The primary issue to consider is that the current owner will be placing a value on the business above and beyond the cost of franchising.  So you will need to evaluate what you will have to pay the franchise to take over the business, and what you will pay the current owner to sell it to you. In short, you will be paying the current owner an amount that represents what he or she believes it is worth in addition to what you will pay the franchise system.  This means that you will almost certainly pay more for an existing franchise than if you started as a brand new franchisee.  In most cases, though not all, the franchise will want to have the opportunity to approve you as a franchisee, and obtain a franchise fee from you.  Certainly any ongoing franchise payments such as royalties, and advertising fees will also continue to be due.

In contrast if you purchase an existing non-franchised business, the value of the business will be entirely determined by what the current owner believes it is worth.  In most cases the owner will back up his or her beliefs by accounting reports, sales figures etc., but at the end of the negotiation it really just comes down to what you as the potential buyer is willing to pay.  It is often well worth the expense of bringing in a CPA to help you evaluate the purchase price.

When purchasing a franchise directly from the franchise system, the cost of the purchase will be detailed in the Franchise Disclosure Document and of course the final purchase contracts.  The cost will almost certainly include a franchise fee, and may include separate items such as training costs, travel for training, equipment purchases, the cost of leasing space if you operate a retail location, lease holder improvements if necessary, grand opening expenses etc.  While this list is long, just remember that it will still probably cost you less than purchasing an identical existing franchise, but you will be responsible for building up the business and creating cash flow for your operations.  In the best of circumstances, when you purchase an existing business you may have the benefit of immediate cash flow.

When evaluating a franchise opportunity consider involving an attorney who specializes in franchise contracts.   If you choose an experienced attorney it is likely that they will have already reviewed the franchise contract for another client, meaning that your costs should be reduced for the same service.  Similarly if you are evaluating an existing business opportunity, give serious thought to including a CPA in your negotiations.

In any case, don’t let you passion get ahead of your due diligence, and enjoy the process of becoming your own boss.

Most people are familiar with the upfront costs that are frequently associated with owning a franchise. There is usually a franchise fee, often a fee for training, the cost of equipment, leaseholder improvements (if you will be operating a franchise with a retail location), money for operating capital etc. However over the life of a franchise, it is possible that a franchisee will pay more in royalties than all of the startup cost combined. While this may seem daunting, in many ways it is actually represents some great things, namely that as a franchisee, if you have paid a lot of royalties, chances are you have also made lots of money.

While there are certainly exceptions to this rule, most companies charge royalties on gross earnings (the earnings your company make before reducing them by expenses). That means, the higher your gross earnings, the higher your royalty payments. Personally I like to see franchises with a well-documented, and modest royalty requirement. It acknowledges to all parties in the agreement that the franchise system will be there for the franchisee to provide long-term support, marketing assistance, and in many cases brand recognition. Having said that, I have seen some top franchises require zero royalties.

In the long run, as a potential franchisee you will need to carefully evaluate the Franchise Disclosure Document and all contracts to determine the costs and benefits of royalties and other related operating costs. For example, look at contracts to determine if future equipment or supply purchases must be made through the franchise. Mark-ups on these required purchases sometimes off-set royalty payments and still account for the fact that as your business grows you will pay more to the franchise system.

Royalties tend to range between two and ten percent, though there are franchises with satisfied franchisees that charge considerably more and great franchises that charge no royalties. Some systems charge a flat monthly rate that makes it easier to predict what long-term costs will be. It is impossible to judge whether a particular number is fair without an understanding of all other costs, and contractual obligations. You should be careful to spend time discussing royalties with existing franchisees when you do your validation process. Ask current owners if they feel they are getting value for the expenditure.

If you are the kind of person who enjoys working with a team and appreciates the fact that a franchise has a prescribed process in place for you to follow, then you will probably also appreciate the fact that paying royalties customarily brings you access to industry experts, and support personnel who will be there when you need them. On the other hand, if following someone else’s process is your idea of a bad day, then franchising probably isn’t a good choice for you, and you are likely to resent long-term royalty payments. Either way, look for a win-win situation and good luck in your endeavors.

Dr. Massingill is a Business Consultant and Certified Franchise Broker with Franchise Thinking. Dr. Massingill teaches Business Management, Computer Science, and Information Science and provides global contract services to mid-sized companies wishing to outsource their CIO (Chief Information Officer) function. Massingill has started, owned and sold several businesses, and as a serial entrepreneur attempts to help individuals identify top franchises.

The cash you are willing or able to put toward the purchase, how much you will need to pay yourself during the critical startup months, your ability to borrow, and potential partners are just a few of the ingredients that will go into the unique funding mixture of your franchise purchase.

Just because you have cash, for example, doesn’t mean that you should deplete it all on the purchase of a franchise.  Like it or not, very few franchises are instantly profitable, so many new franchisees need to specifically plan to have adequate operating capital in place so that they can pay themselves a salary for several months or even years.  This decision alone might cause you to borrow more and use less cash.  Dave Ramsey proponents are likely to want to wait to purchase a franchise until after they can pay 100% cash.  In short, how to finance your franchise opportunity has more to do with your personal needs than what franchise you are buying.

One option is to use funds in an existing 401k plan rather than borrowing money.  The nuances of this demand a much longer article than this, but here are the basics.  Money in an existing 401k plan can be transferred into a special type of 401k that will allow you to purchase stock in your own company.  This often requires that your company be organized as a C-Corporation rather than an LLC or other type of business entity.  Many companies such as Fran-Fund and Benetrends specialize in helping franchisees make this work.  Done correctly this approach can be managed with ease, but it should never be undertaken without the advice of experience professionals and your attorney. It can create some interesting and potentially beneficial financial options, but again should be considered carefully.  Some would consider using existing retirement dollars over debt as a conservative approach while others might consider it quiet risky.  Consult your business advisers if this is a decision you are considering.  One final note, using your funds this way will involve a rather significant one-time fee that often includes the establishment and registering of your corporation.  Despite this, it is often a great choice for careful investors, but it is worth noting that if the amount you are going to use is less then $30,000, you could consider just withdrawing your 401k funds, paying the IRS penalty, and possibly end up spending less to obtain the funding.  This decision, like any funding question that has tax consequences, should only be considered with the involvement of your CPA, your attorney, or both.

Many franchises can be operated with little or no real estate investment, but for those that require a retail space, part of your financing considerations will have to be related to leasing or purchasing real estate.  Purchased real estate can often be self-collateralized, meaning the property will secure the note against it.  Unless you are able to build the space from the ground up, and obtain a loan for the construction, you are likely to have to find a way to pay for or finance lease-holder improvements required by the franchise.

Similarly some franchises require significant equipment purchases while others do not.  If your chosen franchise requires equipment, you will need to find a way to finance the equipment.  Under many conditions lenders can provide equipment loans, or equipment leasing options to lenders who don’t qualify for standard business loans.

Some franchise systems have in-house financing available to qualified buyers others do not.  In-house financing is appealing in many cases, but often may include interest rates that are not as attractive as a buyer might obtain from other sources. Franchises that offer in-house financing are much more likely to spend time and energy evaluating your business expertise, motivation, sales skills, etc. as a means to pre-qualify you as a buyer.

The US Small Business Administration can assist new franchisees with loans.  This is a topic that warrants a complete article, however, here are some limited basics.  SBA loans often come from local banks, and other customary lenders, not actually from the SBA.  Instead they are backed by the SBA.  There are several types of SBA related loans available, but generally lenders want to loan over $150,000 rather than smaller amounts, and these loans will almost always require collateral similar to any other business loan.  In some cases the equity in your existing home might fill this need.  SBA loans often require increased documentation, but you might consider locating a Small Business Development Center in your area to help you evaluate your options and complete your paperwork.  In some cases your selected franchise will assist you with the writing of the necessary business plans and documentation required for SBA loans.

When starting a new business there is always the option of seeking investment capital.  In other words, you can sell a percentage of your new company to investors in exchange for the money to get started.  While this is a fairly common approach to funding a new business, it is less common among new franchisees. This may be due to the fact that many new franchisees leave jobs and become franchise owners as a means to have more control over their own destiny, and perceive even minority investors as a potential threat to that goal.  Similarly, using investment capital requires careful planning, the involvement of attorneys, and an understanding of C-corporations, LLCs and similar complex business structures. Venture capital substantially complicates a business arrangement, and new franchisees often choose to buy a franchise over starting from scratch as a way to reduce complexity.

As a franchise consultant, I always encourage potential franchisees to ask their selected franchise to help them consider funding options.  Top franchises will almost always be willing to provide you information on financial options.  Similarly, I advice clients to seek the advice of their CPA and attorney.

Excellent franchises want to know that their prospective franchisees are financially equipped, not just to pay the franchise fee, but equipped to be successful in the long term.  Franchises generally want to know three key financial indicators about you:  1) Franchisors want to know that you have an adequate amount of cash to pay the franchise fee, and up-front costs.  2) Franchisors want to know that you have adequate credit to obtain funds for the total investment. 3) Franchisors want to know your net worth.

For example a franchise might charge a $25,000 franchise fee, estimate an initial investment of $75,000, estimate a total investment of $110,000 and require a net worth of $250,000.  Many times the franchise will include the cost of necessary equipment, real estate, and other key items in the total investment calculation.

It is important to determine if the franchise has included money for operating capital in the estimate of the total investment.  Some include it, but many don’t.  Operating capital can include many things, but one of the most important to consider is a salary for yourself.  If you need a draw, or salary to sustain yourself while the business becomes profitable, be sure you include this in estimates of your total initial investment.

As you can see, determining the amount of startup money needed to open a franchise is tricky, so ask lots of questions during the due-diligence process, and if you feel overwhelmed, bring in a CPA to help you evaluate the opportunity, or visit one of the small business development centers available in many communities.  Franchise Consultants can also often provide you with materials to help you know what questions to ask. While there are countless books on writing a business plan, the U.S. Small Business Administration offers a Business Plan Template that provides a great starting place.

In general consider the following:

The franchise fee is usually required to be paid in advance and will often be the bulk portion of the cash portion of the investment, unless there is a retail location involved.

If a retail location is involved, a lease will have to be negotiated and often rent for both the first and last month must be paid prior to move in.  A significant percentage of start up costs can be associated with lease improvements, so be aware of what improvements the franchise requires.  If you end up purchasing rather than leasing your space, the start-up costs are often 20% to 30% of the total purchase price assuming you are able to obtain appropriate financing.

Equipment can also represent a huge part of the cost for certain franchises, but equipment can often be financed or leased even for franchisees with limited credit.  Vehicles, if required, also fall into this category.

In most cases, training is included as a part of the franchise fee, but often the expense of getting to the company’s headquarters, and lodging during training are an additional expense.  Even before you make a commitment, franchises will often invite you to a discovery day to meet with key executives, other franchise owners, etc. In most cases, you will be expected to pay for your own travel and lodging for these events.

It is impossible to gauge startup costs for a franchise without detailed conversations with the franchisor.  If the franchise executives you are speaking with aren’t asking you questions about how you intend to deal with startup costs, you may want to consider looking into an alternative franchise. An exceptional franchise will want to evaluate your financial resources and help determine if you have adequate startup capital.

Successful advice-givers aren’t just arrogantly saying they stayed the course while others gave up, rather they are saying if you are in business, you will probably eventually struggle to make payroll, you will lose key clients, you will be sued, you will face political struggles and in worst cases even extortion. Being a small business owner is often overwhelming, and statistics show that many many would-be entrepreneurs just aren’t willing to suffer the stress of staying in business.

“Yeowwwww” you are saying.  ”This guy is cynical.”  Perhaps – but if my assessment of the status quo is cynical, my outlook is not.  If you are thinking about running your own business, you are already among those who assume that roadblocks, and struggle can create opportunity.  So after my cynical tirade, I offer you this encouraging pep-talk:

Believe in yourself.  Don’t doubt yourself, and don’t listen to those that do.

Expect adversity.  Be ready for it, and be acutely aware of the strengths within you to deal with it.

Don’t let mistakes and tactical errors demoralize you, focus on getting your strategy in order.

. . . and because this is a blog on a franchise oriented website – Follow proven systems where possible until you have the resources and maturity to experiment with improvements.  One great way to avoid the mistakes, and improve your strategy is with a top franchise.

Take your time in choosing a franchise that suits your ethics, learning styles, interests and goals.  It can be a life-changing experience.

Our goal at Franchise Thinking is to help you do just that.  There is no cost to potential franchisees for our services.  Let us help.

We would love to tell you that the system we use to help our clients focus their search is complex, but the truth is, it is very simple assuming you already have a database of the best franchises. For example, you believe you would like to work from home. That simple decision will more or less reduce your search by half. Perhaps you also want to avoid telephone sales, once again the number of options is reduced. In this case, fewer choices is not a problem, it is a great blessing, because it allows you to focus on the things that really matter.

Any one of the questions we at Franchise Thinking ask you is simple enough to answer and research on your own, but the real magic happens when we combine all of your dimensions into a single search. Let us show you how it works. There is no obligation, and no cost to you. If you are still not convinced, give us a call and let us put you in touch with some of our recent clients.

Its called Franchise Thinking. It is what we do, and it is what can make your search for your future, much more focused. Click the TAKE THE FIRST STEP button to the left, or call us at 325 267-9111.