Chapter 4
Franchises and Buyouts
CHAPTER OUTLINE
Spotlight: Veteran Franchise Centers
(http://www.recruitmilitary.com/franchises.)
1 What Is Franchising?
Define franchising and become familiar with franchise terminology.
 Franchising Terminology
 Franchising – A business relationship in which an entrepreneur can reduce risk
and benefit from the business experience of all members of the franchise system.
 Franchisor – The party in a franchise contract that specifies the methods to be
followed and the terms to be met by the other party
 Franchisee – An entrepreneur whose power is limited by a contractual
relationship with a franchising organization.
 Legal aspects vital and must be understood
 Franchise contract- The legal agreement between franchisor and franchisee.
 Franchise- The privileges conveyed in a franchise contract.
 Product and trade name franchising- A franchise agreement granting the right to
use a widely recognized product or name.
 Business format franchising- A franchise arrangement whereby the franchisee
obtains an entire marketing and management system geared to entrepreneurs.
 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.
 Multiple-unit ownership- Ownership by a single franchisee of more then one
franchise from the same company.
 Area developers- Individuals or firms that obtain the legal right to open several
franchised outlets in a given area.
 Piggyback franchising- The operating of a retail franchise within the physical
facilities of a host store.
 Multi-brand franchising- The operation of several franchise organizations within a
single corporate structure.
 Co-branding- Bringing two franchise brand together under one roof.
 The Impact of Franchising – Exhibit 4-1 provides the most recent impact results
indicating that franchised businesses provided more jobs than entire industries
Have students provide the names of franchises in the local community.
2 The Pros and Cons of Franchising
Understand the pros and cons of franchising and the structure of the industry.
 The Pros
 Trade Names and Trademarks – success results from intellectual property such as
the names that are well known to prospective customers
 Operations Manual – well-developed and thoroughly tested methods of marketing
and management
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
37
Chapter 4
Franchises and Buyouts

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
 Economies of Scale- A franchise network can buy in larger quantities than an
individual business can, lowering per-unit costs for franchisees.
 Financial Support-Some franchisors provide financial support to prospective and
existing franchisees.
 The Cons
 Financial Issues
 What are the true costs of becoming and remaining a franchisee
 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)
 Franchisor Competition
 Encroachment – The franchisor’s selling of another franchise location within
the market area of an existing franchisee
 Special clauses inserted into some franchise agreements such as noncompete
clauses that may not allow franchisees to use personal skills and experience
 Management Issues
 Limiting sales territories
 Requiring site approval for the retail outlet and imposing requirements
regarding outlet appearance
 Limiting goods and services offered for sale
 Limiting advertising and hours of operation
 Upon contract expiration, requirement to accept new and often costly
provisions
 The Costs of Being a Franchisee
 Initial franchise fee
 Investment costs
 Royalty payments
 Advertising costs
 Exhibit 4-4shows An Estimate of Investment Costs and Benefits by Oreck
Clean Home Center
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
Describe the process for evaluating a franchise opportunity.
 Selecting a Franchise – use publications, advertisements, personal observation, and
print stories
 Investigating the Potential Franchise
 Two-way effort, each investigates the other in the possible relationship
 The Franchisor As A Source of Information
 Review their websites
38
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
Chapter 4
Franchises and Buyouts

Disclosure document – A detailed statement provided to a prospective
franchisee, containing such information as the franchisor’s finances,
experience, sixe, and involvement in litigation
 Existing and Previous Franchisees as Sources of Information
 Becoming a Franchisor
Ask students to suggest franchises they would like to own and tell why they chose that
franchise.
 A Reproducible Model
 Financial Considerations
 Required Assistance
 Operations Manual
 Government Regulations – Franchise Rule (A rule that prescribes that the
franchisor must disclose certain information to prospective franchisees)
 Long-Term Value
 Legal Issues in Franchising
 The Franchise Contract
 Typically a complex document
 Franchisee should obtain legal counsel to anticipate possible trouble spots and
objectionable feature of the contract
 Also discuss with a banker and a professional accounting firm to examine
financial statements
 Especially examine termination and transfer of the franchise
 Franchise Disclosure Statements
 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
List four reasons for buying an existing business, and describe the process of evaluating
a business.
 Reasons for Buying an Existing Business
 Reduction of Uncertainties
 Acquisition of Ongoing Operations and Relationships
 A Bargain Price
 A Quick Start
 Finding a Business to Buy
 Prospective buyer needs to search for a business to buy
 Matchmakers – specialized realtors/brokers that bring together buyers and sellers
of businesses
 Inc. magazine offers the following guidelines on finding a business to buy:
 Determine your commitment
 Establish what you can afford
 Figure out what skills you have.
 Consider lifestyle impact.
Ask students which franchises stand out in their community. Have them tell why.
 Investigating and Evaluating Available Businesses
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
39
Chapter 4
Franchises and Buyouts
Have students look for advertisements for franchises in the local newspaper, on the
Internet, in magazines such as Inc., and Entrepreneur. What common elements occur
in these ads? What would attract a person to the ad?
 Due diligence – The exercise of reasonable care in the evaluation of a business
opportunity
 Relying on Professionals
 Finding Out Why the Business is For Sale
 Old age or illness
 Desire to relocate to a different part of the country
 Decision to accept a position with another company
 Unprofitability of the business
 Loss of an exclusive sales franchise
 Maturing of the industry and lack of growth potential
 Examining the Financial Data
 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)
 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.
 Quantitative Factors in Valuing the Business
 Three basic approaches (Details in Appendix 4B)
 Asset-based valuation
 Market-comparable valuation
 Cash flow-based valuation
 Nonquantitative Factors in Valuing a Business
 Market
 Competition
 Future community development
 Legal commitments
 Union contracts
 Buildings
 Product prices
 Negotiating and Closing the Deal
 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)
 May have an option to purchase the assets only (seller is responsible for settling
any outstanding debts previously incurred)
 Buyer should never go through a closing without the aid of an experienced
attorney who represents only the buyer
Ask students if they would like to own a franchise and then tell why or why not.
40
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
Chapter 4
Franchises and Buyouts
ANSWERS TO END-OF-CHAPTER 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
franchisee) is granted the privilege of conducting business as an individual owner
but is required to operate according to certain methods and terms specified by the
other party (the franchisor). This unique association with another party, which
brings both benefits and restrictions, distinguishes franchising from completely
independent ownership.
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
franchise. Gasoline service stations and soft-drink bottlers are examples. When a
franchise provides the legal right to use an entire marketing system and an ongoing
relationship of assistance and guidance, it is a business format franchise. Fast food
outlets are an example.
Trade name franchising and its close cousin, product franchising, account for
almost 70 percent of all franchise sales. However, the volume of sales and number
of franchise units associated with business format franchising have increased
steadily over the years.
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. The
franchisor is the party in a franchise contract who specifies the methods to be
followed by the franchisee. The franchisee is the party in a franchise contract who
is granted selling and other privileges and whose power is limited by the franchising
organization. Franchisors can sell franchises directly to franchisees, or they may
market these in specific territories through master licensees or area developers.
Franchise facilitators (such as industry associations, consulting firms, and
federal/state agencies) are often a part of the process, since they promote the sale
and implementation of franchises.
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
potential franchisee are as follows:
Advantages
Formal training
Limitations
Cost of a franchise
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
41
Chapter 4
Franchises and Buyouts
Financial
assistance
Operating benefits
Restrictions
on
business
operations
Loss of independence
The major advantages and disadvantages of franchising from the viewpoint of a
potential franchisor are as follows:
Advantages
Reduced capital requirements
Increased
management
motivation
Speed of expansions
Limitations
Reduction in control
Sharing of profits
Increasing
costs
operational
5. Should franchise information provided by a franchisor be discounted? Why or
why not?
Information provided by a franchisor should not be discounted. The franchisor
should not, however, be the only source of information. Since franchisors are
prohibited from making profit predictions for their franchises, either in writing or
orally, a prospective franchisee should be cautious if the franchisor offers any
predictions. Otherwise, the franchisor is an excellent source of information.
6. Do you believe that the Franchise Disclosure Document is useful for franchise
evaluation? Defend your position.
Some students may argue that the government requirement is unnecessary. They
may favor self-regulation by the industry. However, most students will perceive the
document as useful, since it standardizes the type of information available for
evaluation by potential franchisees. For example, knowledge of the bankruptcy
history of a franchise can be very valuable in the franchise selection process.
7. Evaluate loss of control as a disadvantage of franchising from the franchisor’s
perspective.
Within certain limits, a franchisor can specify, in the franchise contract, matters
that concern him or her about the operation of the business. The franchisee is an
independent businessperson and not under the direct or daily control of the
franchisor. In most situations, this is not a major problem. Sometimes, however,
the franchisor may experience this as a drawback when a franchisee fails to devote
sufficient energies to a franchise and it begins to fail. A franchisor may even
consider purchasing back the franchise to salvage the image of the franchise.
42
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
Chapter 4
Franchises and Buyouts
8. What are the possible reasons for buying an existing company versus starting a
new business from scratch?
The entrepreneur wants to start a new business if he/she has a new product or
service that necessitates a new business. Also, those businesses that are available
for sale may be handicapped by poor locations or undesirable facilities that the
entrepreneur wishes to avoid. However, buying an existing business has its
advantages. For example, this option involves less uncertainty (since the business
is operating), relationships with customers and suppliers are already established,
and a business may be available at a price below what it would cost to create one
from scratch.
9. What are some common reasons that owners offer their businesses for sale?
Which of these reasons might a buyer consider to be negative?
As discussed in the chapter, the real reason for offering a business for sale may
never be disclosed. However, most sellers will probably explain their motivations,
if asked. Some of the common reasons are: 1) Illness or aging of the owner, 2)
Desire to relocate and/or retire in a different part of the country, 3) Decision to
accept a position in another company, maybe a competing firm, 4) Business is not
as profitable as expected—more work required than anticipated, 5) Loss of an
exclusive sales franchise, and 6) Perception of lack of growth in the market
segment. (Reason 4, 5, and 6 can easily be considered negative to the buyer. The
instructor should anticipate receiving many other logical reasons from students.)
10. What are some of the nonquantitative factors in valuing a business?
A list of these factors can be extremely long! Almost anything can be a
consideration. In the chapter, however, the authors have selected the following
factors as typical of nonquantitative considerations:
a. Competition
b. The ability of the market to support the business
c. Future community development
d. Legal commitments
e. Union contracts, if any
f. The quality of buildings
g. Product prices – are they competitive?
COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS
Situation 1
1. Should the Bone brothers have anticipated an economic downturn as part of their
due diligence investigation?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
43
Chapter 4
Franchises and Buyouts
Due diligence investigations in general consider the business opportunity from
many different perspectives. Due diligence should consider the future business
atmosphere as one aspect. Informed parties such as bankers and accounting firms
in the area should contribute to that investigation. Students should access the web
site provided with the situation (http://www.franchisewire.com) to help with their
answers to this question.
2. What steps would you take to attract people to your franchised restaurant when
they are trying to save money?
Advertising should include information emphasizing value for the money. As the
brothers feel that they are operating a cost-efficient operation, the cost per meal or
per item on the menu should be compared with more expensive alternatives.
3. What can the Elevation Burger franchisor do to help franchisees during a
recession?
Elevation Burger can hold expenses. For example, if the franchisor requires the
franchisees to purchase from specific venders Elevation Burger can work with the
venders to keep costs to a minimum. Elevation Burger can also keep the fees
charged down and not increase the fees until franchisees are able to pay higher
fees. Elevation Burger should hold fees and expenses to a minimum because it is
in their best interests to do so.
Situation 2
1.
If Siler Chapman had so much trouble running three restaurants as an
independent owner, why do you think he was able to manage so many more as a
franchisee?
Because he had the support of the Franchise. The Franchise could provide him
with advice, guidance and management recipe for success. The Franchise could
also provide Siler with management training, promotional campaigns, reduced
purchasing costs. All of these tools would improve Siler’s efficiency as a
manager.
2.
From a franchisor’s perspective, why might you choose to convert an existing
chain of stores to your model instead of having franchisees who start from
scratch?
Several reasons exist:
a. Reduction of uncertainties. A successful business has already demonstrated its
ability to attract customers, manager costs, and make a profit.
44
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
Chapter 4
Franchises and Buyouts
b. Ongoing operations and relationships, The buyer of an existing business
typically acquires it personnel, inventories, physical facilities, established
banking connections, and ongoing relations with trade suppliers and
customers. You are also acquiring goodwill that the previous owner created. .
c. Bargain price. An opportunity exists to purchase a business at a good price.
d. Quick start. Buying an existing business may be an excellent way to being
operations much more quickly.
Situation 3
1. Do you think Garrett’s experience is normal for someone looking for a business
to buy? Can you think of other sources of information about companies that
might be for sale that would fit his criteria?
Garrett is looking for a business in manufacturing. With his business experience,
he should know about the best aspects of manufacturing. No person should
purchase a business that doesn’t fit his/her knowledge and/or which seems less
likely to be a good investment. Other sources of information could be available on
the Internet as well as in trade publications and from contacts that he and his
partner have developed over the years.
2. For what reasons might someone bid on a business but not be successful in
buying it?
Sometimes a person bids on a business and another bidder is more successful in
the bidding. If the bid is too low, the seller may not feel it is equitable to sell to
that bidder. The seller and the buyer may not be able to negotiate terms that are a
win-win for the two parties.
SUGGESTED SOLUTION TO CASE 4: Two Men And A Truck, International
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?
Answers will vary.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
45
Chapter 4
Franchises and Buyouts
3. 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?
Answers will vary.
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?
One of the most important legal issues to be faced concerns the franchise contract
with Two Men and a Truck, and any provision relating to termination and transfer of
the franchise. You should check on contract provisions that contain overly strict or
vague cancellation policies, and that your rights to sell the business to a third party
are clearly spelled out. Also look for contractual issues that may prohibit you from
competing with Two Men and a Truck in the same area for a restricted period of time.
ACTIVITIES
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
46
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
Chapter 4
Franchises and Buyouts
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: 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 www.startupjournal.com.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated or posted to a publicly
accessible website, in whole or in part.
47