Should you Franchise Your Business?

By: Ronald E. Smith
Published: November 16, 2002

There are three ways to raise capital for expanding a business.

The most obvious way is to borrow the funds that are needed. The advantage of borrowing money is that when the loan is paid off, the business has expanded and you still own all of it. One disadvantage, or course, is that the debt must be paid back with interest. Moreover, if the business expansion takes the form of additional branch offices or stores, now you have to micromanage those extra places of business. If the expansion does not produce branch stores, you will still have more employees than before, more inventory, and so on, all of which requires more attention to detail and less attention to the big picture.

A second alternative is to sell stock. The expense of registering a stock offering can be quite high, but if the stock sales are successful, the funds raised can be substantial. One disadvantage is that your ownership of the business is diluted and you have to answer to the other shareholders. There is also the risk that you will spend $40,000 or more in registering your stock, only to discover that the public won’t buy it.

A third alternative is to franchise your business. The initial fee is much less than the cost of registering stock and no loans are involved. Therefore, you have no debt service and your ownership of the business is not diluted because no stock is sold. As each branch operation opens, it is micromanaged by the franchisee so you are not burdened with its day-to-day operations. You collect a one-time franchise fee as each new franchisee joins your franchise family and derive continuing royalties as your franchisees prosper.

There are two reasons not to franchise:

1. First, you should not franchise your business if running the business requires special skills of the type that can not be learned in a two week training session.

2. Second, you should not franchise your business if you don’t enjoy training and talking to people.

As a franchisor, you leave the business you know so well and become a teacher who teaches others how to run the business. Your days will be spent in teaching training sessions, improving your Standard Operating Procedures Manual as unexpected questions pop up, and so on. Being a successful franchisor is a full time job. Those who try to do it part time always fail because the franchisees rebel when they do not receive the full attention of their franchisor. They expect you to set them up in a successful business and they will sue as soon as they regret becoming your franchisee. The most common complaint is: “My franchisor just took my franchise fee and vanished. They haven’t been there for me like they promised.”

Most new franchises fail. The most common reason for failure is that the franchisor has tried to franchise a business scheme that is half-baked. We often get calls from people who say things like: “I just had a great idea for a franchise. People love the old-time covered bridges so my idea is to franchise a restaurant called The Covered Bridge and all of them will be built of old wood and look just like a covered bridge up in Vermont and when you drive through it the wooden floor will creak just like you’re on an old bridge and they’ll take orders when you enter the bridge and you’ll pick up the order as you leave the bridge and it’s obvious this will be an extremely popular restaurant and cars will always be lined up to get into the bridge and I need for you to get the franchise papers filed yesterday because this is really a hot idea.”

Such “paper franchise” have little or no hope of succeeding. There is no original place of business that can be used as a template for the branches. The originator of the idea has no clue as to how to bring the idea into reality, how much it will cost to open a franchise, where the restaurants should be located, what the menu should be, and so on. There is no Standard Operating Procedures Manual (SOPM) that the franchisee can consult as questions arise. There is no actual experience of operating the system to find out what bugs it might have. If a line of cars forms to enter into the covered bridge, will that line back into the street and block traffic? Will the city traffic authorities close down the facility for blocking the street?

The point is that you must have at least one business location that is successfully operating and you must have an SOPM before you begin selling franchises. To make your franchise successful, you must first prepare an SOPM that tells a franchise owner everything they need to know about the business opportunity that they have purchased. The SOPM is conversational in style and there is no prescribed form for it. It should not be prepared by a lawyer because it requires knowing every detail of the business. The SOPM is what a franchisee is paying an Initial Franchise Fee plus continuing royalties to get. If they pay an Initial Franchise Fee of $15,000 to get the SOPM and to attend your training program, if they are unsatisfied with the quality or thoroughness of the SOPM or the training program, they will sue for a refund and attorney's fees. They will win if a judge rules that the SOPM or the training program is inadequate to arm the franchisee with the skills needed to build a successful business.

Most franchise experts say that the owner should first expand by opening 3-5 branch offices, all owned by the owner to avoid franchise registration, to fully understand how the franchise system will work. Each branch manager should be able to successfully consult the SOPM whenever a question arises. After all branches are smoothly operating, and the SOPM has been proven to be comprehensive, then the time for franchising has ripened.

Many people tell us that they will just call their operation a distributorship or just a business opportunity, and thereby avoid the franchise “hassle.”

The three elements of a franchise are:

1. Initial fee in excess of $500.00;

2. Licensing of a trademark; and

3. Providing substantial assistance or control.

If all three of those elements are present, the business opportunity is a franchise even if you call it something else. If you are charging a fee of more than $500.00, if the new businesses will use the same trademark, and if you are going to help them get started or assist them after they have opened for business, you are in the franchising business and you must apply for and obtain an advertising number from the State of Florida Department of Consumer Affairs before offering franchises for sale.

If you promote your franchise opportunity to a prospective franchisee before your franchise is registered, the prospect could sue you and you would be subject to criminal prosecution. Franchising is a dangerous area of the law and the authorities do put people in prison for violating franchise laws. Too many "con" men have ripped off too many people in the past so all new franchises are immediately suspect, especially since most new franchises fail. You may want to order "The Franchise Fraud" from Amazon.com.

Earnings claims are extremely dangerous. If your Uniform Franchise Offering Circular (UFOC) tells prospective franchisees that they can expect to earn a particular annual income, as soon as a franchise’s income falls short of the promise, they will sue for fraud. Obviously, not all franchisees are equally talented and some work harder than others and some will fail to make the nice income you are promising to them. Your UFOC should include no earnings claims. In fact, the UFOC should not contain any statement implying that the franchisee will be successful.

You will also need to register the franchise in every state where you seek to sell franchises. California will require you to put the money the franchisee pays you into a trust account controlled by a third party and will not authorize release of the funds to you until the franchisee certifies to the state that they are happy with their purchase. Indiana will require that all paragraphs of the UFOC be cross-referenced to the Franchise Agreement (FA). Florida requires a special cover page, and so on. Do not offer franchises in states where you are not yet registered and do not sell to Florida winter residents who maintain their primary household in a state where your franchise is not registered.

After your SOPM, UFOC and FA have been prepared, you must give the UFOC and FA to a prospective franchisee at the first meeting where the franchise opportunity will be discussed. No closing can take place until at least ten days have elapsed since the first meeting and the hand-delivery of the UFOC and FA. The SOPM is not given to the prospect until the closing has taken place. The SOPM includes all of your trade secrets and it must always be dealt with as a confidential document.

When someone first approaches you, saying they are interested in buying a franchise, you must give them an application to fill out. Don’t just automatically give them the UFOC and the FA. The application form must require them to disclose their formal education, their experience, and their financial condition. If they are financially insecure, you can’t accept them as a franchisee. If they have no business experience, they will be a risky franchisee. Another major reason for franchise failures is the franchisor’s failure to screen prospective franchisees. Those who fail will hurt your future franchise operations because every prospective franchisee must be given a list of existing and failed franchisees whom they can call and ask questions. Those who failed will counsel your prospects against investing in your franchise opportunity. You need a careful screening of potential franchisees so that you can ensure that all of your franchises will be successful.

This page has provided an overview of the franchising process. You may want to visit the website of the International Franchise Association at www.franchise.org for further information, or schedule an appointment with us if you have further questions about the process of becoming a franchisor.

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