Financial Statements 101 - The Big Three

Let's get back to basics here and review the big three financial statements you are going to run into in business and personal investing; the balance sheet, the income statement and the cash flow statement.

The Balance Sheet

Simply put the balance sheet is Assets = Liabilites + Equity. Assets include everything you "have", such as cash, inventory and buildings, liabilities include everything you "owe" such as a credit line with the bank for the inventory and a long term note against the building, and equity is the "value to the owners" or let's say for example's sake, the difference between what your building is worth and how much you owe. So, if your building is worth $100,000 and you owe the bank $50,000, then your equity is $50,000. This would be represented on the balance sheet like so:

Of course, this is a rather simplistic picture for even this balance sheet item. You would have other considerations such as accumulated depreciation (how much decline in useful value of the fixed asset have you recorded) as well as the current portion of the long term note (how much is due in total over the next year) but let us stick with the basics for now.

The balance sheet is a snapshot in time of what the company has, owes and is worth. Building on this analogy, the balance sheet is what the company has today (assets), what it owes today (liabilities) and what it is worth today (shareholders' equity.) Digging into the balance sheet, let us look at the first category ...

Assets

Assets are everything you've got, including cash in the bank, inventories, buildings, machinery, etc. as well as certain rights you have with a monetary value. Specifically, this would include your accounts receivable, what your customers owe you. Assets on the balance sheet are ordered from most liquid (current assets) to least liquid (fixed assets.) Current assets generally include the categories of cash, accounts receivable, inventory and prepaid expenses and fixed assets include items such as building and equipment.

Here's what the asset side of the balance sheet looks like with these items. Note the additional categories of other assets and accumulated depreciation. Sample data has been inputted as well so you can follow the math of the line items.

Now, let's turn to the flip side of the balance sheet and take a look at liabilities.

Liabilities

Mirroring the Asset side of our balance sheet, the liability side is going to list liabities from current to long-term. The categories you see here will include current liabilites, which includes accounts payable, accrued expenses, the current portion of debt and income taxes payable as well as long term debt. Here is what the liability portion of the balance sheet is typically going to look like:

Those current liabities are bills that must be paid within one year of the date of the Balance Sheet. Accrued expenses are monetary obiligations similiar to accounts payable (bills to other companies for material and equipment bought on credit). Examples would include employee salaries earned but not paid yet, interest due but not paid yet, etc. Current portion of the debt includes any notes payable (loans due in 12 months) and the payment portion of long term debt that is due in 12 months. Income taxes payable are just what it says - income taxes that are owed but have not been paid yet. Long-term debt is any loan to the company that has to be repaid more than 12 months afte the date of the Balance Sheet.

Let's move to the equity portion of the balance sheet or as properly termed, Shareholder's Equity.

Equity

The net-net to this section of the balance sheet is that if you subtract what you owe from the assets you get the owner's value in the company or equity.

Here is what this portion of the balance sheet looks like:

Capital stock is the original amount of money the owners contributed as their investment in the stock of the company. Retained earnings is all the earnings of the company that have been retained - not paid out as dividends to owners. Retained earnings can be viewed as a "pool" of money from which future dividends could be paid.

So, here's the complete picture, remember it must balance - Assets = Liabilities + Equity:

Next, the income statement.

Seventeen Steps to Franchise Ownership

1. Follow your passions

2. List industries that interest you

3. Understand the franchise type that is best for you

4. Find franchise listings – franchise.org, aafd.org, americasbestfranchises.com, franchisehelp.com

5. Get an idea of franchise costs

6. Determine your income requirements

7. Assess your assets

8. Contact multiple franchisors

9. Fill out franchisor forms

10. Hire an experienced franchise attorney

11. Pre-qualify with a lender

12. Contact current and former franchisees

13. Talk to Potential franchisors

14. Work in a franchise

15. Visit the franchisor’s corporate headquarters

16. Examine the franchise agreement

17. Sign the franchise agreement

Project Management

In the world of programming, a project's life cycle includes more than simply coding away and building something ready to run. Even if it plays a small part in the project, the database design is still integral to the project ... in many ways e-commerce sites, web portals, search engines and customer interfaces are all basically interfaces to the backend database and the database is like the foundation of the house - if you did something wrong there, no matter how nice or trendy the house looks, it will still be torn down by the first wind.

Developing Software Solutions

1) System Requirements - gather system and software requirements.

2) Software Requirements - By the end of this phase, you have a paper describing all the hardware needed for implementing, testing and deploying the application. You also need the software platforms your application will be developed and tested on. This must also include an opportunity study at the beginning and a feasibility study at the end. "Do we really need this from the business point of view?" After you establish the requirements, the feasibility study provides a high-level cost and benefit analysis so that a ROI can be estimated.

3) Analysis - a team of analysts gathers information regarding tasks performed, schedule, equipment, etc. Analysts build the database, describe the reports and the operations the software must do - a written annex is added to the contract with all of these features agreed on by the customer and a timeline. Analysts try to fully understand customer needs - they define software functionalities, transcribing them in a professional analysis for the software engineers.

4) Program Design - Reading from the specifications of the analysis, the design team creates a user-friendly, attractive interface that can be presented to the customer and changed to fit the customer's taste. They develop prototypes that the customer must agree on - usually throw-away code. After this, the coding begins.

5) Coding - based on agreed upon doc., coders should know exactly what to do and code the application.

6) Testing - After coding, the software is installed on a test platform at the customer site and the customer team simulates using the software for a definite period of time. Bugs are revealed and fixed.

7) Operations - Customer has an application that runs by agreed upon date and deploys on production machines.

Now, how best to manage the software development life cycle (SDLC) ...

The Waterfall Method

Just as it is stated, you follow the 7 steps listed above in sequential order. The input of each phase consists of the output of the preceding one.

Advantages

• Simplicity
• Everything is documented and agreed upon with customer
• Because of planning, it is easy correctly estimate the project costs and timeliness.
• The rigorous initial planning makes the project goals clear
• All requirements are analyzed and validated by the customer, so the customer can estimate the benefits incurred by the software application before it's actually implemented.

Disadvantages

• Customer is not able to see the product until it is completely finished = costly to make changes
• It has little flexibility for scope changes during development
• The architecture limitation are often not discovered until late in the development cycle
• Because testing happens at the end of the coding phase, unexpected problems with the code might force developers to find quick fixes at the expense of the planned architecture
• Doesn't work on projects whose requirements can't be rigorously planned from the start

The Spiral Method

This method is more suitable for large, expensive, complicated projects. It is an iterative waterfall in which every iteration provides increased software capability.

It consists of a spiral divided into four quadrants. Each quadrant represents a management process: Identify, design, construct and evaluate. The system goes through four cycles of these four processes:

Proof-of-concept cycle: Define the business goals, capture the requirements, develop a conceptual design, construct a "proof-of-concept," establish test plans, and conduct risk analysis. Share results with user.

First-build cycle: Derive system requirements, develop logic design, construct first build and evaluate results. Share results with user.

Second-build cycle: Derive subsystem requirements, produce physical design, construct second build and evaluate results. Share results with user.

Final-build cycle: Derive unit requirements, produce final design, construct final build, and tes all levels. Seek user acceptance.

Advantages

• The entire application is built while working with the client.
• Any gaps in the requirement phase of the Waterfall method are identified as work progresses
• The spiral representation conveys very clearly the cyclical nature of the project and the progression through its lifespan.

Disadvantages

• Requires serious discipline on the part of the client.
• Executive control can be difficult because in most projects the client is not responsible for the schedule and budget.

The Rapid Application Development (RAD) Method

In this method the client works with the software as it is being developed and consists of the following phases:

1. Business modeling
2. Data modeling
3. Process modeling
4. Application generation
5. Testing and turnover

RAD allows for rapid generation and change of user interface features. The main disadvantage is that the client will always want more enhancements to the software.

Extreme Programming (XP) Method

XP eliminates a lot off the phases from the traditional Waterfall method, is simple and based on communication, feedback and courage.

The professional analysts are replaced with the client, who is very active in the process. The client writes a document named "User Stories" which is a simple description of the desired functionality of the software. The programmers read the doc and give an estimated timeframe of every functionality implementation. The customer then chooses a group of functionalities to be developed first.

The developers use a test-driven design in the implementation phase, meaning that a testing method for the desired functionality is conceived before the code is actually written. Code is written by a programmer under supervision of another who tests it. After the code for the iteration is complete it is given to the customer for approval or disapproval. The programmer keeps improving until that iteration passes.

The software is deployed in a number of releases, composed of one or more iterations - the software gets the final release when all iterations that contain all the functionalities described in the User Stories document pass the acceptance test.

Because no single method is best, a good project manager must know in theory a little about all of them to choose the best one for the current project. In some cases, it might be best to do a mix of methodologies.

The eCommerce Project Cycle

The best bet in eCommerce development is the Waterfall method or some variation thereof.

1. Understanding the customer needs - customer wants an eStore where a range of products can be advertised and bought. You need to know the type of products the customer wants on the site and a little about future strategy.
2. Creating a web prototype - should be only a web site template.
3. Designing the database - developed from the requirements gathering phase and agreed upon by customer. The logical design describes what data you need to store and the relationships between different entities of data.
4. Implement the data tier objects - implement the data access logic that will support the other tiers in your application.
5. Build the middle tier - implement the error-handling, data-manipulation strategies and business logic for your project.
6. Build the user interface - web forms, web user controls, master pages - you can build off of the prototype in 2.
7. Final testing - database is populated with real records, a simulation is made to test the efficiency of the ordering process, any programming errors are revealed.
8. Find/ provide a hosting solution

Franchising Your Small Business - the Fly Speck Part Nine

Master, Master

As an expansion strategy for your business, you might consider master franchising. This is an arrangement in which you grant a franchisee the right to collect some portion of the up-front franchise fee and ongoing royalties in return for recruiting, training and supporting the franchisees. This can lead to rapid growth acceleration for your franchise. The downside is that you give up the right to determine who gets a new franchise - typically the profitable ones who follow the system rules - in a master franchise system this is not the case. New franchises go to those recruited by the master franchisor.

Pricing

"As a franchisor, you need to consider two basic components to pricing your franchise: the up-front franchise fee and the ongoing royalty rate." - Shane

Franchise Fee

The franchise fee is a one-time payment made by the franchisee to the franchisor when the franchise agreement is executed. The idea of this fee is to compensate the franchisor for the cost of getting the business started. It includes the value of goodwill, franchisee's territory, the cost of identifying and training franchisees, location assistance and the costs of signage and other initial equipment costs.

According to a survey of franchisors made by the IFA, the average initial franchise fee is approximately $32,000.

Average Franchise Fees in Selected Industries

Industry Average Franchise Fees Lodging $ 35,200 Restaurants $ 31,900 Printing and copying $ 27,900 Security and safety systems $ 27,100 Hair care $ 25,200 Employment and personnel services $ 22,700 Auto repair $ 22,600 Business services $ 22,194 Fast food $ 20,800 Laundry and dry cleaning $ 19,000 Real estate $ 14,700 Travel agencies $ 14,000

Royalty Rate

"The second major component of the price of a franchise system is the ongoing royalty paid to franchisors by franchisees. As a franchisor, the royalty is your major source of compensation, often accounting for more than 90 percent of the money that you receive from your franchisees over the live of your franchise agreement. In addition to providing you with your profit, the royalty gives you the incentive to support the franchise system over time. Royalties will be used to support your efforts to build the system, to pay for ongoing training, to help existing franchisees work out the kinks in their operations, to develop the brand name, to develop new products and services, and to monitor your franchisees." - Shane

Franchising Your Small Business - the Fly Speck Part Eight

When the Advertising Kicks In

Keep in mind that when you start out as a franchise you don't necessarily want to collect the advertising fee (some do) since you don't have a need for national franchising when you only have 2 or 3 outlets. You might want to write the fee into the agreement but not require franchisees to pay it until you have reached a sufficient size to undertake national franchising.

Support

One of the important benefits of a franchise system is the support it provides the franchisee - you want to provide the back office systems that alleviates the hassles they would have to deal with that would pull them away from doing business. So keep in mind, if you provide too little or not the right kind then you will not attract the right people. Too much and you serve as a wet nurse and your costs run high. The idea is that central office provides the economies of scale in the right areas - back end office, accounting, legal, systems, etc.

More on Support

"In general, you need to get four categories of support right in your franchise system:

• The training that you provide franshisees to get them ready to operate an outlet in your system
• Ongoing support services, such as centralized data processing and inventory control or communications mechanisms, that you offer to franchisees
• Real estate services (for the vast majority of franchise systems that have physical locations) that offer franchisees to help them to identify the right locations for their businesses
• The assistance that you provide franchisees in obtaining financing for their businesses"

-Shane

Marginal Benefits

The marginal benefits of training decline with the amount of training that you provide (200 hours of training is not likely to make you twice as good a house-cleaning franchise as 100 hours) but the costs of training tend to increase in a linear manner with the number of hours of training, there is generally an optimal amount of training that you need to provide to your franchisees.

Take the Field

"Field operations evaluation is a key tool for making sure that franchisees adhere to the rules of the franchise system. Field audits provide an early warning system to identify the need for corrective action when franchisees deviate from system rules." - Shane

Centralized Services

Centralized services include things such as centralized data processing, central purchasing and inventory control. These services are of major value to the franchisee. The economies of scale that are located here offer a significant advantage to franchisees over if they go it alone.

Site Selection

Some franchisors will provide invaluable assistance in site selection: traffic-pattern studies, preselection, etc. This is a good item to offer franchisees since it gives franshisors a mechanism to manage the flow of financial returns from your franchise system.

Franchising Your Small Business - the Fly Speck Part Seven

You Are Going to Need Controls

Here's the set of mechanisms you need to have in place in order to control franchisee behavior:

1. Detailed contracts
2. Reserved termination rights
3. Supply source controls
4. Exclusive dealing requirements
5. Royalty payment ensurement
6. Excess profit provisions to franchisees

This in a nutshell is what your contracts should accomplish:

"To be successful at franchising, you need to write contracts that carefully document the responsibilities and the commitments of your franchsiees, as well as the consequences of failing to uphold these commitments." - Shane

Termination rights spell out that you can in fact terminate the agreement and take back the outlet if one of the franchisees "fails to uphold system standards or fails to follow the policies and procedures as stated in your franchise agreement." - Shane

Additionally, you want to make sure that you provide a list of approved suppliers for cups, utensils, etc. in the franchise and if a certain supply is proprietary to the system (such as KFCs 11 herbs and spices) you want to make sure the source is designated. If it is not proprietary to the system, it is illegal to designate where a franchisee must order supplies from.

Exclusive dealing means that if for example, you own and operate a Baskin Robbins, you can't sell Cold Stone Creamery ice cream in the shop.

As far as royalty payments, franchisees pay royalties based on gross sales - if you leave an opening some will take it and underreport sales to the franshisor in order to get out of royalty payments. The way to circumvent this is to put controls into place - one custard franchise uses special registers that won't allow sales to be erased - and you can audit franchisees and punish them for inaccurate reporting.

Let Them Have Profit!

Bottom line - if you make the franchise profitable for franchisees, they won't necessarily have a reason to cheat. Thus, provide them with excess profits.

Some Terms

You need to set a time limit - "The average term of a franchise contract is ten years, with an eighty-year renewal." - Shane

Back to the 1980s

You want your franchisee to be invested for the long-haul and you want them to have a longer term stake so they have the opportunity to make their money back for improvements, etc but also keep in mind, you don't want a contract to be obnoxiously long so as to create a problem:

"... having long-term contracts can lead your outlets to look dated and stale. In general, franchise agreements call for upgrading at renewal time ... If your business is one in which decor changes often, your outlets can start to look pretty dated if your system has long-term contracts. You've probably seen this as you've traveled around the country. Some older franchise outlets in longer established chains, such as Dairy Queen look like something out of a 1980s move." - Shane

Advertising

One of the key tenents of franchising is to build the brand name nationally. A local advertising push must also be in place but the job of the franchisor is to build the name recognition on the national level. This is done typically through a fund to which franchisees are required to contribute - typically around 3%. You must have this collective advertising bucket to advertise nationally. Franchisees will not pool this money collectively on their own. Set this fee up in your franchising agreement. Typically this rate is a percentage of gross sales.

Franchising Your Small Business - the Fly Speck Part Six

How Much Does it Cost?

It is estimated that the cost of establishing a franchise can be in the neighborhood of $500,000 - so, get it right and keep in mind where franshising does not work so well. It does not work well for example in the grocery business because of narrow profit margins and it doesn't work well in the heating contractor business because the expertise is tacit knowledge.

"In general, three factors make a business appropriate for franchising: The business is based on a proven system for serving end customers; that system can be reduced to a set of operating rules that can be transmitted to others in written form; and there are enough potential buyers of the concept to make it worthwhile to invest in the up-front costs of setting up a franchise system." - Shane

The idea of creating a franchise is that you are providing a system to franchisors that is better than a system they could start themselves. You have already moved up the learning curve in how to provide better customer service, how to provide a better product, etc, and you have the system documented.

"To franchise your business you need to be able to write down the rules and procedures to operate the business, as well as to train others in that system. Operation of your business will provide you with an understanding of the standard processes and procedures to make your business work. Having this understanding will facilitate your ability to sell the system to other people." - Shane

So, essentially, you have to walk your talk. You have to be involved in the business from the get-go in order to figure out what the best practices are or how to do the work efficiently. And in the end, you are selling the system and you will be able to sell if you know why it works.

You Must Be Able To Transfer the Sucker

Your business must:

1. Be easy to replicate.
2. Easily be reduced to written rules and procedures operational-wise.
3. Teachable to anyone and everyone in a relatively short period of time.

Codification Has Nothing to do with Fish

The folks running the franchise have to be able to make decisions based on the written rules and procedures without the owner's involvement. If they couldn't then the franchise owners would get pulled into numerous issues as the franchise grew - an impossible situation. Also, codification leads to contracts which means the folks running the show can be measured as to how well they are matching up to the franchise objectives.

"If you are thinking of franchising a business, you should try to write an operating manual for your business. If you can't do it, that is a signal to you that you might not want to try franchising. There is no way for you to franchise your business if it can't be reduced to a set of rules put down in an operating manual." - Shane

Franchising Your Small Business - the Fly Speck Part Five

The Conflict

Franchisors make money from royalties on gross sales; franchisees are compensated from profits on the outlets that they own.

Thus, franshisors (the creators of the franchise) seek to maximize the level of sales generated across all of their franchised outlets. Franchisees (the owner/operators) seek to maximize the level of profits at their outlets. As a franchisor you will run smack into this conflict. It will be your job to find the balance point - you want to maximize the system-wide sales to hit to maximize your profit from royalities. At the same time you can't burn your franchisees by ignoring their bottom line.

Additionally as the franchisor (the overlord), you want to open as many outlets as possible to maximize sales. Your franchisees (the serfs - just kidding) on the other hand, don't want their territory infringed upon. This can be headed off somewhat with territory agreements - for example, McDonald's provides limits regarding how close franchises can locate to one another.

Watch Out for Free Riders, Hold-Ups, Under-Investment and Loss of Intellectual Property

Free riding happens when one franchisee doesn't deliver on the "brand name expecations" and brings the entire brand image down with him in the eyes of some customers. In addition the franchisee benefits. For example, say a franchisee cuts out a less profitable product that should be offered by the franchise consistently. A customer might perceive this as a lack of consistency across the brand. The individal franchisee benefits because he focuses on higher margin items while the brand gets kicked down a notch in some customer's eyes. To combat this you have to write in strong language surrounding quality standards into contracts and conduct audits.

Underinvestment in Advertising

If there is more than one kid on the block (kid being a franchised outlet), then franchisees tend to scale back on advertising. Why - if their are two Joe's Hamburger Stands in town and Joe's #2 starts a major marketing campaign, Joe's #1 will receive a benefit as well - customers will go to the closest one. Thus, the outlet that free-rides and spends zero on advertising comes out ahead.

To combat this, you write in minimum ad payments to support the brand name building.

This is a Hold-Up

"Hold-up occurs when one party takes advantage of another party's investment in specific assets to extract money from the second party." - Shane. Essentially, the franchisor puts the franchisee in a pickle by threatenting them with termination with a significant amount of equipment on the table. In the equation, it would cost the franchisee more to terminate and replace the equipment than to just continue paying increased royalties. This is a hold-up.

More Under-Investment - What the?

As a franchisee, if you put most or all of your net worth in an outlet, in theory you would be less likely to invest more instead wishing to diversify or say pay off your house. This can lead to under investment in the franchise model.

Property That You Cannot Touch - Intellectual Property

"In many retail businesses, the heart of the business's competitive advantage lies in its intellectual property. This intellectual property could be the firm's methods of operations, as is the case with Merry Maids cleaning service, or it could be the firm's equipment, as is the case with East Coast Original Frozen Custard's frozen dessert machines." - Shane

As a franshisor you must provide the franchisee with the intellectual property that provides the competitive advantage to the business. You have to show them what the intellectual property does in order to market it to them but at the same time you do not want to reveal too much - they can merely replicate it if you do.

Two things to protect you as the franschisor: patents and nondisclosure agreements with your franchisees surounding your trade secrets. But, in the end, "the more people who have access to information, the greater is the likliehood that the information will leak out, even if you sign nondisclosure agreements with the recipients."

Franchising Your Small Business - the Fly Speck Part Five

"Franchising is a valuable business model for companies because it is financially lucrative, providing a mechanism for reducing a company's risk while enhancing its returns on invested capital." - Shane, From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company

Will a new geographic location be successful business-wise? Let the franchisees find out. They will bear some of the risk and can test out new markets. Also, you can pass of the risk and cost of liability for customer injury - in a franchise system the franchisor's have limited liability for the injuries to customers in retail outlets whereas the operators of company owned outlets are liable for customer injury.

Franchising at Amazon

A Look at Franchise ROI

"The financial return on an investment is composed of three factors: the amount of capital invested to generate the return, the revenues resulting from that investment, and the costs of generating those revenues." - Shane

ROI is higher in franshises - why? Low costs - franchises have fewer employees per dollar of revenue compared to company owned outlets making cost structure very low. Due to the fact that royalites are typically collected monthly and bills paid quarterly, the working capital needs for the franchisor can be negative! Also, incentivized owners do not need to be supervised as much as salaried managers.

Franchising Your Small Business - the Fly Speck Part Four

When deciding if your business is ripe for franchising, you must ask yourself if you will be albe to evaluate your franchisee's level of performance easily and secondly, if you can gauge their level of effort. Level of performance should be easy: quite simply, the major metric will be sales and sales will be directly related to the effort franchisee's are putting in to the business - advertising, operations, cleanliness, etc.

Top Ten Industries for Franchising

1. Fast Food
2. Restaurants
3. Automotive Products
4. Maintenance and Cleaning
5. Building and Remodeling
6. Specialty Retail
7. Specialty Food
8. Health and Fitness
9. Child Development
10. Lodging

"For franchising to be advantageous, two conditions must be met. First, a chain of outlets must be superior to independent businesses seeking to serve customer needs (perhaps because standardized procedures and the system brand name give the chanin an advantage). Second, the chain must be better organized through ownership by independent opertators rather than by employed mnagers." - Shane

One advantage to a franchise is that you can beat adverse selection - the process in company hiring in which the less qualified or motivated land salaried managment positions merely because they put themselves in front of the crowd based on the increased pay they will receive in the new position. Franshising can mitigate this scenario somewhat - a person who buys a burger franchise has a vested stake in the business performance and they better be a good operations manager for their own sake. Typically, (in theory) an individual is not going to put up a large some of money to purchase a system they are poor at operating.

Defeating the Shirk

Typically, salried employees will start to "lean" and not "clean" in a situation in which they know their effort will not be rewarded. This is called shirking, one of the reasons government is very inefficient. According to Shane, "one study showed that the mean level of sales at franchised restaurants was 82 percent higher than the mean level of sales at nonfranchised restaurants." No shirking here.

Franchising - A Good to Way to Grow a Company

If you want to grow your business, franchising can provide you a route without having to provide intensive capital. Between 1980 and 2004, Subway grew from 150 to 19,239 outlets - a growth rate of 12,260. In addition, the franchisee's will provide the capital for growth. "Franchisees provide franchisors with up-front fees every time the franchisor adds an additional (franchised) outlet." - Shane. The cost of setting up the location and initial inventory is paid for by the franchisee - franchisees pay for the growth.

In an example provided by Shane, instead of needing $50,000,000 in capital to open 100 $50,000 outlets, you merely have to find 100 franchisees.

Franchising Your Small Business - the Fly Speck Part Three

Brand names breed familiarity. This will be debatable a topic but if you are out of town, hungry and confronted with an unknown restaurant and a known, which one will you most likely pick? Adveturesome folks might go with the unknown but in theory, the majority will go with the familiar.

This is one of the key aspects of building a franchise - building the brand name and thus the familiarity. "In short, franchising provides a much greater advantage to firms in industries in which brand names are an important competitive advantage." - Shane

A Labor Intensive Industry is Ideal

Franchises work better in labor intensive businesses because tthe operator of the franchise has an incentive to not shirk - he has a stake in the operating profits. Thus, he will watch expenses, including labor and will manage more effectively (in theory) than a business that is more capital intensive. (say a gym which is more equipment intensive.)

Franchising Your Small Business - the Fly Speck Part Two

"The first examples of franchising as a way of doing business are found in mid-nineteenth century Germany, where brewers set up contracts with tavern owners to sell their beer exclusively in the taverns." - Shane

In the states, Singer sewing machines was the first franchise but soon, a much bigger name surfaced in the 1890s - Coca Cola. In retail you had Ben Franklin stores around 1920 and then the first food franchise A&W Root Beer in 1924. Because of rampant abuse of the franchising system by franchisors in the 1970s (taking franchisees money and then closing down), the FTC drew up the draft guidelines for Uniform Franchise Offering Circulars (UFOCs), the standard to this day for disclosing franchise opportunities to franchisees. Today, franchishing is now a regulated form of business.

Small-scale production, distribution in a wide variety of different geographic locations

Okay, just what the heck does that mean? Well take a burger stand for example. The burgers are made over and over again on a relatively small scale basis (as compared to say an aluminum plant) and these small scale burger factories can be successful in a variety of different locations - people don't travel far for a meal. In addition, we run into a concept called economies of scale - the central office builds the brand name driving traffic to the burger stands and they strike deals with distributors and vendors and ship the materials. (they get volume discounts.)

But, the flip side to this is that you don't necessarily grow the burger stand by increasing sales from your one spot. In a manufacturing plant you can ship your aluminum overseas. With a burger stand you don't necessarily want to ship the burgers overseas. To grow, you must increase locations.

So, remember ... only franchise if you can acheive economies of scale and the product can be sold in a wide variety of geographic locations. Hamburgers can be sold all over the place and the bigger central office (in theory) the better.

Sometimes a physical location is important

It is easier for McDonald's to set territorial limits because of the brick and mortar aspect of the business than it is for say a cleaning service whose franchisee's can get into a customer turf battle because they go to the customer and are not bound by a physical store.

The power of owner negotiation

Franchishing can be effective because it replaces an otherwise "hired employee" on a fixed wage with a business owner whose income is determined by profitable sales.

Standardize, Codify, Easy to pass on

Filing out tax forms is a standard process. Performing open heart surgery is not. That is why you see franchised tax preparers and not so much health care stands. Additionally, the procedures can be codified or written down. "The routines and procedures underlying the operation, from the ordering of supplies to the serving of customers, to the reparing of machinery. For example, Krispy Kreme gives its franchisees specific donut recipes, as well as procedures for how and when to make donuts. ... To control your franchisees' behavior and ensure that your standards are being upheld, you need to write down those standards in the contract you sigh with them. Moreover, when you franchise, one of the things that you lease to your franshisees is an operating manual, or written set of procedures for running the business."

You must be able to train quickly and to the general population - Subway trains its franchisees in two weeks.

To be continued ...

Franchising Your Small Business - the Fly Speck Part One

According to Scott Shane in From Ice Cream to the Internet, Using Franchising to Drive the Growth and Profits of Your Company, "the basic principles about how to design effective franchise systems ... (are) virtually unknown among practioners of franchising. The net-net being is that if the current franchising developers don't know what the heck they are doing, then, you will be far ahead of the curve by reading the detail here. Starting a franchise of your own might not be such an outlandish idea.

The purpose of this blog is to give you the step by step to start a franchise, the nuances surrounding each step and some context around franchises. In my previous blog - How To Franchise Your Small Business - I provided the bigger picture steps that you need to take to franchise. Here I will provide the details or the "Fly Speck" around those steps.

______________________________________________________________

A non-inclusive list of Fortune 500 company franchise:

McDonald's

Ponderosa

Prudential Insurance

Wendy's International.

Five percent of all franchisors include public companies such as Doubletree Hotels, Big O Tires and Swisher International.

In his book Shane presents to us 11 rules to follow for a company to be successful at franchising.

I will recap each one briefly in this blog.

1. Select the right industry

What is a franchise ...

According to the Federal Trade Commisson:

"The term 'franchise' means any commercial relationship ... whereby a person offers, sells or distributes to any person ... goods, commodities, or services which are: 1) identified by a trademark, service mark, trade name, advertising or other commercial symbol ... or 2) directly or indirectly required or advised to meet the quality standards prescribed by another person where the franchisee operates under a name using the trademark, service mark, trade name, advertising or other commercial symbol."

According to Shane, "the broad category of franchising is made up of tow different business models: product franchising and business format franchising. Product franchising is an arrangement in which one party, a franchisor, develops a trade name and licenses it to another party, a franchisor, develops a trade name and licenses it to another party, a franchisee. The product franchisee contracts for the use of the name to deliver products or services to end customers for a certain time period at a certain location. Examples of companies tha engage in product franchising are Coca-Cola, Goodyear Tires and John Deere.

Business format franchising is an arrangement in which one party, a franchisor, develops a brand name and an operating system for a business, and licenses them to another party, a franchisee. The franchisee contracts for the use of the name and the operating system to deliver products or services to end customers for a certain time period at a certain location. Examples of copanies that engage in business format franchising are McDonald's, Subway, General Nutrition Centers and Wendy's.

The major difference between product franchising and business format franchising is that product franchisors do not offer an operating system to franchisees and business format franchisors do."

To be continued ...

How to Franchise Your Small Business

1) Your Business Must Have Proven Success That Can Be Replicated

Before franchising, Subway had 16 stores with a healthy profit. They reasoned that if 16 stores could be successful then 16,000 would be as well.

2) It Takes a Team

You need to have a strong team in place. Each aspect of the operational structure of your franchise needs to be covered. Someone should be accountable for the Product, Legal, Systems, Communications and Cash Flow. You need an Org chart.

3) The Franchise Proto-type

How will you replicate your business experience in each location? First you must have a defined, predictable experience. You must develop your businesses “franchise proto-type” manual. This includes your operations/policies-procedures manual as well as an accountability standard you will use to ensure the experience is predictable from product to décor to service to marketing.

The System

There is nothing more important in your business than creating a system that works and then sticking to that system. The system runs the business. People are secondary. They run the system. The system is clear-cut and clearly defined. The system takes all discretion, all opinion, and all argument out of the mix and therefore no decision can be made on a whim or made by somebody whose judgment is affected by a particular mood at the time. The system has been put in place because it works and therefore it only needs to be followed blindly by the people who run the system for your business to work. And you don't even have to be there to watch them do it! You are no longer your business and it will not disappear if you are not there. In fact the system can be - and should be - operated by people with the lowest level of skill (otherwise how could you have another 5000 businesses like it). They only have to follow procedure to achieve the consistent, predictable results which are entirely pleasing to everyone from your customers to your employees.

The system is the solution to the problems that have beset all businesses since time immemorial! The free time that you've always wanted, that you listed as part of your Primary Aim will now be available to you.

Managers with little management experience, staff with ordinary skill levels, yet the business thrives on a major league basis because attention has been paid to every detail in the system so that the highest levels of discipline, standardization, order and cleanliness apply in a way which guarantees that customer expectations can be fulfilled in exactly the same way on every occasion. McDonalds' Franchise Prototype was a masterpiece creation and it set the lead for others to follow.

“When you start a business, develop it as if it is a franchise prototype: Systematize everything you do in your business, from how you answer the phone to how you handle customer complaints to how you market and sell your products and services. Document the processes by writing step-by-step sequential procedures.” - Dick McCormick, Biz Success Weblog

This creates across the company consistency.

It provides for shorter training times and allows you to cross-train more effectively.

It allows for a less skilled, less costly person to meet your objectives because the process just needs to be followed as laid out.

“Document your processes if you haven’t already. Put them in a procedure manual. BEGIN with your MOST important systems, those that most affect your customers, those that are the mostexpensive, those that are the most complicated and most likely tocause problems or confusion.

Once the system is documented and in place, you can go back and review the process to see if there is a better way of accomplishing the same thing. Periodically ask yourself if you are accomplishing what you want to accomplish. When you review the process, flow chart it. Evaluate the process and determine 1) If there is any step you can eliminate, 2) If you can develop a more effective sequence, 3) If you can physically position things (paperwork, materials, machines or …) for a better flow , 4) If you are duplicating anything in another process someplace.” – Dick McCormick – Biz Success Weblog

4) Time to Shell Out the Bucks – Get a Franchise Attorney

Yep, sooner or later you are going to have to pay some legal fees. You need the expert advice of an attorney, particularly one with franchising experience. You are going to have prepare an assortment of legal documents including the Uniform Franchise Offering Circular to be viewed by potential franchisees and state and federal government entities. If this guy cannot be your franchise consultant as well then you probably need to find one.

5) You’ve Got Some Convincing To Do

Now you must sell your idea. It is time to find potential franchisees and present your sales pitch. You also need to look over other franchise prospectuses and see how they went about the pitch. You must also follow FTC rules in the creation of the prospectus.

Profitability is important. Again, you are going to have to show a healthy bottom line in the initial business in order to a) successfully sell the model to potential franchisees and b) to even justify the replication of the model – why repeat something that is not working in the first place?

The income you can expect from your franchised business will come in the form of franchise fees, royalties, promotional advertising, vendor rebates, supplies and equipment sales.

You are also going to need to set up “equipment channels” with suppliers. You need to direct your franchisees to the same bucket of suppliers and set up a contractual discount for the equipment.

Does the cookie cutter already work? It’s important to already have multiple, successful locations of the existing business before going on to full-blown franchising. Again, the operations manual must be in place and easy to implement and it should detail how each part of your business works: How are customers greeted, how is the food prepared, what colors are used in the business, what accountability standard is there to guarantee the customer experience is consistent. Everything must be documented. You also must create training programs for franchise owners, managers and employees.

Online resources are available to provide you with a franchise consultant. Google on Franchise Consultant and make sure you spend adequate time researching the short list.

It is important that your business have a unique model. If you own a hamburger stand how does your hamburger stand differ from every other hamburger stand located across the country. You must have a defined, differentiation factor for your business, detailed in the operations manual of course.

Make sure you register and patent your intellectual property. You need a good patent attorney to register your trademark and intellectual property to be used throughout the franchise.

Treat the Business as a System

Summarily, you are replicating the existing success of your business. Your goal is not to work harder and longer hours. Your goal is to own the system through which your business model is disseminated. Thus, you need to step back from the role of hands-on management you have more than likely held and you need to see your role as that of a conductor for the orchestration of the franchising.

Once the franchise has successfully blossomed and a team is in place, you need to determine how your role can become more and more passive. The key here is that you are receiving franchise fees, royalties, promotional advertising, vendor rebates, supplies and equipment sales revenues due to your franchising. You are not creating a full time job for yourself unless of course you choose to take an active role.

The Regulations are a Two Way Street

The Uniform Franchise Offering Circular (UFOC) has to be filled out and there are other regulatory hurdles to be cleared. Although these hurdles are chiefly designed to protect the franchisee, they also protect you as the franchisor should the franchisee begin running the business in a way you disapprove of.

Can it Still Profit?

Remember, a franchisee’s income statement is going to face extra cost that the original business did not: chiefly upfront franchise fees and royalties. Can the business still make a profit in the face of these extra expenses?

Fees, Fees and More Fees

It’s not going to be cheap getting your franchise model up and running. You are going to have to shell out for attorney fees to create the UFOC and get the franchise registered, accountant bucks in order to prepare financials, marketing fees to promote the franchise to franchisees, training fees for both manuals and the staff and for other systems to run the franchise. Depending on the size of the business, this could conservatively run to a quarter of a million dollars.

Some Key Points to Remember:

• Franchising is ideal for distinctive business models that can be easiliy duplicated and scaled.
• Owner attitude must be ambitious - you must be invested in growing the business.
• Focused management interest with business knowledge.
• Innovation must be present.
• Strong profits should be prevalent in current business.
• A strong, experienced team must be in place.
• Should have at least 2 business locations-need to know that the business can be successful in different areas and success is not just a location thing. Also, need to have experienced transfers and a variety of problems from different locations.

Questions to ask yourself before franchising:

Can your success be duplicated or is your involvement/expertise in the business vital to turn a profit?

Is there something about your product/service or the way in which it is produced that is unique enough that it cannot be easily duplicated (people will want to franchise it instead of starting their own very similar business)?

Do you have an operating system that has been tested and can be duplicated and monitored?

Do you have money up-front to finance franchising your business?-There will be a large outlay of money before any franchising royalties will be received-attorney fees, franchise consultant fees, marketing.

Talk to a franchise-experienced attorney-paperwork and determine if a franchise consultant is necessary for you.

Once you are a franchise:

Market, market, market-get your name and the knowledge that you are now a franchise out there to find those who would be interested in owning a franchise.

Redefine your role-no longer sole proprietorship that runs the business and is greatly involved in daily business operations; Marketing/finding franchisees is your new role.

Business Plan Elements

Business Plan Elements

There are four standard sections of the business plan:

1.       The Business

2.       The Marketing

3.       The Financials

4.       The Supporting Material

 

 

1.       The Business

This section discusses all pertinent information relevant to your business.  It might include subsections such as Operations, Legal Structure, Business Model, Management, Personnel, Strengths and Weaknesses, Core Competencies and Challenges, Product or Service.  It covers, soup to nuts, from product conception to follow-up after the sale – how does the business model work?

 

2.       The Marketing

This section details the industry you are in and your place in it.  This covers outside forces – economics, customers, competition, as well as more rudimentary items such as ad campaigns and a traditional marketing strategy.  The sections might include; Target Market, Customers, Competition, Distribtution, Advertising, Pricing, Industry and Market Trends, Strategy and Market Strategy.

 

3.       The Financials

Statements that might be included in this section include; Uses of Funds, Income Statements, Cash Flow Statement, Balance Sheet, Cash Flow Forecast, Profit and Loss Forecast, Income Projection, Sales Revenue Forecast, Income Forecast, Capital Spending Plan, Assumptions, Budget and Break-Even Analysis. 

It is important to benchmark similar companies in this section so you can show where your numbers are in line with the industry and where you have advantages.

 

4.       The Supporting Material

Typically, supporting materials include resumes, letters of reference, credit reports, legal documents, agreements and contracts.

 

In addition, you want to include an executive summary as well as mission and goals.

 

The Outline:

Cover Sheet

Table of Contents

Mission Statement

Executive Summary

The Business

                Strengths and Weaknesses

                Legal Structure

                Business Description

                Product or Service Description

                Intellectual Property Description

                Location

                Management and Personnel

                Records

                Insurance

                Security

                Litigation

                Risk Factors

The Marketing

                Markets

                Competition

                Distribution and Sales

                Marketing

                Industry and Market Trends

                Strategy

The Financials

                Uses of Funds

                Income Statement

                Cash Flow Statement

                Balance Sheet

                Income Projection

                Break-Even Analysis

The Supporting Documents

Taking a Company Public Part One

Any company can be a publicly traded company because there are no minimum asset or revenue regulations.

The reasons why every company should go public:

1)      It offers liquidity to investors should the company start to fail.

2)      It gives you the ability to use the stock as currency for acquisitions.

3)      It gives the insiders and investors leverage at the time of the sale of the company.

4)      Being public allows you to leverage the value of your company because the market capitalization (shares issued multiplied by the share price) are almost always a multiple of the balance sheet of that company.

IPO – when a company issues common stock or shares to the public for the first time.  Typically an IPO issued by smaller companies seeking capital to expand.  Assistance is obtained from an underwriting firm which helps determine what type of security to issue (common or preferred), best offering price and time to bring it to market.

IPOs generally involve one or more investment banks as "underwriters." The company offering its shares, called the "issuer," enters a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell these shares.

The sale (that is, the allocation and pricing) of shares in an IPO may take several forms. Common methods include:

§  Best efforts contract

§  Firm commitment contract

§  All-or-none contract

§  Bought deal

§  Dutch auction

§  Self distribution of stock

 

As an angel investor, you can invest in private companies and, with success, expect to better than double your money.  Or, you can invest in public companies and, with equal success, expect to earn fifty-fold your investment in the same time period.  The public company choice is always the wiser choice because it gives you liquidity should things go wrong and leverage should things go right.

 

How To in General:

One

File a registration statement with the SEC.

a.       The statement must be accurate otherwise it could be suspended.

2)     The SEC will perform a due diligence review of the company to make sure the statement is accurate.

3)     Once they determine it is accurate, they will make the statement “effective” and you will be able to start selling shares.

Two - Underwriting

1)      This process finds out who all of your prospective buyers are going to be.

2)     Includes going through a group of investment bankers who will agree to purchase your company’s securities and then will resell them to the public.

3)     The investment bankers will distribute the preliminary pamphlet to potential buyers so they can see what they are going to be buying.

4)     Your company along with underwriters will go around to different potential buyers and do a marketing trip which includes explaining the business plan including the strategies and business objectives and to answer any questions involving your company going public

Three – I’m Still Standing

Stay in good standing with the underwriters – about a month after you have filed the registration statement, the Securities and Exchange Commission will give you written comments whether or not your registration statement is accurate.

2)     The underwriters will then agree on a price for what they think your stock should sell for.

Where to Start

1)      Research what goes into the registration statement.

2)      The whole process of taking the company public takes about 3 months.

 

Cost

It costs a lot in up front out of pocket expense with figures ranging from $100,000 to $1.5 million.  Total costs and expenses for smaller IPOs can reach 24 to 39 percent of the offering or total monies raised.  But, the company’s net worth is increased and going public makes it easier to get money for growth. 

Here’s a breakdown of the cost categories:

1.       Underwriter costs

2.       Professional costs

3.       Up-front costs

4.       Hidden and future costs

 

The Breakdown

The underwriter’s total fees typically range from 8% to 13%.  This is the largest single cost item in a public offering.  Legal expenses are typically the second largest – on an IPO of $8 million, costs can range between $30,000 and $175,000.   Up-front costs can include stamps, paper, phone calls, special forms, entertainment, and office equipment, up-front costs include registration fees and printing.  Printing costs typically range between $10,000 to $60,000.

How much time does it take?

It can be done in three to four months but if the market is overwhelmed it could take a year.

Key Steps in a Public Offering

1.       Business Plans

a.       Corporate master plan

b.      Underwriter/legal/accounting plan

c.       Condensed plan (executive summary)

d.      Identify preprivate financing

2.       Identification of Associates

a.       Retain attorneys

b.      Identify accountants

c.       Identify underwriters

d.      Establish preprivate financing

3.       Forming the Corporation

a.       File incorporation

b.      Structure public offering

                                                               i.      Identify founders

1.       Percent founders

2.       Percent preprivate

3.       Percent private

4.       Percent dilution

c.       Negotiate underwriter’s letter of intent

d.      Retain accountants

e.      Negotiate outside agreements (patents, sales, licenses, consultants, royalties)

4.       Private Placement Prepreparation

a.       Approval of private placement documents

                                                               i.      Corporation

                                                             ii.      Underwriter

                                                            iii.      State

5.       Raising Private Funds

a.       Establish escrow account

b.      Solicit private monies

c.       Prepreparation of public registration

d.      Break private escrow

6.       Audit and Registration Preparation

a.       Complete initial audit

b.      Retain printer

c.       Retain transfer agent

d.      Approval of SEC registration statement

                                                               i.      Accountant

                                                             ii.      Corporation

                                                            iii.      Underwriter

7.       Filings

a.       Submit registration to SEC

b.      File with blue-sky states

c.       Clear with NASD

d.      Initial comment letter from SEC

e.      Print red herring

                                                               i.      Send syndication indication request

                                                             ii.      Distribute red herring

f.        Second letter of comment and reply

g.       Third letter (if needed)

h.      SEC acceleration request (if needed)

8.       Raising public financing

a.       Arrange due diligence schedule

b.      Sign underwriter’s agreement

c.       Establish public escrow

d.      Print prospectus

e.      File with Nasdaq

f.        Establish syndicate

g.       Distribute prospectus

h.      Conduct due diligence meetings

i.         Place tombstones

j.        Complete public offering

                                                               i.      Legal and accounting opinions

                                                             ii.      Closing papers

9.       Post completion

a.       Break escrow

                                                               i.      Corporation, attorneys, accountants, bank, transfer agent, respective counsel

b.      Establish market makers/quotation

                                                               i.      Pink sheets

                                                             ii.      Nasdaq

c.       Establish trading

d.      File 8-k

Also …

You can use a public company for estate planning purposes to pass on assets to heirs – there is a certain amount of cache to being public as well.  You can raise money yourself and by having a stock symbol and a quote it lets people know there is any exit strategy. 

In going public, the company realizes several objectives:

1. Receipt of capital to fund business objectives
2. Liquidity, or at least potential liquidity, for company insiders
3. Creation of a new form of currency to reward loyal employees or to make acquisitions
4. Obtaining a source of future capital to fund growth
5. Creation of a basis for valuation of insiders’ stock for estate tax or similar purposes, and facilitation of business succession strategies

The categories of companies which the market has been interested in taking public is as follows

1. Companies with a history of successful operations with a demonstrated growth trend that is likely to continue
2. Companies that possess a unique franchise or market niche within a market sector that is experiencing growth and management has a comprehensive business plan to realize profitable growth
3. Companies that possess patent or similar rights to a technology in a market sector which could experience rapid growth by the application of new technologies
4. Companies in a market sector that is experiencing growth headed by an entrepreneur or management team with a successful track record with prior IPO’s

Further advantages for the company

·         Fund start-up operations

·         Purchase equipment necessary for production

·         Increase inventories of both raw and finished goods

·         Support growing receivables

·         Further research

·         Develop the next generation of product

·         Retire prior debt and

·         Increase market share

Articles of Incorporation – the Outline

Article I: Corporate Name

A search has to be done to determine if the name is available.

Article II: Purpose

A broad statement of purpose is beneficial since it will allow for business model expansion and changes in direction.  Some states allow statements such as “to engage in any lawful business” while others will require you to be more specific.

Article III: Duration

This article sets forth the length of time the corporation will exist.  Generally, “perpetual existence” is the way to go.

Article IV: Capital Stock

This is the article where you detail the type of stock you are going to issue – common, preferred, etc.  It is best to leave this article broad as well.  It is typically broken down into the following sections.

Section 1: Classes and shares.

This section simply states, “The authorized capital stock of the corporation shall be [number] shares of Common stock, ___ Par Value, and [number] shares of Preferred stock, ___ Par Value.”

Section 2: Preferred stock

Section 3: Common stock

Section 4: Proxy rules

This section simply authorizes the board of directors to adopt a resolution whereby shareholders may certify in writing to the corporation that their shares are held (controlled or voted) by one or more persons.

Article V: Voting

This closes up an old loop-hole where a few holders of a distinctive class of stock could “rubber-stamp” the decisions of the directors.

Article VI: Preemptive Right

This article states that shareholders do not have the right to acquire, before others, unissued or treasury shares of stock or warrants.

Article VII: Registered Office and Agent

This article gives the address of the registrar of stock for the company and names the specific person acting as registrar.

Article VIII: Board of Directors

This article indicates how the directors are compensated, the length of time they serve and procedures for elections and filling vacancies.

Section 1: Number

Section 2: Classification

Section 3: Initial directors

Section 4: Nominations

Section 5: Powers of the board

Article IX: Conflicts of Interest

Section 1: Related party transactions

Section 2: Corporate opportunities

Article X: Indemnification

This article deals with the process of protecting or providing security against damages or loss as a result of actions taken by the company.

Article XI: Shareholder Meetings and Votes

This article determines the time and place for shareholders meetings according to the corporation’s bylaws.

Article XII: Amendments

This article addresses the amendment of articles of incorporation, usually requiring the affirmative vote of a majority of the shares.

Bylaws

These are the rules governing a corporation.