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Franchising a Restaurant, Explained

Do the benefits outweigh the costs and pitfalls?

As a 24-year-old in his college town of Columbia, Missouri, Joe Sieve frequently ate at a location of Mr. Goodcents Subs & Pastas, a chain based in De Soto, Kansas. While there, he connected with the owner, who shared his success story and inspired Sieve to move to St. Louis and open his own location of Goodcents in 1997, a franchise that ultimately kicked off 20 years in the business of franchising restaurants for Sieve. "When I started my very first franchise, I basically didn't know what I was doing, it was a lot of learning from mistakes," Sieve says. "But it was exciting."

Sieve eventually expanded his business, operating three different restaurant brands — including La Salsa Fresh Mexican Grill and Domino's Pizza — totaling more than 50 restaurants across four different states. He's now the vice president of franchise development at Arby's, which has roughly 3,300 restaurants around the country.

Franchising, which is an American invention from the 1800s, first became popular at Ray Kroc’s McDonald’s. The unique business model allows two separate owners to share in the operations and profits of a business, each providing support and resources. While franchises can serve as a point of entry into business ownership for many Americans, included in the deal is a complex set of operational protocols and assorted challenges. For example, the nature of the operation often prevents franchise employees from unionizing, and recent lawsuits against larger chains have resulted in questions about worker rights and how a franchise is defined. Here, now, a primer on how restaurant franchises work, and what it takes to open your very own McDonald’s, Arby’s, or Chick-fil-A.

McDonald's Flickr/Mike Mozart

What is a franchise?

A franchise is a business where the owners grant third-party operators the rights to use the business’s name, branding, and model in exchange for fees or royalties and ongoing support in the form of advisement or marketing. For the most popular fast food franchises, start-up costs range from $10,000 to well over $1 million, and monthly fees, which are typically calculated as a percentage of gross sales, generally hover around the 5 percent mark, but can be as much as 50 percent. As part of the agreement, each franchisee provides the same goods and services for which the business is known. In the case of restaurants, franchisees serve the same menu (with occasional regional differences), feature the same advertisements, and use the same branding across the board.

How it works

Early on in his franchising career, Sieve says he made a lot of costly mistakes, though none were catastrophic. One major benefit to being a franchisee is the built-in support network of other operators. Throughout the process, Sieve met other franchisees within the system who operated multiple units, and sought advice from them on how to build his own business.

One of the biggest problems first-time franchisees run into is cash, or lack thereof. “I probably was undercapitalized in the beginning,” Sieve says of his initial investment. “There was a lot of learning and innovating that had to be done as a franchisee.” He says guidance in terms of budgeting the start-up costs was limited, and there were some thin years in the beginning. But he ultimately became profitable.

Now at Arby’s, Sieve says his company offers counsel to franchisees throughout the process. While the Georgia-based company looks for potential franchisees with experience operating quick-service restaurants and certain amounts of capital before forming a partnership, it provides support from start to finish, including in real estate development, construction, design, and eventually operations, training, and advertising.

The degree of franchisor involvement, the associated costs, and the overall franchising process varies across restaurant chains. For potential franchisees, the process requires several steps and involves weighing both the benefits and challenges of entering the franchise system.

Budget: This is where every franchise starts. The Federal Trade Commission (FTC) mandates that franchisors provide franchisees with a disclosure document, which outlines the specifics of the agreement, including fees associated with franchising, royalties, and advertising. The disclosure document also reveals any restrictions on where a franchisee can purchase products or supplies to run the business.

Anyone interested in franchising New York City’s world-famous Halal Guys concept, for example, must prove they have $2 million in net worth and $1 million in capital to be considered. Franchisees also must commit to opening five Halal Guys locations and need to demonstrate substantial business experience.

Fees: For most franchises, there are associated start-up fees. For someone franchising a Chick-fil-A for example, there is an initial $6,250 to $37,500 fee. The company fronts the money for start-up costs including land, construction, and restaurant equipment. But the franchisee ends up paying for it over time in fees to the parent company. Chick-fil-A franchisees pay the company 15 percent of gross sales in addition to 50 percent of the remaining pretax profit each month. The chain has 1,464 franchises in operation.

These startup fees differ from company to company. A Taco Bell franchisee will pay an initial fee of $45,000 plus a monthly service fee of 5.5 percent of gross sales, and a fee of 4.25 percent of gross sales for marketing support.

TCBY, the frozen yogurt chain, has an initial franchise fee of $35,000 and estimates that a total franchisee investment will range from $245,700 to $418,000. The company enforces royalty and advertising fees that are a percentage of gross sales (6 percent and 3 percent, respectively). A TCBY franchisee looking to operate multiple units needs $250,000 in liquid assets and a net worth of $500,000.

Market placement: At Arby’s, Sieve says the company discusses financial and operational issues and identifies the areas where a franchisee wants to operate. “We have an entire company devoted to supporting the success of those franchisees,” he says, where a real estate department works with franchisees to ensure a particular neighborhood would have a good mix of potential clientele, and other restaurants but perhaps no other sandwich chains.

Buying or leasing a restaurant: McDonald’s franchisees pay a 40 percent down payment (of total cost of the space) to purchase a new restaurant and a 25 percent down payment to purchase an existing restaurant. Twenty-five percent of the down payment must be in cash, and franchisees can finance payment for the rest of the cost through a lending institution. Once a McDonald’s franchise is up and running, the franchisee must pay McDonald’s a monthly service fee that is based on the restaurant’s sales performance, usually around 4 percent of monthly sales.

As a point of comparison, Subway franchisees work with the company to find a location. Subway negotiates the terms and signs a master lease, with the franchisee signing a sub-lease and paying directly to the landlord each month. Franchisees can also build out their own restaurants in certain cases.

Partnerships: Existing companies and brands can connect franchisees with suppliers to source products for the restaurants. The parent company can also provide guidelines or specifications for equipment needed to run the operation. Subway, for example, presents franchisees with an equipment leasing option and offers to facilitate financing for new franchisees.

Fast Food Franchise Costs, Compared

Restaurant Franchising Fee Monthly Fees Start-up Costs Net Worth Liquid Assets
Restaurant Franchising Fee Monthly Fees Start-up Costs Net Worth Liquid Assets
Arby's $6,250 4%, 4.2%+ $271,950 $1,000,000 $500,000
Chick-fil-A $10,000 15%, 50% $0 $0 $0
Halal Guy's $40,000 2%, 6% $233,600 $2,000,000 $1,000,000
McDonald's $45,000 4%, 4%-12% $1,003,000 $750,000
Subway $15,000 4.5%, 8% $116,600 $80,000 $30,000
Taco Bell $45,000 5.5% $1,200,000 $1,500,000 $750,000
TCBY $35,000 2%, 6% $200,000 $250,000 $100,000
*All dollar amounts are starting approximate costs Credits: Entrepreneur, Business Insider

Advantages

Compared to other types of small business ownership, there are significant advantages to operating a franchise. Most franchisees automatically benefit from the name recognition of the brand they operate. Signing on to extend the reach of a company or concept that already has a loyal following can allow a franchisee to capitalize on the recognition factor and ride the same wave of success.

Halal Guys is a good example: What started out as a cart on the sidewalk has turned into an internationally recognized sensation. To capitalize on that popularity, the company partnered with a successful franchising company called Fransmart, which has facilitated the growth of the brand into new markets including Dallas, Chicago, and Orlando. Fransmart’s CEO Dan Rowe previously told Eater that “a brand has to have its own soul and its own story,” meaning that potential franchisees must also embody and, once they sign on, project that same “soul” that initially attracted people to the brand.

Franchising also has a track record of providing an entry into business ownership for individuals who have immigrated to the United States, a movement recognizable in one of the country’s most recognizable ice cream truck brands: Mister Softee. Franchisees of the soft-serve truck in the early 1960s were largely Irish, Italian, and Greek, as Eater previously reported, and over time, African-Americans, people of Caribbean and Hispanic descent, and immigrants from the Middle East have pursued business ownership via the Mister Softee brand. Mister Softee provides franchisees support with supplies and parts, financing, and marketing, in addition to offering training for those without experience.

Some businesses even incentivize franchising by offering special visas that will allow a franchisee the opportunity to gain permanent residency in the United States, provided the franchisee invests $500,000 in the business and can create 10 new jobs within two years, as the Wall Street Journal reported in 2014. Franchises like Subway have provided a supportive structure for immigrants to join a business and eventually expand their own operation.

Additionally, individuals who operate multiple units of a franchised restaurant can see higher profits, as they are able to spread their fixed costs across multiple units, according to the Franchise Business Review. Multi-unit ownership can also allow franchisees to secure financing, retain staff, and leverage greater influence with the overall brand.

Disadvantages

While multi-unit ownership can result in higher profits for franchisees, signing on to open multiple units in the first place is a large commitment: The risk of failing tends to be higher, even though that risk is distributed across locations. If successful, multi-unit owners can see serious profits, often more so than single-unit operators, per the Franchise Business Review, though the process can take longer.

Mario Herman, a Washington, D.C.-based franchisee attorney, also argues that agreements written by franchisors can be restrictive. For franchisees, he says, it is important to carefully review the franchise disclosure document and consider the cost of goods sold (COGS), the labor costs, and what royalties will be owed a franchisor before entering into an agreement.

“Franchising has brought wonders and great opportunities to many around the world and it’s also given customers huge choices. But like much of what’s going on in this country, it’s ‘cowboy capitalism,’” he says, a phrase that connotes “unpredictability, inconsistency, uncertainty — a kind of ‘Wild, Wild, West of Entrepreneurism,’” where rules can be interpreted differently.

Additionally, as employees at fast-food chains push for an increase in minimum wage (in most cases, $15 per hour), franchisees themselves may be forced to cut hours and reduce jobs, or else raise prices to maintain profitability, as previously reported. This means that while franchisees are essentially run as small businesses, they can be subject to heavier regulations because they are tied to their parent companies.

The joint business model that profits both a franchisee and the overarching franchise holds a unique structure that can affect employment and wages. Employees of a franchised restaurant have long been unsuccessful in unionizing, meaning any wage and labor issues are handled by the franchise owner, rather than the overarching business. This ends up benefiting the parent company, as it limits class action lawsuits.

For Sieve, the advantages of franchising (and of running multiple units, at that) outweighed the negatives. He started out in the business running just one restaurant, which led to a career operating multiple units and eventually to a role overseeing franchise development for Arby’s.

Ultimately, he says, a franchisee’s success depends on to a degree on the concept itself, and “a lot of it depends on what type of development schedule or objective the franchisee has,” and it can be a boon for Americans eager to enter the restaurant business.

“As a franchisor, it’s also our responsibility to protect each of our franchisees’ investment,” Sieve says. “The number one goal of any franchise business is to grow units,” and to do that, “you have to have a true partnership between franchisor and franchisee.”


Dana Hatic is an associate editor at Eater Boston. Dola Sun is a Brooklyn-based freelance illustrator who likes to create illustrations with textures and graphic shapes.
Editor: Daniela Galarza

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