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Hidden Costs When Purchasing a Franchise

Looking to buy a franchise? Don’t be fooled by ads promoting a low franchise fee. Purchasing a franchise is not just a matter of plunking down an initial franchise fee, and letting revenues take care of the rest. There are a myriad of costs involved in the purchase and ongoing operation of a franchise. In fact, a common cause for new franchise failure is lack of working capital.

Overall franchise costs are often determined in part by the industry and the particular franchisor. As a franchisee, you might invest in a hotel franchise with costs in the millions, or you might invest $10,000 for a part-time home-based franchise. Within the same industry, one franchisor might require a significantly greater investment than another. The higher cost, though, may be due in part to an increased number of services and level of support provided by a particular franchisor. So, a lower fee for a franchise may not necessarily mean it is the franchise with the greater value.

The Federal Trade Commission’s (FTC) Franchise Rule requires franchisors to provide prospective franchisees with a disclosure document called the Uniform Franchise Offering Circular (UFOC). The FTC’s intent was that the UFOC provide particular and accurate franchisor information so that prospective franchisees could make informed decisions about purchasing franchises.

Part of this disclosure document describes the costs involved to start one of the company’s franchises, the franchisor’s estimate of the typical total investment by the franchisee, and earnings potential. Prospective franchisees — in contrast to independent start-ups — have the benefit of the franchisor’s knowledge of the costs of developing their business. The UFOC should be carefully reviewed with a qualified franchise attorney and clarification should be sought from the franchisor on any provisions not understood.

Let’s examine the costs of purchasing a franchise.

Initial Costs

Franchise Fee
Set by the franchisor, the franchise fee is paid up-front upon signing the franchise agreement and may be non-refundable (from about $5,000 to $100,000 or more). At the least, this fee gives the franchisee the right to use the franchisor’s name and business concept. Some of the other services this fee may include: site selection assistance and development, marketing and promotions, grand opening events, cost of tuition for initial training, and initial support. When comparison shopping among franchisors, pay particular attention to what services you will receive for the franchise fee.

Net Worth and Cash Liquidity Requirements
Although not an actual “cost,” certain franchisors require prospective franchisees to meet specific financial requirements in order to qualify.

Initial Cash Investment
Franchisors generally demand that franchisees invest at least 30 to 35% of their own cash into the total franchise start-up investment.

Working Capital
Sometimes underestimated, you will need sufficient working capital to support personal and business expenses to the extent that they are not covered by revenues. Depending on the business, you may need as little as two or three months, or as much as two or three year’s worth of working capital.

Loan Applications Fees
Real Estate Costs
Whether you will need to build, buy, rent or lease, there will be real estate costs involved. These costs may include: security and rent deposits, building construction or improvements, civil and architectural drawings and professional fees, zoning expenses, and landscaping.

Professional Fees (i.e., legal and accounting services)
Business Insurance
Check with the franchisor and your insurance broker to determine the types and amounts of insurance you need to carry. These may include: liability, workers’ compensation, property, casualty, business interruption or commercial automobile insurance.

Permits and Licenses
Depending on the type of business you own, you will need to obtain certain permits and licenses. They may include: fire department, air and water pollution control, or sign permits; and business, liquor or sales tax licenses. Although the franchisor should provide you with a specific list of permits and licenses required, don’t assume the franchisor knows all the laws in your particular area. Check with local and state offices to be sure you obtain what is needed.

Although the actual training may be provided as part of the franchise fee, you will most likely be responsible for airfare, hotel accommodations, local transportation, and food for yourself and staff who attend training.

Pre-opening Labor and Salaries
Inventory and Equipment
New franchises typically purchase their equipment and supplies either directly from the franchisor or from suppliers contracted through the franchisor. Check Item 8 in the franchisor’s UFOC where it discloses the restrictions placed on the franchisee’s purchase of supplies and product inventory. Be alert for franchisors who may overcharge their franchisees for goods. Check with several company franchisees to find out if products are fairly priced and effectively delivered.

Decor and Fixtures
Grand Opening Costs or Fees
Ongoing costs

Royalty fees
Payments made to franchisor, typically about five to 10 percent of revenues.

Principal and Interest payments on loans.
Real Estate Costs
Additional Equipment and its Maintenance
Office supplies
Payroll and Taxes
Advertising Fund Fee to Franchisor
Local advertising and marketing costs
Seek advice from a good accountant, who can put together a projection of your planned business and how much money it may generate. Evaluating the information in the UFOC, your accountant can perform a cash-flow analysis and provide you with a good idea of how much capital you’ll need to start and run your business. The money it costs for this service may be well worth it.

It is also important to have a qualified franchise attorney review and evaluate the franchise agreement. This contract sets forth the rules and obligations of both franchisee and franchisor, including payment information and termination procedures. It is critical to understand your rights and obligations under this contract before you sign the agreement.

Matthew Anderson is the founder of The Franchise Shop website which specialises in New Franchises for sale and expert in franchise marketing and franchises