Accounting Best Practices

Be Wise When You Franchise
By Susan Williams
Published: June / July 2008

Franchising, which is now used in more than 70 industries, generates more than $1 trillion in annual U.S. sales. This business model dates back to the 1850’s in the United States with a couple of early successful franchises including Coca-Cola and the telegraph system controlled by Western Union. Subsequently in the 1930’s, such industry stalwarts like A&W Root Beer and Howard Johnson’s adopted a franchising model, but franchising of hotels and fast food restaurants really exploded as our interstate system was being developed in the 1950s.

In addition to being good for franchisors and franchisees, the franchising business model has also been good for America’s economy. In fact, according to a study done by the University of Louisville, Franchising in the Economy, 1991-1993, franchising helped to lead America out of its economic downturn at the time. This is because franchising picks up when good jobs are lost as potential franchisees look to buy jobs and earn profits from the purchase of franchise rights.

So is franchising right for you? Well, franchising can be a great way to start and/or expand a business. In a franchise, the franchisor transfers to the franchisee the right to use the franchisor’s trade name or trademark, product or method of doing business. Simply stated, the franchisor provides the business expertise and the franchisee provides the capital investment.

A few advantages of franchising are as follows:

• Franchising can be relatively inexpensive both from a cost and time perspective because the franchisor has already taken the risk of the learning curve, and implemented a great deal of infrastructure. For this and various other reasons, franchises typically have a much lower failure rate than other new business ventures, making them attractive business investments.

• Franchising is governed by both federal and state law. In addition to Federal Trade Commission filings, each state in which a franchise is to be sold generally requires a “Uniform Franchise Offering Circular” (the “UFOC”) to be filed. This filing provides potential franchisees with extensive information about the franchisor. The wealth of information in a typical UFOC offers an opportunity for a potential investor and franchisee to analyze the risk and rewards associated with such an investment.

• Franchising offers simplicity because a well-run franchisor offers a turnkey business from site selection to lease negotiation to purchasing the equipment and training and hiring the employees. In many cases, the franchisor also provides the advertising for its franchisees, and provides ongoing support and mentoring. Finally, a franchisor may finance a franchisee’s initial investment. But be forewarned that in exchange for doing so, the franchisor would generally impose certain financial controls (e.g. working capital requirements and/or limitations on certain compensation) to protect their investment in the unpaid portion of the franchise fee.

But before you rush off and invest your life savings in a franchise, recognize that franchising is not for everybody. A few of the potential downsides that need to be considered are as follows:

• Franchisors get paid irrespective of whether your franchise is profitable because a franchisor typically collects continuing royalty payments and an advertising fee based on percentages of gross revenues. In addition, most franchisors require that the prospective franchisee have significant net worth and the ability to make a substantial equity investment. Franchisors may also sell products to its franchisees at prices higher than the franchisees might be able to negotiate in an open market, thereby potentially further reducing profitability.

• If you are creatively inclined and/or think you are going to be able to make changes for your particular franchise that have not been approved by a franchisor, then think again because a franchisor will generally do what it takes to ensure the uniformity of its products and/or services (up to and even including cancellation of the franchise agreement) as the value of their franchise is significantly dependent on such uniformity. Said another way, being a franchisee can differ from being an entrepreneur for this reason, and because the franchise agreements generally have definitive lives. As such, franchising may be more akin to renting a business than actually owning it.

• While you may be able to purchase an “area” franchise in lieu of a franchise for a single outlet, you will not have carte blanche, say, with respect to the number of locations you open. Rather, the franchise agreement will assuredly include restrictions with respect to this matter in order to prevent oversaturation in a particular marketplace.

There are certainly other factors to consider, perhaps most notably the possibility that conflicts could arise between you and your partner (also known as the franchisor). Just as in any partnership, an incompetent or dishonest partner can destroy the business, but you may have limited recourse under a franchise because the related agreements are generally advantageous to the franchisor. As with all investments, the decision of “to franchise” or “not to franchise” should only be made after appropriate research and careful consideration. Attorneys and/or certified public accountants that are familiar with the nuances of franchising can assist you in your due diligence.

Kingery & Crouse, P.A.

Susan Williams joined Kingery & Crouse in 2005 as a manager in the Accounting and Auditing Department. During her career, Susan has served a wide variety of large, closely held companies with extensive experience in the industries of construction, manufacturing & distribution, professional service (legal, medical and engineering), hospitality, automobile dealerships, broker/dealers and not-for-profit organizations. You may contact Susan at (813) 874-1280. Find us on the web @ www.tampacpa.com.

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