Can You Lose Money Buying a Franchise? Here’s What to Watch For

There’s one question that pretty much every franchisee asks before investing: Can I lose money on a franchise? 

It’s an understandable concern. Franchising is a much safer path to business ownership, but it’s not foolproof. While the franchise business model reduces risks, it’s not a guaranteed success, and you can absolutely still lose money.

In this article, I’ll break down some ways you can end up losing money on a franchise and how to avoid this situation.

Key Takeaways 

• Like in any business, there are risks to becoming a franchisee, and it’s possible to lose money buying a franchise. 
• Several common reasons franchisees lose money include poor site selection, high overheads, low local demand, and choosing the wrong industry.
• Poor financial management, failing to do proper due diligence, underestimating startup costs, and poor franchisor support can all contribute to an increased risk of losses when investing in a franchise.
• If you do end up losing money on your franchise, you’ll need to assess potential changes, ask your franchisor for support, or consider selling/transferring your business.
• Watch out for red flags like overly flashy sales language, poor performance data, and a high franchisee turnover.

Can You Lose Money Buying a Franchise?

The short answer is yes. You can lose money buying a franchise. While franchises generally have lower failure rates than independent businesses, losses do happen. And it’s not an entirely risk-free business model.

The two-year success rate of franchises is allegedly 8% higher than the success rate of independent startups, which is promising. Long-term success looks even better, with some experts placing the 5-year success rate of franchises as high as 95%!

However, this doesn’t mean you should purchase a franchise business and expect guaranteed success. If you make the wrong investment or run your unit poorly, you could land yourself in hot water and ultimately lose money.

Avoiding common mistakes and doing your due diligence will help reduce your chances of losing money. Picking the right franchise for the right market and running it well improves your odds; if you choose poorly or lack the right experience, even a famous franchise can flop. 

There are also cases when the franchisor is the one responsible for the losses.

There are several high-profile cases where franchisees suffered financially, such as when franchise owners sued Quiznos, claiming the company made them lose money by forcing franchisees to pay inflated costs for food and supplies. In another case, Burger King franchisees claimed that a promotion, which set the cost of a cheeseburger to just one dollar, seriously undermined their profits.

Common Reasons Franchisees Lose Money on an Investment

If franchises have such a high long-term success rate, then why do some lose money? Here are the risks involved in franchising that you should look out for before signing your franchise agreement.

Poor Location Selection

Choosing a bad location can doom your business, even if you’re entering into an agreement with a reputable franchisor. For example, if you open a McDonald’s unit in an area with low foot traffic, the wrong demographics, or an oversaturated market, you may never generate enough revenue to become sufficiently profitable.

High Overhead or Royalty Fees

Franchises have several ongoing costs that can eat into profits. Like all other businesses, you’ll have expenses like payroll, inventory, rent, and insurance, but on top of that, you’ll also pay royalty fees. Most franchisors charge a royalty fee of between 4 and 12% of your gross sales.

You’ll also need to factor in other costs such as contributions to the advertising fund.

If your margins are already thin, these fees can seriously eat into your profits, especially in the early stages when cash flow is tight.

The Business Model Doesn’t Play to Your Strengths

In some cases, the franchise simply ends up being the wrong fit for you. You might like the concept, but the actual day-to-day work doesn’t match your particular skill set. If you’re feeling bogged down by the responsibilities and starting to question whether you’re in the right business, it might be time to start thinking about an exit strategy.

Before committing to a brand, make sure you’ve got both interest and experience in the industry you’re investing in.

Lack of Local Demand

Sometimes, a franchise idea thrives in other places, but the demand in your locale simply isn’t there. The area may be oversubscribed, or the product just doesn’t fit the demographic. Maybe the franchisor opened up too many units in your region, saturating the market. 

This is why I always recommend doing a territory analysis before you buy a franchise.

Too Much Trust in the Brand Name

Many franchise owners find out the hard way that you can’t become successful through a brand name alone. No franchise is an “autopilot” business. If you buy a franchise from a reputable brand, but don’t put the effort into running it well, you may very well end up losing money. 

If you’re not sure whether a brand is worth betting on, schedule a consultation with Franzy. We’ll help you figure out which franchise systems are actually set up for your success.

How Risky Is Franchise Ownership, Really?

The franchise business model is often pitched as a safer bet. And for the most part, this is true.

There are some big benefits to franchise ownership, including brand recognition, a built-in support system, a proven concept, and so on. 

You’ll also be provided with various tools to help manage risks, including training, access to franchisee networks, and pre-made marketing materials.

But like any entrepreneurial venture, franchise ownership is still risky. So it’s important not to treat franchising like a “set it and forget it” business. Instead, it’s more like a business with training wheels.

There are actually statistics to suggest franchisees are just as likely to default on loans as their non-franchisee counterparts. 

Many franchise businesses fail over time, though there’s a lot of mythology and outdated stats around precise franchise failure rates. Most reputable stats suggest the franchise failure rate is between 20 and 50%, which means 5 to 8 out of 10 franchises will turn out successful. Not bad odds!

The key is to treat franchise investment with the same caution and due diligence you’d treat an independent startup. It’s not a given that things will work out, and starting out with this attitude is dangerous in itself. Keep your eyes open: study your franchise disclosure document, do your due diligence, ask the right questions, and research your market well.

What Increases the Risk of Losing Money in a Franchise?

Sometimes, losing money on your investment is out of your hands, and it simply comes down to market demand or poor choices made by the franchisor (such as the Burger King and Quiznos examples above). That said, there are many things that increase your risk of losing money. Let’s take a closer look.

You Didn’t Stay on Top of Your Numbers

Poor financial management is a franchise killer. I can’t stress enough how important it is to keep a close eye on your numbers. Identify financial issues before it’s too late, rather than continuing to bleed money.

Expenses like labor, inventory, and utilities creep up and can shift seasonally. In franchising, cash flow is beyond important, especially because you’ll have to factor in franchise-specific fees. Even if you’re turning a profit on paper, you might still run out of cash if business is slow or unexpected costs hit.

You Didn’t Do Enough Due Diligence

Some franchise failures are doomed from the start because franchisees didn’t do their homework. Just because the franchise seems like a good buy on paper doesn’t mean you shouldn’t do your own research.

Read your FDD with a keen eye. Scrutinize everything, from the franchise’s track record to the franchise agreement, and conduct your own market research. Make sure to consult with an attorney or accountant, or you’ll risk missing red flags.

I also highly recommend that you speak with current franchisees. They’ll be able to give you insider info on what running the franchise looks like.

Skip these steps, and you could end up locked into a 5 to 10-year contract with low margins or in a market that was never right for the franchise in the first place.

You Underestimated the Startup Costs

Not having enough money to get through the startup phase and reach profitability hinders plenty of franchisees. You don’t need to have all of the startup cash on hand. In fact, most franchisees get some sort of funding to finance the venture. But you should make sure that you are able to secure enough capital to fund the entire startup phase.

Franchisors will provide an estimate of the initial investment in the FDD. However, it’s important to note that those are averages; it’s hard to gauge if they’ll match up in the real world. Many things can throw off your budget, such as unexpected expenses and delays, so make sure you’ve got extra working capital to get you through unforeseen issues.

Franchisees can go bankrupt before they break even because they don’t have enough unencumbered funds.

The Franchisor Didn’t Deliver on Support

When you buy a franchise, part of what you’re paying for is support from the franchisor. This generally includes training, ongoing operational guidance, and marketing materials. 

If your franchisor doesn’t deliver on the promised support, it can make things significantly more difficult and will likely hurt your profits.

For example, they might fail to support marketing campaigns that were promised (and paid for by your ad fees) or deliver a subpar training program that leaves you feeling unprepared. 

It’s worth noting that if a franchisor doesn’t provide the support that was promised in your FDD or franchise agreement, you may have grounds to open up a dispute.

What Are Your Options If Your Franchise Is Losing Money?

Is your franchise losing money? First things first. Don’t panic. I know how stressful this can be, but it doesn’t necessarily mean you need to close up.

There are steps you can take to turn things around or plan your next move wisely.

Assess Changes You Could Make

Firstly, take a good, hard look at why you’re losing money. Analyze every aspect of your business, from sales trends to pricing to expenses.

Are there ways to cut costs that you’ve overlooked? Could you reduce waste from inventory or maybe trim down labor hours during slow periods? Perhaps there are untapped revenue opportunities or new promotions you could run?

Sometimes, there are operational inefficiencies that can be fixed. It may be as simple as making a small, strategic tweak, such as renegotiating a supplier contract.

If you can’t spot any room for improvement, consider getting help from a franchise expert or consultant.

Ask the Franchisor for Support

Your franchisor wants your franchise to succeed just as much as you do. I encourage you to reach out early. Their support is part of what you’re paying for, after all, and it’s better to ask for help sooner rather than later.

A good franchisor will work with you to tackle performance issues and may have solutions you haven’t considered (they’ve often seen the same problems crop up before).

Franchisors may send a field operations expert to troubleshoot issues at your location, or they may offer tips learned from other franchisees in similar situations.

Sell or Transfer the Business

This is generally a last resort, but in some cases, your best bet is to cut your losses. If you’ve tried and failed and still can’t make the business profitable, you may look at your options for getting out early.

This might involve finding a buyer willing to take over the location. An entrepreneur with fresh energy or more capital might be motivated to try to turn things around. Obviously, selling a franchise that’s losing money isn’t as easy as selling one that’s performing well. And you shouldn’t expect to recoup all of your investment, but it’s possible, especially if the brand is in high demand.

Keep in mind that selling or transferring your franchise can be a tenuous process. You’ll need the franchisor’s approval and may have to pay a transfer fee. Still, it’s good to have the option if you need to avoid further losses.

In many cases, franchisors will simply buy back the unit, especially if they think the location still has potential for profitability.

How to Spot a Risky Franchise Before You Buy

You are probably seeing a theme here, but the best defense against a high-risk franchise is due diligence. Here are some red flags to look out for to prevent losing money on a franchise investment.

Vague or Overly Polished Sales Language

If the sales rep or brochure of the franchise is too polished and promises too much, it’s time to get skeptical. Buying a franchise isn’t a guaranteed get-rich-quick scheme. Don’t let anybody convince you otherwise. If a salesperson suggests that it’s going to be too easy, make sure you triple-check the facts.

Ask for Real Unit-Level Performance Data

Item 19 in your Franchise Disclosure Document provides financial performance representations, such as the average revenues and profit margins, of current franchisees. Not all franchisors include an Item 19, but if they do, study it closely.

If they don’t include an Item 19, it’s not necessarily a terrible franchise, but you should instead seek out insight from other franchisees. Do not accept vague information about profits. You obviously want to know what to expect when making an informed decision. If you can’t find details, ask your franchisor.

Read Item 20 of the FDD (Franchisee Turnover)

Another important section of the FDD to pay attention to is Item 20. This section lists the number of franchise outlets opened, closed, sold, or transferred in recent years. This is some of the most valuable intel for spotting risky franchises.

Check if there are high closure rates or a pattern of franchisees leaving. If you see, for example, that 20 franchises were opened in the last three years, and 15 are already gone or terminated, that’s not very promising. High franchisee turnover means higher risk, and you don’t want to be part of that statistic.

Talk to Current and Former Franchisees

Talking to other people previously in your position can be a goldmine of information. The FDD should include contact information for current franchisees, as well as former ones (if they’ve left the system recently).

Reach out to some to get their insight. Ask them some key questions, such as:

• Is their location profitable?
• How long did it take for them to break even?
• Did the franchisor support them as promised?
• Any unexpected challenges?

Do Your Own Market Research

Even if the parent company is performing well nationally or internationally, you need to assess its prospects in your own area and region. 

Make sure you’ve got up-to-date numbers on target customers and demographics. Know your competition, and make sure the market isn’t oversaturated. Franchisors analyze this data too, but they won’t know your area as in-depth as you do.

Know the Risks and Make a Smarter Franchise Investment

Yes, you can lose money buying a franchise. But most of the risks that trip people up are avoidable with solid planning and a healthy dose of skepticism. You don’t need to be a finance expert, but you do need to do your homework and make sure to choose a brand that’s a good fit.

Not sure if a franchise brand is the right one for you? Get in touch with us at Franzy, and we’ll help you spot red flags and ensure you’re investing in a franchise you can grow with.