Franchising

When a business’ product is itself

Introduction

You find yourself torn between two attractive opportunities. The first one is an untested idea, but
one that seems to hold great promise. If you can verify the customer need, build and sell a few
prototypes, raise some money, and go into full production, you might have an extraordinary
business success on your hands.

The second opportunity is already tested. Proven to attract large numbers of paying customers.
Procedures and processes have been designed and built and are ready to copy to a new location.

Which sounds more attractive? The second one, right? But there’s a catch. The first opportunity
belongs to you; it’s yours (except for any share you might have to sell to investors to finance it).
You are in control. The second opportunity is a franchise—meaning a business in a box. You’ll
have to pay upfront fees and a royalty based on future revenues for the right to use the business
model. Plus, you’ll have to agree to abide by all sorts of rules and restrictions.

Which one do you want now? It’s a difficult decision, right? Emotionally you may be drawn to
more freedom (opportunity #1) or less risk (opportunity #2), but rationally, you aren’t quite sure
which represents the best opportunity for you.

That’s the point of this note: to define the concept of a franchise, and to give you some questions
to ask and rules of thumb to use when—if ever—you decide a franchise would be right for you.

What is a Franchise?

A franchise is the right to make and sell another company’s product or business format in a
certain geographic area. Said another way, a franchise is like renting someone else’s brand.
Think of it as being “sold” a business “in a box,” in return for an upfront fee and a portion of the
revenues (usually) or profits (less likely).

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The difficulty of growing your own business

It may help to compare a franchise to what it takes to launch and grow your own business.

FIGURE 1. YOUR BUSINESS’ BEGINNING

You making and You and the You, the

delivering customer salesman

In the beginning of a business, you as the entrepreneur sell a product or service to a customer,
and then make and deliver that product or service. In a sense, everything depends on you.

FIGURE 2. BUSINESS GROWING

Later, as your business grows

The entrepreneur

An assembly line or The buying zone

service delivery process -> -> Product
Customer <- <- A sales funnel
process

Later, as your business grows, you find you cannot do everything. You have to add an efficient
assembly line or service-delivery process to make and deliver goods to “the buying zone”—
where the customer makes a purchase—and a sales funnel process to attract, educate, qualify,
and close customers at the same time the product arrives at that buying zone.

FIGURE 3. GREATER COMPLEXITY

As your business grows even more complex

Your Core Business
The entrepreneurial leader
A hiring process to
Attract, screen, hire and train  Employees $$$ <- A money raising process to
attract, screen and close investors

An assembly line or The buying zone

service delivery process -> -> Product
Customer <- <- A sales funnel
process

Soon, you may have to add a process to attract, screen, hire, and train employees, as well as a
money-raising process to attract, screen, and close investors. All of these processes, as well as an

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accounting system to keep track of profits and free cash flows, would be considered a complete
business model for your core business.

This of course assumes your business has survived to reach breakeven—being able to pay the
added costs for all of these processes.

Core businesses also often need a supply chain and/or distribution channels

Your core business is complex enough with processes for sales, manufacturing, delivery, hiring
people, raising money, and keeping track of profits and free cash flows. But you also will need a
supply chain to deliver the raw materials you need and distribution channels if you want others to
attract, close, and service end consumers for you.

Given the difficulty of surviving startup and being able to successfully build all of these
processes and systems, it’s no wonder most startups fail.

So what does a franchisor do?

A franchisor delivers you all of these core processes—and a profitable opportunity—already

built and tested. All you have to do is run the business. The franchisor also may have contracts in
place to provide the supply chain and distribution channels you need.

FIGURE 4. BUSINESS IN A BOX

A franchisor delivers:
a Core Business “in a box”

A hiring process to
Attract, screen, hire and train  Employees $$$ <- A money raising process to
attract, screen and close investors

An assembly line or The buying zone

service delivery process -> -> Product
Customer <- <- A sales funnel
process

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So Why Should You Consider Buying a Franchise?

There are four main reasons to consider buying a franchise:

1. It is hard to find an attractive opportunity, survive the launch period, and add processes
and systems to reach scale.
Good opportunities are hard to find. Even someone who is experienced in investing in a
particular niche, with good deal flow, will have to screen several hundred possibilities to
find an extraordinary opportunity. And almost all opportunities face a great deal of trial
and error between startup and reaching breakeven and even fewer can add the processes
required to scale.

Only 30 percent of the 14 million businesses started every year are still in business ten
years later. And only 1.5 percent of these are profitable enough with the right processes
and systems to operate independently of the founder.1

Recent statistics are difficult to verify, but many franchises do appear to have higher
survival rates than independent businesses.

2. You get help with marketing and finding customers.

A top-notch franchisor will help you find the right location and advertising campaign to
quickly attract enough customers to break even. A few will even have a well enough
established brand name to attract customers with little advertising.

3. There are proven hiring and training processes and manuals.

Franchisors will provide proven manuals and systems for hiring and training employees
and for training you, the franchisee, to manage the business.

4. It’s easier to raise money from investors.

Having a proven model makes it easy to raise the necessary startup capital. Some
franchisors even provide financing for equipment leases or startup capital.

How Does Franchising Benefit the Franchisor?

Franchisors gain from franchising in five ways:

1. Having highly motivated franchisees makes is easier for a franchisor to quickly roll out
new businesses across the country.
Hard-charging, entrepreneurial franchisees—armed with a proven model and their own
startup capital—can quickly roll out the franchisor’s new business concept across the
country. This is especially important if there are few barriers to entry, because with few
barriers an excellent new business model on the west coast might be copied by someone
in New York before company-owned units can be built in New York.
1
Shane, Scott. 2008. The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy
Makers Live By. New Haven: Yale University Press.

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 2. Owners are better managers than salaried managers.
Entrepreneurial owners with a stake in the business are usually much more motivated and
require less training and far less supervision and than salaried managers.

3. Large numbers of franchised outlets make it easier to spread costs.

Having a large number of franchised units makes it easier to spread the sunk investments
and fixed-period costs of creating advertising campaigns or discovering new products.

4. Having franchisees lowers the risk of failure in new markets.

A chain of businesses with successful operations in the Northeast may not be able to be
easily transfer its current business model to the Deep South. Having a few franchisees as
missionaries can lower the risks of failure for a franchisor entering a new area. Once a
new area is proven, the franchisor can add lower risk, company-owned stores.

5. Upfront fees and royalties often capture a large part of the value of adding a new unit
with little capital at risk.
Typically, the franchisee puts up all the money, pays an upfront fee to the franchisor, and
a royalty of 5 percent or more. In a business with 10 percent pre-tax margins, a five
percent royalty is the equivalent of owning half of the equity in the business, with little
downside risk. Because of royalty arrangements, franchisors can generate high returns
with little money at risk.

The Potential Downsides to Buying a Franchise

There are, of course, downsides to buying a franchise:

1. The franchise opportunity may be flawed.

The single biggest downside to buying a franchise is that the opportunity and business
model may be flawed. Sometimes the business model simply isn’t proven; at other times
the opportunity is a short-lived fad. Still other times the market is already saturated with
similar business models or ideas.

2. You may be assigned a limited territory or contract term.

Another risk is that the franchise territory or contract term may be so limited that it
severely limits your upside. For example, if you were the first franchisee to take a new
business model to Dallas, you’d prefer to have the whole state of Texas as a franchisee
territory, rather than a North Dallas suburb. That way, if your first store is a success, you
can roll out many new outlets.

The same goes with the term of your franchise contract. You’d hate to spend five years
proving the franchise model in an area, only to discover that you only have another five
years left on your contract term to recoup your investment.

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 3. You may be overcharged for required raw materials, equipment, or services.
Franchisors often require franchisees to buy raw materials, equipment, and services in
order to ensure product quality. While such a service can be a blessing if the franchisor
passes along bulk discounts, it can be a curse if the franchisor uses the franchisees as a
captive audience to whom they can overcharge for inferior products and services.

4. Suffocating controls.
Often franchise agreements contain strict controls over operating procedures. The best
franchisees may feel that such controls—put in place for the sake of uniformity—limit
their ability to innovate or offer superior service.

Characteristics of Excellent Franchise Opportunities

Excellent franchise opportunities share a number of qualities:

1. There are low investment requirements, high gross and net margins, fast payouts, and
simple operations and supply chains.
For example, the Subway sandwich franchise was started with a $5,000 investment that
turned into a billion-dollar empire. Subway sandwich franchises are particularly easy to
run (how hard can it be to assemble a sandwich?) and have low capital requirements and
high margins (though limited revenue potential).

2. The financial incentives are fair and well aligned.

There are low upfront fees and an equitable sharing of revenues, costs, and profits that
are commensurate with the economics of the business. High upfront costs and onerous
royalty payments can drain the life from almost any opportunity.

3. They allow successful franchisees to continue to roll units out to larger and larger
territories.
Excellent franchise opportunities are not geographically saturated and allow successful
franchisees larger and larger territories to continue to replicate their success.

4. There’s high brand recognition.

There’s an established brand name—like McDonald’s or Holiday Inn—that attract
customers to new franchisees based on the quality and reputation of outlets in other parts
of the city, state, or country.

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The Questions to Ask as a Franchisee

What questions you should ask as a potential franchisee?

1. May I see the financials?

You absolutely, positively must see the operating financials for a large number of
franchisees, successful and unsuccessful, over as long a period of time as possible. Be
sure to do your detective work to break the financials into unit economics to understand
why some franchisees succeed and others fail.2

2. How are the financial risks and rewards split?

Using the financials you were given and your understanding of the franchisor’s unit
economics, build a model that shows how your franchise will perform under a variety of
conditions. Pay particular attention to how revenues and profits are split between
franchisees and franchisors. Is it possible for the franchisor to profit even if your
franchise fails?

3. Is speed of roll out your only competitive advantage?

If the speed of roll out is your only competitive advantage, your revenues and profits are
likely to sag rather quickly. Look at the history for other franchises and business models
that are similar to yours, and find out how long they lasted before price competition set
in.

4. Are raw materials, equipment, and services being sold at or below market?
Good franchisors do not have to profit by selling overpriced goods and services to
franchisees. Is your franchisor taking advantage of its captive market?

5. How much control?

Examine the legal documents. How much control does the franchisor have over your
daily operations? Is it enough to keep “free riding” franchisees from damaging the brand?
Is it so much control that you cannot innovate in any way? How are disputes settled?

6. Are current franchisees happy?

Ask for a list of current franchisees and look online for discussion groups for franchisees.
Learn the good and the bad before you sign a contract.

A Word about Master Franchisees

Some franchisors license large areas of a franchise to a Master Franchisee, who then parcels out
smaller franchise territories. Often these are experienced franchisees, who have become experts
at quickly rolling out franchises because of what they learned working for a previous franchisor.

2
Unit economics is an Acton term for analyzing revenues, costs, profits, and free cash flows based on each unit
sold.

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Master Franchisees can often offer more operational advice to beginners, and sometimes even
offer financing. After that, individual franchisees receive ongoing support from the parent
franchisor—which is different than a subfranchising scheme, in which franchisees only receive
support from a regional subfranchisor, not the parent company.3

But, on the downside for an individual franchisee, a Master Franchisee also takes another piece
out of the overall economics, leaving less for the franchisee. And often a Master Franchisee can
be a sign of a more faddish opportunity (which needs to be rolled out quickly) and smaller
territories.

Later Problems with Franchisors

In the early days of a franchise opportunity, franchisors can offer a lot of value to franchisees by
providing a proven business model, training, and even financing. The further you get away from
startup, however, the less value the franchisor may seem to add, as experienced franchisees soon
learn more about the operational nuances than the franchisor.

As profit margins narrow with competition, many franchisees begin to resent the large share of
profits that royalties and overpriced raw materials consume. (A 5 percent royalty on gross
revenues with 6 percent pre-tax margins is the equivalent to a franchisor owning 83.33 percent of
the equity!)

Later in the life of a franchise, lawsuits between franchisors and large groups of powerful
franchisees are common. Curves, a franchisor of women’s fitness centers, was in 2010 still part
of a three-year lawsuit brought by nearly 250 franchisees. Why? Here’s a good sign that
something was amiss: In three years, 2500 franchisees—almost a third of the total—closed their
doors. This was a franchise that was once opening eight new locations a day. 4

What were some of the charges brought by the plaintiffs? Breach of contract, deceptive trade
practices, and fraud. Curves settled most complaints out of court, and the franchisor vehemently
defended its position, but the specific grievances of the franchisees—legal and in general—were
familiar to these types of breakdowns:

1. Inability of franchisees to innovate.

Franchisees in certain markets wanted to keep later hours to accommodate the growing
late-night crowd that was going to alternative centers instead, but Curves didn’t condone
it.
2. Lack of support from the franchisor.
According to franchisees, Curves was saturating markets with locations so that individual
owners were losing business. And some of those markets had such small populations that
it was hard to justify even one location in the first place.

3
Gompers, Paul A. A Note of Franchising. HBS note 9-297-108. Boston: Harvard Business School, 2001
4
Copeland, Mike. 2010. Waco fitness chain finds itself shrinking, losing more than 1,000 locations. Waco Tribune-
Herald, July 18. http://www.wacotrib.com/news/Waco-fitness-chain-Curves-finds-itself-shrinking-closing-more-
than-1000-locations.html (accessed July 30, 2010).

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So these franchisees were paying 5 percent royalties and a 3 percent contribution for national
advertising on shrinking margins.

All of which goes to say that—even though certain troubles later in the life of a franchise are
inevitable—it’s crucial to set clear expectations from the beginning.

Summary

A franchise is really just a business model “in a box,” a proven opportunity with tested processes
and systems in place that increase the probability of a successful business.

Franchises tend to have a lower risk of failure than most startups and typically do not require as
much entrepreneurial experience to start or manage. The downsides to a franchise are less upside
potential and less flexibility for the franchisee, and often a misalignment of incentives that leads
to disagreements with franchisors.

Just as with owning your own business, there are attractive franchise business models and
unattractive ones, and the timing of when an opportunity is prime and when a market is saturated
can be hard to judge.

The best you can hope for is to carefully do your due diligence, rather than getting carried away
by the hype of a franchisor or by your own emotions. If you look for franchisee opportunities
with low capital requirements, low breakevens, and short payouts, and large territories and long
contract periods, franchising can be a low-risk experiment on your entrepreneurial journey.

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Appendix A
Top Franchisors, 2010

TOP 10 Franchises 2010

Rank Name Startup Costs
1 Subway (Sandwiches and salads) $84,300 - $258,300
2 McDonald’s (Hamburgers, chicken, salads) $1,057,200 - $1,885,000
3 7-Eleven Inc. (Convenience store) $40,500 - $775,300
4 Hampton Inn/Hampton Inn & Suites (Midrange $3,716,000 - $13,148,800
hotels)
5 Supercuts (Hair salon) $112,600 - $243,200
6 H & R Block (Tax prep and filing) $26,427 - $84,094
7 Dunkin’ Donuts (Coffee and donuts) $537,750 - $1,765,300
8 Jani-King (Commercial cleaning) $13,200 - $93,200
9 Servpro (Insurance/disaster restoration) $127,300 - $174,700
10 ampm Mini Market (Convenience store) $1,835,823 - $7,615,065
Source: 2010 Franchise 500®. Entrepreneur magazine. Ranking measures are based on objective,
verifiable financial numbers that indicate financial strength and stability, growth rate, size of system,
startup costs, number of years in business, and termination rate, among others.

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