The pitfalls of franchise models: What you need to know and what to look out for

Franchising plays a significant role in the Australian business environment. There are over 1000 franchise systems operating in Australia, generating business for over 90,000 establishments, employing 561,000 people and with revenue of around $168 billion.

While franchise models operate as part of a recognised brand, the brand alone does not guarantee profit. Every different model and franchise must be treated as a small business and with that comes some key things to know, and some watch-outs to be aware of.

Read more: 7-Eleven’s franchisee financial arrangement is “unusual”: SmartCompany compares leading Australian franchies

The pros and cons

There can be many benefits about buying a franchise, it’s just about finding the right option for you and making sure you fully understand the fine print.

For example, if you are looking at entering an industry you’re not so familiar with, a franchise business can be a good way of starting out and gaining a better working understanding of the industry. The franchisor can offer strong guidance, training and support in the set-up and day-to-day operation. You will have the recognised brand, products and ideally a franchise with proven success.

But the franchisor support can also be a downfall as the control from the franchisor can restrict your business creativity. As a franchisee operator, there will be many aspects that will be out of your control. Consider if you are the kind of person that will be able to handle this control, if not, perhaps the franchisee option isn’t for you.

When operating as a franchisee, the major costs are going to include the franchise fees. The franchise system will be set up to make the franchisor money and will come as an expense to the franchisee. On top of these franchisee fees, the franchise operator will usually need to look after rent and wages.

Recently 7-Eleven has had a lot of eyes being cast upon its operations and model, mainly regarding the cost of wages. The 7-Eleven franchisor profit split is a rate of 57% – 43% on products sold, so effectively the franchisee will only get 43% of the profit and this is used to pay the business costs that include wages, a large expense for a store that is required to be open 24 hours a day, seven days a week. So, perhaps not too attractive of a franchise model when you look a little closer.

Staff are one of the most important aspects of the any business; they must be capable and well-trained. Staff must also be fairly paid for their time and in accordance with the Fair Work Act and minimum award and penalty rates. The franchisee must be aware of this.

Beware the fine print

The key thing to note is when entering a franchise it is essential to make sure you understand all the finer details.

Go over the franchise agreement carefully. It is often good to call on legal support and the support of a chartered accountant in the beginning. Being a franchisee is not something that you want to enter on an impulse. Often franchise agreements require a lengthy time requirement and can be difficult to get out of, making it all the more important to know what you are getting into.

Another example of fine print worth considering is 7-Eleven’s different or unique method of being responsible for the cost of all building rent and outgoings. Effectively the franchisee is not able to own the land where it operates from. It may seem a good idea to take these rent costs away, but you are also losing out on the prospect of increased property prices and what can be the largest asset for the business.

7-Eleven has a property team that finds and selects new stores to be developed. The prospective franchisee then selects the store that is available for sale. Some may argue you are losing creative control in such a business, almost becoming just an attendant at the business especially when you’re unable to vary the products available from what is allowed. All of these factors are determined in the franchising agreement you will sign off on.

Another important aspect to remember is to consider whether or not the franchise will be successful in the area you are setting up in. Is the product range diverse enough? Is this what the customer base wants? How are return customers being encouraged? Just because the franchise system has success in other areas does not mean that the franchise will be successful in your area. Make sure you know the demographics and competition in the area you will be setting up in.

Think before you buy

Being a franchisee is by no means a bad thing as only a small amount of franchisees go out of business. A recent Griffith University report, Franchising Australia 2014, found only 3.5% of franchisees surveyed had stopped operating between 2012 and 2014.

But the most important thing is that franchisees fully understand the contract they are entering into. Like purchasing any business, aspects still need to be focused on: Will I achieve a good return on capital? What are my expected profits? What is my break-even point? What is my return on labour? What are my future cash flow requirements? Also, consider the ‘what-ifs’. What if sales decline? What if cash flow deteriorates? What if a competitor opens closely? Mostly the franchisee will be influenced by the overall condition of the Australian and local economy.

Australia is still considered a tough trading environment, some areas more than others, and a large amount of new businesses fail within the first few years. Competition can be fierce and your management skills must be of a high level. Franchise operations can deliver a number of rewards in economies of scale; reduced costs to the business can be negotiated, such as bank fees and electricity. You are also often able to compare your business to how other franchisees under the same banner are operating. This can offer a better ability to know the areas to improve on and therefore increase profits.

In the initial start-up phase a franchisee is likely to be working up to 60 hours in full-time operation, seven days a week and late nights, which will be demanding. New business owners can find themselves alone and out of their depth. Know your area, your customers, your required profits. Detail, though not admired by all, is crucial when it comes to a franchise and a high level of research is only a good thing.

Harley Bell is an advisor at MGI Parkinson.