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Posted on Feb 21, 2011

Before Buying a Franchise Identify Your TRUE Investment

True Cost of FranchisesIf you’re searching for a franchise opportunity that meets your expectations and qualifications, a determining factor might be the investment you’ll need to make. Having worked in the franchise industry for over 35 years, I can safely state that under-capitalization is one of the leading causes of franchisee failure.

When you’re conducting your search for a franchise you’ll find the amount of the required investment in any number of places, ranging from the franchise website, to various advertising sites, to FranchiseHelp.com's franchise opportunity directory. This investment information should reflect the actual investment as stated in the Franchise Disclosure Document (“FDD”). This is not always the case, since it’s not unusual to find a franchise opportunity ad that simply states a minimum investment requirement.

Your Basic Source of Information:

Your approach as a potential franchise buyer is to identify the real investment dollars you’ll need to get the franchise to profitability. The initial source of this information is Item 7 in the FDD. Item 7 is a schedule that details the estimated investment in the franchise. This schedule includes the cost of various items, including: the initial franchise fee, training related expenses, rent, insurance, professional fees for legal and accounting services, supplies, equipment, licenses and permits and additional working capital. Depending upon the specific franchise, there may be added categories. When reviewing the Item 7 schedule it’s important to know that franchisors are not required to list every type of fee or expense that might be part of the investment in the franchise but rather the likely investment needed to start the franchise. As you work to establish your investment number keep in mind the words “estimated” and “typical.” Item 7 is a guide, and as such, you should use this information accordingly.

Be Aware of the Following:

An important category in Item 7, and one often misunderstood, is Additional Funds. This category must list other required expenses that franchisees will incur before operations begin and during the initial period of operations. In general, a reasonable period, and the one most often used, is three months. Additional Capital is described in the footnotes to Item 7.  When you do your business plan and estimate your future capital requirements, remember that the Additional Capital estimate is usually for 3 months and few businesses will reach break- even in 3 months.

Since most franchisors use a range of expenses, from low to high due to supplier and regional differences, you’ll need to do a more detailed analysis to project what your costs will be.

Identifying Your Real Franchise Investment

Now that you have a starting point for establishing your investment dollars the next step is to do some additional work.

  • Identify all of your anticipated costs as completely as possible. By speaking with existing franchisees, the franchisor and utilizing the advice of your accountant, you should be able to determine the costs you’ll incur.
  • Complete a break-even and cash flow analysis in order to identify what’s needed to cover expenses and reach profitability.
  • Based upon your cash flow analysis and feedback from franchisees identify a credible amount for Additional Capital. Recall that this number in the FDD is typically for a three month period. You may wish to be conservative and plan on six months to break-even.
  • Recognize that in the real world unanticipated events can and will happen. Be sure to plan accordingly.

A major cause of franchisee failure is a lack of adequate investment capital. Since the FDD provides a schedule of the estimated initial investment made by a potential franchisee, costs will vary. Don’t rely upon this information to identify your real investment, since it describes what’s needed to start up the new franchise operation not to reach profitability. Follow the suggestions I’ve provided and use qualified financial advice to identify what your real investment will be. Always remember: calculating your true cost is a critical component of your franchise due diligence process.

About the Author: Ed Teixeira has over 35 years of franchise industry experience as a franchise executive and franchisee. He has served as a franchise executive in the c-store, manufacturing and home healthcare industries and has licensed franchises in Asia, Europe and South America. He has spoken on the subject of franchising throughout the world. Ed operates FranchiseKnowHow which provides information and advice to prospective and existing franchisees and franchisors.

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