When Should You Convert Your Business into a Franchise?

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The term Conversion Franchise refers to the situation in which someone with a successful small business is offered the opportunity to convert his independent business into a franchised business by affiliating with a franchise organization. And so, thereafter, if the proposal is accepted, the business would no longer be known by its former name, but rather by the name of the franchise chain.

Many of these conversions have been successful. The realty brokerage business is one of the more notable instances in which belonging to a large organization with national coverage has facilitated synergies that would never be available to a small or even a regional group of realtors. However, many, maybe even most, conversions are a disaster for the unfortunate person who converted an independent business to a franchise and didn't know how to do the "due diligence" before making the decision to convert.

So many have come to me with this problem, usually no longer having sufficient funds even to hire a lawyer, that I have decided to put the due diligence protocol on this web site in the hope that some fine small businesses may be saved from a franchise conversion disaster.

What is needed to mitigate the conversion decision risk is never offered. What is offered is a franchise agreement with an initial franchise fee, subsumes an initial investment in changing the business identification to that of the franchise organization, a required regular payment to an advertising fund, a required periodic royalty payment which starts with the first dollar of income every month. 

The franchise contract purports to obligate the converting franchisee to a term of affiliation of at least five years, with a non-competition agreement to prevent departure from the franchise chain - you lose your business if you leave. While these are much less enforceable in the context of a conversion franchise, they are not entirely free of enforcement risk, and even if you win you have spent a great deal of money to fund the litigation.

Then, too, there is the cost of re-identifying your business to its old name and advertising blitz expenses to get that name back out there where people are educated and conditioned to accept and patronize it.

Every conversion franchise agreement I have ever seen has these provisions. If this is the deal being offered, and it always is, there are certain obvious exercises that must be done to analyze its investment worthiness. Obvious, yes, but almost never done. I guess it is obvious if you know about it and how to do it. Well, now that you are reading this article, you will know.

The formula is quite simple. You will, by converting to a franchised business, add to your expense profile the monthly royalties (anywhere from 4% to 8% of sales), plus the advertising fund payments (usually around 2% to 4% of sales) plus other expenses. Frequently use of e-commerce facilities and other "support" elements are not included in the fee and royalty structure, but are separately and additionally charged for. These monthly expenses must be added up and subtracted from your profit and loss statement.

What is the impact upon your profit as a percentage of gross sales? That reduced profitability will be your future profit-as-a-percent-of-sales profile if you decide to convert.

What do you get for that? You are told that you will get greater name recognition, the impact of being in a national organization that can generate more sales, "support" (whatever that is), and the privilege to participate in that franchisor's "unique" system of doing business. There is an objective way to determine how much of what you are being told is true and how much of it is blatantly untrue.

The test is that you aggregate the monthly incremental cost of being a franchisee, and mathematically determine how much in incremental sales at the now-reduced profit percentage you will need to reach break even on your having assumed this additional financial burden. Your accountant can do this for you. And that is merely a break even sales number. To make the conversion decision a profitable investment you have to exceed that sales number by a substantial margin.

Once you have derived that sales number, go to Item 19 of the Franchise Disclosure Document (FDD) that the franchisor is required to have provided to you before you signed any contract, and see if sales ranges achieved by their franchisees is provided. If not, you are about to make a big mistake if you decide to convert your business to their franchise.

Immediately and absolutely refuse to convert to any franchise that does not provide their franchisee sales ranges broken down into the categories of: (1) the number of franchisees in the top 25%, the second 25%, the third 25% and the bottom 25%; (2) the number of franchisees in each geographic region that are in each sales percent category (frequently there is great variance in sales performance by region, and knowing which region you would be in can be critical - not all regions perform with equal success profiles for any franchisor); and (3) the length of time the franchisees have been affiliated with the franchisor in each percentage of sales grouping (if it takes ten years to get near the top tier, you don't want to convert your business).

Now that you know how your sales would have to increase just to cover your expenses of conversion, without any incremental profit to you from having converted, ask the question, "How many of this franchisor's franchisees have achieved this sales level?

The reason so many conversion franchisees have ended up in my office wanting to know how to get out of the franchise contract and how to get their money back is that their franchisor had few or no franchisees generating sufficient sales to justify the conversion investment.

It is a loss situation for the converted franchisees. In many instances, the answer to this exercise is that the franchisor has never had even one franchisee with sales at the level you would need to justify converting your business.

This analytical exercise tells you whether the sales pitch about how wonderful the franchisor's stuff really is is true or false. While there may well be franchisees in that system that are satisfied with their relationship with this franchisor, that is not the question. The question for you is whether the affiliation with this franchisor will provide sales results for you to make you happy at the reduced profit percentage caused by the costs of affiliation.

If the results of this exercise are not positive, but for some reason you still wish to consider converting your business and joining this organization, you can mitigate the risk by insisting upon the following terms being put into your franchise agreement:

1. Current sales are exempt from all payments based upon percentage of sales. Percentage of sales payment obligations apply only to sales above current levels.

2. If sales growth does not exceed 20% by the second year, you may terminate the franchise agreement with no non-competition or other constraint upon your right to do whatever you want to do with your business.

3. If you are still in the system when the time comes to renew your franchise agreement, you have the right to renew upon the same terms as your current agreement, with no adverse changes. Many franchisors want you to renew on their new agreement that frequently has higher fees and less protection for you.

4. If you sell your business, your buyer gets your contract, not some new contract with different rights, including renewal rights.

If the franchisor if unwilling to agree to these terms, reject the conversion offer. So endeth the lesson.

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About this Entry

This page contains a single entry by Richard Solomon published on April 17, 2013 7:33 PM.

How to Avoid Excessive Billing By Your Franchise Law Firm & Get Better Results was the previous entry in this blog.

The 4 Easiest Ways to Lose Your Entire Franchise Investment is the next entry in this blog.

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