Franchises – Income Mixology

The original concept for this article was to explore the question “Should I create a franchise out of a successful business and become a franchisor?” While writing the article, it became apparent that a portion of the article should address the question “Should I purchase a franchise and become a franchisee?” This is important because many of the successful independent entrepreneurs who might consider franchising their business have never been franchisees, much less franchisors, and need to consider the experiences of franchisees. Notions About Franchises In my limited experience, I developed a skepticism about franchises despite having a couple of decent experiences as a franchisee. This might be because my two experiences as a franchisee were as the owner of a real estate brokerage and, separately, a business brokerage. These professional service franchises cost considerably less to obtain with lower overhead than many other types of franchises and had the potential to make back the investment in well under a year compared to several years for most brick and mortar franchises. See the table Types of Franchises. I also worked for a solar energy technology and finance company that had a solar installation franchise division. One of my colleagues had considerable franchise consulting experience and I learned a little bit from him. As a business broker, I have represented franchise owners including the owner of an ex-franchise who kept operating after the franchisor went out of business. He and a handful of other owners could still source supplies, use the brand name, and no longer had to pay any royalties or fees or follow any operating guidelines! These experiences led me to some assumptions about franchises. Profit is lower for franchisees than independent entrepreneursFranchisees pay more to start up their business than independent entrepreneursWealthy franchisees tend to be multi-unit ownersStrong brands can be quite expensiveWeaker brands provide unknowable valueMany rosy franchise statistics had to be bogus Later, I performed some cursory online research to see how my assumptions about franchises compared with broader data. Spoiler alert - I was surprised. Types of Franchises I categorize franchises into five groups in order of complexity AND capital requirements. DescriptionCapital RequirementsPhysical LocationEmployeesExamplesJob or OperatorIndividual or small team, lower startup costsLowHome-based or VirtualNone or a FewLawn Doctor, The Maids, Service Master, Jan-Pro, Mr. RooterManagementSmall to large B2B or B2C teamsModerateVirtual or OfficeFew to ManyREMAX, State Farm, H&R Block, Padgett Business Services, TeamLogic ITRestaurant or RetailRestaurant, fitness, salon, hardware, tutoring, dry cleaners, etcHighRetailFew to ManyMcDonald's, Planet Fitness, UPS Store, Dunkin' Donuts, Ace Hardware, Tide Cleaners, SuperCutsDistributionGas stations, soft drinks, vehiclesVery HighCommercial / IndustrialModerate to ManyExxon, Texaco, Goodyear, Ford, Chrysler, John DeereInvestmentHotels, Storage, real estate investmentVery HighCommercialModerate to ManyMarriott, Hilton, Storage Authority, Pods Rosy Franchise Statistics The primary reason for my shock when researching success and failure rates for franchises, and small businesses for that matter, was the incredible amount of conflicting information online. There are many articles that address failure rates or success rates. Many of them do not cite sources, while many of them cite very credible sources, yet the credible sources don’t align. And as typical on the Internet, many of the articles simply mirrored other articles. Several sources, even within the franchise community, cast doubt on some of the remarkable claims that came from the industry that paint the picture that franchising was considerably less risky than starting independent businesses. Other articles point to the flaws of early studies which did not survey the failed franchise owners. Still other articles suggest that franchises fail at the same or similar rate as independent businesses. As a critical thinker, i.e. skeptic, these are the thoughts that crossed my mind: Being in business is how these statistics define success, but nobody would feel successful with a zombie business - one that is hasn't shut its doors, but is simply hanging on.Franchisors provide standard operating procedures, coaching and support in exchange for a cut of profits. Is it a fair exchange? Are these benefits significant enough in the highly competitive markets where many franchises compete like fast food?Is a franchise business more likely to be a zombie business because of the significant percentage of profit that is carved out by the franchisor?Are franchisees able to last longer than independent business owners because franchisees have more capital? Franchises and Immigrants Subway and 7-Eleven are two franchises that have a checkered history of abusive practices against franchisees. These two franchise operations have a higher than average percentage of immigrant or minority owners than other franchises. Some of the abuses may stem from concerted efforts to target immigrants or minorities with less knowledge of the law according to some complaints. Furthermore, regional power has been granted to immigrants or minorities who then recruit and abuse members of their own communities. A common complaint is an overbearing rulebook that enabled franchisors or franchisees on their hierarchy to pressure stores out of compliance, forcing hardship and often preventing franchisees from selling their franchises in the open market. This way, they could buy these stores below market and add to their portfolio of stores. Many immigrant workers will work under less than ideal conditions than typical U.S. workers because our subpar conditions pale in comparison to working conditions or lack of work in their countries of origin. Immigrant families seek opportunities where they can staff their businesses with family members, including children, who are often unpaid or paid less than market wage. The entire family contributes to their own collective success in the long term. According to a franchise executive I worked with, Subway targeted these immigrants because they could handle the low profit margins with a lower payroll. Furthermore, Subways do not carve out territories for franchisees. In fact, quite the opposite. They have been accused of encouraging owners to open more stores before new owners come in, often on the same block. These cautionary tales should serve as a warning about the worst of franchise experiences, and how undifferentiated and unprofitable a franchisee might be despite considerable investment in a well-known brand. Franchisor Considerations Having provided a sobering view of the franchisee experience, let’s jump into the shoes of the franchisor. Franchise brands often arise from a single independent entrepreneur who achieves great success and elects to grow by franchising their operation to others. This is not as easy as leading by example or replicating success through processes. A franchisor must be committed to building a significant support organization. Legal Considerations Stepping up from business owner to franchisor requires a significant step-up in legal expertise. Your customer layers have grown beyond end users to franchisees, your partnerships are now more significant in number and scope, and your intellectual property must be developed and protected. New legal considerations, advice, and expenses are needed in several areas: franchise lawfranchisee agreementsintellectual propertyrisk mitigation with franchiseesrisk mitigation with end customers Operations Scaling your successful business as a franchisor might require 1) evaluating suppliers of goods and services who can grow with you, 2) negotiating purchasing contracts, 3) revisiting logistics and delivery at scale, 4) or mastering real estate, leasing and construction. Technology & Processes Franchisees expect the franchisor to provide efficient processes and technology as well as to lead with cutting edge of technology that changes constantly. Franchisees expect access to vendors and/or pricing they could not otherwise get on their own. Technology and processes must be provided on two levels. A franchisor needs internal technology and processes including private portals, owner documents, and communication channels for and with franchisees, as well as customer-facing technology and processes for franchisees to run their businesses and interface with end customers. Marketing & Advertising Advertising is also constantly changing and must be considered on several levels. Franchisors must have the expertise to guide franchisees on traditional and digital marketing to end customers. Franchisors must be competent at national or regional advertising to support franchisees, especially if they are charging franchisees a marketing fee. Franchisors must also master marketing and advertising strategies to recruit new franchisees. Training & Support Just as some sports stars are not suitable as coaches, only certain entrepreneurs can be effective coaches to others. While technical training is a given, sometimes basic business formation training or even tax planning and personal finance training may be needed by franchisees. This will be especially true if a franchisor is desperate and recruits franchisees with marginal qualifications. The franchisor must have a training plan and infrastructure that includes a regular cadence of meetings, education, and new materials. A learning management system may be needed for courses and testing. A support infrastructure must be in place to respond quickly to current and new franchisees. Motivation & AccountabilityA significant portion of business owners need emotional and psychological support, perhaps even more than they need technical training. Business is hard and life is tough. A franchisor must accept responsibility for being a significant part of the lives of their franchisees. Some form of the Pareto Principle will apply to franchisee performance, which means 20% of your royalties might come from 80% of your franchisees. Meanwhile, you have to elevate, motivate and even babysit the other 80%. Many franchisees will want to tell you how to run the show and then complain if those suggestions are not implemented despite their lack of feasibility. Many franchisees want access to other franchisees, especially the star performers. Even star performers can be challenging. They may demand better terms due to significant performance and contribution to the franchise. If these star performers warrant better terms, is there an easy way to implement sliding scale incentives transparent to all franchisees? Franchisees will naturally find each other. Some may form small mastermind groups that meet on a regular basis. These side meetings that exclude the franchisor may be a threat or an opportunity, but are almost inevitable. They present challenges in the form of negative chatter or loud voices leveraging others to demand policy changes or other demands. Successful franchisors do not simply find others to replicate their success. Successful franchisors must be excited about, and committed to, building significant support organizations. Wearing Two Hats: Franchisor and Operator While it can be challenging to franchise a business and continue to operate the original business or corporate-owned stores, the reality is that the bulk of your profit will come from the business you created for yourself, not for others. This is likely to be the case for many years after franchising. You will want to divide these two activities into two business entities with separate staff. The business you continue to operate becomes an R&D lab breaking new ground that can be packaged, transferred or shared with franchisees. This business is a vital example for current and new franchisees as a vision or aspiration. If you stop operating, franchisees will use that as an excuse to claim that things were easier when you used to be in business. And because the business climate is so dynamic, they could have a very good argument. Financial Considerations Having touched on some key considerations pertaining to franchising a business, it is clear that the capital required for this endeavor is significant. Traditional approaches to alleviate the financial burden include passing fees on to franchisees, but shifting the burden may not be a great solution. Advertising fee charged to franchiseesTech fee charged to franchiseesEvents and conferences charged to franchisees 67 percent of all franchisors who launch don't sell a single franchise in their first two years.July 21, 2022 Entrepreneur Magazine As these financial pressures mount, franchisors look to offset the burden by increasing revenue from up front franchise fees and ongoing royalties and fees. However, initial fees from new franchisees have direct expenses associated with them including recruiting expenses and commissions, training and onboarding. Royalties will trickle in from new franchisees and the lower performing existing franchisees - which could be 80% of them! Failing franchisees will cost the franchisor in payment plans, collections and legal fees. Common Sense Check If the franchisor charges 10-15% royalties plus fixed fees, can the franchisor provide enough value to enable the franchisee to recoup the 10-15% plus their initial investment? Is that realistic in the hyper-competitive industries of fast food, home services, professional services or whatever industry the franchise operates? NOTE: Sources cite a good EBITDA margin is 10% and that S&P firms reach 10-15% in good times. I’ll argue that these percentages can work for large companies, but present significant strain and risk on small business owners who need to be at 20%+ due to the inherently more volatile nature of small business. If the franchisor's added value = the ongoing fees they take from the the franchisee, that part is a wash. Then if we look at the up front cost, let's assume that portion of up front fees not going to the franchisor, such as signage, launch marketing, and location build-out would be there, or should be there, for an independent business owner. Then what is the value in exchange for the initial franchise fee? Initial fees can range from $10,000 to $100,000 with most between $25,000 and $50,000. The franchisor is saving the franchisee from an extended time learning the ins and outs of the business on their own and inefficient start-up expenses. This includes time spent sourcing supplies and vetting partners, time and money experimenting with business strategies and marketing plans, time and money developing name and brand recognition. Customer Centric View As an entrepreneur considering a franchise option, would I be happy paying $40,000 in exchange for skipping the learning curve, and then an even exchange of 12% in ongoing franchise fees in exchange for a 12% bump in revenue because of my franchise affiliation? My answer would probably be ... I wouldn't be happy, but I wouldn't sue anybody. I'd be somewhat disappointed in what was promised, but I'd kick myself for not discounting the hype even more than I did. Success on the franchisee's terms might be: Surpassing their corporate salarySurpassing their expectationsSurpassing what you promised As a franchisor, you must define success for a franchisee on their terms. If you told them up front they were signing up to make minimum wage, they wouldn’t do it. Yet this is the fate of many franchisees. Ask yourself these key questions: Are you willing to be largely responsible for the livelihood of others?Can you under-promise and over-deliver?Will your franchisees be raving fans to new franchisees after the honeymoon period? And then ask these additional questions: Are you in it for the long term?Does your commitment match your aspirations?Are you excited to build a large significant support organization?Are you okay diverting resources from your current successful operations as an owner-operator?Is there a better way to leverage your successful business than to franchise it? "Well they didn't sue me!" is not a business model. The franchising world doesn’t need another franchisor to build a lopsided empire. Plenty of established franchises have lured innocent franchisees into investing tens and even hundreds of thousands of dollars toward an entrepreneurial dream that turned into a low paying job running a zombie business. People can do that on their own for a lot less. Business is hard. New franchisors need to step up and add real value. Better Options Than Franchising Your Business Besides creating a successful business concept with processes, technology, relationships, differentiators and a brand that can be packaged and easily leveraged by others, let’s review the requirements that would-be franchisors must consider: Able to help people achieve success on their termsExcited to build a significant support organizationDeep pockets or access to capitalLong term view: 5 years minimum, 10+ years preferredPassion to continue running the business with corporate owned units This is a huge commitment that requires a lot of capital. This is high stakes with no baby steps. I can think of three alternatives that pose less risk and have a higher chance of success. Licensing While you might think it will generate less revenue than franchising, the previous discussion should have highlighted the considerable expense and low profitability in support franchisees. Licensing is easier, cheaper and more passive than franchising a business. You are giving up control over the quality of the products and services the licensee delivers to the marketplace, but you may be able to address this in the way you run the licensing program. Growing A Team By growing your current operation or team, you are shifting more of your investment back into your own ability as an operator that in the ability of others to succeed with your concept. As a team leader, you’ll still invest in others, but it will be a smaller, more closely managed group of colleagues than a disperse group of, in essence, strangers. You may be more successful dominating a smaller territory with a team versus having a wider footprint of mediocre businesses run by franchisees. In real estate, there are countless examples of star performers who built powerhouse teams within a real estate office rather than start their own brokerage. With the team concept, you can still help people achieve success on their terms. But now that the people you are helping is a smaller group that you can influence more directly, you may have more success and more fun. You are building a smaller support organization that does not require significant investment or as long term a commitment. It also allows you to take a managerial role without participating in the day-to-day in the same way as before. Selective FranchisingTM What if there was a way to work with just the 20% that normally drive 80% of the results? Surely there is a way to better screen for top performing candidates. But identifying star performers via traditional mass recruiting is not so easy. There are inherent challenges when recruiting on a large scale and using a small amount of information over a short recruiting window to pick top performers. What if you were to take a Selective FranchisingTM concept approach described as follows? Leverage the small set of stars you know well rather than try to identify new stars in the universeRather than settle for rather dependents and subordinates, partner with peers and mentors who...can add as much value to you as you can to themhave as much or more capital than youcan provide a strong network of other quality partners for youPartner with those who could be your exit or lead to your exitFind partners with multi-unit potentialExplore partners with synergistic business (supply side, customer side, operations side)Have a pipeline of franchisees just like them (pay the fees to sign up their friends) In order to attract quality “partners” or “franchisees,” you need to provide value of significance to them which may include: Tiered incentives that are generous and win-win, possibly success-sharing incentivesA robust system and sound vehicle for their investmentBoard of Advisor rolesReferral bonuses for bringing on other quality partners, franchisees, or enhancersCreative structures that may lean toward partnership without being a partnership Franchise Your BusinessLicense Your ConceptBuild a Dream TeamSelective FranchisingTMHelp people succeed on their termsHelp a large group of strangers a little bitProvide a large group access and autonomyHelp a small group of known stars go furtherShare a proven opportunity with successful friendsBuild a support organizationLargeSmallFocusedFocusedDeep Pockets and Access to CapitalSignificant Capital RequirementsSmall Capital RequirementsSmall Capital RequirementsSmall Capital to Attract More CapitalTime Horizon10+ years or when you can have a smooth exit10+ years or when you can have a smooth exit3+ years or when you can have a smooth exit3+ years or when you can have a smooth exitContinue as Owner-OperatorNeeded for revenue and to recruit franchiseesNeeded for revenue and to recruit licenseesDelegator with more focused activitiesNeeded for revenue and to recruit Also check out this article with a table comparing buying a business, franchise, and real estate as well as this table on what type of businesses you can buy at different levels of investment. Still Want to Franchise Your Business? If I haven’t scared you away from franchising your business, you probably have strong conviction. As you press on, look for industry advisors who provide balanced views and set realistic expectations. There are credible franchise consultants, attorneys and advisors who will shed light on the pitfalls of franchising. Whether they do so to be transparent or to earn your trust, their balanced presentation is a good sign. On the other hand, beware of those peddling all positives, dubious statistics and false hopes. These peddlers prey on those with misguided ambition, a detachment from reality, and a weak B.S. meter.