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Session 10: Franchising your business

OBJECTIVE: A well executed franchise program can expand a sound business concept into a world-wide organization. In this session you will learn how to franchise your business and what to look out for when doing so.

      Franchising your business

Franchising potentials

A well executed franchise program can catapult a sound business concept into a world-wide organization. 7-Eleven© operates over 36,000 stores in 20 countries. Subway© is operating over 33,000 shops in 91 countries.

If you are operating a business with multiple locations you may have a good model for franchising. Growth can be accomplished by utilizing the capital and motivated management provided by franchises.

But franchising can be a double-edged sword. Mistakes made in a faulty franchising program can turn a successful business into a disaster. The strategies outlined here come from hands-on experience and will help minimize your mistakes.

Advantages of franchising

Franchising provides expansion capital
The need of capital to grow is largely eliminated. The franchise fee paid by the franchisee will normally cover expenses such as fixtures, signs, rent deposits and other opening expenses. This source of cash from franchisees can reduce or eliminate one of the greatest risks of growing: financial leveraging. Instead of borrowing for growth, you franchisees can furnish the capital.

Avoids employee related problems
In a company-operated store the manager and employees are on the company payroll. In a franchised unit, they are employed by the franchisee. This relieves the franchisor of the escalating headaches related to employees, workers compensation insurance and other labor related issues.

Accelerates expansion over a wide area
The franchisor is thus free to expand geographically at a rate that eliminates the three big issues of money, managers and employees. Using Internet technology communication tools, international expansion becomes more feasible.

Franchisee operators are motivated to succeed
Some years ago a chain of doughnut shops switched from operating as a company-owned chain to a franchised chain. In most all cases the company managers stayed on as franchisees. The results of the transition were apparent the very next day. The stores were cleaner, the sales went up, and the donuts were bigger and better. The difference was that instead of managers the stores were taken over by proud owners.

To gain insights into how franchising is perceived from the standpoint of franchisees, here are some pros and cons of buying a franchise, taken from the Starting a Business course.

Disadvantages of franchising

Dr. Dan Nathanson Anderson Graduate School of Business UCLA Dr. Dan Nathanson
Anderson Graduate School of Business UCLA
Play Video
What did Ray Kroc do differently when he started McDonalds?
Sharing profits
Your store concept will need sufficient volume, pricing and lasting power for both you and the franchisee to earn profits over a long period of time. This will rule out commodity products where sales go to the lowest cost provider or to fad based products.

Loss of absolute control
You will no longer have absolute control of how your stores are operated. Instead you will be dealing with a partner who has agreed to operate the store by following your training and instructions.

Lawsuits with unprofitable stores or uncooperative franchisees
If a franchisee is unable to make money or has any other reason to be disgruntled, you can be in for a lawsuit. If even as few as 5% of your franchisees instigate litigation, your loss of reputation and litigation costs can be very damaging.

State and federal franchise disclosure laws
Franchisors are regulated by both federal and state laws. You will need a franchising lawyer to draw up your franchise disclosure documents including a franchise offering circular. The documents will include a franchise agreement and will require disclosure of your company's financial and other information.

Prove profitability first in company operated stores

Start with company owned stores
Selling franchises is the least difficult problem in starting a franchise chain. There are always eager entrepreneurs ready to buy franchises. But it would be a mistake to start a franchise operation without first establishing a completely proven operating model and system. Most concepts will take two to five years to prove out. Without a profitable operation in place to begin with, you could be betting your company's future because a failed concept can result in an avalanche of franchisees' lawsuits.

Require profitability for both franchisor and franchisee
Your pilot plant stores, operating before you franchise, must demonstrate sufficient pricing power to satisfy both you as franchisor and also the franchisee. This would eliminate commodity type products where there is no pricing power other than selling at the lowest cost. Generally speaking pricing power can be defined as the power to increase your prices without lessening the demand for your product. The lack of sufficient pricing power can result in franchisees failing through burn-out and overlong hours.

Importance of conservative growth rate

While your growth rate may seem only limited by your ability to sell franchises and open stores, there are important reasons to carefully restrict growth rate, especially in the early years of development. A new franchise offering that projects hundreds of store openings in three to five years should be considered a high risk. Rapid early growth creates the following problems:

  • Compromises are made in the selection of store locations. The famous three qualities to consider in selecting real estate are true: location, location, and location. Finding good locations is like finding gold nuggets: you have to turn over a lot of rocks. And the success or failure of each franchisee will be largely tied to the quality of his or her location.
  • Too often compromises are made in lease terms. Issues such as rent, term, options, cost of living adjustments, non-compete provisions, go-dark provisions, signage and common charges all need to be carefully negotiated with terms that will produce profitable stores. While it is the franchisees who takes on the lease obligations, their defaults become your bigger problems in the form of franchisee lawsuits and tarnished public image. .
  • Risk of cannibalization and over saturation. Stores that are placed too close together end up competing for the same customers. Following decades of building a wonderful reputation, a new management at Kirspy Kreme Doughnuts over-expanded in California resulting in financial disaster for the company and bankruptcy to franchisees.
  • It takes time and experience to build up the overall infrastructure necessary to support a growing chain. Responsibilities such as franchisee training, area management, store accounting, store supervision, product development, real estate development all need to mature through experiences learned during early growth years.
  • Growth should be focused on developing specifically designated marketing areas to enable the clustering of stores and gain the benefits of cost effect advertising, supervision and delivery systems. But clustering must be disciplined so that franchisees do not overlap.

Should master leases be with the franchisor or franchisee?

There are two ways a franchisor can structure the leases covering store locations.

Franchisees lease from landlords.
Franchisors have the franchisees sign leases directly with shopping center owners. A standardized lease form is furnished for submittal to prospective landlords. In this approach the franchisor usually takes on the responsibility of selecting and sometimes negotiating locations.

Some franchisors use this approach in order to not be obligated for the lease payments. The liability of a 20 year lease at $5,000 per month is $1,200,000. This is a huge number to burden the franchisor's balance sheet. But there are two big problems associated with this approach:

  • Since the franchisor does not control the site, an unhappy franchisee is far more likely to walk away from the franchisee agreement
  • Landlords who control good locations do not want to sign leases with "non-credit" tenants. They want to deal with the more financially responsible franchisors.

The franchisor controls the real estate.
In this approach, the franchisor locates, negotiates and signs the leases for the stores and subleases the premises to franchisees. This puts power in the hands of the franchisor to evict franchises who are not meeting franchise agreements or for other reasons and releasing to new franchisees. Exposure for the huge rent liabilities is mitigated by use of a sub-let clause which permits franchisors to re-lease premises to other franchisees or to non-franchised tenants.

As a franchised operation grows in size and financial strength, it can borrow money much less expensively than paying rent to landlords. Most all well-seasoned franchisors control their locations either by being the underlying tenant in leased spaces or by owning locations and leasing them to franchisees.

Importance of operating franchisees

Avoidance of investor franchisees
Most successful franchisees operate their stores and are not absentee investors. An investor adds a third party to the profit pool (along with the franchisor and the store manager) that is usually hard to support. Potential investor-franchisees should be screened out early in the application process.

Under some circumstances matured franchised companies will negotiate "area" franchisees where the franchisee is responsible for a geographical area and multiple stores. For example this plays a more important role in franchising overseas where an area or even a country franchise may be appropriate.

Special business skills required of franchisor

Phil Holland Founder, My Own Business Phil Holland
Founder, My Own Business
Play Video
What are some of the advantages and disadvantages of becoming a franchisor?
Screening of franchisees
A franchised company is only as good as the quality of their franchisees. It is a good investment to retain the service of a professional to assess potential franchisees. They can be found under the heading "franchisee employee assessment" in search engines.

Don't be misled into zealous growth because you find a lot of potential franchisees clamoring for your offering. There are lots of entrepreneurially minded people seeking to operate franchised businesses. Your challenge will be to install filters when interviewing potential franchisees so that selected candidates all demonstrate integrity, intelligence and energy as well as the intention to become active operators. As Warren Buffett has said, "People with integrity are predisposed to perform; people without integrity are predisposed not to perform. It is best not to get the two confused."

Real estate development
Real estate development plays a key role in franchising. These functions include:

  • Creation of the design and working drawings of stores including equipment and fixtures.
  • Negotiation of store leases in shopping centers or other appropriate locations Normally the franchisor will be the lessee and the franchisee the sub-lessee.
  • Securing building and occupancy permits.
  • Build-out of store premises including fixtures and equipment.
  • Participate in store opening process.

Site selection is a key factor in the success of a franchised chain. Each business has its own individual site criteria. For example a donut shop should be on the side of the street going to work and a liquor store should be on the side going home. Through research and experience you need to create a "Site Model" that will provide a measurable, non-emotional, objective way to evaluate potential locations.

You can create your own "Site Model" by assigning different values to the factors that are most important for your particular business. Then each location can be numerically evaluated and compared against these measurements. The following example form will give you a methodical approach for evaluating the strengths and weaknesses of each potential location. Here are the steps:

  1. Evaluate your site location for each factor on a scale of 1 to 10, Number 10 being the highest.
  2. Decide the importance of each factor to your particular business on a scale of 1 to 5, number 5 being the most important.
  3. Multiply the grade by the weight to determine the points for each factor. Add up the points to get a total score. Repeat this process for each site to gain an objective, comparative analysis.

Site Criteria Table
FactorsGrade 1-10Weight 1-5Points
Traffic count: Cars or pedestrians   
Visibility access   
Proximity to competition   
Zoning   
Parking (include off-street parking)   
Condition of premises   
Proximity to customer generators   
Income level of neighborhood   
Population density   
Ethnic make up of neighborhood   
Age factor   
Directional growth of area   
Area improving or deteriorating   
Crime/shoplifting rates   
Availability of qualified employees   
Labor rates of pay   
Supplier proximity   
Terms and rental rates   
Adequacy of utilities, gas, & water   
Transportation accessibility   
Total Points 

Some things to keep in mind in site selection:

  • There's no such thing as the "last good location."
  • Copycatting your most successful competitor's site criteria can help you avoid making mistakes.
  • If you are building a chain of stores, never sign a lease on your second location until your first location is profitable and proven.
  • It is better to pay fair rent on a great location than pay great rent on a fair location.
  • Don't rely on leasing agents to make your site decisions.
  • Driving streets and walking neighborhoods is a good way to scout for locations.

You will need to decide whether to build an in-house store development department which will be responsible for all aspects of site location and leasing or to outsource to commercial real estate brokers. A drawback to using brokers is the risk of conflict of interest issues.

Specialized legal council
Your legal council will be responsible for approval and compliance with all documentation including the offering circular, the franchise agreement and the sublease agreement. It is important that your legal council be experienced in corporate work and experienced in franchising law. If you are interested in an international franchising program, global expansion will require special skills. Please visit International franchising in the Global expansion session of this course.

Training and operations management
McDonald's founder Ray Kroc has said, "If we are going to go anywhere, we've got to have talent. And, I'm going to put my money in talent". You will need franchisees that are well trained, well motivated and well supervised. Once your franchise chain is established, a good model to emulate is McDonald's center of training excellence, Hamburger University. Their mission (as yours should be) is to emphasize consistent operations procedures, service, quality and cleanliness.

Area supervision
Ongoing oversight will be required to maintain consistency in quality and adherence to procedures. In the food service business it is correctly stated that "you are only as good as your last meal served". Area supervisors also provide valuable feedback. One of the greatest rollouts in Subway's© history came from an operator's suggestion made to an area manager for a new sandwich promotion.

Escrowing of franchise fees until unit opening

This recommendation may not be applicable to multi-national franchisors but it would be a sound policy for start-ups. The franchise fee should be escrowed and disbursed to the franchisor upon opening of the store.

An unsuccessful franchising concept will usually trigger a bankruptcy of the franchisor as well as the franchisees. If this happens and the franchisor has commingled franchise deposits, franchisees that have not yet opened stores will lose the fees they have paid. Franchisors who follow a policy of escrowing franchise fees will gain in the following ways:

  • Protect the deposits of franchisees in waiting.
  • Generate a larger pool of franchisee prospects to select from. (More will come).
  • Self-impose a healthy financial discipline.

Disclosure requirements

Stan Henslee CPA Stan Henslee
CPA
Play Video
What mistakes are made when companies franchise their business?
Offering circular, franchise agreement and store lease
Transparency in all matters and risks will be the key in disclosures to franchisees. The three main legal agreements will be the offering circular, the franchise agreement and the store lease. It's best to have legal council that is experienced in the franchising industry.

Audited financial statements
Audited financial statements provide the highest level of audit scrutiny. It should be considered a necessary expense of becoming a franchisor.

Profit and loss statements from franchised stores
Your prospective franchisees should have access to the P & L's of operating stores of their selection. Disclosing P & L's from only the best stores can lead to claims of misrepresentation.

Pending litigation including with franchisees
The quality of your franchise will be evaluated by what percent of your franchisees have filed lawsuits. Generally speaking 1% or less indicates a good record, 3% indicates further investigation and 5% or more could indicate serious problems.

You should be prepared to disclose all lawsuits including past and present ones with franchisees.

Contact information on past and present franchisees
The most important "due diligence" investigation made by a prospective franchisee will be what he or she can learn from your operating stores. So follow the principle "we have nothing to hide' by furnishing open access to your franchisee roster.

Top Ten Do's and Don'ts

THE TOP TEN DO'S
  1. Create a location site model to evaluate locations.
  2. Budget the franchise fee to cover start-up expenses.
  3. Start with company owned stores.
  4. Prove profitability first.
  5. Understand you will no longer have absolute control.
  6. Consider your franchisee as your partner.
  7. Hire and retain a franchise lawyer.
  8. Screen out passive investors as franchisees.
  9. Retain a professional to assess potential franchisee.
  10. Follow the principle "We have nothing to hide".
THE TOP TEN DON'TS
  1. Overlook your current store managers as potential franchisees.
  2. Franchise a commodity product or service.
  3. Start franchising without establishing a profitable and operating model.
  4. Fail to create a franchisee training center.
  5. Neglect ongoing oversight to maintain consistency.
  6. Cherry pick P & L's to present to prospective franchisee.
  7. Commingle franchisee deposits with your business account.
  8. Grow rapidly to begin with.
  9. Hesitate to close an unprofitable location and relocate franchisee.
  10. Withhold contact information of franchisees past and present.

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