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.