The most common barrier to expansion faced by today’s small businesses is lack of access to capital. Even before the credit-tightening of 2008-2009 and the “new normal” that ensued, entrepreneurs often found that their growth goals outstripped their ability to fund them.
Franchising, as an alternative form of capital acquisition, offers some advantages. The primary reason most entrepreneurs turn to franchising is that it allows them to expand without the risk of debt or the cost of equity. First, since the franchisee provides all the capital required to open and operate a unit, it allows companies to grow using the resources of others. By using other people’s money, the franchisor can grow largely unfettered by debt.
Moreover, since the franchisee — not the franchisor — signs the lease and commits to various contracts, franchising allows for expansion with virtually no contingent liability, thus greatly reducing the risk to the franchisor. This means that as a franchisor, not only do you need far less capital with which to expand, but your risk is largely limited to the capital you invest in developing your franchise company — an amount that is often less than the cost of opening one additional company-owned location.
Another stumbling block facing many entrepreneurs wanting to expand is finding and retaining good unit managers. All too often, a business owner spends months looking for and training a new manager, only to see them leave or, worse yet, get hired away by a competitor. And hired managers are only employees who may or may not have a genuine commitment to their jobs, which makes supervising their work from a distance a challenge.
But franchising allows the business owner to overcome these problems by substituting an owner for the manager. No one is more motivated than someone who is materially invested in the success of the operation. Your franchisee will be an owner — often with his life’s savings invested in the business. And his compensation will come largely in the form of profits.
The combination of these factors will have several positive effects on unit level performance.
Long-term commitment. Since the franchisee is invested, she will find it difficult to walk away from her business.
Better-quality management. As a long-term “manager,” your franchisee will continue to learn about the business and is more likely to gain institutional knowledge of your business that will make him a better operator as he spends years, maybe decades, of his life in the business.
Improved operational quality. While there are no specific studies that measure this variable, franchise operators typically take the pride of ownership very seriously. They will keep their locations cleaner and train their employees better because they own, not just manage, the business.
Innovation. Because they have a stake in the success of their business, franchisees are always looking for opportunities to improve their business — a trait most managers don’t share.
Franchisees typically out-manage managers. Franchisees will also keep a sharper eye on the expense side of the equation — on labor costs, theft (by both employees and customers) and any other line item expenses that can be reduced.
Franchisees typically outperform managers. Over the years, both studies and anecdotal information have confirmed that franchisees will outperform managers when it comes to revenue generation. Based on our experience, this performance improvement can be significant — often in the range of 10 to 30 percent.
Speed of Growth
Every entrepreneur I’ve ever met who’s developed something truly innovative has the same recurring nightmare: that someone else will beat them to the market with their own concept. And often these fears are based on reality.
The problem is that opening a single unit takes time. For some entrepreneurs, franchising may be the only way to ensure that they capture a market leadership position before competitors encroach on their space, because the franchisee performs most of these tasks. Franchising not only allows the franchisor financial leverage, but also allows it to leverage human resources as well. Franchising allows companies to compete with much larger businesses so they can saturate markets before these companies can respond.
Franchising allows franchisors to function effectively with a much leaner organization. Since franchisees will assume many of the responsibilities otherwise shouldered by the corporate home office, franchisors can leverage these efforts to reduce overall staffing.
Ease of Supervision
From a managerial point of view, franchising provides other advantages as well. For one, the franchisor is not responsible for the day-to-day management of the individual franchise units. At a micro level, this means that if a shift leader or crew member calls in sick in the middle of the night, they’re calling your franchisee — not you — to let them know. And it’s the franchisee’s responsibility to find a replacement or cover their shift. And if they choose to pay salaries that aren’t in line with the marketplace, employ their friends and relatives, or spend money on unnecessary or frivolous purchases, it won’t impact you or your financial returns. By eliminating these responsibilities, franchising allows you to direct your efforts toward improving the big picture.
The staffing leverage and ease of supervision mentioned above allows franchise organizations to run in a highly profitable manner. Since franchisors can depend on their franchisees to undertake site selection, lease negotiation, local marketing, hiring, training, accounting, payroll, and other human resources functions (just to name a few), the franchisor’s organization is typically much leaner (and often leverages off the organization that’s already in place to support company operations). So the net result is that a franchise organization can be more profitable.
Unfortunately, it is difficult to quantify or prove this contention. This much we do know: Research done during the past 10 years shows top quartile franchisors put an average of 40 and 45.6 percent to the bottom line in 2018 and 2019 respectively. How many industries can you think of where net incomes in this range are even possible?
The combination of faster growth, increased profitability, and increased organizational leverage helps account for the fact that franchisors are often valued at a higher multiple than other businesses. So when it comes time to sell your business, the fact that you’re a successful franchisor that has established a scalable growth model could certainly be an advantage.
When the iFranchise Group compared the valuation of the S&P 500 vs. the franchisors tracked in Franchise Times magazine, the average price/earnings ratio of franchise companies was 26.5, while the average P/E ratio of the S&P 500 was 16.7. This represents a staggering 59 percent premium to the S&P. Moreover, more than two-thirds of the franchisors surveyed beat the S&P ratio.
Penetration of Secondary and Tertiary Markets
The ability of franchisees to improve unit-level financial performance has some weighty implications. A typical franchisee will not only be able to generate higher revenues than a manager in a similar location but will also keep a closer eye on expenses. Moreover, since the franchisee will likely have a different cost structure than you do as a franchisor (she may pay lower salaries, may not provide the same benefits packages, etc.), she can often operate a unit more profitably even after accounting for the royalties she must pay you.
As a franchisor, this can give you the flexibility to consider markets in which corporate returns might be marginal. Of course, you never want to consider a market you don’t feel provides the franchisee with a strong likelihood of success. But if your strategy involves developing corporate units in addition to franchising, you’ll likely find your limited capital development budget won’t allow you to open as many locations as you’d like. Franchisees, on the other hand, could open and operate successfully in markets that are not high on your priority list for development.
By its very nature, franchising also reduces risk for the franchisor. Unless you choose to structure it differently (and few do), the franchisee has all the responsibility for the investment in the franchise operation, paying for any build-out, purchasing any inventory, hiring any employees, and taking responsibility for any working capital needed to establish the business.
The franchisee is also the one who executes leases for equipment, autos, and the physical location, and has the liability for what happens within the unit itself, so you’re largely out from under any liability for employee litigation (e.g., sexual harassment, age discrimination, EEOC), consumer litigation (the hot coffee spilled in your customer’s lap), or accidents that occur in your franchise (slip-and-fall, employer’s comp, etc.).
Moreover, it’s very likely that your attorney and other advisors will suggest you create a new legal entity to act as the franchisor. This will further limit your exposure. And since the cost of becoming a franchisor is often less than the cost of opening one more location (or entering one more market), your startup risk is greatly reduced.
The combination of these factors provides you with substantially reduced risk. Franchisors can grow to hundreds or even thousands of units with limited investment and without spending any of their own capital on unit expansion.