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What To Be Aware Of When Buying A Franchise In Canada
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When buying a franchise in Canada, it is important to conduct thorough due diligence, to the point where you can complete a detailed a cost-benefit analysis of the franchise opportunity (to determine to what degree it can enable you to satisfy your financial and lifestyle goals.
Before you even begin to consider franchising, is important to understand what a franchise is. A franchise is the legal agreement between a franchisor and franchisee, where the franchisee is granted license rights to use the franchisor’s name and/or trademarks to sell/distribute products and/or services for a specific period of time, usually five or 10 year terms; most franchise agreements also have the opportunity to renew for additional terms. Under the license, the franchisee also agrees to utilize and adhere to the franchisor’s business systems and processes – and for good reason too! For good franchise systems, these systems and processes have been developed over years of accumulated experience (both positive and negative) of the franchisees within the system. This consolidated learning enables new franchisees to launch their business with greater efficiency, while avoiding costly mistakes, and thus forms part of the value equation.
The franchise license is granted in exchange for an initial franchise fees and ongoing royalties; franchisors should be able to clearly define and justify the value they are providing for the fees they are asking. There is no set rate for initial franchise fees; the majority of franchisors’ fees are between $25,000 and $45,000 but it is not uncommon to find fees as high as $75,000, especially for service-based businesses. There is also no set rate for royalties; royalties are calculated prior to any profits and are typically structured in one of two formats:
1. a percentage of gross sales (the most common format):4% to 6.5% is quite common for retail and food concepts; 7% to 10% is quite common for service-based businesses.
2. a monthly flat fee: this type of royalty structure can range from $400/month to as much as $2000 per month; the advantage of this type of royalty is that the more business you do, the more you get to keep. The disadvantage though is that even if you’re not doing well, you still have to pay the monthly fee
Most franchisors also charge a marketing fee; this is often misunderstood by prospective franchisees. In most jurisdictions, marketing fees collected essentially belong to the base of franchisees; the franchisor administers this fund, often with input from their franchisee base. They are not allowed to use these funds for general business purposes.
Fees to buying a franchise in Canada are not always apparent. The Canadian Franchise Association (CFA) offers a list of fees and guidelines of financial terms and conditions to franchise agreements. Most franchise licensing contracts include an upfront franchise fee due at time of signatory on agreement.
Here is a list of some common benefits to buying a GOOD franchise in Canada, please keep in mind though that not all franchisors have everything on this list:
• initial and ongoing Training from head office;,
• Proven product and service offerings
• proven marketing and business generation methodologies,
• proven operating systems
• coaching, Supervision , mentoring and consulting
• Collective buying power,
• Continuous research and development
• Tremendous knowledge and experience resource base of other franchisees to draw upon.
These benefits combine into a very strong offering that often enables franchisees to get a much faster start in business and achieve higher levels of success than the non-franchised independent business owners in the same industry.
Here are some common drawbacks of franchise ownership:
• You have to pay initial franchise fees: We like to think of it this way though: If you’re going to go into business, you are going to have to pay a “tutelage fee” when you buy a franchise, the initial fee should reflect reasonable value for the kind of benefits mentioned above. For business owners who start a business from scratch, there will also be a “tutelage fee” while these entrepreneurs don’t have to pay the initial franchise fees, their tutelage fees often come in the form of unforeseen business expenses, costly mistakes, missed opportunities, etc. The trouble is that it’s incredibly difficult to determine how costly these can be, but since we’ve been involved in franchised businesses as well as started businesses from scratch, it is our clear belief that the “tutelage costs” associated with independent businesses are much higher than initial franchise fees!
• In most cases you have to pay ongoing royalties: after 22 years in this business, we’ve yet to meet a franchisee who likes writing royalty cheques. However, the simple fact of the matter is in good franchise systems, there is tremendous ongoing value derived from being part of a growing franchise system. In order to square off with this drawback, you should talk to enough existing franchisees within the system you’re considering and asked them this critical question: “On a scale of 1 to 10, how much value are you getting for your ongoing royalty dollar?” Listen very closely to the answers you hear!
• Most franchise systems have some form of territorial restrictions
• Loss of independence: when you join a franchise system, you are definitely going to give up some measure of control over how to execute the business, but this is often much less of a factor than most people initially perceive. In highly structured bricks and mortar-type of businesses (like fast food restaurants), then the owner is definitely managing the business to a very tight and predetermined set of standards and processes; it is these types of businesses where the most independence is sacrificed. In a lot of business-to-business and business-to- consumer service-based franchises, the franchisee has much wider operational latitude – these types of businesses often appeal to mid and senior executives from corporate Canada.
• Brand problems are shared:
• Limited expansion possibilities
Part of finding the right franchise means determining the right balance between benefits and drawbacks.
“The big 5” Franchise Buying Risks
1. “Mismatch” is likely the biggest cause of underperformance and failure in franchising today!
In spite of the wide perception that of franchises being low risk investments, the fact is that the sustainability of a franchised business will largely depend on the effectiveness and efficiency of each individual franchisee’s operations. It doesn’t matter how good the franchise business model is, if the franchisee is not following the established processes, guidelines and rules, the business is still likely to fail. It is for this reason that it is critical that the prospect of buyer thoroughly understand the critical roles and activities required to drive success on a day in, day out basis, so that they can identify to what degree they will be able to perform those tasks.
2. Undercapitalization is another one of the biggest contributors to failure – the trouble is that too many people who buy franchises use the vast majority of their available savings and borrowing power to buy the franchise, with the expectation that they will be able to achieve breakeven within a short period of time. Unfortunately, far too many businesses take longer than people expect to achieve breakeven and positive cash flow; if there are insufficient capital reserves to inject into the business, then there is a high risk of the franchise will fail because bankers are highly unlikely to lend additional funds until the business can demonstrate strong performance. To plan safely and avoid this high risk factor, you should have at least six months more and ideally 12 months more working capital available as a safety buffer (i.e. if you are planning for the business to take six months to achieve breakeven, then you should have 12 to 18 months of working capital available)
3. Not all franchise systems are created equal – just because something is franchised, it doesn’t mean it’s good, it just means that it’s been duplicated. The younger the franchise system, the higher the risk that the systems and processes have not been fully developed, and the higher the risk that the demand for the product or service is not fully proven. It should also be noted that some franchisors who have been around for many years do not bring enough innovation to their business; the brand risks becoming tired, their systems and processes become obsolete, or both! Someone can bring tremendous intellectual capability and transferable skills to a franchise opportunity, but if the opportunity is not supported by key trends, or if the franchisor’s business model is weak, this individual also faces a high likelihood of failure.
4. Market Saturation – unfortunately, too many people get excited about a specific industry where there is lots of initial growth, but there is no predictable path for long-term sustainability. Numerous competing franchise brands pop up and lots of people buy into the concept, only to find 3 to 5 years later that the demand has significantly waned and thus their business fails. An example of this was the bagel business in the early 90s – within a four-year period, hundreds of franchises were awarded, but within five years the vast majority of them had closed. Part of the problem was that several late entry franchisors created a “me too” strategy to capitalize on the interest, but they did not have sustainable market differentiation.We see a current flurry of activity in several subsectors in the food industry that demonstrated similar pattern: poutine, burgers and frozen yogurt – in each of these cases there are dominant strong players, but caution should be exercised when considering late entry upstarts that don’t offer sustainable differentiation.
5. Lack of optimum location availability – the three rules of a retail business are location, location and location! The less sophisticated the franchisor’s franchise location strategy and practices, the higher risk for the franchisee. There should be a minimum of key selection criteria that the franchisor governs location approval with; it is important to ask existing franchisees how much support they got in location selection and how good that support was. The flurry of activity noted in the market saturation point above has put tremendous pressure on location availability so you want to be very careful; you should not settle on an inferior location.
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