By Michael Seid, Managing Director, MSA Worldwide
Since the end of World War II, franchising has been the primary vehicle that has successfully taken small businesses and grown them into national chains in the United States.
Franchising is ancient and is not limited to fast food, video rentals, or automotive services. It finds its roots in ancient China and was used primarily by governments throughout the Middle Ages. It first appeared on the U.S. scene after the Civil War, and became a force to be reckoned with in the post-war ’50s. It boomed in the ’60s, policed itself in the ’70s and matured in the ’80s. Since the ’90s it has continued to outstrip the achievements of the rest of the economy.
Over forty cents of every retail dollar spent in the United States today is spent in a franchised location, and you would be hard pressed to drive down a single main street in America or spend a day shopping for almost any product or service without passing by or making a purchase through a franchised operation. Overseas, American franchisors are emerging as a world force, with the transfer of business technology being widely viewed as a stabilizing force in emerging economies.
The principal reason manufacturers, retailers, and services companies often give for choosing franchising is simply a shortage of capital. Franchising allows them to quickly open more locations than they could corporately, using funds primarily provided by franchisees.
Franchising solves an even more critical shortage; that is, management and labor. In a period where every company is facing the crunch of a tight labor market, franchisees provide the local management and local recruitment of labor necessary to open units and deliver to customers the high quality of service and products they demand.
To succeed today, all businesses must deliver on the promise of their brand – high quality products and services delivered with consistently high customer service. This has historically been the strongest draw for choosing franchising. When done well, franchising has an extraordinarily low rate of failure and, contrary to popular beliefs, is not overly burdened by regulations or excessive litigation.
At its essence, business format franchising is simply a method for distributing goods and services. It is not, as many people believe, the franchising of a product.
Wendy’s does not franchise hamburgers, Midas does not franchise mufflers, and MotoPhoto does not franchise the development of film. What they each franchise is the business system that delivers the product or service. It is the entire method of doing business, the name, the product, decor, and methodology of delivery that is franchised.
Franchising has been applied to an extraordinary number of diverse industry segments. Today, it is not surprising to see Fortune 100 companies, high tech firms, and healthcare providers considering franchising. Its power to create successful distribution channels and high returns on invested capital is too compelling for them to ignore.
Franchising enables companies to decentralize the cost of operating the local operation, while reducing the cost of headquarters operations using non-dilutive third party capital to expand the system. All these have a positive impact on a company’s return on investment.
When a company decides to open 100 new locations, each requiring $250,000 per location, they have a capital need of $25,000,000 plus the ongoing costs and working capital required to grow the business. They also have to find the manpower to manage and operate the business – and that is assuming they can find the locations. Using a franchising strategy, the cost of starting a franchise system is usually significantly less than the cost of opening up one unit. The advantage is that, once established, the system can be replicated with little additional cost and managed with lower corporate operating costs than in traditional distribution methods. The cost and capital required for opening up each of the 100 individual units is borne by the franchisees and not by the franchisor.
Franchisors deal very effectively today with all of the complex business issues faced by “traditional” business structures, including brand management, pricing, national accounts, inventory purchasing, point of sale innovations, IT systems, centralized billings, collection, accounting, Initial Public Offerings, end of season designs, or research and development. Whether product-based, service driven, high tech, full-time, part-time, home based, mall oriented, upscale, or blue collar, franchising has been applied successfully.
Modern franchise programs can and do maintain and often exceed the level of sales, quality, and consistency found in the best-managed company-owned operations. The motivation and entrepreneurial spirit of the franchisee to succeed, coupled with the right of the franchisor to inspect, police, and if necessary terminate the relationship, leads to operating consistency, quality, and innovation.
Franchisees tend to manage their costs better than company employees. After all, the franchisee is spending their own money. Spoilage and shrinkage are typically reduced and labor costs are better managed. Franchisees usually are often more careful in making hiring decisions and controlling wages and benefits as well as overall labor cost by better scheduling. With ownership comes the desire to profit and succeed, as well as the fear of failure. It is this risk of failure coupled with the “Great American Dream” of business success that drives franchising.
Franchising is also an engine of product and service innovation. Franchisees are constantly looking to improve their unit’s performance and to make the best use of their assets. Some of the major innovations in franchising today were the ideas of the franchisees. Certainly unit managers have good ideas, but when a supervisor turns down an idea, or the raising of the idea comes with some risk, these ideas never see the light of day. Franchisees are different. Independently and through franchisee advisory councils working with the franchisor, franchisees press for innovation – and that benefits the brand.
There is an abundance of talented executives with the financial resources to become franchisees. The downsizing of corporate America has created a relatively new breed of entrepreneur – the outplaced corporate executive. These former “blue suits” have discovered franchising and are using their parachute to develop either multiple or large scale franchised businesses. The reason franchising is so attractive to them is that many career managers are reluctant to put their fate into the hands of corporations, and prefer the opportunity to achieve for themselves independently. These well-educated and self-motivating entrepreneurs bring a level of skills and business talents that no business could afford to employ as local management. .
The success record and stability of franchising is beginning to be appreciated by institutional and other sophisticated investors. Franchising has become an acceptable alternative investment strategy for investors because it can meet or exceed their target returns. With an understanding of the franchise dynamics, Wall Street now appreciates how franchising meets their performance requirements. Investors are taking positions as equity owners of franchise systems and multi-unit franchises to enhance and complement their portfolios.
The principal benefits that financial investors bring to franchisors are capital and the benefits that come from rapid market penetration. This enables franchisors to develop a core market strategy as well as a secondary market strategy to meet critical mass objectives. The core markets, the more densely populated areas requiring larger investments to create critical mass, can be the primary focus of the franchisor. Investor groups can provide the capital required to open multiple locations in the franchisor’s core markets, which enables quick market development.
Franchisors are able to expand their systems with a seemingly unlimited source of expansion capital, and this capital is available without stock dilution or increased debt. Each new unit opens with a consistency of appearance and quality of service that enables these companies to dominate the markets they enter.
The franchising relationship has been described as “a pooling of the capabilities, know-how and expertise of a franchisor with the capital and motivated efforts of the franchisee.” It is also a pooling of the capabilities and capital of independently owned franchises to develop markets and compete, as a unit, effectively against the competition. Local unit management is able to anticipate local market changes and effectively respond to local needs using the system, the training, and the tools provided by the franchisor. For businesses with markets available for expansion, but which lack the capital, franchising may be the only method available to them.
Franchisors are often able to operate with a smaller corporate and field organization than “traditional” businesses. The franchisor’s headquarters and field organization has the responsibility of franchisee compliance, quality assurance and assistance rather than direct unit management. Franchisors receive up-front fees, brand marketing and advertising are largely franchisee-funded, and they may earn profit from the sale of merchandise and services to their local units. All this is achieved while providing the public with superior and consistent products and services, as well as protecting and enhancing the value of the company’s brand.
Control over the brand comes from the agreement between the franchisor and the franchisee and is supported by the risk to the franchisee of losing their investment in the business. The franchisor can effectively ensure that the systems of operation, product lines, trade dress, marketing programs, and all relevant aspects of the business are executed consistently by the franchisee. The franchisee runs the business on the local level – is motivated to succeed – and is obligated to follow the franchisor’s direction on the material aspect of the business.
Franchising, however, is not the right strategy for every company – and many companies that chose to franchise now wish they had not. Care in choosing franchising is a must. Every business has its own unique requirements, and these requirements must be factored into the decision to franchise.
If there is one significant risk for franchisors and franchisees today, it is in the systems that have been “packaged.” Packagers are companies in the business of developing franchise programs that take a “cookie cutter” approach to business development. Often they lack the care to determine whether a business should be franchised, and in developing the underlying system to franchise force the emerging franchisor into a preconceived box which neither reflects the uniqueness of the business nor supports the franchise system long-term.
Every company, prior to investing in the development of a franchise system, should thoroughly examine the appropriateness of franchising against established industry benchmarks. The risk of not completing a feasibility examination can be measured in the cost of the development, the damage to the existing business, and the risk for those individuals who become franchisees.
Once the decision to franchise is made, the development of the system should only progress by strategically developing the entire concept. This requires integrating the operations, training, marketing, financial, and legal aspects of the company in order for management to perform their main management functions of planning, organizing, staffing, directing and controlling.
Each program should be designed to reflect a company’s structure and culture.
It is important to understand that it is the system that will be offered, and the system that will guide both the franchisor and franchisee to success. The legal documents and marketing materials, while required and necessary to sell franchises, are not sufficient to operate a successful franchise program
The reason franchisees have a higher success rate than independent start-up companies has little to do with the quality of their products or services, the ambition and hard work of the owners, or their available capital. The reason is that franchisees are better prepared to begin and to operate their businesses when the franchisor has carefully developed their franchise program and manages the franchise system professionally. Good franchisors have made mistakes and survived them; great franchisors make certain that their franchisees don’t make the same mistakes.
Franchising has been the engine for small business development these past sixty years. The next sixty even look brighter.
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