Is Investing in a Franchise Better than Starting a Business from Scratch?
Why investing in a proven small business franchise concept may be your next best career move.
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Buying a franchise seems like a straightforward way to start a business with a reasonable chance of generating a profit; after all, franchised brands tend to have significant consumer appeal already, and in some cases, thousands of franchise owners are already making money from the opportunity. It is, in many ways, less risky than starting a business from scratch based on an idea of your own, but does it truly offer the chance to make you independently wealthy?
Let's start with a brief review on how franchising works. Every brand does things a little differently, but the basics are always the same. You'll pay for the rights to open a business that bears the same name and/or sells the same products and services as the "parent" business. Most brands force you to follow certain policies for locations, pricing, hiring, and so on, but once the business is up and running, you'll have some role in ongoing management and decision-making, and will be entitled to some or all of the profits generated by that location.
Long-Term Earning Potential
Franchisee success stories make it seem more than possible to build wealth with franchises; they make it seem like the norm. There are thousands of franchise owners in the United States who have used their franchises to accumulate enough wealth to retire on (and retire very comfortably).
But of course, the real profitability figures suggest the possible outcomes are more diverse, and these businesses are complicated. According to data gathered from the Franchise Business Review, the average pre-tax income of a given franchise varies wildly depending on its industry. At the bottom of the list, with 1,571 survey respondents, was the travel and recreation industry, where franchises generated an average pre-tax income of $38,471. Near the top, with 200 respondents, was the automotive industry, where pre-tax income hit an average of $106,000.
There are also outliers at various levels of investment and in various industries. The same report found businesses that cost $1 million or more to start that weren't generating a profit, or were losing money. There are also businesses generating a mere $100,000 in gross sales, yet were returning a net profit of 50 percent.
It's easy to imagine yourself as a positive outlier in this scene, generating massive net profits, but it's more likely that you'll be at the average level or lower, especially if you're a new franchise investor. Making $106,500 a year isn't bad (assuming you're in the best possible industry, and doing an average amount of business), but it's only going to make you rich if you can find a way to multiply that income, while living frugally. Opening more franchises could be the answer, or you could take the income and invest in conventional equities.
Barriers to Entry
This picture of an "average" franchise does seem to make it possible to generate wealth using this entrepreneurial model. However, there are a few barriers to entry that prevent most aspiring franchisees from getting to this point:
- Franchise fees. Buying a franchise requires you to pay an initial fee, as well as the costs of establishing a physical location, hiring workers, and so on. On top of that, you may need to pay royalties or ongoing monthly franchise fees to the main brand. Initial franchise fees alone may be as low as $10,000 or over $100,000, and together with the costs of opening a business, it could end up costing you hundreds of thousands to millions of dollars to get started. In other words, you may need to have a substantial level of wealth before you can even open a franchise.
- Tight margins (and no wiggle room). Many franchises have thin profit margins. Their goal is to generate as much visibility and customer appeal as possible, so they need to sell products and services for low prices. Depending on the rules and restrictions of the franchise, you may not have the power to increase these prices, even if your backend expenses increase. This makes it hard to generate a consistent profit, even if you're seeing a suitable amount of revenue.
- Entrepreneurial experience. Solid business fundamentals are a requirement if you're going to own a successful franchise. While the brand you're buying into may already have customer appeal and revenue-generating potential, it's still on you to choose the right location, hire the right leadership, follow the rules precisely, and keep your team attentive and well-trained. If you've never owned a business before, your rate of failure increases significantly.
The Bottom Line
The bottom line is that while a franchise can make you independently wealthy, it isn't a guarantee. Choosing the right business in the right industry, and going in with preexisting entrepreneurial experience and/or existing wealth can help, but your income-generating potential may still be somewhat limited.