Q: How does a franchisor make money?

A: Usually, a franchisor sells the right to a franchise for a hefty fee over the actual out-of-pocket costs of setting up the business. Then the franchisor receives ongoing payments—usually a percentage of the sales, not the profits. Most franchisors also sell supplies and services to franchises.

Q: In selecting a franchise, should I be more concerned with the initial fee or the ongoing franchise fees?

A: If you are buying into a successful franchise, you should be more concerned about the ongoing charges. These costs are paid yearly. And, because these fees are typically extracted from sales rather than profits, they can cut your profits to shreds. For example, if your pretax profit margin is 10 percent, but your franchise fee is 5 percent, your profit is halved!

If you are buying a less established franchise, be leery of up-front costs. You could lose your investment altogether if the business fails.

In either case, you should examine all costs and contracts, and talk to current franchise owners before signing.

Q: Is it worth it to pay a percentage of sales, even for a really good franchise?

A: This is the 64 million dollar question you must ask yourself. Many people who buy franchises think that it is a great deal when they are able to turn an early profit—but in later years, with experience under their belts, they come to view the franchise fees as onerous.

You need to evaluate what you are getting by buying into a franchise and how valuable what you are buying will be to you in several years. If you are just using the franchise as a means of learning industry skills, then you might be better off working for someone else for a little while instead. On the other hand, if you already have industry skills and business expertise and want to apply them through an established brand-name business in a competitive market, then the franchise route may be right for you.

Q: Besides the franchise fees, what other costs should I watch out for?

A: Often you will have to pay a percentage of local, regional, or national advertising costs as a separate fee over and above the franchise fees. You may also be required to purchase supplies and services directly from the franchisor.

And you also need to be aware under what conditions your franchise agreement can be revoked and how often the franchisor tends to exercise that option.

Q: What else should I watch out for in buying a franchise?

A: If you are relatively inexperienced in running a business, buying a franchise may be a much better option for you than starting a business from scratch. But do be aware that even a franchise isn’t a foolproof expressway to business success.

In addition to issues that may be peculiar to the particular industry you are buying into, there are general issues that should be considered. Can you sell the franchise easily, and how? Can the franchise fees be increased for any reason? Are new competitors affecting market share? What level of applicable industry or business skills did the typical franchise owner possess before he or she bought into the franchise?

Get out and talk to as many current franchise owners as you can before making any commitments —this just can’t be overemphasized!