For companies considering franchising, the decision to franchise
can be a daunting one. We often liken this decision to choosing a
mode of transportation. When choosing a vehicle to get from one
place to the next, we first consider how far we need to go, how
fast we have to get there and what obstacles are in our way. The
closer we are to our goal, the more choices we have for
transportation.
If your growth goal is just down the block, you could drive your
car, ride a bicycle or walk. But if you're trying to get to the
moon, only a rocket ship will do.
But once the decision to franchise is made, the new franchisor
faces some basic "design" considerations. As most
franchisors soon find out, franchising itself comes in many
flavors. Franchisors can expand aggressively with more risk and
more expense-or they can expand more conservatively and with less
risk and less expense. Put simply, the question you need to address
is, "Should you build a Corvette or a Volvo?"
Starting with the End in Mind: Goal-Oriented
Planning
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When counseling new franchisors on their development options, my
first question is always the same: "Where do you want to be in
five years?" It is vitally important to start with the end in
mind.
But when asked about their growth plans, many new franchisors
tell me their goal is to "grow as fast as possible," and
sometimes the more thoughtful among them will add, "as long as
we maintain quality." But they're all, unfortunately,
missing the point.
Growth does not come without a cost. And faster growth comes at
a greater cost. That cost is measured in dollars, commitment, time
and risk.
More important, success in franchising, like any other business
endeavor, rarely comes about by accident. It is the result of
carefully drawn out plans that start with goals systematically
reduced to tactics. So we encourage our clients to be specific
about their goals, and to design their tactics around achieving
very specific objectives.
Let's say, for example, that a new franchisor decided they
wanted to sell their business in five years for $10 million. We
would typically want to start by translating that goal into
actionable tactics. As a first step in this particular case, we
would divide that $10 million by an assumed selling price. If, for
example, we believed the franchisor could sell the business for
seven times earnings before interest and taxes, dividing that $10
million by seven would indicate the company needs to achieve an
EBIT of approximately $1.4 million by the time they are ready to
sell. In order to make this actionable, however, we need to
determine how many franchises the franchisor needs to sell.
Going further, if the franchisor anticipates average unit
volumes of $500,000, we might then look at comparable franchisors
and do some financial analysis to determine that this franchisor
should charge a 6 percent royalty. If, after conducting our
financial analysis, we determine this franchisor can then bring 35
percent to the bottom line (the number achieved by top quartile
franchisors in a recent IFA study), we could estimate that the net
contribution per franchise might be about $10,000. Thus, to achieve
their goal, this franchisor would need to open about 140 franchises
in the next five years.
Of course, this is a gross over-simplification. It does not
account for franchise fees, product sales or other sources of
revenues, such as profits from company-owned locations. And we have
not determined the service and staffing needs required to make
these franchisees successful. But it provides us with a starting
point.
Assuming the franchisor wants to achieve the "hockey
stick" growth curve that leads to maximum valuation, this
franchisor might attempt to sell 10 franchises in year one, 20 in
year two, 30 in year three, 50 in year four, and 75 in year five
(assuming not all the year five stores will open in year five).
This "game plan" can now be used to develop specific
tactics designed to meet these goals.
Based on industry averages, this franchisor should now be able
to calculate a specific budget for franchise marketing activities
and know precisely whom he needs to hire and when he needs to hire
them. In fact, every step of this process can be mapped out so the
franchisor can develop a series of specific tactics and budgets to
attain each year's specific objectives.
But what if this franchisor does not have the resources to
achieve the year-one plan? What then?
In that case, our budding franchisor has four basic choices:
- Revise his goal downward
- Extend his timeframe for achieving that goal
- Bring in outside capital (and simultaneously increase goals to
offset equity dilution)
- Implement more aggressive franchise structures in order to
accelerate growth
Strategies for Speeding Growth
One strategy that is increasingly favored by new franchisors
looking for accelerated growth is the use of alternative franchise
structures. In most franchise systems, franchises are awarded for a
single location. While the franchisee may later be granted the
right to one or more additional locations, the process of continued
growth is controlled solely by the franchisor.
Closely related to a startup franchise, some franchisors in
highly fragmented markets choose conversion franchising as a means
of accelerating growth. A conversion franchise is granted when a
franchisor awards a franchise on different (usually preferable)
terms than an individual franchise, based on the fact that the
franchise prospect has an established business, established
clientele and/or requires less training.
Franchisors who go the conversion route find their prospects are
generally easily identified-reducing marketing costs substantially.
And since these franchise prospects generally have established
business relationships, they begin paying royalties sooner (and
early royalties tend to be larger). Moreover, these franchisees
require less in the way of training and initial support.
That said, conversion franchising presents some significant
challenges. As entrepreneurs, conversion franchisees can be more
difficult to control than startup operators. And since the best
operators are already successful, they tend to be difficult to
convert, while the worst operators, who may be desperate to
convert, still need to be avoided by the astute franchisor.
Finally, post-term restrictive covenants (e.g., noncompete
agreements) are more difficult to enforce if the conversion
franchisee is operating within the franchisor's industry prior
to joining the franchise program.
Another structure used to accelerate growth is area development
franchising. An area development franchise is similar to an option
agreement in which the area developer is granted an exclusive
option to open a pre-established number of franchises in a defined
geographical territory according to a pre-defined opening
schedule.
From the franchisor's perspective, an area development
strategy is often attractive, because it enables the franchisor to
work more efficiently with a limited number of area developers in
larger markets that would otherwise be dominated by multiple
startup franchisees. Area developers are often better capitalized
than startup franchisees, and more experienced in terms of business
ownership. On the negative side, however, a franchisor often
assumes greater risk by awarding large markets to area developers
in advance of their demonstrating to the franchisor that they will
be strong operators and contributors within the franchise system.
Moreover, while area development contracts can be responsible for
large numbers of franchise sales, the need for each area developer
to open sites according to a development schedule that allows them
some time between unit openings (combined with the fact that many
area development contracts go unfulfilled), can mean the
franchisor's market penetration is, in fact, slower-not
faster.
Lastly, some franchisors have adopted an area representative
strategy to supercharge franchise sales and growth. Popularized by
the likes of Subway, Mail Boxes Etc. and Quizno's, area
representative franchising involves the grant of a territory in
which the area representative is subsequently allowed to sell
individual franchises. In essence, the subfranchisee becomes a
smaller version of the franchisor-selling franchises and providing
a predetermined set of services (training, support, etc.) in return
for a fee-splitting arrangement relative to franchise fees and
royalties.
While providing the franchisor with the fastest form of growth,
subfranchising done improperly can lower the level of quality in a
system (since a third party is involved in quality control) and is
generally responsible for lower levels of profits on a per
franchisee basis (because the subfranchisee is a "middle
man" who requires additional "compensation"). Adding
this extra layer between the franchisor and individual franchisee
can also result in less control within the franchise system.
The Risk of Slow Growth
I typically encourage my clients to start conservatively. It is
my belief that new franchisors are more likely to fail from
over-aggressive expansion than from a more conservative approach.
It's much easier to expand more aggressively once a franchisor
has established and proven its basic systems for supporting the
initial group of franchised locations.
In my experience, the key to success in franchising is not
franchise sales. Franchise sales are not the hard part. In fact,
generally speaking, franchise sales are simply a function of
franchise marketing.
The key to success in franchising is successful franchisees. If
your early franchisees are successful, you are on your way. But if
early franchises fail, it is almost impossible to recover. So while
franchises can be sold as fast as we can line up qualified
prospects, the real question to be addressed is whether or not we
can adequately support this influx of franchisees.
That said, there are times when a company may judge the risk of
aggressive growth to be less than the risk of losing its market
leadership position. And when that is the case, there is an
argument to be made for more aggressive growth strategies.