How To Develop A Franchise System: Part 5: Threshold Analysis
Next, let’s cover the Threshold Analysis, an essential step in developing a franchise system. Every business can be franchised, but not every business should be franchised. What are the factors that make your business a feasible franchise opportunity? You must understand the metrics, criteria, and whatever your business needs to become a successful franchise.
Your franchise system must be sustainable; who you market to, when do you market, etc. Know your brand personality. Understand your supply chain, what kind of training is needed, and much more.
Video Transcript:
In franchising we talk about franchisability, feasibility, threshold analysis. What a threshold analysis tells you is whether your business is franchisable, whether you should go to market as a franchise. There is no provision in the law in the US and in most countries that tells you when you can franchise a business and when you can’t . Quite frankly, every business can be franchised, but not every business should be franchised.
There are certain business which are wonderful operations which we look at as a company, and we explain to the company owner that that business should stay as a company-owned system rather than being franchised. Most often it’s because they don’t have enough on the bottom line to sustain the additional fees that are required of franchise systems.
What we look for, when we look at a feasibility study or threshold analysis, we look first at the prototype. Now, since I can franchise anything, I actually don’t need to have an operating system - I can franchise an idea. But having an idea is not enough. The franchisor should be operating profitable businesses that the franchisee is going to operate. They should have done it more than once, they should have done it in more than one market. You do not want in a successful franchise system to think of your franchisee as a guinea pig. It’s unfair to them.
You need to understand seasonality and all types of things. The only way you understand the operating aspects of that business - who the customer is, what type of marketing works, how much labor you need, what the seasonality is, what the inventory requirements are, all of that only comes once you have an operating location. So having a prototype is the first step in the Threshold Analysis.
You should be able to define the criteria for the locations, its layout, its interior decor, its exterior design and signage; you should know what its construction and development costs are, its competition, its seasonality. That business has to have a brand personality. Unless you’re operating a prototype, you don’t even know if you can execute that personality. You have to know marketing: who you’re marketing to, what are the best ways to market, when do you market, do you market into a busy season, or do you wait until a busy season to start to market?
You have to know what your pricing strategy is. Your brand, is it a brand that you’ll recruit customers because you’re a discount house, or do you sell items at a premium price? There is a difference - both companies are successful, but Timex has a different pricing strategy than Rolex, and both are appropriate. You need to understand the operating costs; you need to understand not just who you’re going to train, but how much training do they need? You need to understand your supply chain, you need to understand a lot of things. And all those things are coming from an operating prototype.
You have to make certain that the business is economical, that even if the business is profitable as a company-owned location, will the prototype be able to sustain franchise fees and pay down debt in a reasonable period of time for franchisees? When will it go break-even once you put in franchise fees; when does it go cash-positive; is it a reasonable period of time? Will that prototype business, once you’ve layered on the fees required for the franchise system, will the return on investment be acceptable for each class of franchise being offered?
Franchising isn’t as simple as each location being run by an individual; if you’re selling to a multi-unit franchisee, depending upon the class of franchisee that you’re using in that multiple unit - they could be strategic franchisees, they could be investment franchisees - is the return on investment acceptable so that they will make the investment, more important, will they make the additional investment to open additional locations?
Do you have a proven product or service? You can have a trend, you can have a fad; bad businesses that are going to be around for 5 or 10 years and then vanish. They may be very successful franchise systems - you see them all the time in places like the yogurt industry - where back in the 80s there were 47 yogurt franchises - they went away; a couple of them survived; and today you now see the yogurt business built back up, and it will go through a trend as any business will, but is it based upon a well-established consumer demand?
Why is the Hair Club, the hair care industry so successful; why is the hotel industry so successful; why is the QSR market so successful? They’re successful because there’s an established consumer demand for those products and services, and businesses are filling those demands, it’s not a fad business, it’s a sustainable trend. A business needs to have a level of quality that distinguishes it from the competition; it’s not a matter of whether or not you’re coming into a saturated market. When Dave Thomas started Wendy’s, McDonald’s and Burger King had already exceeded 1,000 locations.
Think of Five Guys. Five Guys comes into the market relatively recently, when McDonald’s has more than 20,000 locations. And yet Five Guys has a great product they bring to the market. Think of brands like Firehouse Subs, competing with companies like Subway. Subway is a massive company with units all over the world; Firehouse Subs has today 1,000 locations - why? Because their product was different, it distinguished itself from the competition, it built up a consumer following for an exceptionally good product. A business will then have a high return customer base.
You want to make sure you own your trademarks, your service marks, because you’re going to license those marks to the franchisee. If someone else is using that mark, it’s going to get very confusing for advertising and marketing. Make certain whatever brand you go to market with is a brand you own, and if you don’t, take a step back - you only have a couple of locations, likely - and change the brand name. It’s very difficult, it’s very emotional, but it’s important that you own your own brand mark, even though I can tell you that it’s not a requirement under the law that you own the marks that you’re licensing. But for brand confusion purposes, you need to do it.
When we look at Threshold, we’re looking at feasibility - we can franchise anything, but there are types of businesses that lend themselves better to franchising. Sales of retail goods and services - very easy. Most restaurants - I say most because you want to replicate the quality of the product, therefore when you get into the need for a chef, not so easy. Steakhouses are easy. When you’re starting to do a French restaurant, that’s difficult, because replicating that chef is very hard.
You want to have margins that allow for the fees and leave an adequate return on investment. You’d like an industry that has lower regulation, but at the same time, today we’re franchising medical practices, practices where there are high amounts of regulation, so what you have to look at is how do the regulations impact the business? So if you’re looking at a medical franchising and dealing with things like stark laws, the fact that the doctor is not going to be able to share the patient revenue with you, is there a sustainable revenue level in practice management and insurance and other aspects? but lower regulation franchises are certainly much easier to deal with. You want a stable market, and a market with low technology. It’s not that the market’s not complicated, but if the technology around that business is fairly easy, it’s much easier to franchise that system because you can get the consistent, sustainable replication, It’s easier to replicate things with low technology than high technology.
You want an operating system based upon an organized concept. You need to be able to systematize your business and be able to codify it in manuals and training programs. The franchisee is going to be executing your strategy at a distance independent from your day-to-day control; it’s their business. So it has to be systematized. If you can’t write your system down, it’s very difficult to franchise it. It had better be simple to operate, so it can be consistently executed. And your prototype should have been in business for a sufficient period of time so that you can project its future.
One of the things we frequently see is companies looking to franchise where the industry is already well developed. Think again of the hair care industry, where there are lots of Mom & Pop beauty salons. People go into their local beauty salon, local nail salon, and the industry looks like it’s saturated with lots of competition. The truth is that a branded offering comes into the market and in a fragmented industry like hair care, that’s one reason that brands work so well. They suck up the consumer demand and the consumers will now trust in a brand because buying from a branded location, in the consumer’s mind, reduces the risk. There’s a reason that people buy an Apple or Dell computer, the reason is they’re reducing the risk than buying a non-named or unnamed brand.
If you want to be able to expand rapidly, if you’re only thinking of opening up a half dozen or dozen locations in your system, if that’s your goal, there are far better ways than going through the regulatory and other issues around franchising. You want a business that you can expand, and you want to make certain that your expansion goals are realistic. Don’t look at the McDonald’s, don’t look at the Subways or Five Guys or Fantastic Sam’s or any of the brands that have been around for 50 years with thousands of locations. You have to realize that the majority of franchise systems today likely have under 200 locations. So you want to make certain that you have realistic expansions plans and can financially support the growth, and you want to be able to financially support the growth for your break-even. Do you have the management bandwidth to support the franchisees, or could you acquire that, can you afford to hire the necessary management and operating people to support your franchise system?
Will your brand survive in multiple markets? There are brand strategies, when we’re looking at companies, where we recognize that brand cannot work in a market or certain markets. There are southern brands which are exterior brands based upon a long growing season, or the brand needs an outside where it’s warm; that just doesn’t work up in Boston. Vice-versa, if you’re in the ski business, it’s tough to sell ski supplies where there is no skiing, unless you’re doing water skiing. So you have to make certain that your brand will work in multiple markets and that there is a sufficient number of markets that want your product.
But don’t think that your brand has to go nationwide; very few franchisors successfully launch nationwide. Think of Dunkin’ Donuts. Dunkin’ Donuts is just now getting out to the West Coast from its Boston hub; they’re just now getting into Dallas, Las Vegas, and that’s a brand that’s been around for more than 50 years. They dominated their local market, they became a very large basically regional brand, and now with those resources they are ready, with a change in strategy, to expand nationwide and probably worldwide. Great product, but the brand needed to have the resources to now successfully compete against Starbucks.
Is your brand teachable? Is the system able to go to franchisees and teach them how to run and manage your business in a reasonable period of time? Sure, there are lots of brands out there with which the franchisee will tolerate a long period of training - McDonald’s, Domino’s Pizza. Those brands recruit from inside and people will be there a long time learning the business, but most franchise systems are teaching their franchisees how to run the business generally in a couple of weeks, sometimes a little bit longer. You have to be able to teach the franchisee how to manage the day-to-day of the business in a reasonable period of time; understand that the franchisee generally - themselves, their management, some of their staff - they come out to your headquarters, they move into a hotel, they’re going to be giving up their jobs, they’re going to have expenses going out, and having them there for a long period of time if they’re not running a business which is generating revenue for themselves is very difficult.
You also need to look at whether there’s sufficient staff for that franchisee with the education and skills that are needed, and if it is a licensed or regulated industry, are there enough people with those licenses out there - doctors, pharmacists, plumbers, electricians, tradesmen? You need to make certain that they have the skills that are required, and that the underlying resources are there for the franchisees, including their staff, and whether those people can be taught your system of delivery.
Is the cash investment reasonable? Will the franchisee be able to raise the capital required to make the investment in your franchise business? Granted, there are SBA loans available, but is your business eligible for those types of loans and investment? Is your investment feasible? That’s one of the major questions we have to deal with. Do you have serious cash flow deficiencies? Think of the average retail business that relies upon the Christmas season for most of their cash flow during the year and most of their profit. What happens to the franchisee that opens up in January? Wholly different cash flow situation from the franchisee that’s opening up in August. The August franchisee has a couple of slow months as they’re building their business, and then they get into the rush of the Christmas season and the cash flow comes in. The January franchisee has to wait nine months until that season opens. So do you have serious cash flows and how do you deal with those cash flow requirements? Will the franchisee meet their return on investment goals based upon the anticipated classes of franchisee, including the period of time that they’re expecting to break even?
So you need to make certain that you can provide to the franchisee training, headquarters and field support, confident consulting advice on the issues they’re going to face, you want to make certain that your brand breathes, and that you can look at product and service enhancements not just to compete with the competition, but to make sure the competition is trying to compete with you as you bring things to market. You want to evolve the business over time so that it is staying fresh along the way.
You want to make sure that your franchise system is marketable. It is amazing how many times companies call us up and say that 50 people have come through the door and they wanted to know whether I’m a franchise. That’s a very exciting thing to take place. But there’s a difference between somebody saying “Are you a franchise” and “I am willing to become your franchisee.” If the only people telling you that your business should be franchised are your mom and dad, likely you’re not franchisable. At the same time, if people are coming and in and asking “Are you a franchise,” it’s a great indication, but there’s more that needs to be done to make certain that there’s truly a market out there of people willing to invest.
You want to make certain that there’s a sufficient number of potential franchisees that meet whatever profile of franchisee you need to have. You’re not selling a franchise to anybody, you’re selling franchises to a specific profile of person that can execute your business strategy the way you want it. That class of personnel needs to have capital. So if you were doing beauty salons, well, there are lots of beauticians out there, lots of barbers out there that may want to invest in your franchise, but they may not have the two nickels to rub together that make a quarter million or a hundred thousand or fifty thousand dollar investment in your business.
So the franchisees you’re looking for, you need to know what their profile is, are there a sufficient number of them, do those people have the capital, and most importantly, are they willing to invest that capital in your brand? Are you able to convince people that they should trust in you and your brand, and that you are not just a pipe dream that’s going to come down? So make certain that your offering is marketable, and make certain that it’s so marketable that when the second group of franchisees call up, the first group that are operating your business, they get the message and validation that your concept not only supported the fees necessary to provide them with a return on investment, but that it gave you enough resources so that you could provide to those first franchisees not just the services you promised, but the services the franchisees needed to be successful.
If you are not successful with your first group of franchisees, it is very difficult to recruit in a second group of franchisees, because the first group, they trusted you, they bought into the excitement - but the second group of franchisees will call the first group to find out if the excitement was worthwhile.