way to look at this is that the business should pay itself off in 3 years if it continues to net $100,000 in annual profits. This multiplier is usually determined by the seller, a broker, and can be negotiated.
Where equity becomes a bit harder to quantify is when you factor in goodwill and your customer base. These two things certainly have a value but not all franchises allow you the franchisee to capture this equity! Let me explain…
Let’s say you purchase a franchise restaurant business and that it cost you $500,000 to build a brand new location. It’s the first of it’s kind in the city but the brand is relatively established elsewhere. After operating the franchise restaurant for 10 years, the annual profit of the business is $200,000 per year. Based upon evaluations that you received from business brokers and your accountant, you’ve determined that your business is worth between $600,000 – $800,000!!! Here’s the catch! Some franchise head office’s force you to sell the business back to them for the same price that you paid 10 years earlier!!! Where anyone else would reasonably pay you what the business is worth $600,000-$800,000, head office will only give you $500,000 and then they in turn will sell the business to another party for a greater amount. They argue that it’s them who owns the goodwill of the company and therefore they should capture this gain upon sale of the business.
Special Improvement fees: In many franchise agreements, there are clauses that outline payments that you must make in order to upgrade the business. In most cases this can be after 7 or 10 years of owning the business, or it can be upon the sale of the business. If you’ve borrowed money from a bank to build or buy your franchise business, many loans amortize over 5, 7, or 10 or more years. That means that as your bank loan finally becomes paid off, that now you must spend an additional amount of money improving your location or renovating your business to make it more current. This can be a fairly substantial sum of money, and you may need to acquire the money from the bank all over again!
Sometimes at the time of sale, franchise head offices may or may not include an improvement fee as a condition to the approval of the sale. In most cases the buyer is not willing to pay this fee, therefore the seller (you) must make this payment!
Royalty fees: Royalty fees are the regular payments that you make to franchise head office to license the franchise name, operating rights, policies, and procedures. Something that most people do not understand is how these fees are calculated. Royalty fees are always based on GROSS SALES AND NOT NET PROFIT OR LOSS! If you’re business grosses $100,000 in sales in a month but you still end up losing $10,000 after all of your expenses, you still pay royalties on the $100,000 in sales that you grossed!
Another thing that you should really consider is that you are required to pay these fees ongoing for the life of the franchise agreement! Once you’ve established your business and are independently operating your franchise smoothly, these royalty payments will continue to be required each month, no exceptions! At some point, these fees will end up being in the hundreds of thousands of dollars, and it’s likely that you could see less than a simple thanks in return! Some franchise fees range anywhere from 5% or 6%, all the way up to 17-18% or higher!!!
Marketing fees: Marketing fees are fees that are also paid on top of royalty fees. These proceeds are also calculated based on your gross sales and are collected by head office for marketing and advertising purposes. I want to caution you that these fees are not collected by your franchise location and then added to your account to be used later for your specific market. In many cases, the franchise head office uses the money for marketing initiatives as they see fit, which may or may not drive traffic or have a direct impact in your market. In worse cases, there may not be any direct investment into your market whatsoever and it’s highly likely that you may still need to spend a fair amount to advertise your business.
Legal and training fees: These fees are usually outlined in the franchise agreement and you should review them in detail before signing anything. Legal fees are the costs incurred for franchise head office to review the sale agreement, and to properly review the documents before they approve the sale. Training fees are fees used by head office to train new franchisees who have bought the business from you. If in the event that you decide to become a multi-unit franchisee, it’s important to note that you may be on the hook for paying a legal and training fee for each location in the event that you sell your businesses even if you sell them all to the same buyer. Essentially the same buyer would only need 1 training fee but technically head office can legally charge you for each location involved in the sale.
Disclosure document: There are many things that I have outlined above that should be cause for slow and diligent review before proceeding into a franchise business! Some provinces and states require franchise head office to provide any potential franchisees with a disclosure document. This document provides you with a transparent look into the business before you have committed to signing a franchise agreement. Do not trust this disclosure document as your sole resource! Always ask franchise head office for permission to contact other franchisees in order to get references and opinions on things. Try to be as random as possible in order to get a broad spectrum of references. This will give you the best idea on how the franchise business works as well as how the franchise head office operates.
I hope these few points will guide you well in your FI journey!
