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The Pros and Cons of Investing in a Start-up Franchise

by Ed Teixeira

It can be enticing to invest in a new franchise; however, don't expect to be investing in the next KFC or McDonalds. Purchasing a start up franchise has its risks and disadvantages.

The Pros of Investing in a Start-Up Franchise

  • There should be a large selection of available territories and because it's a new franchise there may be an opportunity to obtain a first right of refusal for additional territory.
  • A new franchise concept can attract interest. Depending upon the industry and type of franchise, some new franchises start off very fast. This can be a plus for the first group of franchises.
  • Since start-up franchisors want to build a foundation of new franchisees they may be willing to concede some items that a larger franchisor would not.
  • The initial franchise fee and on-going royalties are often lower for a start-up, because it's a new franchise. If the fees are comparable to or higher than an established franchise in the same industry, than you may wish to look elsewhere.

  • In some cases a start-up franchisor may be willing to finance a portion of the initial franchise fee.
  • Most new franchisors take a more nurturing and supportive role with the first group of franchisees. A new franchisor wants to avoid franchisee failures as much as possible and is often willing to provide assistance above and beyond what is required.

The Cons of Investing in a Start-Up Franchise

  • Apart from the original business that spawned the new franchise there is no track record that can be evaluated. This makes it virtually impossible to measure any franchisor performance.
  • There are few or no franchisees to provide validation or feedback.
  • There is typically little brand recognition regarding the products and services offered by the start-up franchise.
  • Many new franchisors will have little or no experience operating a franchise system. If the franchisor doesn't recruit staff with franchise industry experience, it can dilute the effectiveness of the program.
  • Since it's a new franchise program the training programs are untested. It can take several training sessions of new franchisees and quality feedback to establish effective franchisee training.
  • Some start-up franchisors lack the capital needed to fund new growth and employ qualified staff. This can lead to a franchisor being overly dependent upon initial fees as a source of working capital, which can result in selling franchises to unqualified individuals.

A lack of franchise history can make validating the performance of a start-up franchise program very difficult. If you're considering purchasing a start-up franchise here are some tips to follow and be sure to engage the services of a qualified accountant and franchise attorney to assist in the evaluations.

Tips for Evaluating a Start-Up Franchise

  • Evaluate the performance of the business used to launch the franchise

Because a start-up franchise is new there is usually limited franchisee history that can be used to evaluate the quality of the franchise. This means that added focus must be placed upon the business that served as the model or launching pad for the new franchise. It's critical to obtain as much financial information as possible regarding that business. Use your accountant and franchise attorney to assist in your evaluation. Obtain a detailed evaluation of the business. Know what the sales and earnings have been. Offer to execute an NDA if the franchisor resists disclosing financial information. If the franchisor refuses to disclose information than walk away

  • Detailed scrutiny of the franchise program

How will the addition of a royalty and other fees on the franchisee income statement impact the projected bottom line? This is another reason to have financial information pertaining to the business. If the pre-tax income was 15% before any royalty fees then a franchisee could be looking at less than 10% in pre-tax income.

Tie in basic terms of the franchise agreement such as territory, royalty and fees to the operation of the original business. Will the franchisee operate in a much smaller territory than the original business? Add the royalty and other fees onto the income statement of the business as a way to determine how a franchisee income statement could look

  • Market analysis and competitive review

Does the franchisor have a detailed market analysis? There should be data that will demonstrate there is a market for the franchise products or services. If you and your advisors need to rely upon lots of talk and little substance, you could be headed for trouble. You'll also need some information regarding competition. Some competition can be a positive sign whereas no competitors could mean there is limited demand in the market.

  • Franchise capitalization

The franchisor is required to provide financial information in the Franchise Disclosure Document. Your accountant needs to review this information to confirm that the franchisor has sufficient capital to operate and grow the franchise. Too little capital can lead to aggressive franchise selling in order to obtain franchise fees. Some registration States require new franchisors to provide a guarantee and/or escrow of initial franchise fees so that the franchisees receive the agreed upon services. Limited capitalization could prevent the franchisor from providing services and support to new franchisees

  • Franchisor experience and staff

When a business owner starts a franchise program they go from running one business to two. In addition, the founder may have limited franchise experience. Since the majority of start-up franchisors will have limited staff it's important to conduct a thorough appraisal of franchisor staff. You and your advisors will need to gauge the business competency and capability of the founder. At the start-up phase of a new franchise quality of staff is more important than the number of staff.

  • Franchisee feedback

Unless you're the first franchisee there will be franchisees you can contact for feedback. If the franchisees are new with a limited track record, zero in on quality of franchisor training, support and responsiveness. Be sure to focus on financial performance. Is the franchisee on target or are they behind their financial projections?

According to noted New York attorney Michael Einbinder "Buying a franchise from a startup franchisor presents unique opportunities as well as risks. As one of the first franchisees you may have more leverage than in negotiating with a mature franchise system. The risk lies in the lack of experience and possibly undercapitalized state of a new franchisor. As with any investment, the key is your due diligence. "

2015 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow.com and Chief Operating Officer, FranchiseGrade.com. He is a former franchise executive and franchisee. He can be contacted at 631-246-5782 or at  franchiseknowhow@gmail.com



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