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Franchising and the SBA: Look Before your Leap

According to the IFA’s Economic Impact Study prepared by PricewaterhouseCoopers, from 2001 to 2005 the growth rate of franchise businesses far outperformed other businesses in terms of economic output and job creation. From 2001 to 2005, franchise businesses grew by over 41 percent, an annual rate of more than 8 percent, 1.5 times the rate of other businesses.

Franchises propelled employment growth with job creation growing by 12.6 percent compared to 3.5 percent for all other businesses, representing a 300% greater rate of job creation. With Statistics like these, it’s not hard to see that interest in franchising is huge. And, getting started can be relatively easy with help from the Small Business Administration’s (SBA) 7(a) loan program. But, is it too easy? And, do borrowers do enough due diligence? Based on our own experience, the excitement of opening your own business and the momentum of the “deal” may be causing more than a few buyers to fall down on basic due diligence.

According to the SBA, seven out of 10 new employer firms survive only 2 years, half at least 5 years, a third at least 10 years, and a quarter stay in business 15 years or more. But, it can still be very hard to get reliable data on first year performance by many franchises. Federal law does not make it easy for entrepreneurs to get and many simply don’t do enough due diligence. For example, franchisors don’t have to disclose default rates or average first-year store revenues with potential franchisees.

The Franchise Rule is supposed to give prospective purchasers of franchises the material information they need in order to weigh the risks and benefits of such an investment. The Rule requires franchisors to provide all potential franchisees with a disclosure document containing 23 specific items of information about the offered franchise, its officers, and other franchisees.

The Franchise Disclosure Document (FDD) details the financial performance of the franchise and offers a snapshot of the average revenue a franchisee makes. But Item 19, intended to provide insight into a franchise’s financial performance, is often calculated to put the best possible light on the franchise system’s numbers. Earnings are reported in ranges that can be so large (e.g., $50,000 to $500,000) as to be useless. Of course, these numbers may not even be shared at all since filling out Item 19 is optional.

The following report based on data published by the SBA documents the loan failure rate for franchises by Brand for many of the popular franchise brands. If you are thinking about starting a franchise, keep in mind that many factors will affect your survival and some of those factors many not be within you control, but prior business experience, strong financial management skills and adequate capital reserves are essential. And, of course, spending the time upfront to see how other franchisees have done.

Don’t let this post or the default rates stop you from chasing your dream, but they are a reminder that not all dreams come true. So, look before you leap.