Friday, July 29, 2016

12:12 AM

What Is a Franchise?
A Beginners Guide to Franchising and the Franchise Business Model

Wendys announced today that, in a move to help its franchisees deal with rising costs resulting
from minimum wage increases, it would make available digital self-service kiosks to its more than
6,000 locations, allowing business owners to reduce employee counts and protect
earnings. Although this should come as no surprise to anyone who is even remotely familiar with
economics, Ive seen a lot of folks around the Internet talking about Wendys corporate profits;
about the executive and board of directors. This demonstrates a total lack of understanding about
how a business like Wendys structures its franchise agreements. It occurred to me that, just as I
once explained what a holding company is, how it is structured, and why it is valuable in certain
circumstances, it might be beneficial to do the same thing for a franchise. What is a
franchise? What are some standard franchise agreement terms and rates? How are franchises
legally structured? I have about an hour before dinner, just brewed a fresh pot of coffee, and am in
the teaching mood so for those of you who are unfamiliar with this unique business model, allow
me to introduce it to you.
The best place to start is the title of this essay: What is a franchise?
What Is a Franchise?
The word franchise is used to describe an arrangement in which one business, the franchisor,
allows another business, the franchisee, to use its name, trademarks, trade secrets, intellectual
property, branding, operating systems, and internal support resources in a specific geographic area,
sometimes with an exclusivity provision that guarantees no other franchises will be granted within
a specific buffer zone so the franchisees arent cannibalizing sales from each other, in exchange for
some sort of payment.
How Does a Franchise Work?
Since it was Wendys news story that inspired me to write this article, well start by looking at the
Wendys franchise system first.

The Wendys Company, which is structured as a holding company, came into being through a long
line of events; descended from the original hamburger business started by Dave Thomas, which
once owned Canadian chain Tim Hortons, and a hedge-fund food enterprise called Triarc, the
former parent of Arbys. (Side note: This is one of the reasons inexperienced investors make
mistakes when attempting to do historical case studies. If you pull the Form 10-K filing for
Wendys, the numbers you are looking at are not the numbers for the business Dave Thomas built
prior to the merger. If you look at historical price quotes for Wendys stock, the figures that are
NAC to be filed 2015 Page 1

prior to the merger. If you look at historical price quotes for Wendys stock, the figures that are
returned are not for the business Dave Thomas built. This new enterprise, which is called Wendys
and which now owns Wendys, is not the same thing. It is actually the old Arbys, which no longer
owns or is called Arbys. Welcome to corporate America and the dynamic nature of capitalism.
For the right operator, in the right location, with the right set of conditions, owning a Wendys
restaurant can be a wonderfully profitable opportunity. Essentially, he or she (for the sake of
brevity, for the remainder of this piece, Im going to use he as a majority of franchise owners
have historically been men) gets to plug directly into a system instead of having to invent the wheel
from scratch the furniture is standard, the signage is standard, the equipment is standard, the
supplies such as cups and bags are standard, the building design is standard, and the moment he
hangs up his sign, he has instant brand recognition. People who didnt even know he was in
business the day before will walk in, or drive through, his restaurant, handing over cash and credit
cards to buy Wendys old fashion hamburgers and fries, a Wendys famous chili, or a Wendys
Frosty, all but guaranteeing seven-figures in annual revenue straight out of the gate under most
scenarios. That is because Wendys has been building its reputation for generations. His job, as the
person owning and operating the individual restaurant, is to run it as efficiently as he can because
he gets to keep the profit.
Wendys benefits from this arrangement, too. In effect, they are given enormous synthetic
equity. The franchisee has to put up all of the money, including cash and proceeds from bank
loans, to get the restaurant built, staffed, and operating with start-up working capital, plus pay a
one-time franchising fee of $40,000, which covers a 20-year franchise term (after which point,
either a new contract is signed or the restaurant goes out of business), a $5,000 application fee,
and some other fees, including a $325 per person background check fee. On top of this, Wendys,
as the franchisor, is entitled to a 4% royalty on all sales generated at the franchisees
restaurant. Wendys also requires the franchisee to put 3.5% of sales into a national advertising
budget that pays for things like television commercials, as well as 0.5% of sales into a local
advertising budget that promotes the restaurant in the city or town where it is
located. Furthermore, the franchisee agrees to let Wendys control things related to the brand
experience. A Wendys franchisee, for example, could not suddenly decide to start selling crab
cakes by going to the local supermarket and buying crab, marking it up, and adding it to the menu.
A Franchise Agreement Can Benefit Both Sides of the Deal, Franchisor and Franchisee
When everything goes right, it can be a dream arrangement for both the franchisor and the
franchisee. From the franchisor prospective, you have this partner come along who give you a
bunch of cash upfront, pays all of the costs of building a restaurant, staffs it, operates it, and isnt
guaranteed any sort of income. Instead, your incentives are aligned because you get an on-going
royalty on sales so the higher sales go, the more cash floods into your checking account; a nearly
infinite return on capital. The franchisee can focus on knocking it out of the park by executing
better than his local competitors; making the drive-through run like a well-oiled machine, keeping
up on landscaping, making sure the restrooms are pristine, determining pay and compensation
policies, dealing with a break-in in the middle of the night, and much, much more. Many self-made
millionaires have been minted from franchising, on both sides of the deal. For the right person,
NAC to be filed 2015 Page 2

millionaires have been minted from franchising, on both sides of the deal. For the right person,
who can drink the proverbial Kool-Aid and put his ego aside so he buys into the system, franchising
can be a gold mine. (The biggest mistake Ive seen when looking at historical failures in the
franchise business model were individuals who didnt like being told what to do so they bucked the
system and became enemies with the franchise. Its a personality thing that causes a lot of pain
and, in many cases, financial suffering, too. This is an area where the right temperament and
values match is vital to success.)
In terms of franchisor profitability and total number of franchise millionaires spawned, the worlds
leading franchisor, McDonalds Corporation, has a unique twist on the franchising business model
(the parent company of Subway, the sandwich shop chain, has more franchised locations). The
idea was developed by one of the triumvirate in the McDonalds pantheon, Harry Sonneborn. Back
when the company was cash-strapped, Sonneborn created a model that involved McDonalds
leasing a plot of land and custom-constructed building from a real estate owner, then sub-leasing
that land and building to the franchisee so, in addition to the food royalties the franchisee paid, the
real estate lease income was flowing to McDonalds, as well. This has led to the oft-observed
phenomenon of McDonalds really being a real estate empire in drag. By some accounts,
McDonalds is the largest landowner in the world. These days, of course, it is so wealthy that it
doesnt need to bother with the original lease. Instead, it can buy the land outright, develop it for
the franchisee, then keep all of the rental income instead of paying the original lease
holder. Would-be franchisees still flock to the place, hoping to get their own restaurant, because
even with the 4% service fee on sales of food and beverage, and the rent, and the ancillary fees,
one of the surest ways to end up a member of the top 1% is to own a few McDonalds restaurants
in a market. Similar to the owners of Coca-Cola bottling rights, the local McDonalds franchisee is
almost always one of the richest folks in town.

The franchise system is the reason when you walk into most Wendys, McDonalds, you can
normally spot a sign that says something like, This restaurant proudly owned and operated
by Smith Family Hamburgers, LLC. That is the actual business from which you are buying your
food. It is most likely a local person who has setup his local business as a limited liability
company. He had to fund it with his own money, get bank loans, sign an agreement with the
franchisor, hire employees, including managers, train them, oversee the whole thing, and, he
hopes, generate more revenue than he does expenses so there is a profit remaining for him taking
such a large risk. He has the power to set prices and, within reason and in many cases, hours. Its
his company. As long as he abides by the terms of his franchise agreement contract, the franchise
cannot be taken away from him. (Even if it is, that business remains, it just cant operate using the
franchisors intellectual property and name. If a franchisees company had built up something like
$3 million worth of Treasury bills, that money isnt going anywhere. They could transform
themselves into a real estate development firm or go build an apartment building or
something. There are cases of franchisors not renewing franchise agreement with franchisees
when the terms expire, in which case they had to figure out something else to do.) There are some
cases of franchisee companies becoming so successful that they go public, selling part of
themselves in an IPO to either provide liquidity for the founders or raise even more capital to open
even more franchised restaurants.
NAC to be filed 2015 Page 3

even more franchised restaurants.

In the case of automation, Wendys, the franchisor, is making available the technology and
processes for automation to its franchisees because it believes it will allow them to run their
business more efficiently. If minimum wage costs go up to $15 an hour, it can devastate the profits
of the franchisees business, the LLC that is the actual operating restaurant owned by the local
entrepreneur. If that entrepreneur raises prices to offset those costs, and sales remain steady
(enough people stick around at the higher prices to offset the lower unit volume assuming there
was a loss of traffic), Wendys is still collecting the same absolute dollars due to its royalty
rights. However, it wants the franchisees to be as successful as it can. It also wants to keep costs
low for customers. It can serve both by replacing those would-have-earned-$15 employees with a
kiosk. Thats not all. Even better from a customer satisfaction point of view not particularly
important from my perspective as I think its a horrible thing for civilization, all things
considered there seems to be a lot of indication that millennials prefer ordering online or at a
machine so they dont have to talk to a human.
The Franchise Business Model Can Be Found in a Diverse Range of Sectors and Industries

Franchising isnt limited to fast food. For example:

Retail franchise businesses include everything from nutrition supplement stores such as GNC and
Complete Nutrition to home improvement stores such as Ace Hardware (Ace is unique in that not
only is it a franchised business, but the franchisees collectively own the franchisor so they make
money on their share of its earnings, too); furniture and electronic rental places such as Aarons
and Rent-A-Center; 7-Eleven convenience stores an BP gas stations; Supercuts hair salons and
Anytime Fitness gyms.
Hotel franchise businesses include such well-known chains as Hampton Inn, Days Inn, Holiday Inn,
Super 8, Motel 6, Hilton, Dubletree, Homewood Suites, Embassy Suites, Wyndham, Ramada,
Travelodge, Ritz Carlton, and Comfort Inn and Suites.
Financial and business services franchise companies include Allstate insurance agencies, H&R block
tax locations, American Title Loan lenders, and Express Employment staffing centers; Re/Max and
Coldwell Banker real estate brokerages; Hertz Rent-a-Car.
Home services franchises include things like Rooter-Man plumbing, Molly Maid cleaning, and
Servpro disaster recovery services.
The list of franchise businesses keeps going car repair operations, hearing aid providers,
locksmiths, daycare and child education centers, eyeglass shops, cigar stores, tanning salons,
moving services, tutoring, landscape maintenance. Franchising is a major part of the American
economy, which is one of the reason the recent National Labor Board ruling declaring that
franchisors are responsible for things such as the payroll policies of franchisees is such a big deal,
threatening the entire business model. Personally, I dont think the ruling survives longterm. There is too much money and power at stake, and too many vested players, to permit it. If it
does, you will see mass automation rolled out on a scale that would make Henry Fords head
spin. The insurance industry is already looking at the implications for franchise liability under the
new paradigm. McDonalds is already challenging it in court which, if it doesnt survive, the
Democrats and Republicans in Congress will come together to create some sort of joint bill
rescinding it, if not outright, in effect.
NAC to be filed 2015 Page 4

rescinding it, if not outright, in effect.

Franchising is all about pairing up existing systems and brand equity with local operators who have
capital, creating an arrangement where both, ideally, come out better than they were.
Not All Franchises Are Created Equally
One of the major innovations of Ray Kroc at McDonalds was the alignment of incentives with
franchisees. While other franchisors made money by selling things like kitchen equipment, cups,
straws, uniforms, etc. to franchisees, Kroc refused. Instead, he had McDonalds identify the best
vendors for the job then let the franchisee select from among the vendor list, making no money off
of it. He wanted them both focused on the same thing growing sales at the restaurant because
he knew it gave them a chance to generate more profit and his franchisor company, McDonalds,
collecting more royalties. Everything else was a distraction and threatened the partnership-like
spirit of what he wanted. His competitors thought he was a bit nuts to turn down what they saw a
lucrative source of free money but Kroc turned out to be right in the end. He and his franchisees
steamrolled across the country, then world, out-competing everybody. Even today, though, not all
franchisees have gotten the memo. With only a few exceptions, Id be careful about getting into a
franchise arrangement where I wasnt on the same side of the table as the franchisor.
Additionally, if your sole objective is generating the highest return you can, you need to examine
the return on capital different franchises offer, not just the absolute profits they generate. Subway
restaurants, to use one real-world illustration, typically require a lot lower investment than a
McDonalds restaurant so even though they generate lower annual profits, their returns on capital
can be superior for the operator. If youre starting out with a smaller pool of capital and have a
career to expand it, it might make sense to consider owning a chain of Subway franchises,
instead. Sure, they arent comparable in my hometown, there is a beautiful new, well-run
Subway shop right next to a newly updated McDonalds and the McDonalds is almost always
packed, two-drive-through-bays deep while the Subway hardly has a visitor but thats where the
art of being a good operator comes into play; knowing your market, knowing what the numbers
should be for each specific location. (McDonalds does have some company-owned stores that
arent franchised but these are mostly held in inventory until a good franchisee can be found as the
firm is committed to an asset-light approach that emphasizes returns on capital.)

Some of the Best Chains Refuse to Franchise Except in Exceptionally Large, National-Level Deals
One of the interesting things about franchising is that, all else equal, franchise stores, restaurants,
or locations tend to outperform company-owned stores, restaurants, or locations. This is because
of the superpower of incentive. When you have a local owner operator living in the community,
working alongside his employees, seeing the customer day-in and day-out, and who gets to keep all
of the surplus performance above the fixed expenses and royalty fees, miraculously things can
happen. Put the same restaurants in the hands of a salaried employee, even with certain profit
sharing arrangements, and its never quite as successful. Even still, some brands insist upon total
control.
Starbucks is one of them. With the exception of some foreign accounts and things like domestic
NAC to be filed 2015 Page 5

Starbucks is one of them. With the exception of some foreign accounts and things like domestic
Barnes & Noble locations, Starbucks is entirely company-owned. You cannot open a Starbucks
franchise. The same goes for Chipotle. This means that they keep 100% of the earnings, though,
and not just fees and royalties. Its a trade-off. Neither is right or wrong. It does take a lot longer
to grow using the company-owned philosophy because it demands a lot more reinvested equity
whereas a franchise-only model is effectively a license to print unrestricted money that can be
distributed. On the other hand, the franchise-only model suffers from all kinds of challenges. A
bad franchisee can ruin the brands reputation in a market or band together with other franchisees
to challenge the franchisor, which is a distraction. Exclusivity is something you want when
operating a franchisor. The last thing you need is a bunch of poor operators out there destroying
the name youve built.
Some Final Thoughts on Franchises

One of the biggest problems with franchises is that they can be extremely difficult to turn around if
something goes wrong, especially if expansion was too rapid and low-quality franchisees were
brought into the mix. They are also not accessible to everyone as the best franchises typically
require a much larger-than-average net worth, of which a significant portion must be in cash. For
example, Wendys requires a net worth of $5,000,000 or more of which at least $2,000,000 must
be liquid. McDonalds, in comparison, has its own net worth requirements aside from which it
requires the owner / operators of a new McDonalds franchise to pay at least 40% cash out of their
own pocket for the opening of a new restaurant. With the cost of a new restaurant ranging
between $944,352 to $2,172,045, thats a nice chunk of change. (McDonalds is quite wise for
insisting upon this. By allowing only 60%, maximum, to be financed from traditional sources, it can
help ensure the financial stability of the franchisees operating company so it doesnt have to worry
about it running into financial trouble due to a highly speculative capital structure.) On the other
hand, financing can be a lot easier to come by. There are many specialty lenders who jump at the
chance to help those awarded a McDonalds franchise borrow money as they know McDonalds
standards are high enough, and real estate location policies strict enough, that failure is relatively
rare, reducing underwriting risk. Additionally, when a franchisee goes to retire, its much easier to
sell a portfolio of McDonalds franchise businesses than it is your own stand-alone restaurants as
there are plenty of new want-to-become franchise owners, and existing would-like-to-buy-more
location franchise owners, waiting for the chance to snap up profitable locations.
From <http://www.joshuakennon.com/what-is-a-franchise/>

NAC to be filed 2015 Page 6