Playing by brand standards to create consistency

A franchise occurs when a franchisor licenses its trade name and intellectual property — the brand and its operating methods (its system of doing business) — to a person or group who agrees to operate their business to the franchise system’s brand standards. The franchisor defines the brand promise it wants delivered to consumers, provides the franchisee with initial and continuing support, and then ensures compliance by the franchisee on how it delivers on that brand promise. The magic of franchising is that consistent brand standards can be achieved at each location without the franchisor being involved in the day-to-day management of the franchisee’s business.

In exchange, the franchisee pays an initial franchise fee to join the system and a continuing fee known as a royalty to remain a part of the franchise system.

People have grown accustomed to the consistency that comes from shopping at branded locations. From the comfort of knowing exactly what you will find when you check into a Courtyard by Marriott, to the quality of the chicken at a Popeyes Louisiana Kitchen, or a haircut at Sport Clips, people know what they will get when they purchase under a franchisor’s brand. The number of companies and industries bringing goods and services to consumers through franchising is growing, limited only by the imagination of the people who understand its potential application.

Setting your sights on success

Franchising creates opportunities for business ownership to create personal wealth and generates local jobs. It also consistently delivers products and services on a global basis to the brand standards established by the franchisor.

As you explore becoming a franchisee, be wary of statistics that talk about the “success rate” in franchising. As late as 2000, the International Franchise Association (IFA) published statistics that claimed that franchisees had a success rate of 95 percent — versus a failure rate of 85 percent for nonfranchised start-ups in their first five years in business. Those statistics turned out to be inaccurate and misleading.

The IFA has frequently reminded franchisors to not use those out-of-date and misleading statistics, but unfortunately, some franchisors, franchise brokers, and franchise-packaging firms (one-stop shops that offer “cookie-cutter” franchise advice) continue to use them to attract potential franchisees. What should be important is how well a franchise system is doing, and it is irrelevant in choosing any franchise opportunity whether or not franchising in general is doing well. You should be very wary of working with anyone who still uses invalid claims of franchise industry success statistics. In fact, it’s strongly recommended that you don’t work with them at all.

Franchising can be a very effective method of getting into business, but that depends on how carefully the franchise system is structured and supported. Even in highly successful franchise systems, locations can fail for a host of reasons. It is up to prospective franchisees to conduct a proper examination of every franchise opportunity that interests them.

Traditional franchising

The industries in which you most often find traditional franchising include soft drinks, automobiles and trucks, mobile homes, automobile accessories, and gasoline. The franchisee is typically selling products manufactured by the franchisor. Some examples include Coca-Cola, Ford Motor Company, and John Deere.

Although traditional franchises look a lot like supplier-dealer relationships, the difference is in the degree of the relationship. In a traditional franchise, the franchisee may handle the franchisor’s products on an exclusive or semi-exclusive basis, while the supplier-dealer may handle several products, even competing ones. For example, Tempur-Pedic mattresses may be offered by a national dealer network that also offers other bedding brands in its retail stores.

The traditional franchisee is closely associated with the franchisor’s brand and generally receives more services from its franchisor than a dealer would from its supplier. Frequently the franchisee provides some pre-sale preparation before a product is sold (such as you find with Coca-Cola, where the franchisee manufacturers and bottles the soda) or some additional post-sale servicing (such as you find at a Ford dealer with your periodic maintenance programs).

In a traditional product-distribution franchise, the franchisor licenses its trademark and logo to its franchisees, but it typically does not provide franchisees with an entire system for running their businesses. Measured in total sales, traditional franchising is larger than business-format franchising, covered in the next section.

Business-format franchising

The business-format franchisee gets a complete system for delivering a franchisor’s product or service. The major difference between a traditional franchise and a business-format franchise is that business-format franchisees operate their business based on a business system largely prescribed by the franchisor. The role of the franchisor is to define the business system and establish the brand standards, whereas the role of the franchisee is to independently manage its business on a day-to-day basis to achieve those brand standards.

McDonald’s doesn’t franchise hamburgers, and Domino’s doesn’t franchise pizza. What they provide to their franchisees is a system of delivering their branded products and services. Although traditional franchising is larger than business-format franchising, because the size of the individual transactions is larger, more than 80 percent of all franchise locations in the United States are the business-format type.

It is the franchisee’s execution to a franchisor’s brand standards that produces consistency — the foundation for a business franchisee’s success. Interim HealthCare, Sport Clips, PostNet, PuroClean, Twin Peaks, and Firehouse Subs are all examples of business-format franchises. The business-format franchisor provides a detailed system, and franchisees are trained and supported in their independent management of their business.

The confidential operating and procedures manuals (the how-to guides of every great franchise) provide the franchisees with the information they will need to establish, operate, and manage their businesses. The goal in a franchise system is for customers to get the same brand experience each and every time they shop in one of the franchise’s locations, and the manual is one of the tools to achieve that important goal.

Although the franchisor provides a comprehensive business system, it is the franchisee’s responsibility to manage all the day-to-day affairs of the business. After all, the franchisee is an independent business owner simply operating under a license.

Although franchisors may specify uniforms and other brand standards related to how a franchisee’s staff looks (think tattoos, beards, piercing, cleanliness), franchisors don’t generally provide any other human resource requirements. Who a franchisee hires, how much they are paid, what benefits they receive, which hours they work, and how they are promoted and disciplined are all the sole responsibility of the franchisee. Because human resources are the sole and exclusive responsibility of the franchisee and not the franchisor, franchisors and franchisee are generally not considered joint-employers and are not liable for each other’s actions or inactions.

Social franchising

Social franchising is the newest form of franchising. Social franchising is the application of business-format franchising’s techniques and methods to the delivery of products and services to address the needs of people who live at the base of the economic pyramid (BOP). The term BOP refers to the estimated three billion people in the world who live on less than $2.50 per day. Social franchise systems generally focus on the lack of access to basic needs such as safe drinking water, adequate food supply, authentic drugs, quality healthcare, education, sanitation, and energy. These products and services have historically been delivered primarily by governments, churches, and nongovernmental organizations (NGOs) with mixed results.

NGOs provide a beneficial and important service in bringing critical products and services to the poor. But traditional methods used to provide this type of support are less sustainable than those found in social franchisors. Traditional methods typically lack the level of brand standards found in franchising, and NGOs usually don’t typically focus their resources on training and supporting local operators as do social franchisors.

The social franchise model is emerging as a powerful tool for the international development community because of its potential to scale (expand). All the elements found in commercial franchising — including agreements, manuals, training, headquarters and field support, consistent supply chains, brand standards, and enforcement — are also found in a social franchise system.

A significant problem facing both social franchisors and NGOs is the frequent inability of consumers to afford the products and services, and the necessary reliance by the system on donations and other financial contributions. Because most NGOs use a top-down structure (the opening of locations), this often leads to an insufficient focus on ensuring that local product and service providers can sustain the standards found in commercial enterprises like social franchising.

Evolution in social franchise systems is generally driven by the same reasons found in commercial franchising — changes in consumers and competition. In an NGO, changes are frequently caused at the direction of donors and the unique products and services they want the NGO’s system to deliver. This, above all else, is one of the reasons that NGOs are not able to achieve the sustainability found in franchising.

Just two examples of social franchises are Living Goods (https://livinggoods.org/) and VisionSpring (https://visionspring.org/). For more details on social franchising, check out www.socialsectorfranchising.org/.

The world through franchisor lenses

Who a franchisor is may vary. It can be a large or small company with a long history of successful operations or it can be a start-up with little or no experience. Some examples include the following:

• Roark Capital is a private equity firm with over $6.5 billion in equity capital. Some of its portfolio companies include 1-800-Radiator, Anytime Fitness, Arby’s, Auntie Anne’s, Batteries Plus Bulbs, Bosley’s, CARSTAR, Carvel, Cinnabon, CKE Restaurants, Corner Bakery Café, Econo Lube N’ Tune & Brakes, Great Expressions Dental Centers, Il Fornaio, Jimmy John’s, Maaco, Massage Envy, McAlister’s Deli, Meineke, Merlin, Miller’s Ale House, Moe’s Southwest Grill, Naf Naf, Orangetheory Fitness, Pet Supermarket, Pet Valu Pet Store, Primrose Schools, Pro Oil Change, Schlotzsky’s, Take 5 Oil Change, and Waxing the City.
• Foumami, Dat Dog, Beverly Hills Rejuvenation Center, and America’s Escape Game are small and relatively new to offering franchises.
• Firehouse Subs, Sport Clips, FASTSIGNS, BrightStar Care, and 7-Eleven are larger, well-established franchisors.

All great franchisors provide their franchisees with a uniform operating system and train and support them to independently manage and operate their business. When looking at franchising, consider that new businesses don’t usually fail because their products or services are of low quality — they fail because of unknowns and lack of resources. Established franchisors have made and survived their mistakes, and that is one of the benefits of working with established companies — you can generally avoid a lot of the minefield of blunders that start-up businesses usually face.

Franchisors don’t set standards, nor do they provide assistance, out of the kindness of their hearts. It is important to them that their franchisees deliver a consistent, sustainable, and replicable quality of products and services to consumers. They need the system to grow, prosper, make profits, and achieve a solid return on investment at every level, and to achieve that they design their systems so that franchisees can easily execute to their brand standards. If they do that well, franchisees can make money, stay in business, expand, and pay fees. The franchisor’s brand value grows as more people shop at its branded units — and because of everyone’s success, additional investors will want to become franchisees.

The franchisee’s end of the bargain

When you invest in a franchise, you are not buying a franchise. You can’t because all the franchisor is providing to you is a license allowing you to use its brand name and methods to operate your business, and you only get those rights for a specified period of time.

As a franchisee, you own the physical assets of your business: the land, building, equipment, and so forth. You are not buying the franchisor’s brand or systems, and in some franchise systems, the franchisor may even retain the right to purchase your assets when the franchise relationship ends.

It may not sound like much of a deal, but here’s what you get when you join a well-established franchise system:

• Brand standards and enforcement by the franchisor
• A proven and successful way of doing business
• A recognized brand name
• Training and ongoing field and headquarters support
• Research and development into new products and services
• Professionally designed local, regional, and national advertising and marketing programs
• Often, a chance to invest in additional franchises
• A shortcut around the common mistakes of start-up businesses
• Often, a buying cooperative or negotiated lower costs from suppliers for many of the things you need to run and operate the business (ingredients, advertising, insurance, supplies, and so on)
• Your fellow franchisees as a network of peer advisors
• Sometimes a protected market or territory in which to operate your business

Franchisors don’t always provide their franchisees with a defined area around their location in which no other company-owned or franchisee-owned business are allowed to operate. Many do, but even then the market area provided may not be an exclusive territory and may only be a protected territory. An exclusive or protected territory may be defined by the following:

• The radius or area around the franchisee’s location
• The number of households or businesses in an area
• The number of people who live in an area
• Zip codes
• Counties

• Metes and bounds using highways, streets, or other geographic measures

  Metes and bounds is an old English term still used in real estate today. A mete defines the measurement or distance, and the bound describes the physical feature like a road or a river. You will see it frequently used to describe territories in franchising.

• Any other method that defines the area in which no other same-branded location may be established or in which the franchisee has some protection

From the franchisor’s perspective, if the territory is too large, the total market will not contain enough locations to achieve brand recognition. From the franchisee’s perspective, if it is too small or if other locations are too close, there may not be enough customers to support the business.

The goal for franchisors when granting any type of territorial protection is to ensure that they have the right to develop sufficient locations in an area to achieve brand penetration — the number of locations in an area sufficient to service the market and to ensure that consumers see the brand frequently.

Even when a franchisee is granted territorial rights, it may not be permanent and may only be provided for a limited period of time. Some franchisors may also require franchisees to reach certain levels of performance to maintain those rights. And in some systems, a protected territory may overlap with another. If you are a prospective franchisee, make sure you read the contract, and consult with a lawyer to make certain you understand the territorial rights the franchise agreement provides.

Flying solo: Single-unit franchises

A single-unit or direct-unit franchise is just what it says it is: As a franchisee, you obtain the right to own and operate one franchised business from a franchisor.

Over the years, most franchise systems have grown one franchise at a time. It is the classic method and, until the past few decades, was the most common type of relationship in franchising. As people looked for a way to get to their dream of independence through business ownership, franchising became their chosen vehicle. In a single-unit franchise, the franchisee (often along with family members) generally manages and supervises the business on a day-to-day basis. It is how their family makes a living.

There are more single-unit franchisees looking for opportunities than there are multi-unit investors (covered later in this chapter). Also, because the locations are managed directly by the franchisee and generally are a significant part of the franchisee’s family income, single-unit operators tend to be better focused on operating their locations to brand standards and contributing to the neighborhoods in which their businesses are located. That’s because they usually live in the community, their children go to the same schools, they attend the same houses of worship, and their customers are their neighbors.

Growing a family one franchise at a time

As single-unit franchisees prosper (see the preceding section), eventually they will want to acquire another franchise from the same franchisor. After all, they have an understanding of the business, have a relationship with the franchisor, can project the return that an additional unit can generate, and know the types of locations that work best. Initial training likely won’t be needed, and some of the key employees they already have may be perfect managers in their second and third locations.

As they add additional locations, their little chain now can leverage off of the prior locations by sharing staff, inventory, storage, and back-of-house resources like bookkeeping and payroll processing. Investing in additional franchises is a terrific way to grow, because with experience their risk is generally lower than when they made their initial franchise decision, and even though they have more franchises, the relationship between the franchisor and franchisee is substantially the same.

However, growing one location at a time is different from agreeing to operate multiple locations from the beginning, because you don’t usually obtain a reduction in initial or continuing fees and you’ll continue to share the market with other franchisees. But with more units and more money invested, you will tend to be noticed more often by the franchisor and its staff because they are hoping you will continue to grow and grow and grow.

It’s important to understand that franchisors will periodically update their franchise agreements, and franchisees who acquire additional franchises are likely to find variations between their original contract with the franchisor and the new franchise agreement for later units. Your franchisor may also include cross defaults in the agreements, meaning that if you can be terminated at one location, the franchisor reserves the right to terminate all your franchises at the same time — even if every other location is operating perfectly.

As with all franchise agreements, you should have a qualified franchise attorney work with you. They may be able to also help you negotiate some changes to your agreements, including personal guarantees, cross defaults, and changes in fees that other franchisees may be required to pay.

Multi-unit developers

Instead of growing one location at a time, many franchisees instead choose to become multi-unit franchisees right from the start. By entering into a multi-unit development agreement, a developer obtains the right and the obligation to open a specific number of locations during a defined period of time and usually within a specified contiguous geographic area.

For example, say you want to open ten hair salons in your town. You can go to the franchisor and buy one franchise at a time (see the preceding section), but you have certain risks:

• You may have to share the market with other franchisees from the system. And by the time you’re ready to grow, the best locations for your brand may have been taken by other franchisees, or worse, the franchisor may have achieved critical mass in your market and is no longer offering additional opportunities where you want to grow.
• Even if the franchisor is offering a better “deal” to multi-unit developers, it may not be offering that same deal to single-unit franchisees, and you likely won’t have the necessary leverage you need to negotiate the changes you want.

To avoid these risks, you can enter into a multi-unit development agreement and agree to open and operate your multiple locations, say over the next several years, and the franchisor will grant you an exclusive market to develop your little chain.

If possible, you want your multi-unit development agreement to include market exclusivity, ensuring that you are the only franchisee operating in your area. Frequently, though, there may already be locations up and running in the area you want, and you’ll need to decide whether market exclusivity is important to you prior to making your investment decision.

A multi-unit developer will typically pay the franchisor a fee for the right to enter into a multi-unit development agreement. As you sign a franchise agreement for each new location, generally a portion of the multi-unit development fee is credited by the franchisor against your initial franchise fee.

Expect that your development obligations will be specific. For example, instead of simply agreeing to ten units over five years, your agreement will usually have precise dates that you must meet, such as requiring that you have your locations open and operating on January 1, July 1, and so on during the term. These opening dates are important to the franchisor, so if you think the time provided for development is too restrictive or ambitious, this is something you and your attorney should discuss with the franchisor before you sign the development agreement.

Don’t expect the franchisor to allow you to slip on your opening dates later on — missing those dates might trigger certain terminations and cross default rights by the franchisor, including the loss of your development rights and the fee you have paid.

Frequently, the initial franchise fee for locations developed after the initial franchise in a development agreement will be reduced from the franchisor’s standard initial fee. However, how the franchisor applies your development fee to the initial franchise fees you will owe varies from company to company.

In most franchise systems, as the franchisee signs a new single-unit franchise agreement and pays the initial fee, a pro-rata portion of the development fee paid will be applied to the initial franchise fee due. In other situations, you will receive no credit and you may pay the full initial franchise fee for each location.

You can expect that the development agreement may modify some portions of your franchise agreements. In addition to changing the initial franchise fees you may be charged, the franchisor may offer a reduced royalty after a certain number of locations have been developed, and changes in training, site selection, and development are common. You can also expect your franchisor to require you to have a general manager overseeing your units, and it may require you to have someone on staff to conduct the training of your staff.

Advantages for the multi-unit developer include the following:

• You gain the ability to shift personnel from one location to another depending on where the staff is needed.
• You may be able to establish a commissary or kitchen and combine the preparation of products for all the locations or save on freight and other costs by buying in greater quantities at a lower cost and storing inventory in a centralized warehouse, allowing for smaller retail locations and lower real estate costs.
• General managers overseeing multiple locations may reduce management costs at each location. Franchisees may only need an assistant manager, and with consolidated back-of-house support staff, including a trainer, internal costs on a unit basis can be reduced.

Why are two agreements needed? Because the multi-unit development agreement and the franchise agreement serve different purposes. The multi-unit development agreement lays out the rights and obligations being granted to open the locations, and the franchise agreement governs how each location, as part of the franchise system, will operate.

Make certain that the market you select can handle the number of locations you’ve committed to open, that you have the financial backing to live up to your development obligations, if the first location gets off to a slower start than anticipated, and most certainly, that you are ready and able to operate each location per the terms of the individual franchise agreement.

Master franchising

When you become a master franchisee, you become a franchisor in an area and are authorized to offer subfranchises through your master franchise license. As with any franchisor, your master franchisor will prepare and provide to prospective franchisees its own franchise disclosure document (FDD) and agreements that will contain information about you and your services.

In most master franchise relationships, the first thing you will likely be required to do is open and operate a few locations of your own. Once that has been accomplished, you will then be allowed to offer franchise rights to other franchisees (called subfranchises) to open and operate franchises in your market.

You will sign a master franchise agreement with the franchisor and usually pay a master franchise fee. Because your subfranchisees pay you their initial franchise fees and continuing royalty, typically you share a portion with your franchisor. The percentage split will vary widely depending on the franchise system. There is no standard master franchise relationship:

• The subfranchisee may execute a franchise agreement directly with the franchisor or with the master franchisee.
• The franchisor may or may not have the right to approve the new subfranchisee.
• The subfranchisee may receive training and continuing support from the franchisor, the master franchisee, or both.
• The subfranchisee may pay fees directly to the master franchisee, to the franchisor, or a combination of both.

Of all the types of franchising relationships, the master franchise or subfranchise relationship is the most complex.

With the exception of foreign franchisors entering into the United States, don’t expect a lot of U.S.-based franchisors to offer a master franchise relationship today. Although it is still used to some extent by U.S. franchisors internationally — and the trend is shifting away from master franchising to multi-unit development relationships, as technology and other advancements have made it possible to better directly support franchisees internationally — its popularity is waning.

The hired gun: Area representatives

Both an area representative and a master franchisee acquire a territory in which to solicit and support franchisees, and both share in the initial and continuing fees collected from franchisees with the franchisor. The difference is that the area representative is not a franchisor, does not deliver his or her own FDD, and doesn’t execute any agreements with the franchisees. In essence, an area rep is a commissioned sales and field support person for the franchisor.

As in a master franchise relationship, the area representative pays the franchisor a market development fee for the opportunity to develop and provide services to a specific minimum number of units, during a specified time period in a defined area. Once recruited, the franchisees sign their single-unit and multi-unit development agreements with their franchisor.

For many of the same reasons discussed in the preceding section, the use of area representatives is on the decline. An area rep can recruit franchisees quickly. But because they share in the franchisor’s fees, rather than earn their income as an employee, there is a strong argument that they tend to depress the exit or enterprise value of the franchisor despite their potential advantage in recruitment. When the franchise system is sold, the buyer of the system will value the continuing revenue stream available, and sharing of royalties with an area representative will reduce the value of the system to the buyer.

Area reps also are focused more on expansion and less on supporting the franchisees. Should that occur, the franchised businesses in their area — if not in the entire franchise system — suffer, and there is the potential for a higher level of closures and litigation.

There are ways to address some of the downsides of an area representative relationship by structuring the rep’s role and modifying their fee arrangement to be based on the performance of the locations in their area. Still given the downside risks and the availability of alternative growth strategies, it’s expected that the use of area representatives will continue to decline.

The advantages

Your chance of success in franchising can only be as strong as the franchise system you select and how well you manage your business. Well-structured and managed franchise systems that support their franchisees generally offer the benefits discussed in this section.

The disadvantages

Before investing in any franchise you need to understand some of the disadvantages that come in a franchise relationship.