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Chapter 4: Franchises and Buyouts

CHAPTER 4: FRANCHISES AND BUYOUTS

CHAPTER OUTLINE

Spotlight: Castro Enterprises: The Innovative Franchisee

1) What Is a Franchise?

LO1: Define franchise, and have an understanding of franchise terminology.

a) Franchising Terminology

i) Franchise- a legal an commercial relationship between the owner of a trademark,

service mark, trade name, or advertising symbol and individual group wishing to

use that identification in a business.

ii) Franchising – A business relationship in which an entrepreneur can reduce risk

and benefit from the business experience of all members of the franchise system.

iii) Franchisor – The party in a franchise contract that specifies the methods to be

followed and the terms to be met by the other party

iv) Franchisee – An entrepreneur whose power is limited by a contractual

relationship with a franchising organization.

v) Two primary forms of franchising are:

(1) Product and trade name franchising- A franchise agreement granting the right

to use a widely recognized product or name.

(2) Business format franchising- A franchise arrangement whereby the franchisee

obtains an entire marketing and management system geared to entrepreneurs.

vi) Franchise agreement- a legal contract with the franchisor spelling out the

relationship and obligation of each other.

vii) Master licensee- An independent firm or individual acting as a middleman or

sales agent with the responsibility of finding new franchisees within a specified

territory.

viii) Multiple-unit ownership- Ownership by a single franchisee of more then one

franchise from the same company.

ix) Area developers- Individuals or firms that obtain the legal right to open several

franchised outlets in a given area.

x) Piggyback franchising- The operating of a retail franchise within the physical

facilities of a host store.

xi) Multi-brand franchising- The operation of several franchise organizations within a

single corporate structure.

xii) Co-branding- Bringing two franchise brand together under one roof.

b) The Impact of Franchising – The International Franchise Association (IFA)

sponsors studies of the impact of franchising on the American economy. According to

a 2012 study, franchised businesses actually provided more jobs than entire

industries, including durable goods manufacturing, financial series, construction,

nondurable goods manufacturing, and information. Direct employment in 749,499

franchise establishments totaled 8,102,000 jobs.

i) Have students provide the names of franchises in the local community.

2) The Pros and Cons of Franchising

Chapter 4: Franchises and Buyouts

LO2: Understand the pros and cons of franchising and the structure of the industry.

a) The Pros

i) Trade Names and Trade Marks – success results from intellectual property such as

the names that are well known to prospective customers

ii) Proven Business Systems and Operating Plan – well-developed and thoroughly

tested methods of marketing and management

iii) Training Support – provides a proven track record leading to a probability of

success; training programs may be excellent or poor and should be carefully

considered

iv) Supply and Purchasing Power- A franchise network can buy in larger quantities

than an individual business can, lowering per-unit costs for franchisees.

v) Financial Support-Some franchisors provide financial support to prospective and

existing franchisees.

b) The Cons

i) Financial Issues

(1) What are the true costs of becoming and remaining a franchisee

(2) Other issues include such things as churning (actions by franchisors to void

the contracts of franchisees in order to sell the franchise to someone else and

collect an additional fee)

ii) Franchisor Competition

(1) Encroachment – The franchisor’s selling of another franchise location within

the market area of an existing franchisee

(2) Special clauses inserted into some franchise agreements such as noncompete

clauses that may not allow franchisees to use personal skills and experience

iii) Management Issues

(1) Limiting sales territories

(2) Requiring site approval for the retail outlet and imposing requirements

regarding outlet appearance

(3) Imposing requirements regarding outlet appearance

(4) Limiting goods and services offered for sale

(5) Limiting advertising and hours of operation

c) The Costs of Being a Franchisee

(1) Initial franchise fee

(2) Investment costs

(3) Royalty payments

(4) Advertising costs

(a) Ask students to identify factors that lead to variation in these costs (e.g.,

nature of the business, reputation of the franchisors, etc.)

3) Evaluating Franchise Opportunities

LO3: Describe the process for revaluating a franchise opportunity.

a) Selecting a Franchise – use publications, advertisements, personal observation, and

print stories

b) Investigating the Potential Franchise

i) Two-way effort, each investigates the other in the possible relationship

ii) The Franchisor as a Source of Information

(1) Review their websites

(2) Disclosure document – A detailed statement provided to a prospective

franchisee, containing such information as the franchisor’s finances,

experience, sixe, and involvement in litigation

iii) Existing and Previous Franchisees as Sources of Information

c) Becoming a Franchisor-Ask students to suggest franchises they would like to own

and tell why they chose that franchise.

i) A Reproducible Model

ii) Financial Considerations

iii) Required Assistance

iv) Operations Manual

v) Government Regulations – Franchise Rule (A rule that prescribes that the

franchisor must disclose certain information to prospective franchisees)

vi) Long-Term Value

d) Legal Issues in Franchising

i) The Franchise Contract

(1) Typically a complex document

(2) Franchisee should obtain legal counsel to anticipate possible trouble spots and

objectionable feature of the contract

(3) Also discuss with a banker and a professional accounting firm to examine

financial statements

(4) Especially examine termination and transfer of the franchise

ii) Franchise Disclosure Statements

(1) Franchise Disclosure Document (FDD) – A document that provides the

accepted format for satisfying the franchise disclosure requirements of the

FTC

4) Buying an Existing Business- Ask students to list four reasons for buying an existing

business, and describe the process of evaluating a business.

LO4: List four reasons for buying an existing business and describe the process of

evaluating a business.

a) Reasons for Buying an Existing Business

i) Reduction of Uncertainties

ii) Acquisition of Ongoing Operations and Relationships

iii) A Bargain Price

iv) A Quick Start

b) Finding a Business to Buy

i) Prospective buyer needs to search for a business to buy

ii) Business brokers – specialized realtors/brokers that bring together buyers and

sellers of businesses

iii) The Small Business Administration offers the following guidance on finding a

business to buy:

(1) Identify your interests

(2) Consider your talents

(3) List conditions for your business

(4) Quantify your investment

c) Investigating and Evaluating Available Businesses- Have students look for

advertisements for franchises in the local newspaper, on the Internet, in magazines

Chapter 4: Franchises and Buyouts

such as Inc., and Entrepreneur. What common elements occur in these ads? What

would attract a person to the ad?

i) Due diligence – The exercise of reasonable care in the evaluation of a business

opportunity

ii) Relying on Professionals

iii) Finding Out Why the Business Is For Sale

(1) Retirement

(2) Illness

(3) Partnership or family disputes

(4) Unprofitability or failure of the business

(5) Burnout

(6) Lack of capital growth potential

iv) Examining the Financial Data

(1) The first stage in evaluating the financial health of a firm is to review the

financial statements and tax returns for the past five years or for as many years

as they are available (NOTE: if these are not available, think twice before

buying the business)

(2) Nondisclosure agreement- An agreement in which the buyer promises the

seller that he or she will not reveal confidential information or violates the

seller’s trust.

d) Quantitative Factors in Valuing the Business

i) Three basic approaches (Details in Appendix 4B)

(1) Asset-based valuation

(2) Market-comparable valuation

(3) Cash flow-based valuation

e) Nonquantitative Factors in Valuing a Business

(1) Market

(2) Competition

(3) Future community development

(4) Legal commitments

(5) Union contracts

(6) Buildings

(7) Product prices

f) Negotiating and Closing the Deal

i) Calculated value may NOT be the price eventually paid for the business (but does

provide the buyer an estimated value to use when negotiating the price)

ii) May have an option to purchase the assets only (seller is responsible for settling

any outstanding debts previously incurred)

iii) Buyer should never go through a closing without the aid of an experienced

attorney who represents only the buyer

(1) Ask students if they would like to own a franchise and then tell why or why

not.

Chapter 4: Franchises and Buyouts

ADDITIONAL DISCUSSION QUESTIONS

1. What makes franchising different from other forms of business? Be specific.

Franchising is an alternative to business ownership whereby one party (the

2. What is the difference between product and trade name franchising and

business format franchising?

A franchise that only provides the right to use a trade name is a trade name

3. Identify and describe at least four of the key terms in franchising.

The franchisor and franchisee are the two main parties in the franchise system.

4. Discuss the pros and cons of franchising from the viewpoints of both the

potential franchisee and the potential franchisor.

The major advantages and disadvantages of franchising from the viewpoint of a

Chapter 4: Franchises and Buyouts

A list of these factors can be extremely long! Almost anything can be a consideration.

SUGGESTED ANSWERS TO YOU MAKE THE CALL EXERCISES

Situation 1

1. Do you think that Patterson really does not know or care whether or not he is

making money? Can he succeed in two locations if that is his attitude?

2. What type of background do you think you would need to run a 1-800-Got-Junk

franchise?

3. If you were Patterson, what support would you expect to get from the franchisor?

Chapter 4: Franchises and Buyouts

Situation 2

1. What risks do you think you would face if you were a successful manager in a

large organization who suddenly had an offer to go into business for yourself?

2. Why do you think Treadwell decided to become a multibrand franchisee instead of

just staying with KFC?

Situation 3

1. Why do you think Phil is thinking about business ownership after the success he

has achieved working in other companies. Why do you think he wants to buy

instead of starting a business?

2. What questions do you think Phil should ask of a seller if he finds a business that

he likes?

Some questions that Phil should ask of the seller would be:

Chapter 4: Franchises and Buyouts

license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4-9

SUGGESTED SOLUTION TO CASE 4: TWO MEN AND A TRUCK®

1. Limiting sales territories is one of the common restrictions that franchise contracts

impose on franchisees. Do an Internet search for TWO MEN AND A TRUCK

franchises in your immediate area. How many are there? Does this number reflect the

company’s population requirements?

2. Which moving companies compete with TWO MEN AND A TRUCK in your area? Are

there differences in their rates of success? How could you measure those differences?

Are there differences in their advertising? In their rates for items such as boxes and

packing supplies? Which companies have an advantage, and why?

3. Suppose that after owning a TWO MEN AND A TRUCK franchise for five years, you

decided to go out on your own with a new moving company called Four Movers. What

kinds of legal issues would you face?

The essential response should address whether or not the franchisee signed a non-

ADDITIONAL ACTIVITIES

Chapter 4: Franchises and Buyouts

Purpose: The purpose of these activities is for students to experience the intricacies

of buying an existing business and to create a written plan to organize the process of

doing so.

Setting it up: These activities are suited to individual assignment, but they could

also be worked on in teams of two students. It might be difficult to manage this as a

short group activity because there is not enough work for the exercise to be a

successful in this context. By requiring students to complete a full business plan

template for acquiring an existing business, however, you could have students or

student teams work on this activity throughout the semester.

Tell the students to imagine that each of them have just inherited $500,000 business

capital from an elderly relative who admired their entrepreneurial spirit. The only

stipulation in the will is that they must use the money to buy, and make plans to run,

one of the small businesses that are for sale locally [for this exercise the students may

choose what’s “local”.] Also, before the money will be released to them, they must

submit a preliminary business plan to the trustees of the estate [you]. Finally, tell

students that they must start the process of buying an existing business immediately

or the inheritance will pass to another likely entrepreneur in the family! To begin:

1. Have students search for a local business for sale on the Wall Street Journal’s

online center for entrepreneurs at http://www.startupjournal.com/.

2. Next, have them find the template, “Business Plan for an Established Business”, on

the SCORE Web site, http://www.score.org/template_gallery.html. Then have

students fill out the General Company Description (page 5) with all the

information they can gather on their chosen business for sale and submit it to you

as the trustee.

3. When their plan is complete, have them checking it plan against the

recommendations of the Small Business Administration at

http://www.sba.gov/smallbusinessplanner/start/buyabusiness/index.html.

Extension:

Have students use a template to produce a complete business plan for purchasing the

established business they’ve selected for this exercise. A robust template can be found at

“Business Plan for an Established Business”, on the SCORE Web site:

http://www.score.org/template_gallery.html; or at www.startupjournal.com, a section of

the Wall Street Journal’s Web site that will lead to the small business area site for wsj.

Sources: Small Business School video; www.moschowder.com; Kerry Miller, “The

Restaurant-Failure Myth,” BusinessWeek (Small Business Edition), April 16, 2007, online at

www.businessweek.com/smallbiz/content/apr2007/sb20070416_296932.htm; S.C.O.R.E., a

small business counseling site at www.score.org/template_gallery.html; the Small Business

Association Web site at www.sba.gov/sbdc; Wall Street Journal’s site for entrepreneurs at

Chapter 4: Franchises and Buyouts

www.startupjournal.com. Mo’s On The Waterfront, Tradition Turned Legend, book available

at Mo’s web site, published in January 2005.