Editorial

The Tortoise and the Hare

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 the obstacles that are in our way. The closer you are to your goal, the more choices you 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 are 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. One 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 next question you will need to address is “Should you build a Corvette or a Volvo?”

Starting with the End in Mind – Goal Oriented Planning
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 that 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 those franchisors are, 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 importantly, 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 that are 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 that 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 that the franchisor could sell the business for seven times earnings before interest and taxes, dividing that $10 million by seven would indicate that the company will need 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 will need to sell.

Going further, if the franchisor anticipates average unit volumes of $500,000, one might then look at comparable franchisors and do some financial analysis to determine that this franchisor should charge a 6% ryalty. If, after conducting our financial analysis, we determine that this franchisor can then bring 35% t 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 that 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 year three, 50 year four, and 75 year five (assuming that not all of 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 should know precisely who he will need to hire and when he will need to hire them. In fact, every step of this process can be mapped out so that 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 start-up 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 that 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 start-up 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., non-compete 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 start-up franchisees. Area developers are often better capitalized than start-up 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 that 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, care must be exercised in the structure of responsibilities, as subfranchising done improperly can lower the level of quality in a system (as a third party is involved in quality control) and is generally responsible for lower levels of profits on a per franchisee basis (as the subfranchisee is a “middle-man” who requires additional “compensation”). Adding this additional layer between the franchisor and individual franchisee can also result in less control within the franchise system.

The risk of slow growth
At the iFranchise Group, we typically encourage our clients to start conservatively. It is our 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 our experience, the key to success in franchising is not franchise sales. Franchise sales is 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.

But with 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 if that is the case, there is an argument to be made for more aggressive growth strategies.