Buying a new, unproven franchise can be a high-risk venture. Professional advice can help minimize the gamble.
In 2005, business partners and first-time franchise operators Karen McGinn and Gene Bowen bought an iSold It eBay drop-off franchise and opened it in a storefront on a busy street in Woodstock, Ga., about 30 miles from Atlanta. At the time, the Solana Beach (Calif.)-based franchisor, which also lists items on marketplaces such as uBid (UBHI) and Amazon (AMZN), had a novel concept, but it would soon spawn its share of imitators in pursuit of its promising, untapped market: people who want to sell their stuff but don’t want to go online to do so.
For McGinn and Bowen, starting an iSold It was relatively inexpensive—about $150,000 to get a store up and running, compared with the $500,000 to $1 million price tag of the average McDonald’s (MCD). Plus, the pair says company executives told them in person and in conference calls that their stores would be profitable within three months of opening. ISold It Chief Executive Officer Ken Sully denies that any iSold It representative made earnings estimates.
The pair says it never turned a profit. “The problem is, the whole concept doesn’t work,” says McGinn. Having to auction off a wide variety of items on eBay made it hard to compete with sellers who specialized in one category, she says. To make matters worse, each new drop-off store that opened was a new source of competition, since most buyers shop online, not locally. Instead of earning money, the pair ended up spending $1,500 to $3,000 a month to keep the business going.
Long Odds, Lots of Competition
And finally, when they replaced iSold It’s software system with a new system—citing its unreliability—the franchisor terminated their franchise agreement explaining they had violated its terms. The process took less than seven months, and the pair estimates it spent between $300,000 and $350,000 in total—including fees for legal counsel.
Few franchisees fall as hard or as fast as McGinn and Bowen did, but their story could serve as a warning for prospective franchisees who assume that a new franchise is a sure bet.
There are more new franchise opportunities than there were just a few years ago, increasing the odds of picking a concept that doesn’t work out as expected. According to Arlington (Va.) franchise industry researcher FRANdata, the number of businesses that submitted franchising applications more than doubled between 2003 and 2005, from 208 to 521. Last year, that number dropped to 394.
Sold in Distress
“These franchisees are basically going into an unproven, high-risk venture, yet they’re also saddled with the fees and loss of autonomy and freedom associated with franchising,” says Sean Kelly, a franchise consultant with Leola (Pa.)-based Idea Farm and operator of the blog Franchise Pick. ISold It, for example, had been in business only a few months before selling its first franchise. For pioneer franchisees, one question looms large: What is the potential for profit? As McGinn and Bowen found out, it’s not an easy question to answer.
To date, nearly 600 iSold It stores have opened—but more than 60 have closed or been sold in distress. The company halted the sale of new franchise units in the U.S. this year, and CEO Sully issued a letter to franchisees stating that the company “has not been profitable since 2004,” and that “We do not feel comfortable selling any new franchises until we get the failure rate lower.”
That caused Entrepreneur magazine, which had bestowed the franchise with the title of “Top New Franchise of 2007,” to remove it from its online list in June. And in July, franchise owners received a revised version of the company’s Uniform Franchise Offering Circular (UFOC)—the central document in a franchise contract. In boldface underlined type on the second page, the document reads: “The iSold It franchise system is still new and unproven…. We cannot and do not guarantee that your store will be profitable.”
No Disclosure Necessary?
That disclosure should have been made when iSold It first franchised its stores, says attorney Michael Webster, whose Toronto firm specializes in franchise law. “ISold It had no business experience,” he says, so it was never in a position to make earnings estimates like the one McGinn and Bowen say they were given during a meeting for potential franchisees in January, 2005. Webster has kept up with iSold It’s story on franchise Web sites such as Blue MauMau. He has not advised any of the chain’s franchisees; however, he thinks the company could be held responsible for civil penalties.
Sully stands by his belief that early franchisees knew they were buying into an unproven chain, and that no disclosure was necessary. “We told everybody that this is sort of like the wild, wild West” he says. “It’s a brand-new concept and nobody knew for sure where it was going.” Disclosure was added to the UFOC recently, he says, “because of the number of stores that weren’t understanding the complexity of the business.”
Mark Moger, a retired DEA agent who opened an iSold It store in Buckingham, Pa., in January of this year, has no qualms with the way the opportunity was advertised to him. “Did they promise me a pie in the sky? No, they didn’t,” he says. “But I didn’t want to sell food, I didn’t want to get involved in retail, so I got into what I know: service.” By focusing on the larger inventories of business-to-business clients, and developing some product niches, like jewelry, Moger eked out his first profit in August. He plans to open another store next year.
Call Your Lawyer
Ultimately, it is up to the buyer of a new franchise to sniff out an opportunity where the risk may be too high. “A new franchise doesn’t have a track record, so you need [to find] information about how it’s been tested in the marketplace, the experience of the people in the business, and what kind of training resources they offer,” says Terry Hill, spokesperson for the International Franchise Assn., a Washington (D.C.) trade group that represents both franchisees and franchisors.
For the best advice, consult an attorney who specializes in franchising. These professionals will help translate a prospective franchise’s UFOC and find the red flags often buried in its fine print. “The major problem is that nobody ever reads these,” says attorney Webster. The UFOC contains a list of contacts for existing franchisees and ones who have gone out of business. Webster says it’s worth calling current and former owners to hear their stories, as well as working in an existing store for a few weeks to help evaluate potential.
Performing this type of due diligence could take the edge off the new franchise gamble.
Source: Business Week