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 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."