Outside Insights | December 2011 | By Guest Author

10 Things to Look For in a Franchise

These indicators help determine if you’re likely to find the financial and lifestyle return you’re looking for.

Lance Vaught, director of operations for Penn Station and franchisee John Dorger
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With more than 574,000 restaurants in the country, there are enough restaurant franchise opportunities to make your head spin. Almost 50 percent of these restaurants are brand concepts, not independently owned. It is important that prospective franchise buyers are well equipped with the knowledge to spot the franchising opportunity that matches their goals and provides the best chance of success. Whether targeting fast food, fast casual, or casual dining, it is the responsibility of the franchise buyer to be well informed and diligently investigate each opportunity.

Concepts do not change and adapt to individual franchisees’ goals and aspirations. Therefore it’s critical to understand management’s short-term and long-range plans for their brand. Some concepts grow more slowly and methodically, preferring to ensure the ultimate success of each restaurant that opens. Other concepts try to open as many locations as quickly as possible, often with as many franchisees as possible, with the thought process that if 80 or 90 percent succeed, the brand will continue forward on a strong path. While this may sit well for the concept, it certainly isn’t positive if you are part of the 20 percent that lost your capital in the process.

The Federal Trade Commission requires all franchisors to disclose a Franchise Disclosure Document (FDD) to candidates at least 14 days prior to signing any contracts or collecting any money. The FDD is a legal document and its purpose is to disclose comprehensive information about the franchisor and the franchise offering, giving potential franchisees the tools to make educated decisions. The document is divided into a cover page, table of contents, and 23 categories called "items.” Two of the 23 items contain pertinent information candidates should focus on.

Hidden fees and costs are a red flag as they usually indicate franchisor profit from food or equipment purchased by franchisees.

Item 19, “The Earnings Claim," is an optional disclosure under the FTC Rule. Many estimates state that approximately 20 percent of franchisors make a financial performance representation. The unit "earnings" are material facts that, if compelling, should be disclosed to new buyers by the franchisor. Item 20 provides an up-to-date account of the number of units and discloses all closures and sale transfers. Item 20 also provides the names and contact information of franchisees and former franchisees, who should be contacted for information in the due diligence process.

Franchise candidates should create a written checklist to help sort through the abundance of opportunities. Use the following key indicators to choose the right concept that will help you realize the financial and lifestyle rewards of successful franchise ownership.

1. Return on investment (ROI)/initial investment. ROI is directly related to the inherent risks of a particular franchise investment. If the ability for an investment to generate predictable returns is less certain, the risk is consequently higher. Request the average initial investment so you can project ROI.

2. Item 19 Financial Performance Representation (FPR). Item 19 is the answer to one of the first, and one of the most legally dangerous, questions asked by a potential franchisee: “How much money can I make?” Candidates should know, at a minimum, the average unit volume (AUV), average overhead (rent, utilities, etc.), and average operating costs (food, paper, labor, etc.) to help compute net operating income (NOI). If no representation is made, one might wonder the reasons why.

3. Item 20 and the success rate. Franchise buyers should understand how many units have closed and the underlying reasons for failure. Dividing the number of closures by the number open for business will reveal the success rate.

4. Fee and cost structure. Identify and study all fees and costs associated with a franchise, including initial fees, continuing fees, equipment and food costs, post-term fees, advertising fees, penalty fees, and hidden fees and costs. Hidden fees and costs are a red flag as they usually indicate franchisor profit from food or equipment purchased by franchisees. Find out if the franchisor profits from purchases made by franchisees, in the form of vendor rebates. Also, recognize that the lowest royalty doesn’t equal the most profit.

5. History of litigation. Be wary of franchise systems with a long history of litigation. All litigation is listed in the FDD.

6. Support and infrastructure. Study and compare all support areas: initial training, construction (if necessary), grand opening support, ongoing support, marketing, technology, and so on. The more support franchisees receive for the initial franchise fee and ongoing royalty fees, the better.

7. Franchisee communication. Study the relationship between the franchisor and franchisee. Contact franchisees to discuss their satisfaction, but don’t limit your contact to existing franchisees. Contact former franchisees as well and understand why they left the system. Additionally, franchisee associations and participation in that association are indicators of a healthy system.  

8. Product or service. A superior product and service with established and recession-proof market demand will increase your chances of success.

9. Systems and procedures. Much of the consumer appeal of a franchise system lies in the fact that, no matter where they go, if they patronize one of that system's restaurants they'll get the same quality of service and product they would get anywhere else.

10. Branding. Does the franchisor work harder to protect the integrity of the brand and to protect from litigation? The brand is a concept’s face to the world. It is the company's name, how that name is visually expressed through a logo, and how that name and logo are extended throughout an organization's communications. A brand is also how the company is perceived by its customers and the associations and inherent value they place on your business.

While each of the above items should be evaluated independently, it is imperative a franchise candidate consider each of the items in the aggregate. For example, a concept might have an extremely low royalty fee structure, but if their food costs are substantially higher because of rebates paid to the franchisor from franchisee purchases, the lower monthly royalty is negated.  

Restaurant ownership is not for the faint of heart. It is hands-on, hard work, and long hours. However, for those who are willing to investigate alternatives prudently using a checklist encompassing the above key indicators, it can be extremely rewarding.

Scott Keller is director of sales for Penn Station East Coast Subs. The Cincinnati-based brand has more than 225 locations in 12 states.