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Franchise Start-Up Considerations

Franchising is a method of retail business in which the investor/franchisee makes an investment in the form of a franchise fee in exchange for the right to promote goods, services, and/or processes directly to the public. A franchise usually has a recognizable name or trademark. Franchising involves the integration of independent companies at different levels and in different areas of production and distribution. This integration permits more effective sales and advertising.

Franchises exist in at least three different forms:

1. The manufacturer-sponsored retailer system
An example of this arrangement is the car industry, where car manufacturers license dealers to sell its product. The dealers are independent businessmen who agree to meet certain standards and conditions of sales and service.

2. The manufacturer-sponsored wholesaler system
An example of this arrangement is the soft-drink industry, where soft-drink manufacturers license wholesale bottlers in various markets who buy the concentrate and then carbonate, bottle and sell the product to retailers in local markets.

3. The service-firm sponsored retailer system
Familiar franchises include auto rental, fast food, and motel businesses. Here, a service firm organizes a complete system for bringing its service effectively to consumers.
Pyramid schemes vs. Franchises
Legitimate franchises exist in all sorts of industries. There are also illegitimate, and illegal, businesses calling themselves franchises that are actually pyramid schemes. These schemes are not focused on selling products, but rather on getting other people to pay to join the scheme. This provides the organizers of the scheme with a lot of money, but usually does little or nothing for the investors. Be sure to investigate any franchise opportunity to make sure that it is not a fraudulent pyramid scheme.

Choosing a Franchise

Purchasing a franchise can be a good way to become an entrepreneur, and enter the world of business ownership. Potential investors should be cautious – like any other investment, there is no guarantee of success. While buying a franchise may reduce the risk of investment by enabling the investor to associate with an established company, it may be costly. Franchise owners may not control many aspects of their business, and be contractually obligated to the franchiser in a variety of ways.

A franchise typically enables the investor or “franchisee” to operate a business. By paying the franchise fee, which may cost thousands of dollars, the franchise may operate the business under the format developed by the company, or franchisor, the right to use the franchisor’s name, and sometimes, assistance in setting up or marketing.

Prior to entering a franchise arrangement, the potential “franchisee” (or investor) should consider the following:

  • Franchisers frequently hire independent contractors on commission to close a franchise deal. Remember that his/her claims for success in the franchise and his/her extolling of the advantages of and potential for the franchise merge into the signed contract. Check the contract for a provision whereby the franchisee waives liability for any representations not appearing in the written contract.
  • Additional costs may overwhelm a new business if they are unexpected. The costs for setting up a franchise may include: royalty payments and advertising fees to the franchiser, the initial outlays for rent or real estate, equipment, licenses, insurance, initial inventory, and employees. Remember that all of these expenses may have to meet exact specifications set by the franchiser, and may have to be purchased from vendors the franchiser designates.
  • Potential franchisees should remember that even though the franchisee owns the business, they are not completely independent. The franchiser may control the choice of site, design of the location, advertising, methods of operation, the goods for sale and their prices, and the sales area. The areas that the franchiser will control must be clearly stated in the prospectus given to potential franchisees.
  • Be realistic in choosing a franchise. Take into account not just how much money will be invested initially, but how much money you can afford to lose and how much income you must have. Also, realistically assess your abilities in sales and business administration.
  • Potential franchisees should carefully investigate franchise offerings, and take time to think about any offer that is made. Don’t let high pressure sales tactics sway you. Investors should be fully aware of all costs and restrictions before committing to a franchise agreement, which can last 20 years. The Federal Trade Commission (FTC) and many states have instituted disclosure rules to help protect potential investors.

The Federal Trade Commission Franchise Rule

The Federal Trade Commission (FTC) Franchise Rule requires franchises, vending machine and display rack business opportunity ventures to disclose material facts in a prospectus, and further prohibits material misrepresentations in the offering and sale of franchises. The following types of businesses are covered by the FTC rule:

A. The franchisee sells goods or services that meet the franchiser quality standards or bear its mark; the franchiser exercises significant control over or extends significant help to the franchisee; and the franchisee is obligated to pay $500 or more to the franchiser within the first six months of commencing business; or

B. The franchisee sells goods supplied by the franchiser; the franchiser secures vending machine or rack display locations for the franchisee; and the franchisee is obligated to pay $500 or more within six months of beginning to do business; or

C. While the business opportunity does not actually fall within the above definitions, it is represented as falling within one of the above.

The following information must be furnished to prospective franchisees at least ten (10) days before signing the contract:

  • identifying information and financial information about the franchiser, and a description of the franchise; business experience, litigation and bankruptcy history of the franchiser and the franchiser’s directors and key executives; money required to be paid by the franchisee to obtain or commence the franchise operation;
  • continuing expenses to the franchisee in operating the franchise business that are payable in whole or in part to franchiser;
  • a list of people with whom the franchisee is required or advised to do business, and the services or real estate that must be purchased, leased, or rented;
  • description of fees that must be paid (e.g., royalties, commission, etc.) by third parties to the franchiser or any of its affiliates as a result of a franchisee’s purchase from such third parties;
  • description of any assistance available from the franchiser, such as financing, training programs and advertising;
  • restrictions placed on a franchisee’s conduct of its business;
  • required personal participation by the franchisee;
  • termination, cancellation and renewal of the franchises;
  • statistical information about the number of franchises and their rate of terminations;
  • franchiser’s right to select or approve a site for franchise;

Further, a franchiser (or a franchise broker) who makes an earnings claim through advertising or a direct sales pitch, must provide the prospective franchisee with a document which includes the following information:

  • a statement describing the material bases and assumptions for each earnings representation made, including the number and percentage of outlets achieving the same results as those claimed;
  • cautionary language – whose text is set forth in the rule – concerning the projectability of the representation to the prospective franchisee’s future experience;
  • a notice that evidence to substantiate the representation is available for inspection upon reasonable demand; and
  • a cover page which sets forth the name of the franchiser, the date of the document, and a statement – in the rule’s terminology – advising the prospective franchisee of the importance of the document.

While the franchiser is not required to provide the substantiation for such claims, he/she must have back-up material for each claim available to prospective buyers or the FTC upon reasonable demand. The rule also requires the franchiser to provide a copy of the franchise agreement to the prospective buyer at least ten days before the agreement is to be executed.

For more information, see the FTC consumer resources site

Last Modified: December 5th, 2009