Franchising: An Overview

Franchising
• A risk adjustment mechanism
–“de-limits” resource and
management constraints
• A pathway to entrepreneurship
–that is NOT limited in scale
Micr oso ft C li pAr t Gal ler y
 Risk Adjusted
Entrepreneurship?
• Entrepreneurship starts with opportunity
and opportunity starts with market demand
• A product or service delivery system is
required to fill the demand
• Brand equity leverages wealth creating
potential
 Franchising
• Over 600,000 franchised outlets
in the USA
• 37 % of all retail trade in the US
• Huge international potential
– 12% in France
– 10% in the UK
 Ownership of Outlets
• 13% ” company owned”
• 87% franchised
• 1 to almost 500 outlets owned by a
single franchisee or franchisee entity.
– 75% own only one outlet
 Franchisees

• Average franchisee
– Owns 1 unit
– 5% own 30 or more outlets
– has been in business 9 years
– sales of $682,500
– spends 8.5% on promotion
– makes $59,000 in after tax profit
– Average investment of $155,000
 Franchisors

• Traded at a 23 P/E last year.

• Outperformed the S&P 500 for
most of the last 10 years.
• Carried no more or no less risk
than the S&P 500.
Franchisor =
Owner, producer, or distributor of
a service or trade marked
product.

Franchisee =
Non-exclusive rights for the
product or service.
 THE KEY TO FRANCHISING:

• Distribution of the productive benefits of

the relationship
 PRODUCTIVE BENEFITS =

• The stream of income

The Key to the Relationship is the
allocation of the productive
• Franchise Fees: One Time, Up Front.
• Royalties: Scheduled payment of a % of top line
sales
• Product Sales: Distribution network for
manufactured goods or a mark-up on a national
contract.
• Lease on Real Estate, Building, or Machinery and
Equipment: Market cap rate or “Percentage Rent”.
• Profit from Operating.
 Why Franchise (or, how are the
productive benefits created)?

Tradition Views Expanded Perspective

• Management • Operational synergy
• Money • A growth imperative
• Marketing • Spatial pre-emption
• Merchandise • Creating a brand lever
FRANCHISE OR STAND ALONE?

• PDV of income stream

– Are the fees worth the growth in
business
 WHY FRANCHISE?
• TO GAIN ACCESS TO
FRANCHISEE CAPITAL

• TO EXPAND RAPIDLY AND

PREEMPT COMPETITION

• TO GROW EFFICIENTLY
 WHY DO FIRMS FRANCHISE?
RESOURCE SCARCITY
1. Capital
2. Promotional economies
ADMINISTRATION EFFICIENCY
1. Franchisee Labor - more efficient?
2. Company operations more difficult to monitor?
COMBINATION OF RESOURCE SCARCITY &
ADMINISTRATIVE EFFICIENCY
1. Hybrid capital instrument
2. Hybrid organizational form
 REALITY OF FRANCHISING
What Happens When You Franchise If You Are Not Careful
• TO GAIN ACCESS TO FRANCHISEE CAPITAL…becomes..
The Franchisor becomes the Capital Conduit…and…
The franchise has a tendency to Under-Invest/

• TO EXPAND RAPIDLY…..becomes…..
Reaching beyond the growth rate which is sustainable...and . .
Losing control of standards and deteriorating the trademark.

• TO GROW EFFICIENTLY. . . .becomes. . . . .

Franchisees don’t do more volume but they are more
profitable…
The Franchisor and Franchisee Firms have divergent goals -
Profit versus Volume - and Behavioral Conflict Manifests.
 WHAT DO I LOOK FOR IN A
FRANCHISE?
• SUCCESSFUL COMPANY OR PILOT
OPERATION

• STRUCTURAL SUPPORT - IN PLACE

– appropriate quantity
– appropriate use

• A WELL DEFINED GROWTH PLAN

 TYPICAL FRANCHISOR
SERVICES TO LOOK FOR:
• Documented operational policies & procedures
• Location success factors documentation and site
finding assistance… specifically tied to the primary
target audience (PTA).
• Building specifications & construction supervision
• Franchisee and employee training programs
• Marketing supported by research which targets a
primary audience (PTA)
• An integrated monitoring, support, control, and
feedback system.
 WHO SHOULD FRANCHISE?
• How important is on-site entrepreneurial capacity?
• Are there economies of scale?
• Can you make a cookie cutter?
• Can control & feedback be integrated?
• Is there a supply issue?
• How fast do you want to grow?
• How much capital do you have?
• What is the trade mark potential?
• Be country specific, if US, be state specific.
• Take an objective look at your charisma!
 THE FRANCHISE RELATIONSHIP IS
GOVERNED BY A LICENSE AGREEMENT
• Length of the agreement
• Renewal terms
• Obligations of the Franchisor
• Obligations of the Franchisee
• Required payments
– Franchisee fee… One time, up front
– Royalty… A fixed % of sales
– Marketing & advertising expenditures
• Product purchase arrangements
• Territorial rights
• “Then Current” language
• Death or disability
• Dispute Resolution
 OBLIGATIONS OF THE
FRANCHISOR

• Do they tie to “The Promise” and to your

due diligence
 OBLIGATIONS OF THE
FRANCHISEE
• Adherence to the operating manual
– watch for “Then Current” language
• Product Purchase Arrangements
– Market enhancement test for tying
– Specifications
– Approved Suppliers List
Watch for one supplier on the list or
tailored specifications.
OBLIGATIONS OF THE FRANCHISEE

MARKETING… TYPICALLY THREE LEVELS

1. National advertising
– Creative development
– Materials production (POS, print, radio, TV)
2. Regional cooperative
– Purchase of media, implementing national plan
develop thru the NAF
3. Local
– Store or local trade area promotions
LENGTH OF THE AGREEMENT
• 1 to 20 years The correct length amortizes
the investment with a “Market” return

• Termination clause has

– A standard of “reasonableness”
– Right to cure
 RENEWAL TERMS
• Extension Fee
• Property Rights
– (Real Estate/ Machinery & Equipment/
Inventory)
• Timing of notice/length of renewal
• Automatic renewal by law in some states
 TERRITORY RIGHTS

• Is there an “Exclusive” territory?

• Does the exclusive territory match the PTA and
site development criteria?
• Are there “Area Development agreements”?
• Currently the hot legislative issue in
franchising.
FRANCHISING IN PRACTICE?
The License Agreement
• Real Estate Development
• Construction Specification and Supervision
• Training
• Pre-Opening Support
• Continuing Services
• Performance Standards & Monitoring
• Field Support
• Operations Research & Development
• Marketing, Advertising, and Promotions
FRANCHISING IN PRACTICE?
The Pay Attention to Details List
• The Operations Manual
• Territorial Rights
• Product Purchase & Typing Arrangements
• Dispute Resolution
• Term of the Agreement
• Termination
• Sale of the Business
• Death or Incapacity of the Franchisee
• Real Estate Relationship
 WHAT DEFINES THE LEGAL
RELATIONSHIP?
• The UFOC
• The contract (license agreement)
• Operations manual
• Policies and procedures
• Franchise Association Input
• Leasing & purchasing issues and behavior
 LEGAL THEORIES
• Contract claims
• Implied covenant of good faith and fair
dealing
• State specific laws
• Federal Trade Commission & Sherman
Anti-Trust
• RICO
• Fiduciary Duties
 HOW DO YOU FIND A
FRANCHISE?
• Uniform Franchise Offering Circular
(UFOC) from the F.T.C. and thirteen
states.
– New offering document with greater
disclosure in 1996.
UNIFORM FRANCHISE OFFERING
CIRCULAR (UFOC)
• List of Officers
• Litigation
• List of all Franchisees
• List of Franchisees terminated in the previous 12
months
• Store count information
• Audited Financials of the Franchisor
• Summary of the L/A
• Earnings claim (optional)
• Specimen copy of contracts
 STATES REQUIRING
FRANCHISE REGISTRATION
• CALIFORNIA • NEW YORK
• HAWAII • NORTH DAKOTA
• ILLINOIS • RHODE ISLAND
• INDIANA • SOUTH DAKOTA
• MARYLAND • VIRGINIA
• MICHIGAN • WASHINGTON
WHEN MUST DISCLOSURE
BE MADE?

First face to face meeting between the

franchisor and prospective franchisee

or

Ten (10) days before execution of the

contract or payment of any money
 HOT LEGAL ISSUES
• Encroachment
• RICO
• Vicarious liability of the franchisor
• Earnings claim
• Arbitration and mediation
• Venue
• Territory exclusivity
 THE FUTURE IS NOW
• Non-traditional expansion
• High tech territorial encroachment
• Automatic deposit of royalties
• Franchisor self regulation
• Legislative initiatives
• Web enabled functionality
• Multi-franchise ownership
• Hybrid business models
Public Franchisor Market Performance Jan 90 through Jul ‘00

600.0
Performance Index (B ase 100=1/1/1990)

500.0

Franchise Super Performers

400.0

300.0

200.0

100.0

0.0
Jan-92

Jan-96

Jan-97

Jan-98

Jan-99
Jan-90

Jan-91

Jan-93

Jan-94

Jan-95
Jul-91

Jul-92

Jul-93

Jul-94

Jul-95

Jul-97

Jul-98

Jul-99
Jul-90

Jul-96
Month-Year

Franchisor Index (Base 100=1/1/90) S&P500 Index (Base 100=1/1/90)

Franchisor’s Systematic Risk (Beta) Distribution, 1990-1999

Histogram
12

10

4
Frequency

2
Std. Dev = .88
Mean = 1.15
0 N = 83.00
-.50

0.00

.50

1.00

1.50

2.00

2.50

3.00
Systematic Risk (Beta)