From the October 2006 issue of Wealth Manager Web • Subscribe!

October 1, 2006

Open for Business

A tested business method, an established name, the opportunity to be your own boss, and a low failure rate. No wonder many clients are attracted to the lure of a franchise.

Those who invest in one can usually expect advice from experienced colleagues as well as assistance with marketing, training, insurance and financing. Owners can often also count on an established base of consumers who already know and like the franchise. And according to the Small Business Administration, less than 5 percent of all franchise units fail annually. Compare that with the 30 to35 percent of small businesses that typically close within the first year. For those with the right financial and psychological profile, a franchise can be a great opportunity.

The model is pretty simple--a balance between being your own boss and being an employee: The franchisee generally pays an upfront fee to purchase the right to establish the franchise in an agreed-upon territory and then pays ongoing royalties based on a percentage of gross sales per location.

"Many are attracted to franchising because they like the idea of being their own boss while having a corporate partner," says Chris Perry, CFP and Managing Director of Fleming, Perry & Cox, a financial advisory firm in Stamford, Conn. In fact, it's been said that the key advantage to a franchise is that you are "in business for yourself but not by yourself." A franchisee often becomes a member of a network of like-minded business people sharing a brand and operating in almost exactly the same way. According to the International Franchise Association (www.franchise.org), there are more than 760,000 franchises operating in the U.S. They employ over 10 million and annually kick more than $1.5 trillion into the economy.

And they are proliferating. "More industries are choosing franchising as a method of business expansion," says IFA president Matthew Shay. From 2003 to 2005, the number of concepts grew 67 percent in 17 of 18 industry categories. While retail food--with nearly 500 concepts--leads the way, franchises like American Deck Construction, Wellington Pet Care and Sarah Care Adult Day Care have joined the family.

Today there's a franchise model for nearly every kind of business including Clutterbusters!!, which offers hands-on professional organizing services, and Molly Maid, which provides residential cleaning help. More sophisticated franchises such as the self-explanatory Instant Tax Service and BrightStar Healthcare, which furnishes personnel for the healthcare marketplace, are growing in popularity. Jani-King, founded in 1969, is the world's largest commercial cleaning franchisor with more than 11,000 franchise owners worldwide. Even the "Soup Nazi"--made famous by TV's "Seinfeld" and renamed "Soup Man"--has joined the party, offering his previously secret recipes and other methods for success to those willing to pony up from $79,500 to $198,500. In 2005, 180 Soup Man franchises were sold according to company figures. But not all franchises lead to a pot of gold. What about Krispy Kreme and Kenny Roger's Roasters--both of which fizzled in their own oil after scandals rocked the very foundations upon which franchisees were banking? As always, investors need to be careful.

Grab a Bucket and Mop

According to Perry, many potential franchisees--including active retirees--have already had successful corporate experiences and look to franchising as a "second career." Among other things, they're attracted to the prospective cash flow, often reasonable entry costs and training. The IFA notes that while investments vary, potential franchisees should plan on spending anywhere from $20,000 to $100,000 to meet "investment parameters" of most franchise companies. But no matter how much risk franchisees and franchisors try to iron out of the equation, pitfalls remain.

"Problems like staffing, background testing of employees, theft, the rising costs of benefits and escalating real estate values can be problematic for even the most qualified franchisees," notes Perry. "Some potential franchisees are dazzled by the perceived glitz. Not everyone can do it."

"No investment is immune to the 'R' word," says Ruben Ruiz, an advisor in San Antonio, Texas. "Risk is about education and knowledge of all types of risk associated with any investment. It's simply a matter of what type of risk, such as business risk. Will it produce a profit and succeed?" This is exactly what advisors must uncover for risk-averse clients.

"Many who start franchises forget what it's like to go back to the point of incompetence, to where they started their career. They forgot how to learn," says Joe Mathews, author of Street Smart Franchising (Entrepreneur Press, 2006). Mathews, who's worked with Subway, Blimpie, Motophoto and Entrepreneur Source, founded consulting firm Franchise Performance Group in 2002. "Many franchisees are so results-oriented they focus more on the bottom line than on what it takes to win. The first year should be about learning and implementing the winning formula. Cash flow will come," he says.

A cash-flow guarantee is hard to come by, but many hint at it. In its print advertising, Golden Corral Buffet & Grill bills itself as a "10,000 Square Foot Cash Register" with $1.38 billion in system-wide sales in 2005. It seeks franchisees with a $2.5 million net worth and $500,000 liquidity. Aaron's Sales & Lease says its owners enjoy average annual pre-tax earnings of $166,629. It later notes that this is an estimate, and if one relies on such figures, "You must accept the risk of not doing as well." Talk about your disclaimers! Petland boasts average annual sales of $1,660,222 with a minimum cash investment of $115,000 and financing available for "qualified candidates."

Consider Subway, for example. Its "Eat Fresh" campaign capitalizes on the trend to eat better and healthier-- a far cry from the deep-fried concept that propelled KFC and other predecessors. Customers love the idea that bread is baked daily at each location, and the sandwiches are comparatively low in fat. No wonder there are some 26,000 Subway restaurants in 85 countries. The Subway chain has also held Entrepreneur magazine's Franchise 500 (www.entrepreneur.com/franchise500) number-one designation since 2001. With an estimated $72,000 in start-up costs--compared with $655,000 for a Dairy Queen or $179,000 for a Dunkin' Donuts--its business plan is as lean as its recipes.

In general, there are key signs to look for in choosing a franchise opportunity: How long has the company been franchising? Any track record less than five years may be suspect, according to Mathews. Every franchisor should be dealing from a position of financial and managerial strength. Before signing any agreement, try to determine what the company's main source of growth capital is. Can it sustain itself with its own sales, or does it need money from outside investors to keep growing? This could be a warning that unit sales are not rising or the concept has some weak points. What is its expansion experience? If the company looks like it might be trying a "new concept" with your client's capital, it may be a good time to look elsewhere. Examine the company's cash flow and debt-to-equity ratio. What's its legal history? How profitable is the average unit? What are typical first-year gross sales? What's the employee turnover rate? How is insurance provided?

"Some franchisors provide insurance; others tell you how much coverage you'll need and leave it up to the franchisee," says David Mannato, an independent insurance agent near Albany, N.Y., who works with clients in the franchise business. It took one of Mannato's clients a full year to open a fast food outlet. "He had to have income during this phase while trying to set up the franchise." Insurers will usually want to visit the location before issuing coverage says Mannato.

Examine the royalty fees. These generally range from 5 percent to 10 percent of gross revenue and are the main revenue sources for the best franchise companies. The upfront or entry fees generally cover only the costs of locating and training qualified franchisees.

Also look at attitude. A true franchise company acts like a partner with the franchisee and does not view him as a short-term cash fix. Perry notes that clients he's helped ease into a franchise have usually been well-educated individuals who've had successful corporate careers and are looking for a new challenge, but don't want to go it totally alone. But even when backed by a thoroughly tested system, any franchise is far from a guaranteed winner.

"If you don't take care of your business, you'll lose it," says Ekrem Bardha, a Detroit area McDonald's franchisee since 1974. McDonald's is a "tough but very fair partner," says Bardha. "There are times I was confused, but there are reasons for the way they do things. They want you to succeed."

Indeed, franchises are very rigid business models, and meeting capital requirements may actually be the easiest step. "A franchise follows a system; this can be like having another boss," says Ralph Loberger, vice president of franchise development for Online Trading Academy, an educational franchise that teaches securities trading. Loberger, who spent more than 20 years in franchise development for Mobil Oil and Midas Mufflers, says an entrepreneur and a franchisee are not the same and cannot be advised as if they were.

Once negotiations get serious, the franchisor will provide a Uniform Franchise Offering Circular (UFOC) spelling out the legal and business relationship. This serves as an X-ray of the franchisor--its history and key personnel as well as agreement basics including fees, financing, trademarks/patents, quotas, earnings/financials, territories, legalities, record keeping/reporting, estate issues, dispute resolution, termination rights and just about every other rule you'll need to follow.

No matter how much your client may love making tacos from a secret recipe, this is where the love affair ends and reality begins. It can be worse than a pre-nuptial agreement. Consider, too, that estate issues can get costly and complicated when several units are involved. Most franchisors will give heirs a limited time in which to decide if they'd like to continue the business in the event of the franchisee's death.

It is critical to obtain a list of names and addresses of franchisees who've sold or lost their franchise over the last three years. "It's normal for a mature franchisor to have about 15 percent of outlets for sale," notes Mathews. Questions to ask already established franchisees are: How long have you been in business with this company? How are they treating you? Do they honor their agreement? What were you doing before this? Are you happy? Obviously a high failure rate is a key warning sign.

Personality, the Biggest Risk

But helping clients decide if a franchise will work for them takes more than the tested formulas and meeting capital and experience requirements. Advisors should focus part of their efforts on what they know about the candidate's personality and lifestyle. Running a franchise is not easy, and believing otherwise is one of the industry's greatest misconceptions. A "patented system" does not mean all problems are solved.

Can your client regularly put in 12-hour days? Will the family be supportive? Is the client able to get along well with others, including customers, employees and the franchisor? Franchisors insist that their stringent standards--from the choice of a computer system to the length of employees' hair--are religiously followed. Will your client adapt to the rules, or is he or she too much of a free spirit? Will having to order from pre-approved suppliers or wear a uniform every day prove aggravating? Contracts can be exceedingly complex, and so-called franchise brokers may not be entirely independent. Is one's territory truly protected? What legal protection does the franchisee--who's usually taking the greater financial risk-- receive?

"The people most likely to invest in a franchise--higher risk takers-- are usually the type that's most resistant to following processes and systems others create," says Mathews. "Those most likely to buy a franchise are also by profile least likely to follow the system they just purchased. People most likely to follow the system are also usually the most risk averse."

"Having to follow a system can drive an entrepreneur crazy. Personality tests are hit or miss, but can help," says Loberger, who generally recommends that true entrepreneurs avoid franchises. The courtship can vary widely. Some potential franchisees come on board in six or seven weeks while others can take 11 months. "It's critical to find the right person," Loberger says. "This is the risk the franchisor takes."

The higher the franchise's success rate, the easier it is to bring on more franchisees, which is why it is the franchisor that controls the relationship and must carefully cultivate it if it is to blossom. Discovering after the papers have been signed that the system does not fit the franchisee's personality can be disastrous. "We've gotten a few people out at the right time," says Perry, who generally advises that about 20 percent of investable assets be directed into a franchise. "Investing too much of the nest egg can create a financial hardship."

"Find the right franchise," advises Bardha. "Be sure they have a history of success, and that you'll work hard and keep a positive attitude. A process for success alone is not a process to print money. Many franchisees have gone bankrupt. A franchisee must be willing to do what he's supposed to do."

What about the Money?

Franchisees are sometimes surprised at the breadth of questions they are asked when applying for funding, according to Dave Russell, executive vice president of GE Capital Solutions, Franchise Finance. "Lenders ask a lot of questions about every aspect of your business, your past and personal financial affairs," counsels Russell. "It's always better to be upfront even if you've had issues that negatively affect your ability to qualify for a loan. Lenders understand past mistakes, but take issue with concealment, particularly if something is discovered after the application has been submitted and the process begun."

"Capital has to come from savings or a loan," says Ruiz. "It's up to the client which way they want to go. They need a business and marketing plan if they are serious about making a profit or a living in a franchise business."

From the lender's viewpoint, financial strength and a prospective client's credit history as well as industry experience are the most important requirements. Other key factors are brand strength and site location.

"Be prepared to provide operations and financial data to support the performance of the business--it's your chance to show off the operation and all you've achieved to get the best financing terms," says Russell. "If you're new to the industry, most lenders want you to have an experienced operating manager with incentives to stay and help you run the business." Brand strength and the financial health of the system play a large role in determining credit terms and availability of capital. Unit level performance and location are the key items for determining how much debt can be supported.

The lender should have thorough industry knowledge, as well as an understanding of the franchisee's operations and brands. "Franchisees want a lender with an established track record of long-term industry lending," says Russell. A healthy long-term relationship with a dedicated lender can provide access to capital for new construction/renovations, equipment and future acquisitions. An advisor can help by reviewing lending documentation, making introductions, and being certain that any agreement is fair to both parties before going forward.

And Then There Are Taxes

"Essentially, franchisees are not taxed any differently than a standard business in the same industry," says Aaron Chaitovsky, CPA and partner in charge of the franchise division at Citrin Cooperman & Company in New York City.

"Franchisees are usually salaried employees with an entrepreneurial bent. When they become franchisees, they essentially become owners of a turnkey operation which is very different psychologically and in terms of their tax status," says Chaitovsky.

Franchisees should meet with advisors to understand what the best corporate structure would be. They must register for, collect and pay payroll and sales taxes; understand minimum wage laws; verify working papers; schedule work hours; understand employee versus independent contractor situations and navigate many other issues.

When acquiring a franchise, the taxpayer acquires a number of different assets. "She cannot simply deduct the costs as she pays them," counsels attorney Dean L. Surkin of the tax department at Rosen Seymour Shapss Martin & Company LLP in New York. Payments to acquire the franchise agreement must be amortized over 15 years, while furniture and fixtures are generally depreciated over seven years.

Cash flow is one of the most difficult aspects facing franchisees. "A typical franchisee will pay upfront, startup and organization costs, yet in almost all cases the IRS requires these be amortized over a 15-year period," says Chaitovsky. Similarly, co-op advertising funds may also have limited deductibility based on how much is spent on the franchisee's behalf in any given year. "As an accountant," says Chaitovsky, "if you don't understand the franchisee's industry, it's better to refer their business elsewhere."

Does a franchise offer all the answers to a client seeking a new business opportunity? Possibly. An advisor ready to probe the issues can help make sure the final decision is the right one.

Joseph Finora Jr. last wrote in the June 2006 issue about managing clients with exotic collections.

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