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.

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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.