The Cost of Franchising a Business
Creating An Entirely New Business This system is extremely powerful, as it essentially frees the franchisor from capital constraints – and allows the franchisor to open franchises virtually “as fast as they can sell them.” But that last sentiment, while true in some respects, can be a very dangerous sentiment if taken too literally. One of the most important things to remember when making the decision to franchise is that you are creating a new business – not simply an extension of your existing business. Regardless of the business you started in, you need to understand that franchising is the business of selling and servicing franchisees. And your first and most important priority must be to make your franchisees successful. While this new business allows the franchisor the ability to grow very quickly and in a highly leveraged way, you still need money to make money. So how much is enough? The 31 Flavors of Franchising Take for example, the case of a new franchise company that wishes to open one or two more units in their own local market by franchising. Perhaps the business owner is looking to provide an opportunity to their relatives or to their existing employees. Perhaps they only have modest expansion goals. In this scenario, the prospective franchisor needs only to concern themselves with two basic costs: legal and quality control. From a legal standpoint, an inexpensive attorney specializing in franchising (it is recommended to retain an attorney who is a franchise specialist, as this area of the law is highly regulated and complex) might develop their basic legal documents (franchise agreement and Uniform Franchise Offering Circular) and other related work (trademark protection, license agreements, etc.), for as little as $25,000. Depending on the state in which the entrepreneur will offer and open franchises, they may also need to comply with some state registration laws that could cost several thousand dollars more. This new franchisor will probably want to create a new corporation, will need to capitalize that corporation, and will need to have a CPA conduct an opening audit of that company’s balance sheet (up to three years of historical audits will be required if the existing company will be the franchisor, but most new franchisors opt for the creation of a separate franchise entity for a variety of reasons). And while certain states will look askance at a weakly capitalized franchisor, in non-registration states, there are no laws or guidelines governing initial capitalization. So, a couple of thousand dollars might cover the creation of this new entity. Despite a desire for conservative growth, an entrepreneur will still want to control quality – after all, they have built their name and reputation over the years with painstaking care, and they will not want to take a chance on hurting their existing business by allowing the brand to suffer. Thus, this new franchisor will need to create an operations manual that will be the governing document controlling quality within the system. Without this operations manual, a new franchisor runs significant risks relative to brand maintenance, as the operations manual defines the standards of quality that will be required of the franchisee, and as such is incorporated directly into the legal contract between the franchisor and franchisee. (And as such, its standards become legally enforceable.) While some entrepreneurs choose to develop their own operations manuals internally, this path carries certain risks. The operations manual, if properly crafted, not only will control quality, but will also limit the franchisor’s liability relative to the acts of the franchisee and the franchisee’s employees. In order to do that, the operations manual will not only need to cover day-to-day operations, but will also need to cover a wide array of topics – and will need to do so in a way that does not create incremental liability (through negligence or inadvertently creating an agency relationship). But even if this business were to create a professionally developed operations manual using a company such as ours, the costs of developing this manual would likely run under $25,000. So for this hypothetical company looking to sell a few franchises locally, the documents needed to get started could be developed for about $50,000. But what of the company with more aggressive growth plans? How High is “Up”? Legal costs for a more aggressive roll-out may need to include additional state registrations and may also include more aggressive and/or complex development contracts (area development contracts, area representative contracts, etc.). Each registration or filing state will have fees for registering the franchise (there are 14 registration states and a number of business opportunities states that the entrepreneur may need to be concerned with), and the fees charged by these states will aggregate somewhere north of $6,000 – not including the incremental legal costs charged you by your franchise attorney. All tolled, the legal costs for this more aggressive franchise program can reach $50,000 or more. A more aggressive growth strategy, by its very nature, will also require additional planning. While a company planning on conservative growth can probably get away with a fairly informal planning process, aggressive growth dictates a thorough understanding of the competitive environment and the financial implications of each business decision. These financial and structural decisions need to be built on a solid understanding of the organization that the new franchisor will need to execute this plan, and of the costs of building that organization in terms of people and capital. The aggressive franchisor must bear in mind that even seemingly small mistakes, when multiplied times hundreds of franchisees, can equate to the difference between success and failure. The most ready illustration of this comes from an examination of the royalty structure. While the difference between a 4% and 5% royalty may seem like a small one, that additional 1%, could cost the franchisor $5,000 to $10,000 or more per franchise sold. That “1% mistake,” when multiplied times 100 or more franchisees and times five or more years on the contract, can easily mount into the millions. Unfortunately, this more thorough planning process can be quite expensive. Depending on the nature and scope of research conducted on the market and on competitors, the amount and complexity of financial planning, and various other factors, the costs of hiring a consultant to assist in the development of these plans could range between $25,000 and $35,000. In more complex situations, this planning can become significantly more expensive. Quality control will also become both more cumbersome and more expensive. With more franchisees going through the system, there will be a need for a more formalized training program, and perhaps training videotapes and other training tools. Again, this could double the costs of your quality control. Of course, the biggest difference between the conservative and the aggressive growth franchisor will be found in the areas of franchise sales and marketing. While the conservative franchisor will be content to let prospective franchisees come to him and operate in a reactive fashion, the aggressive franchisor will want to “make it happen.” This will start with the development of professionally designed marketing materials. A full-sized, four-color brochure is virtually the cost of entry in modern franchising. This brochure not only sells the franchise opportunity to the prospective franchisee, but it also plays a key role in demonstrating the credibility of the franchise to key influencers – accountants, attorneys, bankers and spouses – who will play a key role in the franchise selection process. The design of a good brochure will cost between $7,000 and $10,000. Printing this brochure, depending on print process, paper quality, quantity printed, and a variety of design specifications (full bleeds on pages, dye cuts, stapling, etc.), will cost another $8,000 - $10,000. For companies with physical units (or companies that plan on using a lot of direct mail or trade shows to promote their franchise), another great tool is the mini-brochure. This brochure, typically done in a two or three-fold format, can be produced in quantity relatively inexpensively (design costs and printing costs totaling around $5,000), and serves as a lead generator more than as a credibility piece. A professionally designed web site is also essential. In addition to franchise information, this web site should be equipped with lead collection forms and, ideally, an autoresponder matrix that helps the franchisor sort the wheat from the chaff. And this site needs to be optimized for franchising. While web sites are increasingly less expensive to create, you can still budget $10,000 to $15,000 for a really good one. For franchisors looking for more aggressive growth, franchise sales videos are increasingly important in the sales process as streaming video becomes a more integral part of the Internet. Professionally produced videotapes promoting the franchise offering can generally be developed for between $15,000 and $25,000. At least as important as the marketing materials will be your marketing budget. Depending on the size of the investment in a franchise opportunity, the new franchisor should budget between $5,000 and $7,500 (and in some instances more) per franchise to be sold to a promotional budget. For a franchisor planning on selling 20 franchises in their first year, an annual marketing budget of between $100,000 and $150,000 is not at all unrealistic. Of course, some of these funds will be recaptured as the franchisor begins to realize franchise fee income, but since it takes an average of 12 weeks to sell a franchise, the aggressive franchisor should have at least have five to six months worth of advertising money – or about half their annual budget -- on hand when they get started. In order to optimize these expenditures, the savvy franchisor will also invest in primary market research (to better understand his prospective franchisee) and in a first-rate marketing plan. While inappropriate for more conservative franchisors, these planning activities will add another $10,000 - $15,000 to the budget. But the single biggest investment that you will have in the development of an aggressive franchise company will be in your people. Most companies getting into franchising for the first time do so by leveraging off of their existing staff. Oftentimes, the entrepreneur who founded the business will act as the primary franchise salesperson, with support from staff in the areas of operations and training. And while this will work in most growth scenarios, the more aggressive the growth scenario, the sooner the business owner should plan on bringing on incremental staff to fill key roles in the areas of franchise sales, franchise training, and field support. The first hire for the aggressive franchisor is generally the franchise salesperson. A proven franchise salesperson will generally command a compensation package in the low six figures, with at least some of this package being performance based. Top franchise sales pros can command twice the salary or more – but are generally worth their weight in gold. Again, you should expect that the franchise salesperson will begin earning his keep by selling franchises relatively quickly (a good franchise salesperson should be able to sell 12 – 20 franchises per year), but you should anticipate the need to fund at least four to six months of their salary (depending on the nature of the franchise) without any fee income. Add to this salary the fees you will pay to an executive recruiter to locate this top talent (who will generally command a fee of 25% of first year’s compensation), and you can probably budget $75,000 in personnel costs before selling the first franchise – should you go this route. Other hiring generally comes later – after franchise sales have started and the royalty stream is established – but again, the more aggressive the growth, the earlier these hires need to take place. While this article provides an overview of the costs of getting into franchising, the best way to get a reasonable understanding of all of these costs is to develop a cash flow analysis that accounts for all of your hiring, marketing, legal, and development needs, as well as for the inflow of franchise fees, royalties, and other sources of income. While many factors will influence your ultimate cash need, a good rule of thumb is that an aggressive franchise program may require a cash flow budget of $250,000 to fund development costs and franchise growth until franchise sales begin “paying for” incremental personnel and advertising needs. But remember, rules of thumb, like thumbs in a softball game, are often broken. There are numerous instances in which franchisors have succeeded in growing significant franchise companies with far less – and other instances in which companies have failed at franchising having invested far more. While it is important to be properly capitalized to franchise, it is important to remember that the costs of creating this franchise company, even in aggressive growth scenarios, is often less than the cost of starting just one more company operation. That investment in a franchise program can grow to be a franchisor with hundreds, or perhaps thousands of franchised units – affording the aggressive entrepreneur with leverage not found in any other means of business expansion. Mark Siebert is the CEO of the iFranchise Group, a Homewood, IL based franchise consulting firm. This article originally appeared in Entrepreneur magazine. |