Is Buying A Franchise Wise?

By Glenn Curtis AAA

Many people think that buying a franchise is a sure way to become a millionaire, but in reality, there are a number of reasons why becoming a franchisee isn't all it's cracked up to be. In this article, we'll take a look at some important considerations before you dive head-first into a franchise purchase. (For related reading, check out Share The Wealth With Franchises.)

Pesky Start-Up Costs and Royalty Fees
Start-up costs and royalty fees can put a serious damper on a franchisee's take-home pay. For example, when opening a McDonald's, the franchisee must not only pay money toward the location, he or she must also pony up a $45,000 franchise fee for the right to operate the business for a period of 20 years. After 20 years, assuming the company agrees to renew the contract, another $45,000 franchise fee is charged.

The total monetary layout to open a McDonald's franchise can range anywhere from $500,000 to $1.6 million.

The real kicker, however, is the ongoing royalty fee. Here's how it works: Each and every year, franchisees must pay the franchise a fee equivalent to 12.5% of sales. It also means that no matter how successful you are as a business owner and how innovative you are at driving revenue, you'll always have two partners: Uncle Sam and company headquarters.

In Pictures: Top 7 Franchise Dangers

The unfortunate part is that royalty fees are pretty standard in the franchise world. In fact, Burger King charges its franchisees 4.5% of sales in addition to a $50,000 franchise fee, and Dunkin' Donuts has its franchisees cough up 5.9% of sales each year in addition to a franchise fee that can range anywhere from $40,000 to $80,000, depending upon the location.

Subtract payroll, food costs and taxes - in addition to these royalties - and it's easy to see why life as a franchisee may not be the life of luxury you imagined.

Lofty Raw Material Costs
In order to maintain consistency among their offerings, most franchises insist that their franchisees buy raw materials directly from them or from a supplier with which they have a "special" relationship, meaning that they receive rebates on what the franchisees order. In any case, the prices that they charge for these materials (either the company or the supplier) are often much higher than what the materials would be sold for elsewhere.

In fact, it's not uncommon for some fast-food franchisees to pay 5-10% above prevailing market value for a box of lettuce or tomatoes, or other produce that could easily be bought elsewhere. After all, produce is produce, right? It's fairly consistent from vendor to vendor. The point is that over a year's time, the premium that a franchisee may have to pay for raw materials can equate to big bucks!

Furthermore, if the franchisee does decide to go elsewhere for its raw materials and it violate the initial contract, the franchise has the legal right to terminate the relationship and, theoretically, the franchisee could lose his or her entire investment.

Lack of Financing
Most franchises don't provide financing. This means that the franchisee will probably have to tap his or her savings or obtain some other source of financing (such as a small business loan). In other words, the franchisee is on his or her own!

With that in mind, some franchises, such as Lawn Doctor (which offers lawn and turf treatment services), will finance franchise fees, start-up costs, inventories and equipment to help their franchisees get started. Situations like these are particularly attractive because although franchisees will probably have to put up a portion of their personal assets as collateral for the loan, at least they won't have to zero out their bank accounts or tap retirement funds to set up shop. (To read more about financing, see Should You Take A Loan From Your Plan?, Getting A Loan Without Your Parents and Qualified Plan Loans: Guidelines To Operations.)

Lack of Territory Control
While most franchises will limit the number of stores that they open in a given area because of fears of market saturation and diminishing returns, many franchises will still try to fit as many retail locations into a given area as possible.

That's why it's not uncommon to see five different McDonald's locations within a five- mile area - the corporate head is trying to squeeze every last dollar out of the territory. But the individual franchisee is really the one who suffers. Every time a new location opens within close proximity, their potential market is essentially cut in half!

Lack of Individual Creativity
Franchises demand uniformity. In fact, everything from in-store décor, signage, products offered and the uniforms the employees wear is dictated by the franchise. For a person who likes to be creative this can mean a bleak existence.

Unfortunately almost every (if not all) franchise has similar requirements. So, if you like to be your own boss, a franchise is probably not for you.

Franchise May Not Know Your Area
You've probably heard many times that "location, location, location" is the most important factor in determining the success or failure of any business.

The point is that unless the franchise sets up shop in a favorable location that's going to support the business, the franchisee will have an incredibly difficult time making ends meet.

Take the Pizza Hut that's located about five miles from my home as an example. Now I'm sure that the folks who compiled the demographics on the area and secured the location for the franchisee thought it would work out fine. After all, the town is chock full of people and in close proximity to a major highway.

But what headquarters probably failed to uncover was that the location is also virtually surrounded by adult communities. In other words, people who usually aren't too keen on eating pizza or dining out with any frequency. In addition, a few miles up the road where the younger (pizza eating) crowd is located, there are four or five mom-and-pop pizzerias that provide stiff competition.

Therefore, although franchises may be able to do a quick demographic study and gauge whether there is a good chance that a location will fare well, they rarely know an area as well as the locals.

Bottom Line
Running a franchise is a serious decision that should be made with care. If you're looking to buy a franchise, learn as much as you can about the company, its products and the city or town where you are looking to set up shop. Even a great product and a great location won't guarantee a healthy bottom line, so make sure that you are aware of all the pitfalls of being a franchisee before you sign up for the job.

To keep reading about owning a small business, see Plans The Small-Business Owner Can Establish, 401(k) Plans For The Small-Business Owner and What are some commonly missed deductions for business owners?

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