Franchises: Challenge for the Unwary

Kieran Liston, Director, Liston Landers

While it often sounds like the ideal lifestyle, taking on a franchise business is fraught with danger for the unwary and can quickly turn what should have been a pleasant dream into the worst of nightmares.

This is particularly true in the current poor economic climate (defined by falling interest rates) where declining corporate business turnover has many companies reaching for the retrenchment package option as a way of reducing overheads in the longer term.

As a result, many redundant senior and middle management personnel that were earning $100,000 to $150,000 a year are reluctant to be caught again in the firing line – and are now in the market for a franchise business as a way of permanently avoiding the sack.

However, there are several major considerations for people considering this option, particularly in the worsening 2012-13 economic climate.

First, you need to understand that purchasing a franchise is buying a system on how to run a business. Then you need to realise the system is so well documented that people know exactly what to do in every aspect of the business.

Potential franchisees must be prepared to feel comfortable with this level of control over the business into which they are sinking their investment.

They also should know that, for any business to be successful, net profit needs to be at least 20 per cent of turnover – a goal that might be difficult to attain under present conditions as retail sales continue to fall throughout Australia.

This is why it is vital for any person seriously considering a franchise to obtain the latest possible figures (no more than a month old) because historical statements may not reveal the true financial position of the business. Another issue critical for business health is rent – which should not be allowed to exceed 10 per cent of turnover for the business to maintain its success.

Since the adverse affects of the global financial crisis in 2008, many strip shopping centre landlords have reduced business rents to ensure as many businesses as possible stay afloat.

For the first time in 35 years, we are now seeing large shopping centres following suit as they recognise this has become a major problem. Under such circumstances, a prospective franchisee would be well served to discuss a new and lower rental agreement with the franchisor.

Any person seriously considering a franchise future must remember that any franchise system is only as good as the franchisor who set it up in the first place – and the larger the number of franchisees, the more likely the business will be successful.

A good guideline is the level of monthly royalties the franchisor expects franchisees to pay to cover marketing and administration costs.

About eight per cent is the norm and potential franchisees should be wary of franchisors wanting large sums up front but offering lower monthly royalty percentages (say five or six per cent) as compensation. This could mean they are planning to leave the franchisee holding the bag with no support. Eight per cent royalties enable the franchise to develop new products and employ a business development manager to assist franchisees with ongoing support – particularly in tough times – to ensure the business remains a viable entity.

The role of the business development manager is to visit franchisees and assist them to increase their revenue while reducing production costs.

They might suggest a change in the product mix in order to achieve this goal. For example, one product could be particularly successful and it may be better to concentrate on that at the expense of less popular alternatives.

Reducing product range and stock levels is a recognised method of lowering costs, but business development managers also can assist with marketing programs that hopefully will increase turnover.

Potential franchisees should be aware of the fact there are two types of franchises – established businesses and greenfield or new sites.

The franchisor will always become involved when one of his or her franchisees wishes to sell to a newcomer. What the new owner is buying is the franchise agreement (the licence to operate), plant and equipment and the goodwill of the existing business.

Franchise agreements are usually of 10 years duration and a fast food outlet, for example, might cost $60,000. At the end of 10 years, the agreement can be renewed for another $60,000.

On top of that, are the monthly royalties to cover marketing and other administration costs and potential franchisees also must not forget about goodwill.

This is a significant factor when purchasing an established franchise and for a popular fast food outlet can be up to 3.5 times the net profit.

It goes without saying that greenfield sites are much more costly to establish because of the need to fit out the new premises with plant and equipment – and might involve an outlay including franchise fee of $250,000 to $300,000.

However, one of the factors new franchisees don’t realise is that, while established businesses are often more affordable up front, after five or six years the franchisor usually applies pressure to refit and upgrade the premises. Under these circumstances, most franchisees would ask for a top up of their agreement to ensure they can recover their investment.

While many franchisees head for the convenience of a major shopping centre, strip shops are often a better location.

If the franchise is in a large shopping centre, it may need to contend with the centre owners who might insist on using their own (usually more expensive) fitout experts for any required renovations. In a strip, the franchisee only needs to worry about the landlord and the franchisor.

One of the major considerations 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.

This is where personalities often come into play. So unless the franchisee is prepared to follow a system, it may not be a suitable business model. Another important factor is how to motivate young employees who do not see the business as a career path. They might be 16-year-old girls working in a bakery who are there simply to earn pocket money. Their career aspirations are not the same as that of the franchisee and their loyalty to the business will probably depend on how much they get paid.

Dealing with the human resources needs of 30 or 40 young employees in these circumstances can be a challenge - made more complex by those franchisees who plan to take on more than one franchise.

This is where franchisees need comprehensive HR skills and the awareness to keep young staff motivated. The more successful franchises regularly use on site reminder training videos to ensure the business runs according to plan.

Kieran Liston has 40+ years specialist knowledge in the area of valuing franchises and provides consulting services to existing and potential franchisees.

Chartered Accounting firm, Liston Landers strives to be recognised by both their clients and the business community as a market leader in the provision of ethical, innovative and solution oriented financial and accounting services.

Phone: 03 9509 0366