How Does A Business Franchise Work?

Let’s say you wanted to open a restaurant or gym in your city. There’s a nice location that you think that it could generate enough traffic to be a profitable business. You could take out a loan and open a small business. You stay up late, pouring over branding ideas, business models, and marketing strategies. The gym gets named “Burt’s Boot Camp,” or the restaurant is named “Heirloom.” Now you have to fight to build a great product, operate the company, and gain a market share.

One problem. Data from the Bureau of Labor Statistics show that about 20% of small businesses fail in their first year and 50% of small businesses fail by the fifth year. Which means you’ve just bet your career on a coinflip.

At this point, if you’re still intent on running your own business, you may want to consider franchising.

How Does a Business Franchise Work

Why Business Franchising Helps Both You and the Corporation

Benefits of Franchising

Your artisan sandwich shop failed because it was a novelty. Only a small percentage of the city is the adventurous foodie type, and they came to “Heirloom” for a few years until a newer, more hip place opened down the road. Now it’s year 5 and you’re closing shop.

Instead of fighting for profits in the overcrowded novelty restaurant space, you could open a location of a known company, like Planet Fitness. Some companies like Planet Fitness are franchises, meaning that they sell the rights to their brand and distribution for certain fees. You take on the financial and personal risk of opening a location of the business, and companies give you brand awareness, existing customers, and distribution networks. 

What You Get

The franchisee (you) gets training and an audience that knows the brand. Instead of running a small marketing operation, a percentage of your sales goes to support a global marketing strategy that benefits all franchise locations. Instead of trying to get awareness for your product, you get to focus on running the business. And the failure rates are much, much lower–which we will talk in length about later.

What Planet Fitness Gets

The franchisor (Planet Fitness) gets an owner-operator with skin in the game. There is a sense of pride and passion that comes from being the sole person responsible for the livelihood of a restaurant, gym, or hair salon.

Because franchisees put in their own money and take out loans in their own name, the company also divests itself of some of the financial risks. It can be more aggressive with opening new locations, knowing that it won’t bear the sole brunt of financial losses.

Finally, the company makes assorted fees and profits from the business. Even if it’s only a small percentage, this adds up over thousands of locations.

What are the Qualifications for a Franchisee?

McDonalds Franchise

They don’t just pass out McDonalds locations to anybody who wants one. Every company has their own standards that they use to vet potential owner-operators, but a few things are standard.

  • Capital on hand. For example, opening and running a McDonalds will cost anywhere from $1 to $2M. That’s why McDonalds requires that potential franchisees have at least $500K pre-borrowed assets on hand.
  • Experience. McDonalds is pretty clear that they only hand out new locations to existing, successful owner-operators of a franchise.
  • Training. McDonalds trains part-time for about 12-18 months.

The Costs of a Franchise

Franchise Costs

Most franchises have three major costs for you to consider: startup costs, licensing fees, and a percentage of sales. Companies that have high startup costs and licensing fees will generally allow owner-operators to keep a higher percentage of profit. 

  • Startup costs: The amount you will spend on the building, equipment, space, employee training, and associated stuff you need to build the business from scratch.
  • Licensing fees: The amount you pay to use the company’s branding and image.
  • Percentage of sales: Think about this as an ongoing, monthly licensing fee. You pay a percentage of your sales each month for the rights to continue to benefit from the company’s image, brand, and marketing.

For example, Subway has famously low franchise costs. It’s only $15K for the franchise licensing fee and anywhere from $100K to $385K for startup costs. In total, Subway will cost between $120K and $400K to get off the ground. 

McDonalds and Taco Bell, by comparison, are both in the $1 to $2M range. 

But while McDonalds only takes 4% of individual franchisees profits, Subway takes around 12.5% of franchise profits. The more you risk early in the process, the more you stand to make later.

Do Franchises Make Money?

Some people who open a franchise lose their entire investment. While companies do their best to avoid partnering with the wrong person or putting a building in the wrong location, it happens. Additionally, franchises fail for no good reason. Some Dunkin’ Donuts location fails in high traffic areas, while other locations succeed in low traffic areas. Restaurant margins are notoriously wafer-thin, and it is impossible to predict all of the factors.

A report by the Franchise Business Review found that around 16% of food franchises earn over $200K and around 37% earn less than $50K. Notably, they only surveyed owners who are still in business. This study shows that you’ve got only a 63% chance to make more than $50K, and that’s after you’ve beaten the statistics that show how you might fail and close up shop.

The Financial Risk of a Franchise

Financial Risks of Franchises

You might have a 16% chance of landing a franchise that earns over $200K a year, but that only counts franchise owners that have made it. A recent report through the Small Business Administration showed that around 17% of franchise loans made through the SBA between 1991 and 2010 failed. That means that you’ve got only an 83% chance of paying back your creditors, much less of making back your initial investment. 

Keep in mind that big franchises often require that franchisees have capital on hand before they even take out a loan. If that capital becomes implicated in startup costs or as collateral, the losses can be more than just the franchise loan.

Additionally, the same report showed that from 2006 to 2010, the number rose to 19.3%. As a small business culture’s shift to encourage local startups and smaller, hip brands, the franchise culture can be dangerous.

Doing some back of the napkin calculations should tell you that you’ve got about a 20% risk of losing your entire initial investment, which in investment terms, is certainly an enormous amount of risk. 

The Bottom Line

A franchise allows you to own and operate a single location or business unit of a large company that you may know and love. The franchisor (company) gets a dedicated owner-operator with skin in the game and also divests themselves of some of the financial risks of opening a new location. The franchisee (you) get training, brand recognition, distribution networks, and resources. 

While a 20% loan failure rate sounds bad, and a 37% chance of less than $50K a year isn’t exactly an encouraging prize, keep in mind that these stats look better when compared to raw small business data. According to Bureau of Labor Statistics, about 20% of small businesses fail in their first year and 50% of small businesses fail by the fifth year. 

Compared to a coin-flip chance of success by year 5 for your small artisan hamburger shop, Subway doesn’t look like such a bad idea.

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<span style="font-size:12px;font-weight:500">Author</span><br><a href="https://wealthpursuits.com/author/kevin/" target="_self">Kevin</a>

Author
Kevin

Kevin is an ambitious entrepreneur that is obsessed with all things related to finance. From a young age, Kevin has always been involved with side hustles ranging from online selling to freelance work. Over the years, Kevin graduated from side hustles and started launching multiple online and offline businesses. Kevin is a serial entrepreneur who loves starting new businesses and exploring all things related to business and finance. He is constantly looking for new ways to save money, invest money, and create income streams.

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