Future Action

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learning objectives After studying this chapter, you will be able to:

LO14- 1

Describe the elements of franchising.

LO14- 2

Explain the process of buying a franchise.

LO14- 3

Discuss the process for buying an existing business.

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Franchising and Purchasing an Existing Business

LA MADELEINÉ AND PATRICK LEON ESQUERRÉ

In 1965, Patrick Leon Esquerré earned his MBA from a leading business school in France and went to work for an international accounting and consulting firm. Over the years, although not trained as a chef, he had an increasing number of opportunities to work with people in the food industry, including those who planned the food-related stages of the pope’s visit to Paris. In the early 1980s he met an American who wanted to bring a variety of American-themed concepts, such as a rodeo and a honky-tonk made to look like the famous Billy Bob’s, to Europe. Ultimately, however, the pair decided instead to bring French food to the United States. Unfortunately for Patrick his American partner went bankrupt before he could fully start the business. The result was Patrick had to back the venture with his own money: $100,000.

Ultimately Patrick was able to find other investors to join him. Key among them was Stanley Marcus, who had founded the chain of Neiman Marcus department stores. Marcus became both an advisor to and key supporter of Patrick. This relationship opened many doors for the business. For example, when Patrick tried to establish their first location near Southern Methodist University in Dallas, the real estate agent wanted $21 a square foot in rent with a three-year minimum lease, first year’s rent in advance, and would offer no improvements to the property. After a call from Stanley Marcus, the rent became $14 a square foot with a nine-year lease, one month’s rent in advance, and $50,000 from the landlord for improvements. The first café opened in 1983.

Today, 30 years later, La Madeleiné includes franchises in its operations and has over 60 restaurants. Patrick is no longer the sole owner, instead capturing much of his sweat equity by selling the chain to Group Le Duff; however, Patrick is still involved in the business as an advisor.

Questions 1. What do you believe would be involved in creating a franchise operation for your business? 2. How long do you believe that Patrick should have run his business before he was ready to start franchising? Why? 3. We have discussed establishing legitimacy of a new business as critical. Do you believe that is the role Mr. Marcus

played in this firm? Do you have similar individuals that could help establish the legitimacy of your business?

Sources: E. Elan, Restaurant News 39, no. 5 (January 1, 2005), pp. 116–18; D. Eng, “Even Texans Can Love Quiche,” Fortune 158, no. 4 (2013), pp. 27–30; La Madeleiné web page http://lamadeleine.com/history/

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Cheryl Williams A good friend of Betty and Joan’s, the founders of Friends’ Home Health Care, was Cheryl Williams. She observed the hard work and risk that the two founders of Friends’ Home Health had taken on. Even though she was impressed with her friends, she decided to take a different path. In thinking through what she would do, she knew her inclination for risk taking was less than that of the Friends’ Home Health founders. In addition, she did not have the same sets of skills that were readily applicable to a business in home health care. She also knew that organization was not one of her strong assets. In fact, she really needed to gain some discipline for her own success.

The resulting path seemed to take advantage of Cheryl’s strengths and yet compensate for her shortcomings. Specifically, she decided to find a franchise to purchase. The opportunity for success is much higher with a franchise than it is with an untested start-up, if for no other reason than that the business model has been tested and refined prior to a new acquisition of the franchise. In addition, there is some level of support (although it can vary considerably) from the business that sells the franchise. Thus, franchising seemed to offer a calculated risk she could tolerate. She also knew that franchises typically came with operational systems already in place. These preexisting operational systems would help Cheryl to overcome her shortcomings in organization.

However, the realization that a franchise might offer the best opportunity for her was just the first step in her business start-up process. Which franchise should Cheryl choose? An initial investigation found that there were thousands of franchisors, with wide variations in the availability, price, resource requirements, level of support, and success rate of those various franchises. Cheryl knew that she wanted to be in a service industry with lots of customer contact, and while her experience in sales was deep, it was not very broad (she had been with the same company since she graduated high school 10 years earlier).

She therefore began looking for holes in the services provided by businesses in the city in which she lived. Two specific opportunities came to light. The first was in fast food; specifically, there was no sandwich shop in her part of town. Although there were hamburger joints, pizzerias, sit-down establishments, and ethnic restaurants, there were no sandwich shops. The second opportunity seemed to be with companies that provided extra storage for people. Cheryl lived in a fast-growing section of town where people were constantly moving but did not always have a place to store their goods. Cheryl felt that there were strong opportunities for both types of franchises and therefore began to investigate each in more depth.

Cheryl next looked into the specific firms in these two industries that offered franchising in her area. For the storage industry, the first was a storage facility with a fixed location close by where people lived, while the second was a box arrangement in which people filled a large container at their home that was then shipped and stored in locations that were more remote. Each type of franchise was relatively expensive. Even without buying the land where things were stored, the costs could easily run over a $1 million dollars. The franchisors seemed to provide start-up support and strong management, which was attractive. However, this was far more than she could afford even if she mortgaged all of her personal assets. Therefore, she ruled this idea out and began to focus on the possibility of a sandwich shop.

In her initial screening, she found that the cost of a variety of franchised sandwich shops was dramatically less. The cost could be as low as $50,000 and rarely would exceed $250,000. In each of the franchises she investigated, she would not have to own the building but could lease her space, which would significantly lower her costs. However, the range of services offered by the franchisor to the franchisee also varied greatly. She began a more detailed examination of the franchises available. Ultimately, she narrowed it down to three franchises. Each of these had an initial cost of approximately $150,000, had very strong operational plans, and had well-developed support services. For example, each of these franchises helped the franchisee locate the store in the best location available and had managers on staff that worked on-site during the pre-start-up and start-up phases of the business. Furthermore, although it would be a stretch financially, she and her husband believed they could put together sufficient funds to begin this type of operation.

After initial conversations with each of the three potential franchisors, Cheryl contacted several franchisees from each of the franchisors. She chose the franchisees by looking in phone books in different cities. The sample she selected may not have been ideal since it was not a random selection, but it avoided using the franchisors’ lists, which she figured might provide one-sided information.

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Interestingly, even within her limited sample, Cheryl found that franchisees for two of the companies had significant complaints about support and value for their dollar. Only one franchisor had no franchisees that were unhappy. Looking at the success statistics (profit levels, sales growth, number of franchisees that go out of business, and increasing sales price of franchisees wishing to sell), Cheryl found that this one franchisor ranked the highest in the industry. This franchisor offered a relatively unique concept for a sandwich operation, utilizing a wrap that was somewhat like a tortilla. Further, the franchisor used a seven-mile radius as its competitive density, meaning that no other franchisee of that particular brand would be allowed to open a shop within seven miles of Cheryl’s. Thus, the strategy of the firm, its product, and its operations all seemed to be a good fit with Cheryl’s skills and needs, and with the opportunity that Cheryl saw in the area. She proceeded to start negotiations to buy a franchise from this franchisor.

QUESTIONS 1. What are the questions and concerns Cheryl Williams should have focused on as she began her investigation of

franchises? 2. Franchisors do not sell a franchise to anyone that wants one. What could Cheryl do to become an attractive candidate as a

franchisee for the franchisor?

This book has focused principally on the process of starting a new entrepreneurial business from scratch. Two other common options exist for individuals interested in starting their own businesses. The first is purchasing a franchise. The other is purchasing an existing business. Both of these activities have opportunities and drawbacks in comparison to starting a new business and we will examine these, beginning with the opportunities and drawbacks with franchising.

LO14-1 Describe the elements of franchising.

The Elements of Franchising The purchase of a well-honed, thoughtfully positioned franchise can dramatically decrease the downside risk inherent in the process of starting a business. Franchising can be viewed as the new business entrepreneur’s creation of a business from a well- established formula. Thus, the franchise is essentially a prepackaged business, where there are policies, procedures, and buying patterns in place prior to beginning operations.

The franchisor is the firm that originates the idea for the business and develops the operational methods. The entrepreneur is the franchisee. The franchisee pays a fee to obtain a franchise from the franchisor. This fee entitles the franchisee the right to open a branch of the business in a given area, use the franchisor’s name, and operate a business within the guidelines of the agreement. The franchisee also receives operational advice on how to run the business and typically some level of marketing support to promote the firm. Responsibility for the business location, establishment of the business, and build-out is the franchisee’s, and must usually be fulfilled in accordance with the specifications of the franchisor.

The franchisor, in turn, establishes minimum standards regarding the operation of the business. For example, the franchise agreement is the basic contract generated by the franchisor for all franchisees and it usually contains clauses requiring the purchase of supplies, the displaying of marketing material, and the payment of fees that are based upon the sales of the branch operation. The requirements, however, may be more extensive. For example, McDonald’s requires that its franchisees

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clean not only their own property but also the territory that borders their franchise unit.

franchisor

The firm that originates the idea for the business and develops the operational methods, then sells them to franchisees.

franchisee

The entrepreneur who buys the franchise from the franchisor.

franchise agreement

The basic contract generated by the franchisor for all franchisees; it usually contains clauses requiring the purchase of supplies, the displaying of marketing material, and the payment of fees that are based upon the sales of the branch operation.

The International Franchise Association reports that in 2007 (the latest data available at the time of publication) that franchises made up almost 900,000 establishments in the United States, providing almost 18 million jobs.1 The range of franchises you use every day would likely surprise you. For example, most hotels, most restaurants, and many daily service providers are locally owned franchise operations.

In part, the reason franchising is so widespread is that the franchisor can offer a standard, well-known product, that is produced by a consistent, well-tested process. The group purchasing power for supplies, supported with specific regional and perhaps more generic brand-building national advertising, furthers the success of the franchise. The franchisor will also continue research and development on the products and processes that a small single business simply could not afford to pursue. This all occurs with the entrepreneur spending less of her resources than if she had had to found such a firm by herself. The franchisor benefits by enabling a rapid expansion while minimizing the funds invested in that expansion.2

The success of franchising is dependent on the hard work of the franchisee and the value added by the franchisor.3 You will recall that we discussed agency theory in Chapter 2. There are factors that mitigate alignment of goals between a manager and an owner. In a franchise operation, businesspeople work for themselves, not for some large corporation and, as a result, all the decisions that the entrepreneur makes are to maximize the value of their own business. The success of franchising is also a result of the fact that the franchisee will act in ways to maximize the profit of the business where a corporate employee might not do so, a prediction consistent with agency theory.4

Going into business with a Sonic franchise, for instance, allows you the freedom of ownership while also providing built-in support. How might ownership differ for franchisees versus traditional business owners?

The franchisor makes money in a variety of ways, including these: (1) selling the franchise to the franchisee; (2) selling supplies to the franchisee; (3) collecting a percentage of sales; and (4) in some cases, providing company-specific training courses/materials. For example, a very successful franchisor such as Sonic, which sells hamburgers and related items using a drive-in format in more than 40 states, charges a fee to obtain a franchise, but the significant income comes from royalties and being able to sell the franchisee items that range from Sonic-labeled hamburger wrappers to the peppermints that come with the food. The franchisor typically argues that it can obtain the supplies cheaper through its bulk buying; plus, it wants to ensure that the output continues to be a consistently high-quality, name-enhancing experience, since it is sold under the Sonic brand. A franchisee that has inconsistent quality or service not only hurts her own business, but impacts the brand image of all franchisees.

The continuing revenue stream to the franchisor from royalties and selling of inputs to the franchisee is a more important revenue source than the initial fees for selling the franchise. Thus, the franchisor and the franchisee are successful by helping each other. The franchisor makes money when the franchisee stays in business, needs lots of inputs, and pays continuing royalties. On the other hand, the franchisee is successful if the franchisor puts a program in place for all of the franchisees to be successful, such as high-quality marketing, good site selection, high-quality products, and continuous research into both product/process development and brand management.

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LO14-2 Explain the process of buying a franchise.

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The Process of Buying a Franchise As we have emphasized throughout this text, the entrepreneur that is best prepared will be the most likely to succeed, whether her focus is starting a business from scratch, buying a franchise, or purchasing an existing business. Thus, many of the issues in choosing a franchise are similar to the issues already examined in this text.

General Franchise Questions Some issues can be viewed as broad, generic issues rather than issues specific to that particular franchisor. These general issues include the following:

1. The potential franchisee should carefully evaluate her individual interests and skills to determine a potential fit with running a franchise and to identify an industry or multiple industries in which she wishes to attempt to purchase a franchise.

2. When determining the industry to enter, each potential franchisee should examine that industry, the potential competitors in the industry, and their position relative to other new franchisees that are entering the industry.

3. The potential franchisee should carefully examine the competitive strength of various franchises in the industry. For instance, what are the various sustainable competitive advantages in the market?

4. The individual looking to buy a franchise should identify a franchisor that is the best potential match for him or her in terms of support, history, expansion plans, and so on.

5. The person considering a franchise should examine that franchisor as though the potential franchisee were buying the whole business. This includes contacting other franchisees to discuss their experience as well as comparing the franchisor to other franchise opportunities.

Specific Franchise Questions Each franchisor will have a different package it will try to sell a franchisee. The franchisee needs to examine the exact package that is offered and balance the cost and the benefits offered. The issues to consider in examining which franchise to purchase include these: what a franchise includes; franchisor and franchisee obligations, as stipulated in the United Franchise Offering Circular (UFOC); and steps in the process of obtaining a franchise.

Each of the issues to consider in purchasing a specific franchise will be examined in turn.

What Does a Franchise Include? An extraordinary range of support can be provided by a franchisor to the franchisee. This ranges from simply buying into a name and general plan for operation to what almost amounts to a full partner for your business. There is no universal standard regarding what is provided by a franchisor; instead, as in any market system, different franchisors offer distinct sets of supports at varying prices. The entrepreneur must choose which package of benefits she wishes to pursue, at what price, and with what level of control by the franchisor. The discussion below lists some of the issues that a new businessperson buying a franchise should consider to ensure the franchise has the right mix of supports and costs for him.

Both the franchisor and the franchisee have an alignment of interest in their mutual desire to produce a quality product and successfully expand the business. However, they can have honest disagreements about what is best for the organization. Franchisors make decisions based on what is best for

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the total business; franchisees want to have the ability to cater to their local market. Thus, can you as a local franchisee of a sandwich shop in Texas add hot peppers to the standard sandwich—or if you are in Wisconsin, can you add sauerkraut to the same sandwich? The franchisor may want uniformity and thus consistency, but the franchisee will want the flexibility to meet local needs. The individual buying a franchise needs to examine if the franchise will have the level of flexibility she feels is necessary for success.

When you purchase a franchise, you typically are buying some consistent items, although the specifics of what you are buying in each individual case should be examined. These include the right to:

1. An established name, branded products, and service. 2. Operate under that name for a period of time. The time period is usually some standard, such as 5, 10, or 20 years. 3. A single store or the right to have multiple units.5

4. A commitment from the franchisor to limit the number of franchises within a specific radius of the new franchise. This is one of the most important issues involved in the purchase. One of the key competitive advantages is having the name- brand operation without having to compete against fellow franchisees. In the best situations, franchisees work with each other in local geographic areas.

The franchisor typically provides both the operational systems and the monitoring techniques to run the business in a manner that matches the rest of the organization. The specificity of this operational information varies widely from franchisor to franchisor. You will recall from Chapter 12 that an in-depth understanding of operations is necessary to be successful in an entrepreneurial business. Although most of the operational management systems will have been designed by the experience of the franchisor, the franchisee must intimately understand both why and how these systems work. To illustrate, if you purchase a franchise for a shop that makes photocopies, the franchisor will have established procedures for the design of the internal layout of the shop, plus the look and feel of the physical storefront. It will have established processes for virtually every type of service that could be requested by a customer. If you do not have at least a minimal understanding of copy shops, it will be difficult to judge the operating system the franchisor is providing. Buying a franchise does not eliminate the need for the entrepreneur to have a deep understanding of the business. If you do not have that understanding you cannot judge the quality of the operational support provided by the franchisor.

True understanding of those processes comes from experience. In many cases, potential franchisees are required to work in an established operation of the business for some period of time prior to their being allowed to purchase a franchise. This time period allows the potential franchisee the opportunity to learn the business from the ground up, learning the procedures not from a manual, but from experience with an established operation. This fact is particularly important since some franchisors have very specific limits on how many changes you can make to their operational systems. The franchisor wants a franchisee in Oklahoma City, Oklahoma, and another in Utica, New York, to operate in essentially the same manner in order to develop and preserve the brand. A careful examination of the amount of regional or local customization available can be an important part of the business acquisition process.

A number of specific support areas that the potential franchisee should use to evaluate the franchisor’s operations include the following:

1. Accounting Support. As part of the operational aspects of the business, the franchisor will often provide an accounting system that is custom tailored to the dual needs of the franchisor and the franchisee.

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2. Marketing Support. This is a broad area that encompasses such things as brochures, signs, logos, television advertisements, newspaper advertisements, sales techniques, and internal business design. The quality, quantity, and overall value of each of these items can vary widely from franchisor to franchisor. There are also some significant downside risks to this apparent positive. First of all, advertising support comes at a price. Most franchisors charge each franchisee a fee that becomes part of a larger common advertising budget. The franchisor develops the advertising and buys the spots or spaces in the newspapers. Doing this centrally allows for volume discounts as well as expertise in ad development and placement. Second, if you are the only franchisee in Colorado while most of the other franchisees are in Minnesota, Iowa, and Wisconsin, you are likely to see a smaller relative share of the advertising budget being targeted to your area. Thus, you would want to know what the franchisor’s marketing plans are if you are the isolated franchise in Colorado.

3. Training. Franchisors offer a variety of training opportunities for the new franchisee and their employees. These include classroom training, training at other locations, having an experienced manager work at your location for a period of time, or, as we have mentioned, working at a current establishment. The more that is offered as part of the franchise fee the better it is for the franchisee. In addition, the availability of continued training opportunities should be an important criterion to help ensure franchisee success.

4. Real Estate Services. Some franchisors operate a large and profitable real estate brokering service. Others offer a more basic site selection service, or nothing at all. The assistance in real estate selection, acquisition, building construction, and the like, can be invaluable if done professionally.

5. Other Services. Human resources support to develop performance management programs; quality control methods; forecasting; and purchasing of equipment are all very valuable services that act as guidelines rather than mandates in deciding on a franchise.

As this discussion indicates, there is a wide range of potential activities that the franchisor may provide to the franchisee. The range of those activities, the quality of those activities, and the cost should be judged by the entrepreneur.

EXERCISE 1 1. Rather than starting a business from scratch, you have decided to look into franchises. What industry and what franchise opportunities

might you consider? 2. What special skills do you bring to the franchise? 3. What market conditions exist that suggest to you that this franchise might be successful?

Government Requirements for the Franchisor–Franchisee Relationship. The principal governing mechanism of the franchisor–franchisee relationship is the Uniform Franchise Offering Circular (UFOC). As with many business domains, at one time there were excessive abuses in the industry. Individuals thinking they were buying a franchise that gave them an opportunity for success found that they had paid for what amounted to little more than a name, which often had a terrible reputation. The result was the passage of the UFOC, which specifies what information must be provided to the franchisee prior to her investment.

Uniform Franchise Offering Circular (UFOC) The principal governing mechanism of the franchisor/franchisee.

This document must be provided to the franchisee early in the process of her buying a franchise. In effect, the UFOC is a franchisor disclosure document with 23 specified items:

1. The Franchisor, Its Predecessors, and Affiliates. Full disclosure on any predecessors to the current business and other businesses affiliated with the business must be disclosed.

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2. Business Experience. The background of the principals must be detailed. Issues such as how long they have been in the business and their experience in the industry must also be detailed. You want to make sure those running the franchisor have experience in the industry.

3. Litigation. Any pending litigation must be noted. Such litigation can destroy the value of your franchise if it concerns issues such as who developed the idea for the product and your franchisor loses.

4. Bankruptcy. Any prior or current filings by firm or key management must be disclosed. 5. Initial Franchise Fee. Under items 5 and 6, the franchisor must disclose all fees that are charged. 6. Other Fees. The “other fees” category is an area that entrepreneurs should clearly understand. The cost of the initial

purchase of the franchise may appear low, but if there are extensive fees that the franchisor can charge the franchisee for services that are offered, the value of the franchise may be very different than initially thought. The supports provided may appear to be desirable; however, there may be separate costs for those supports that are independent of the initiation fee to buy the franchise.

7. Initial Investment. This is more than the initial fee paid by the franchisee; it includes a reasonable estimate of the total investment needed to begin operations.

8. Restrictions on Sources of Products and Services. This is one of the critical parts of the document, where franchisor sourcing is detailed. The potential franchisee needs to be clear about what must be purchased directly from the franchisor and what may be sourced independently.

9. Franchisee’s Obligations. Specific obligations must be listed. For example, the franchisor may require that the product be produced by certain equipment and that equipment be replaced on a certain time schedule. These restrictions can extend into domains that the entrepreneur may not initially consider to be the purview of the franchisor. Thus, once again questions such as what flexibility the entrepreneur will have in operating the franchise need to be examined. For example, upon opening, you as the franchisee may be happy with some balloons, having the local mayor cut a ribbon, and a story that goes into the local paper. But the franchisor may have an extensive program that it requires of all new franchise openings. The franchisee may be required to fund these activities through various fees, whether or not he agrees with the program.

10. Financing. Many franchisors make significant financing available to potential franchisees. The financing available and terms are outlined in this section of the document.

11. Franchisor’s Obligations. In this section, all of the ancillary services are detailed. As outlined above, this may include site selection, training, placing experienced managers on-site for a period of time, and so on.

12. Territory. This section details the amount of exclusivity your franchise will have relative to other operations of the franchisor.

13. Trademarks. Items 13 and 14 detail the exact status of all trademarks, patents, copyrights, and trade secrets that are part of the business.

14. Patents, Copyrights, and Proprietary Information.

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15. Obligation to Participate in the Actual Operation of the Franchise Business. The franchisee can be required to take an active role in the daily management of the business, as opposed to simply hiring managers.

16. Restrictions on What the Franchisee May Sell. This section lists limits placed on the franchisee by the franchisor. The franchisor may put extensive restrictions on the franchisee as to what she can do with the product and its production.

17. Renewal, Termination, Transfer, and Dispute Resolution. The exact method of dispute resolution is detailed, along with which party will have the financial responsibility.

18. Public Figures. This details any public figures or celebrities involved in the business and what they are paid. 19. Earnings Claims. This section contains a description along with some specific detail regarding the financial

performance of typical franchisees. 20. List of Outlets. 21. Financial Statements. 22. Contracts. This section contains sample contracts you will be asked to sign later. 23. Receipt. You will be asked to sign a page to acknowledge that you received this information. The entrepreneur is well served to study the document carefully to understand all of the details of the business arrangement.

It is a long document, and should be read through several times and reviewed with an attorney prior to agreeing to the stipulations. A clear understanding of the document now will prevent significant problems in the future.

Franchise Process. The founding of a franchise is quite similar in form and method to creating a new business from scratch. A significant up-front cash payment is necessary, and the ability to leave the venture if the entrepreneur does not enjoy the business is severely limited. Similarly, an assessment of the skills of the individual should be a mandatory beginning of any new business investigation. If the individual has no skills in styling hair and he buys a hairstyling franchise, the odds of success are not particularly good, regardless of what supports are present in the franchise.

A successful franchisee has taken steps to understand the new market, such as location, longevity of demand, and skills needed.

Depending on the franchisor for market analysis is a poor move under any circumstances. The market must also be thoroughly and independently understood by the potential franchisee. As we pointed out earlier, sometimes there is a very good reason that no similar businesses are in a particular area. We knew an individual who was searching out a franchise to buy. She hit upon the idea of buying a franchise that supplies temporary employees to local businesses. Unfortunately, all of the local businesses (and there were only a few) used only full-time employees. The market for temporary workers was severely constrained. We would also caution against purchasing a franchise that is part of a fad. Pet rocks were a lot of fun for a while, but owning a pet rock or Pog franchise was a disaster for the franchisees. Fads died as quickly as they were born, but the franchise agreements lasted anywhere from 5 to 20 years. It does little good to invest money in a franchise that will see demand for the product disappear quickly. In the case of a fad, we have very simple advice. Get in, make as much money as you can as an independent, and GET OUT!

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The International Franchise Association is a good source for quickly locating potential franchisor firms; its Web page can be found at www.franchise.org. Each of the franchisor firms typically has a Web page where you can request information from that firm. They will gladly send you a packet of information that details the firm’s operations, its business, and the costs of the franchise. At this stage, there will be a very short application form that the entrepreneur must fill out. With this information the franchisor will call the entrepreneur and have a phone interview to ensure that the individual is at least a potential match for the firm. The entrepreneur needs to note that it is a mutual selection process. The franchisee can select among one of the 10,000 or more franchise opportunities. The franchisor also gets to decide to whom it will sell a franchise. Given the geographic restrictions imposed by many franchisors and encouraged by the franchisees, it is in the best interest of the franchisor to pursue only the most motivated, best capitalized, and most skilled individuals. A poorly performing or disruptive franchisee detracts from the overall operation as well as taking time and effort of the franchisor away from the business of growing the brand. Because of this, it is simply easier to make sure that there is a match between the two parties from the beginning.

Once the potential franchisee has been vetted (a credit and personal background check has been completed), the entrepreneur will be sent the complete UFOC and asked to fill out a more complete application. A series of meetings ensues between the franchisor and other franchisees in the area, between the franchisor and the potential franchisee, and between the potential franchisee and the other franchisees in the area. The ability to meet other franchisees is critical in the evaluation process. Although the UFOC does not require that specific information on profitability of individual franchises be provided, it is quite simple to back into such information by calculating the total profits of the group and then dividing by the total number of franchises. Unfortunately, there may be a bimodal distribution, with some great performers and some that perform poorly. The ability to interact with franchisees in your geographic area, with similar profiles to what you can expect from your operation, helps provide great insights into the reality of the franchise life. You will gain tremendous insights from these individuals regarding their relationship with the franchisor. The relationship between franchisor and franchisee is somewhat like a marriage; they are both dependent on each other for success. If the relationship is an unhappy one, there can be nothing quite as miserable. Existing franchisees can also provide insight regarding the value of the franchisor’s staff. Many of the services that the franchisor provides are dependent on the quality of the people providing the service. Marketing advice is a qualitative area that can be either very helpful or of limited value, depending on who is developing and delivering the research.

Assuming that both parties are pleased with their findings, negotiating the deal is the next step. Although the franchise fee tends to be set in stone, most franchisors are willing to negotiate on a wide range of items. For example, if there are few franchises in an area, the franchisor may be willing to finance a greater portion of the start-up expenses, provide additional marketing support, or even pick up some of the initial expenses of a franchise in order to get a foothold in a new geographic area. Similarly, if you have had prior success in business and the franchisor is new, it might negotiate a completely different deal with you in order to get started with a self-sufficient operator. Also, very high-profile individuals frequently can negotiate unique deals. For example, in a region of the country where there is a professional athletic team, high-profile players on that team often obtain preferential opportunities. This allows the franchisor to publicize that that person is one of its franchisees. The entrepreneur

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should explore what aspects of the contract are negotiable by making a list of wants and desires.

ETHICAL CHALLENGE Over the past few weeks you have been reviewing the franchise agreement for a new concept in fruit, which is made to look like a flower design. You have met with several current franchisees and talked with the franchisor on more than a few occasions. You have had the opportunity to see them in operation and to look at the books. After all this effort, you have concluded that you don’t need the franchisor to run a business like this one. You’ve decided to open up your own fruit into flower design and delivery shop and plan to run it virtually the exact same way as is done by the franchisees.

You have made a significant effort to make some of the operations different, but you also like most of what you saw. What you didn’t like was the up-front fees, which were estimated to be over $500,000, and the fact that you would have to pay the franchisor 8 percent of sales.

QUESTIONS 1. Do you have any ethical obligations to the original franchisor? 2. No one is required to buy a franchise; therefore, isn’t their opening all the books simply their means of trying to

make a sale? 3. Does a firm have any obligation other than to make money?

Some areas that such negotiations should explore include up-front capital requirements, financing arrangements, and continuing fees. Does the ability exist to purchase other franchises or build out the existing franchise? The time frame of the franchise (5, 10, 20 years) may be negotiable, as well as a first right to renew your franchise. An important consideration is not only the territory of the initial franchise, but also first rights on adjacent or fast-growing territories. Some franchisors will have performance quotas to maintain the franchise; if your business faces performance requirements be sure to ask what those quotas are and what percentage of franchisees meet the quota. If you fail at those quotas, or some other aspects of the franchise, can you negotiate the remedies to solve that problem? Does the franchisor require a personal guarantee? The personal guarantee is something many successful entrepreneurs seek to avoid, because it places their personal assets at risk. Are there operational constraints that you feel would put you at a disadvantage relative to your competition that you wish to have the franchisor waive? The entrepreneur is well served to take the time to work with a lawyer and develop a solid contract that meets the needs of the franchisor and still gives the franchisee the best opportunity for success.

EXERCISE 2 1. What specific concerns do you have regarding a potential franchise? 2. Put together a list of three items that you must have in place prior to accepting a contract to purchase a franchise. 3. Do you believe that franchises are more or less risky as compared to beginning a new business from scratch?

LO14-3 Discuss the process for buying an existing business.

The Process for Buying an Existing Business We covered the process of obtaining a franchise first because this process is well defined and well regulated, and there is a wealth of information available to anyone who would like assistance. Another very popular means of going into business for oneself is the purchase of an existing business. To illustrate the concept and some of the difficulties in buying an existing business, consider the friend of the Flow Right Brewery & Bar founder, named Jack Chen.

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JACK CHEN

Jack Chen was a good friend of Chris’s and as Jack observed Flow Right prosper he became more convinced he should follow his desire to go into business for himself. He had a good job working for an engineering firm where he was able to use his computer and technology skills, but he felt that his prospects for rising any further in the organization were limited. He was increasingly concerned with the strategic direction that the firm was pursuing and believed that the advice of long- time employees was being routinely ignored. This led Jack to begin to investigate new business opportunities.

Jack knew he wanted to do something that took advantage of his computer and technological skills. Therefore Jack began to look at new businesses tied to the Internet. He knew that phone apps were a market that was exploding in size; however, he also knew that getting noticed among all of the apps out there was very hard to do. Jack also knew that social networking was a high-growth area for technology. One recent study found that those with mobile devices spend over 30 percent of their time on social networks. Outside of the biggest players in each market the rest of the field tended to be very fragmented.

In each area, the issue came down to how to structure his venture so that it was unique in the marketplace and attracted sufficient attention to make a business. He thought of potentially focusing on some specific niche, such as a sport or a given activity, but soon found that there were already extensive numbers of such activities; there was even one for scrap bookers.

Next Jack explored virtual data rooms. He knew that increasingly, firms were moving out paper copies from their offices to load documents on “the cloud.” One aspect of this transition is that firms would need secure locations to place documents for their far-flung teams when conducting sensitive activities, such as due diligence for a merger and acquisition. The result is the creation of virtual data rooms, which hold the data securely. It is expected that the virtual data room industry will double between 2014 and 2017 to over $1.7 trillion dollars.6 However, it takes a large staff to do such work, so the initial investment appeared to be approximately $500,000 by the time start-up costs were considered. While the two largest firms have relatively small market shares, Jack was still concerned that these firms would be very aggressive in their pricing and hard to beat.

This led Jack to look at Internet-based franchises. He found that these franchises could cost from $99 to $25,000. He believed the actual costs would be double or triple the cost of the franchise by the time he included other start-up costs. However, with total costs at less than $100,000, Jack thought these franchises were potentially a great option.

QUESTIONS 1. What factors should Jack focus on when evaluating an Internet-related franchise? 2. The key success factors of franchises typically are the operating systems they provide the entrepreneur, which help the

entrepreneur ensure that he can run the business effectively from day one. Would such a benefit also be present in an Internet franchise?

How to Buy an Existing Business Similar to a franchise, an existing business has the benefit of having an established set of processes; although unlike a franchise, a continuing business has an established cash flow that you are purchasing. As such, the operation has a higher likelihood of success when compared to starting a business from scratch, and yet as Jack Chen’s experience illustrates, that does not mean that buying a business does not take as much planning and thought as starting a business from scratch. There are still significant risks involved in buying a business.7

Because a business you may buy is an ongoing entity, there is a greater premium attached to the business than if you started it from scratch. The primary exception to this is if you buy a troubled business at a discount. If that is the case, you will need to quickly restructure that business. Turnaround is a special topic and requires very specific skills for you to be able to act quickly to reverse that decline.8 Our typical advice to entrepreneurs

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is to not attempt such activities unless they have specific skills and a plan to turn around a business that is in significant decline.

For the purchase of a reasonably stable or healthy firm, all of the same processes that have been discussed in this text should be the foundation of your effort. Therefore, you first need to understand your own skills and abilities and the nature of the current market. Assuming that you have completed all of the preliminary analysis effort, there are still several unique aspects to purchasing an existing business. These include (1) locating a business to purchase; (2) developing a plan for the business; (3) negotiating a deal to acquire exactly what you want from the operation; and (4) organizing the process of change within the organization.

Locating a Business to Purchase. Locating a business for sale is a job that takes lots of patience and effort. There are business brokers in virtually every city in the United States that specialize in selling businesses. Additionally, businesses are listed for sale in newspapers, in local magazines, and on websites. All of these are fine places to start your search process; however, we recommend several other means for finding a business that meets your needs:

business brokers Businesses that specialize in selling businesses.

1. Attorney and CPA firms may have clients who have expressed their desire to sell their business. Contacting local firms and asking about businesses they might know that are for sale usually yields some interesting possibilities.

2. Our personal favorite way to find a business to buy is to identify a particular business that you believe is not maximizing its opportunity, one to which you believe you could bring unique skills and advantages that could propel the business. We recommend that you put together a short letter to the owner indicating your interest in the business and follow that up with a request to take the owner to lunch to discuss the opportunity. Most (if not all) owners of an ongoing business are willing to listen to an offer to buy their business.

3. The trade association for an industry usually maintains a listing of all member companies and is a wealth of information regarding the status of various organizations within the industry.

4. The local Small Business Administration Office and/or the Small Business Development Center in your area has significant contact with businesspeople and both are geared toward supporting and encouraging the growth of entrepreneurial business.

5. Another favorite of ours is to look at the bankruptcy filings in your local community. Many companies file for bankruptcy due to lack of financial resources or poor management practices. The opportunity to contact these individuals and buy the operation before the bankruptcy procedure is completed can be the source of a business at a bargain price. However, remember that this effort would be a turnaround project that would require unique skills and abilities.

Plan of Operation. Once you have located a business for sale, but prior to beginning the negotiations to purchase the business, you as the potential entrepreneur should develop a plan of operation for the business. The cost of the business should include any premium for its current performance. What will you do differently from what is currently being done? If you are paying a premium for a business but have no plans to change the business operations, then how do you hope to achieve success?

Will you bring a new mission to the business? Will you position the firm or its product differently? Do you have some unique talent or skill that will make the business that you are considering buying a success, or make it more successful? An understanding of what you have to offer and what the current business is missing will provide the basis for your

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negotiations. What is important to the current owner may or may not be important to the potential owner, given the new direction for the company. Adding value to a business is a critical step in the process of deciding to purchase a business. We would recommend that the entrepreneur take the same approach as was outlined in Chapter 5 to develop a new mission for the organization. What are the resource-based advantages of the new organization under the new leadership?

Having developed a new plan for the business, the potential entrepreneur is prepared to negotiate the deal. In Chapter 13 we outlined procedures that a seller should use to put her business in the best position for sale, as well as negotiation strategies. We would recommend that a potential buyer do the same and demand this from any seller.

Finally, there is the complex issue of organizing the process of change from the former business to the new business. Although there are a number of ways in which this can be accomplished, the tasks are relatively the same. We must point out that there is a lot of nuance and “art” in the handling of these processes. Once negotiations are complete and all contracts are signed, there will be a transition period that should be spelled out in the contract for sale. During that transition time period, a number of tasks should be completed. The new owner should accomplish the following:

1. Meet and discuss the transition with every member of the current staff. If there is a layoff plan, then that should be enacted immediately.

2. Spend significant time being visible in the new operation, talking with employees, making suggestions, and doing some of the more menial work.

3. Make all significant changes in one day so as to alleviate any lingering concerns by the employees. 4. Implement new metrics and standards as soon as possible. 5. Ask the former owner(s) not to be at the business for several weeks while the transition is taking place. Loyalties and

work processes get confused when the former owner is around every day. 6. If appropriate for the type of business that has been purchased, send out a letter or e-mail to every customer and supplier

informing each one of the ownership change. Ideally this letter should be signed by both the former owner and the new owner.

SUMMARY This chapter examined two common methods for becoming an entrepreneur. Both techniques fundamentally rely upon all of the same analysis and development techniques that have been developed in this text. Franchises are a well-developed and expansively available method for starting a business. There are more than 750,000 franchises in the United States, and franchises are rapidly expanding in many parts of the world.9 Franchise operations run the gamut from those that are fully developed complete partners in business to others that are little more than a name. Franchises significantly improve the chance of survival for an entrepreneur but do not eliminate the potential for failure.10 We reviewed the UFOC as well as those areas that are unique to a franchise operation. We finished the chapter with a discussion of the unique considerations involved in buying an existing business.

KEY TERMS business brokers franchise agreement franchisee franchisor Uniform Franchise Offering Circular (UFOC)

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REVIEW QUESTIONS 1. How does a franchise work? 2. How do the franchisee and the franchisor differ? 3. What is the benefit of buying a franchise versus starting your own business? Are there any drawbacks? 4. What are the questions a person should ask herself before she starts a franchise? 5. What is typically included in a franchise? 6. What is the UFOC? What are its major provisions? 7. Why would someone buy an existing business? 8. How do you locate a business that you would like to purchase? 9. Once you actually buy the business, how do you make sure that you are successful?

INDIVIDUAL EXERCISES 1. Starting with the Independent Franchise Association Web page, www.franchise.org, put together a plan for purchasing

a franchise. 2. For the industry that you chose in Exercise 1 of this chapter, how many franchise opportunities exist? 3. What resources exist to help you in your effort to acquire a franchise?

GROUP EXERCISES 1. Form small groups in the class. As a class, pick one industry, such as retail restaurants. Have every team then select a

franchise to buy in that industry independently. a. What is the range of franchises picked? b. What is the range of costs and services offered? c. Why did each team pick the franchise that it did? List your top five reasons for picking that franchise. d. Each team should make a five-minute presentation on the franchise it picked as if it were selling the idea to an

investor. e. Then vote as a class for the best franchise idea.

ENDNOTES 1. International Franchise Association, “Building Local Businesses one Franchise at a Time,”

http://buildingopportunity.franchise.org/ 2. R. Dant and P. Kaufmann, “Structural and Strategic Dynamics in Franchising,” Journal of Retailing 79 (2003), pp. 63–

76. 3. M. Grunhagen and M. Dorsch, “Does the Franchisor Provide Value to the Franchisee? Past, Current, and Future Value

Assessments of Two Franchisee Types,” Journal of Small Business Management 41(2003), pp. 366–85. 4. J. Combs and D. Ketchen, Jr., “Why Do Firms Use Franchising as an Entrepreneurial Strategy? A Meta Analysis,”

Journal of Management 29 (2003), pp. 443–66. 5. J. Bercovitz, “The Option to Expand: The Use of Multi-Unit Opportunities to Support Self-Enforcing Agreements in

Franchise Relationships,” Academy of Management Proceedings, 2002, pp. Y1–Y7. 6. J. Quittner, “Thinking of Starting a Business? Lock Down Profits in Virtual Data Rooms,” 2013, www.inc.com/best-

industries-2013/jeremy-quittner/virtual-data-rooms.html 7. S. Kaufman, “Before You Buy, Be Careful,” Nation’s Business 84, no. 3 (1996), pp. 46–48. 8. R. Doyle and H. Desai, “Turnaround Strategies for Small Firms,” Journal of Small Business Management 29, no. 3

(1991), pp. 33–43. 9. M. Haller, “Slow Steady Growth to Continue for Franchises in 2013,” International Franchise Association, 2013,

www.franchise.org/Franchise-News-Detail.aspx?id=58916 10. S. Holmberg and K. Morgan, “Franchise Turnover and Failure: New Research and Perspective,” Journal of Business

Venturing 18 (2003), pp. 403–19.

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CREDITS Opener: Anthony92931/CC-BY-2; p. 255: Ron Heflin/AP Images; p. 258: Mike Mozart/Flickr/CC-BY-2: p. 263: jakerome/Flickr/CC- BY-2.

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