Last Friday afternoon I was a guest on KSEV Radio AM 700 with host Aubrey Thoede and had the opportunity to discuss a subject that many call-in listeners wanted to learn more about....starting their own franchise. But buying a new franchise is not the best way to go about achieving the "American Dream."

Once you've hit five years, your odds of survival go way up," Birch said. "Only two to three percent of businesses older than five shut down each year." http://usatoday30.usatoday.com/money/smallbusiness/columnist/abrams/2004-05-06-success_x.htm

Everyone reads or hears about big corporate mergers and large company acquisitions. However, big corporations aren't the only companies being bought and sold. Profitable, privately-held small businesses are changing hands everyday. These transactions are done behind the scenes and are not reported along with the daily stock market news. These business exchanges fly under the radar of the public at large -- which may be part of the reason that it is not commonly understood that buying an existing small business is the most viable path to being a successful business owner.

If you are considering your options for going into business for yourself, buying an already established profitable business should be the first option on your list and starting a new franchise the last. Here are six slam-dunk reasons why:

(1) The Real Scoop On New Franchise Failure Rates

The failure rate of franchises is greater than most people realize - far greater. Everyone has probably heard the rumor that new franchises only have a 5% failure rate. Well, I was somewhat suspicious of that standard. So, in order to back up my suspicions, I did the research. I was surprised to find that there is very little independent study out there. Most research and reporting about success rates of franchises is sponsored by the franchise companies themselves! So, with that in mind, there is good reason that we only hear about how successful new franchise are. Well, here's the real story....statistics:
  • Companies that sell franchises go under at a rate of about 15% a year, meaning in any given five-year period, 75% of franchisors disappear.
  • Thirty eight percent (38%) of franchise units fail over a four-year period, vs. only 32% of independent non-franchised startups.
  • Franchises make lower profits than independent businesses.
  • Many franchisees never make much money. Average profitability is poor, especially after taking into account the purchase price of the franchise.
Some of the reasons for not fully understanding the chances of failure of a new franchise include the fact that many non-performing franchise units are taken back by the franchisor or resold to a fellow local franchisee at less than start-up cost. The franchisor doesn't consider them failed enterprises and they never show up as a "closed" business thereby distorting the real story.

Armed with this knowledge, don’t mistake the information provided to you by the franchisor for a balanced consumer guide. It is a carefully engineered sales pitch. Getting hold of the information you need to make a rational buying decision is difficult, to say the least. So use your common sense and a healthy dose of cynical discretion. Franchise agreements always favor the franchisor. It is very easy to be swept away in the heat of the moment and get into a binding contract that is not in your best long-term interests. And it is very hard to get out of a franchise agreement without taking a big financial loss. Remember, the main purpose of franchising is to make the franchisor wealthy.

Compare the odds of starting a new franchise with buying an already established business. More than 80% of existing small businesses that have been purchased by new owners are still in business five years later, as reported by business brokers and substantiated by data from a special tabulation by the Bureau of the Census produced for the Office of Advocacy of the U.S. Small Business Administration.2003 SBA Office of Advocacy Study.

(2) No Guarantee Of Success Despite The Hype

Yes, franchises are a known entity and have proven concepts. When you buy a new franchise, it comes with franchise support such as national marketing campaigns and materials for local campaigns, has established relationships with suppliers, and established methods of operation. Training is provided and is usually substantial. You can obtain SBA financing and some franchise companies provide additional loans to new franchisees...sounds good so far. Many franchise companies will even provide a demographic study to assist with choosing a location for the new business. Population, drive-by traffic, potential customer base and a whole series of factors go into the results of the study that will indicate that "theoretically" the business should do well. Ah, but they can't guarantee your success.

An existing successful enterprise has a mature infrastructure and proven systems that include suppliers, methods of operation, and a trained staff already in place. Financing options include SBA backed loans, conventional lending institutions, sellers notes, and 401K plans to name a few. There is nothing "theoretical" about the company's market presence and location that is already established and proven. The proof? Cash flow and paying customers. As for training, all sellers provide at least two weeks training and assist in the smooth transition to the new owner. They may even stay for a longer period of time with agreed upon compensation and if personal circumstances allow.

(3) High Upfront Cost - Can You Repay The Debt

New locations can take a year or more to build and initial start-up costs of a new franchise can far exceed the cost of buying an already established business. Keep in mind that initial start-up franchise costs touted by the franchisor may not include such things as real estate, staff, payroll taxes, local licenses, advertising, or inventory.

On the other hand, all the expenses incurred by an existing business are known quantities. The bottom line -- when you examine the possibility of purchasing an existing business, expenses are already factored into the non-"theoretical" profits. You do not have to go through the trials and tribulations of trying to get enough customers to make a profit because established customers provide an established cash flow, aka money. With an established cash flow it is just a matter of managing the available cash to achieve your business goals. You do not have the extra pressure of finding enough business to pay the bills or hiring and training a new staff. Security and peace of mind goes a long way! When you buy an existing business, at least you know what you are getting for your money. You will know what kind of loans you can get based on the proven cash flow, if the investment will allow you to achieve the standard of living you expect, and if you will realize a reasonable return on your cash investment.

(4) Fees, Fees, and More Fees

A percentage of monthly gross revenues (yes, before expenses!) will be levied as royalty fees (forever!) for the privilege of using the franchise trademarked name and procedures -- which cuts into your profit potential. Other fees you will have to pay include a franchise fee, training fees -- and, in some instances -- a monthly fee for marketing materials and ongoing support. If you are planning future growth and expansion, you will be paying additional fees for licensing the rights for each additional market area.

When you acquire an existing company, the only required fees you pay are taxes. There may be licenses associated with certain types of firms or other regulatory requirements based on the industry. Yes, the debt will have to be paid, but there's an end in site -- a loan has a definite pay-off date. Growth potential of an independently-owned enterprise is only as limited as the market for its product or service and the financial capacity of the owner(s). You are not tied to some radius within which you are allowed to expand.

(5) No Entrepreneurial Freedom

Do you have an innovative entrepreneurial spirit? Do you dislike being told what to do? Do you want freedom with your marketing plan? If so, owning a franchise is not for you. Franchise contracts have very explicit standards, allowing little or no alterations or additions to the brand, stifling any creativity on the part of the franchisee. You must use their system and follow their rules. Some franchise contracts dictate how much to pay your employees and stipulate that you must buy supplies only from their approved list of suppliers, possibly at higher costs than you could find from other vendors. The reputation of your franchise is only as good as that of the franchise company, so any difficulties that the franchise company encounters will have a direct impact on you.

There are enormous growth opportunities with owning a non-franchised, independent company. You can acquire additional businesses, open up new locations, try new marketing campaigns, and add new products or services just to name a few. The fact that you can raise your prices whenever you deem necessary may seem like a luxury in comparison to the opposing reality when you own a franchise.

(6) When It Comes Time To Sell

There can be very restrictive terms if and when you decide to sell a franchise. For example, the buyer will be required to pay a transfer of ownership fee, pay for training, and must be approved by the franchisor.

If you own an independent business, and grow it, you can sell it for vastly more than you paid for it...which makes good investment sense. This is not the case for most franchises because of poor profitability and growth potential.

In Summary

There are some great franchises out there with solid business models but may have frigid rules and ongoing fees that can bog you down. Franchising has been around for a long time and will continue as a viable choice. But don't start a new one, buy an existing franchise, a resale - one that is already up and running successfully. Even though the disadvantages noted above will still apply, at least you will be able to review its sales history so you have some idea of whether it is a money-maker or a lemon.

Buying an existing independent business with all the ingredients for success already in place is a safe investment and a platform from which to grow and launch new ideas. By far a much more flexible and less risky avenue to successful business ownership. No matter which road you take, however, there are no guarantees. You still need to be a sharp businessperson to make it work.

You Decide

The articles below and our own experience for the past 32 years of selling businesses are the sources from which I derived my conclusions.

Hidden Risks of Franchises
Safer to Buy A Franchise? - Think Again
Franchise This