To many, the American dream means one thing: becoming your own boss.
There are many paths to achieving this dream, but the most direct is through entrepreneurship. However, starting your own business is a tremendous risk, and even with hard work and dedication, it might not pay off in the end.
To mitigate this risk, many potential entrepreneurs look to franchising opportunities. They provide a recognizable brand, a proven and successful business model, and open connections to discounted rates from suppliers. It’s a win-win for everyone!
But not all franchise opportunities are the same. And like any smart business owner, it’s essential to do your due diligence before signing a contract. If you’re not keen on how to do it, no worries!
In this article, we’ll explore the steps to evaluating a franchise opportunity, examine their profitability, and how to decide between an established or emerging franchise.
What are the Steps to Take when Evaluating a Franchise Opportunity?
Let’s not sugar coat it. Evaluating a franchise is a serious task and not a simple one. After all, most franchises require anywhere from $50k to over $1 million to get started. It’s a large investment that’s often a significant portion of someone’s life savings and not something to rush.
Because of this, the Federal Trade Commission (FTC) requires that all franchisors provide a franchise disclosure document (FDD) to any potential new franchisee at least two weeks before signing any agreement. In fact, you can’t get a small business loan from the U.S. Small Business Administration (SBA) unless they approve the FDD.
The FDD lays out 23 sections of information regarding every aspect of the franchise, from financial outlooks to financing, fees, and information regarding training and support. With the FDD in hand, you can start your process of evaluation.
Step 1: Work with a franchise attorney and accountant
If you already know how to evaluate a franchise, then you wouldn’t be here. So it’s safe to assume you’ll need help with contracts and balance sheets.
Before evaluating a franchise opportunity, take note and work with a qualified franchise attorney and accountant. They have experience dealing with the franchise industry, evaluating franchise agreements, and reviewing financial statements.
Skipping this step in the evaluation process makes all other steps void because you’ll need someone to help you decipher the legal language and numbers involved in the next steps.
Step 2: Evaluate the current market
With your franchise attorney and accountant hired, it’s time to inspect the current business market around the opportunity.
Most franchisors will have a solid market analysis—if they don’t, it’s a major red flag—available that shows their franchise’s viability and growth potential. But even with their analysis, It’s a good idea to independently evaluate their numbers, as they might have some biases.
Next, examine the competition in the market. It’s the cornerstone of capitalism, so you need some competition, but you want a ‘Goldilocks’ scenario. Too much competition shows an oversaturated market, but too little could mean that there’s no demand for the product. Your attorney and accountant can help you evaluate this fine line.
If you’re looking at a rapidly growing sector with minimal competition, it’s a good sign you may have found a solid franchise market.
Step 3: Evaluate the franchise fees and financial statements
The basis for any franchisor to create a franchise is to receive royalties and fees to use their brand and business model. This core of their business model allows franchisors to expand and increase revenue and brand awareness rapidly. And it means more money in the pockets of franchisees too.
But that doesn’t mean they should take advantage of you as a franchisee. It’s important to evaluate that the initial franchise fee is comparable to similar franchises in the market. Also, look into any ongoing charges for revenue royalties, advertising fees, or any other services offered by the franchisor.
Like any investment, you want to be sure that you’ll get a return, and the franchise appropriately allocates your investment funds to the proper channels.
Step 5: Find out about training and support
Speaking of returns, another key element to evaluate is investigating what kind of training and support the franchisor provides. Starting a new business is complex. People buy into a franchise because it eliminates many trials and tribulations of getting a business off the ground.
If the franchise you’re looking into doesn’t have a solid training and support system, then what’s the point of investing? Look into franchisors willing to help you go the distance with modern training procedures and ongoing help in the business’s day-to-day functions. Check with current franchise owners about their experiences to gain first-hand information.
Step 6: Review the financial statements and business plan
Franchisors who are not a startup have years of financial data available for potential new franchisees. Evaluating these numbers is the key step for determining whether the franchise is a viable investment.
Within the numbers, look for things like growing revenue streams from royalties and increasing profits. We’ll explore profits more in the next section, but be sure to work with your accountant to get a qualified read of the balance sheets.
Once you see the financials are reasonable, you can move on to the business plan. Being a franchisee requires that you follow the rules and procedures of the franchisor’s business plan. If you don’t, they can hold you legally liable for violating your agreement.
So if you don’t agree with or like the business plan, or find that you’re not willing to follow it through, then that’s another key red flag, and you may want to move on to another investment.
How do you Evaluate the Profitability of a Franchise?
As stated, working with your attorney and accountant is key. But that doesn’t mean you can’t learn how to see profitability in a franchise. With your accountant, ask these key questions:
- What are the annual sales?
- How long did it take for the franchise to achieve these sales numbers?
- What are their key performance indicators (KPIs) for franchisees?
With their overall sales and KPIs in mind, you can look into their average sales per unit (location). The FTC doesn’t require franchisors to disclose this information, but most do in section 19 of your FDD. The average sales per unit gives you a rough estimate of what you can expect to earn at your location and will provide you with an idea of its profitability.
Last, move on to section 20 of the FDD, where you should find statistics on new franchise success rates. Again, though it isn’t required, most franchisors provide this information. It gives you an outlook on how many new franchises succeeded in the past three years.
It’s not a direct sign of profitability, but you definitely won’t make a profit if the franchise has a track record of closures within three years. If the franchisor doesn’t provide this information, look into the SBA loan failure rates by the franchise brand to see who’s made money and who didn’t.
Evaluating Established vs. Emerging Franchises
The key difference between established and emerging franchises is the amount of financial information available. With existing franchise brands, you’ll have years of data tracking the successes and failures of each of their locations, along with growth numbers.
This information can be a beneficial indicator when choosing a franchise, but that doesn’t mean it discredits evaluating emerging franchises. When looking into an emerging franchise, you must take the steps we’ve listed above and assess the information within a limited window. You still want lots of profitable locations and growth in emerging areas with a solid training and support structure.
If the emerging franchise withholds some of the information discussed, it could be a red flag that the company doesn’t want to disclose failed franchises.
Outside of the financials, prospective franchisees should look into the leadership of the emerging franchise. Do franchise professionals lead the company, or is it someone who wants to take their company into franchising? Does the leadership team have extensive experience managing and growing franchises?
Though leadership can change, you want to see that the company has solid, experienced franchise leadership to guide the company to growth and success.
If you’re looking to be your own boss, franchises are a solid path to a career as a successful entrepreneur. Just be sure to do your due diligence and work with your attorney and accountant to evaluate any franchise opportunities you’re considering. Should you have any doubts about your evaluation, refer to this guide to keep yourself on track, and good luck with your career as a new franchisee!