The Franchise Sniff Test

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One key to business success is to avoid the natural temptation to rush into a new business enterprise without thorough due diligence investigation first. The "Sniff Test" is a common a common sense approach to evaluating a new business opportunity designed to spot red flags early, before large amounts of time or capital have been invested.

Franchises have a higher overall success rate than do other business start-ups. Successful franchises offer proven business systems and structures, including training, that guide new entrepreneurs to success.

 Not All Franchises Are Bona Fide

Not all advertised franchises offer bona fide business opportunities to potential investors. Following these sniff test procedures will help unearth franchises that are profitable for the franchisers, but not for franchisees:

  • As an investor, what value do you add to the process?
  • Obtain a list of at least 20 new franchisees to contact.
  • If a product is involved, ask for the name of the manufacturer.
  • If a service fee is required, determine sales volume required to break even.

 What Value Do You Add to The Process?

A crucial, early question to ask yourself when considering a franchise is, "What value do I add to the process?" In other words, why does the franchiser need you, and other new investors to be involved? Bona fide franchisers need new franchisees to cost-effectively expand their business base. Thus, their success is tied to your success: a win-win proposition. Beware of companies that promise, "no inventories, no employees, you don't have to sell anything ...

" If it sounds too good to be true, it probably is. Successful businesspeople are never lazy. Advertisements that appeal primarily to greed or laziness should immediately send up red flags. If you aren't adding value to the seller-to-buyer link, you will probably be enriching a fly- by-night company with the funds you invest. Beware of "get rich quick" appeals; the franchiser will get rich, not you.

 New Franchisees, Your Most Valuable Resource

Insist that the franchising company provide a list of at least twenty names with phone numbers. When only a few contact names are provided, these are likely to be large, well-established owners, not representative of most first-year owners. It is virtually impossible for the franchiser to provide a large list of first year franchisees, all of whom are extremely successful and happy. Call as many of the names on the list as you can.

The goal is to survey a representative cross section of franchisees. Make sure to ask them if the franchiser delivered the promised services and training. Ask them lots of questions. How helpful was the training to running their franchises? Were there any surprises? Did they encounter unexpected expenses? How successful are they at operating their new businesses? Calling many new franchisees is the most important sniff test step; the one most likely to alert you to potential problems or misrepresentations.

The goal of the calls is to answer a simple question: Does the franchiser do what they say they will do? If the answer is "yes," proceed to the next sniff test step. If the answer is "no," head for the nearest exit as fast as you can, tightly holding your wallet. Remember, if the opportunity is bona fide, these contacts can be an excellent source of valuable business ideas.

 Ask For the Name of the Product Manufacturer

Franchisers that primarily sell machines or equipment to franchisees, profit by brokering a service to link vendors (manufacturers) to buyers (franchisees). The franchisers profit by selling the equipment at a substantial markup to franchisees. As a potential investor, it is your responsibility to ensure the markup is not excessive.

Contact the franchiser or peruse the literature to learn the name of the manufacturer of the equipment you will be purchasing as a franchisee. Call the manufacturer and ask them the following question: How much would it cost if I could buy your equipment directly from you? If the amount is one-half or one-third of what the franchiser proposes to charge you, you should strongly reconsider.

The underlying business may be bona fide, but you will be paying too much for the equipment. Once you have purchased equipment from the franchiser, they will have made their money and will have no vested interest in your success as a franchisee, not a good proposition.

 Beware of Excessive Service Fees

Some franchisers broker knowledge in exchange for a service fee. For example, a company advertises on the radio that you can earn "20 to 25% return on investment, risk free, by selling hot dogs." This sounds too good to be true, and probably is. Suppose the company offered to train franchisees for a $12,000 fee to sell hot dogs and the average profit margin on each sale was 10%.

This sounds reasonably good. But ask yourself, "How much must I sell before I break even on my investment?" In this example, you must sell $120,000 worth of hot dogs to earn $12,000 in profits thus covering your original investment or breaking even. Finally, ask yourself, how much time and effort would it take for you to equal or exceed $120,000 in sales.

Assuming you worked the business part-time, would it be realistic to project you could make enough transactions to sell $120,000 in six months or one year? The answer depends on your skills and abilities and available time. If the answer is "no," you would probably do better to invest the money in mutual funds.

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