Franchise Due Diligence: What you should know before buying one

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Franchise Accountants
Director | Consultant
October 9, 2020
minute read

Is it a viable business option?

The COVID-19 recession has dealt a harsh blow to businesses of all sizes. Falling profits are seeing many companies make tough choices between standing down their staff,and turning to large-scale retrenchments as a way of staying afloat for the long term. All this uncertainty is leaving many people looking for more flexible career options. 

As such, some may be looking to a business franchise as a way of controlling their future and avoiding the alternative of unemployment in a competitive market.

The benefits of owning and running a franchise can seem like an attractive change on paper, at least. You get the freedom to work for yourself, and the ability to start a new business without necessarily starting over from scratch. You may also think that the established reputation and image of your brand will give you a leg up. 

And in most cases, you’d be right. But franchise businesses can be fraught with danger for the unwary. 

So when looking into purchasing a franchise there are several major considerations that one must keep in mind, particularly with the constantly shifting COVID-19 situation casting its shadow over the worldwide economy.

You’ll have freedom, but you’re not in control

Buying a franchise isn’t a licence to run your business your way. After all, you’re not starting your own business from scratch you’re buying into someone else’s. Purchasing a franchise is better thought of as buying a system on how to run a business.

The system you’re buying in to is so well documented that people know exactly what to do in every aspect of the business. So, potential franchisees need to be prepared to work within a rigid system, and feel comfortable with this level of control over their investment.

You need to know the numbers

For a business to be successful your net profit needs to be 20 percent of your turnover, a goal that may be difficult to attain under current conditions, as retail and hospitality figures continue to fall all over the country.

As such, it’s important that anyone considering a franchise obtains the latest possible sales figures, ideally no more than a month old. In such a unique time in our nation’s history, historical sales figures have no way of revealing the true financial position of the business

Another thing to be aware of is rent. In order to maintain your success, your new franchise’s rent should never exceed 10 percent of your turnover.

The good news is that there is currently more power in the rental bargaining chip. According to Macquarie analysts, the results of the pandemic and pressure on the retail sector could see retail rents fall as much as 15%. Major shopping complexes and small shopping strips are seeing shutters close, which makes new tenants all the more enticing.

Under these circumstances, prospective franchisees may have the upper hand in negotiating a new and lower rental agreement with the franchisor. Ensure you engage the services of an experienced franchise accountant with a proven track record.

Ensure the numbers stack up

A franchise is only as strong as its name

Anyone seriously considering a franchise future must remember too that the franchise system itself is only as strong as the franchisor running it.

Under normal economic circumstances, the higher the number of franchises, the more likely the business will be successful. But we’re not in normal circumstances.

A good guideline is the level of monthly royalties the franchisor expects the franchisees to pay to cover marketing and administration costs. Typically, 8% is considered a standard amount. Franchisees should be wary of franchisors wanting large sums up front, while lowering monthly royalty percentages (say around 5 or 6%) as compensation. This could mean the franchisor is planning on leaving the franchisee high and dry, with no support structure.

8% in royalties is a comfortable amount. This figure enables the franchise to employ a business development manager who can be there for new and existing franchisees and provide ongoing support—particularly in tough times—to ensure their business remains viable.

The role of the business development manager is to visit franchisees and assist them in increasing their revenue while reducing production costs. They know the business inside and out, so they can provide insight that helps each individual franchise thrive. This can include things like suggesting changes to their product mix in order to capitalise on local tastes, reducing product range and stock levels, or assisting in marketing programs that can help boost turnover.

What type of franchise are you buying in to?

Potential franchisees should be aware that there are two types of franchises out there available to you: established businesses and greenfield sites. Both come with their own set of costs.

When it comes to established businesses, the franchisor will always become involved in the deal when one of their franchisees is looking to sell to a newcomer. There’s a lot more scrutiny involved. This new owner is buying not just the franchise agreement essentially, their licence to operate but also any plant, equipment, and goodwill of the existing business.

A base franchise agreement is typically 10 years in duration. A fast food outlet agreement may cost around $60,000, and at the end of this 10 years, the agreement can then be renewed for another $60,000. Monthly royalties add to the cost on top of this.

But goodwill you’re buying can be a big factor in how successful your franchise is. A popular established location or venue can earn up to 3.5 times the net profit of a similar venue elsewhere.

 Greenfields sites, on the other hand, are much more costly to establish. You’ve got to deal with a new fit-out to the premises, new plant and equipment, new licences, and starting your reputation from scratch. This can involve an outlay, including the franchise fee, of $250,000 or more. 

But while established businesses are often more affordable up front, after five or six years the franchisor often applies pressure to refit and upgrade the premises. Under these circumstances, most franchisors will ask for a top up of their agreement to ensure they recover their investment.

Location, location

Major shopping centres have typically been seen as the smart option for setting up a new franchise. But with current social distancing measures in place, and reduced ease of access, strip shops may be a better location in the long term.

On top of the worsening spending numbers, franchises within a large shopping centre have to contend with the centre owners who insist on using their own (usually more expensive) fit out experts for any required renovations. Conversely, as part of a strip the franchisee only needs to worry about their landlord and the franchisor.

Staying in your lane

One of the major considerations new franchisees often forget is that, if they don’t follow the franchise guidelines, under the franchise code the franchisor can walk in and take over the business. So unless you’re ready to follow a strict system, and deal with the competing personalities you’re likely to encounter, it may not be a suitable business model for you. 

Another important factor is how to motivate young employees who don’t see the business as a career path. It’s a common first job for many people; you get a part-time job to earn a bit of money, with no other thought than how it fits around your school and social obligations. Their career aspirations aren’t the same as those of the franchisee, and their loyalty to the business will probably depend on how much they get paid.

Dealing with the human resource needs of 20 to 30 young employees in these circumstances can be a challenge, one made even more complex if you plan to take on more than one franchise.

This is where franchisees need comprehensive HR skills and the awareness to keep their young staff motivated. The more successful franchises regularly use on-site reminder training videos and a good dash of trust and personal accountability to ensure their business runs according to plan.

The final word

Owning and operating a franchise can be a fantastic way to gain the freedom and fulfilment you’ve been looking for in a career. But it comes at the cost of working within a rigid system, with strict guidelines in place that determine how to run your business.

And with the world in a constant state of social and economic change, it’s not a decision that should be made lightly. Only those who are truly serious about owning their own franchise should consider it as a viable business option in the current climate.

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