Franchise Facts & Fallacies

Table of Contents

                                Introduction

                                I. As a Franchisee

                                                - First Steps

                                     - Beginning the Research

                                     - Franchise Brokers

                                     - Franchise Trade Fairs

                                     - Big Ticket Franchises

                                     - Financing

                                     - Commitment

                                II. As a Franchisor

                                    - Comments on Developing a Franchise System

                                    - Beginning the Research

                              Appendix I: The Origins of Franchising

Introduction

    Franchising is defined in Wikipedia as: “using another person's business model. The franchisor grants the independent operator the right to distribute its products, techniques, and trademarks for a percentage of gross monthly sales and a royalty fee. Various tangibles and intangibles such as national or international advertising, training, and other support services are commonly made available by the franchisor. Agreements typically last from five to thirty years, with premature cancellations or terminations of most contracts bearing serious consequences for franchisees.”

    A common fallacy is that McDonalds was the first franchise. In fact the origins of franchising go back to the landed aristocracy in the Middle Ages. A brief history of the concept is given in Appendix I. Franchises range from kiosk businesses, where the entry costs (franchising fee and beginning working capital) could be just a couple of thousand dollars, to McDonalds, where the entry costs for a prime urban location can easily reach a million, to “big ticket” franchises with multi-million dollar requirements. 

    Franchising may be considered from two points of view (1) running your own business as a franchisee and (2) offering a franchise system as a way of rapidly gaining market share as a franchisor. These aspects are treated in turn.

 I. As a Franchisee

First Steps

    Becoming a franchisee is a legitimate, fulfilling and profitable alternative to starting your own business from scratch, given some critical assumptions. These may be cogently summarized with the word Quality. The franchise must be one of quality.  And make no mistake, many are not. Furthermore, you must bring the right qualities to that franchise, i.e. there must be goodness of fit. 

    You see a pressing need for supplemental education for children in your area. You are considering companies such as the Sylvan Learning franchise, and have found a perfect location. You are convinced a franchise there will make a ton of money. However your primary motivation is to seize the opportunity. You did not like school. Revered teachers were never role models for you. You have little patience for children. Are you really the right person to market remedial education to concerned parents, to manage dedicated teachers and to create and maintain an environment that delights children?

    A homily that bears repetition is that the best way to become successful in business, as in life, is to love what you are doing. You bring real passion to educating children, are full of enthusiasm about the teaching concepts of the franchise and bubbling with ideas of how better to help children in your market. That attitude will be read by your customers and your employees – and be a key success driver for you.

    Your first step, therefore, is deciding what you want to do, and where (in what city, town, or rural area) you want to do it. The “what” and the “where” are discussed at the beginning of “Start-up (EBO) Strategy” with a treatment of the classic What Color Is Your Parachute? by Richard Nelson Bolles. The official site for this career bible is www.jobhuntersbible.com.

Beginning the Research

Five "Starter" Websites and Two STRONG Book Recommendations

"Starter" websites

    1) The Franchise Foundations  website of Kevin Murphy is a good place to start for franchisees (and franchisors as well). He is a franchise attorney, J.D. University of San Francisco, who also has an MBA in international business from San Francisco State University. His firm, has offices in San Francisco and Singapore. The site has solid content, including a series of good articles at "Buying a Franchise."

    2) The International Franchise Association has an extensive website, which should be examined. 

    3) The AAFD, American Association of Franchises and Dealers, is also noteworthy. AAFD apparently has awarded only nine or ten companies its Fair Franchising Seal. (This number appears pessimistic. For instance, McDonalds restaurants have indeed failed. However that they often are very good businesses indeed is supported by the fact that the majority of franchisees eventually expand to owning several locations.)

   4) www.franchise.org.au/buying-a-franchise.html  This website in Australia includes questions one should ask before buying a website.

    5) www.franchisebusiness.com.au/ An attractive feature of this website, another Australian one, is the "Ask an Expert" section on its landing page. Clicking on it brings you to a variety of people with franchising expertise.

    As neccessary and worthwhile as Website research is, one still needs to go further.  Therefore reading at the least the two books discussed below is strongly recommended. 

    Downbeat: First read the ominous -- but fair -- book by Robert Purvin, whose career is as an attorney representing franchisors. He knows what he is talking about in The Franchise Fraud: How to Protect Yourself Before and After You Invest, 1994, republished 2008. The book is a little dated, but still a must read. For instance, the franchisor is not required to disclose failure rates or how they are calculated! Assuming that after finishing this book you are not paralyzed by terror, but rather tempered by sober caution, proceed to the book below.

    Upbeat: Now that your eyes have been opened, if you still wish to proceed, read, study and re-read the book about franchising, another "must read:" The Educated Franchisee: The How-To Book for Choosing a Winning Franchise, Bascom Hill Pub. Group, 2008 by Rick Bisio, a franchise consultant, and Mike Kohler. The book title in the preceding sentence is linked to the associated webite, also a good resource, with for instance, information on disclosure documents. The outstanding, practical book has three main sections:

    Part I: Is buying a franchise the right decision for me?

    Part II: How do I evaluate a franchise?  

    Part III: What should I do after signing the franchise agreement?

    To comment on these in turn:

    Part I: Right decision - also review your worksheets from What Color is Your Parachute !

    Part II: Evaluation - Critical are, first, to review carefully the FDD (Franchise Disclosure Documents), formerly known in the U.S. as the UFOC (Uniform Franchise Offering Circular), second to talk to many current franchisees and third, that your legal advice not come from a general business attorney, but rather from one who specializes in franchises. 

    Franchise attorneys offer FDD reviews (including the flat fee service of Kevin Murphy). Properly done, you´ll get better advice -- and control costs -- if you have read the document yourself thoroughly, compared the boilerplate paragraphs to other FDDs, and ask specific questions. You can also visit your local law school and ask a professor´s recommendation for a bright student to help you in forming your legal questions. However be careful with this approach.

    Focus on asking questions for answers you really need. Don´t get carried away with irrelevant ones to show how smart and industrious you are. Your franchise attorney may enthusiastically respond with a major research effort, with the billing clock running every minute, to show how smart and industrious he is! 

    Before beginning serious due diligence, you need to be able to say yes to the following questions (op. cit. p. 121).  Is the franchise:

      - a good fit for my vision, and my financial needs?

      - available where I want to live?

      - going to be satisfied with my ability to meet its prerequisites?

      - in a growth mode, ideally, in a growing industry?

    In his electronic newsletter of March, 2011, (available at his cited website) Rick Bisio adds further key questions, which may be summarized as follows:

      - Does the franchise systematically reduce your business risk?

      - Is the franchise evolving, seeking to improve the opportunity?

      - Are the franchisees "raving fans" who genuinely enjoy helping one another?

      - Besides on-going training and support, will the franchisor also support your exiting the system?

    Having answered yes to these questions, now you can begin your serious due diligence to determine the goodness of fit for this business in the area you want, and for your own capabilities and goals.

    Part III: After signing - Already in place is your team: the professional advisors (accountant, attorney, banker) and a coach/mentor, ideally a senior successful franchisee who has already "been there, done that," seen it all. With their help, hit the ground running!

Franchise Brokers

    Rick Bisio´s book is also strongly recommended by an interesting company in the U.S., a franchise broker, Franchoice. The company operates similarly to a real estate broker. However instead of showing you a number of houses, which are a fit to your lifestyle and budget, it shows you a number of franchises, which are a fit to your “business style” and budget. Similar to a real estate broker, the seller (i.e. the franchisor) pays the commission, not the buyer. Comparable services are also offered by some business brokers. Considering a broker’s services could also make sense for someone outside of the U.S., as a number of quality U.S. franchises have followed McDonalds example of seriously expanding overseas.

Franchise Trade Fairs

    After having educated yourself about franchises, such as by reading the books recommended above (among others), and perhaps talking to a franchise broker, you may want to visit a franchise trade fair. These are held all over the world, Franchise Expo Paris being just one example. This major show is next scheduled for March 18-21, 2012. Some of the largest and best attended ones (also by many foreign visitors) are held in the U.S. An example is the National Franchise and Business Opportunities Show.

Big-Ticket Franchises

    These include ones for a luxury car dealership, a hotel or a multiple location franchise such as Panera Bread. Single unit franchises are not sold by this bakery. Instead you receive rights to a development area where a minimum of 15 outlets would be operated. As of 2008 one needed a net worth of $7.5 million and liquid assets of  $3 million dollars to be considered as a franchisee. 

Granted, the initial license fee for some other big-ticket franchises, such as for a Hilton hotel, can start as low as $85,000, cf. Hilton Development. However the costs of constructing or leasing the property are orders of magnitude larger.

Financing

    Banks tend to like financing a franchisee, especially for a well-known franchise. In this case "well-known" means that a very low franchisee failure rate is credibly documented. In the U.S. the Small Business Administration (SBA) overseas a federal guarantee program of bank loans to start or expand a "small" business (generally, one with less than 500 employees). The SBA has been favorably disposed to the acquisition or expansion of a franchise outlet since at least the 1980s. An interesting aspect of franchises in the U.S., including big-ticket ones, is that they can be financed with a self-directed retirement rollover, sometimes referred to as an ESOP (Entrepreneurial Stock Ownership Program).

    Rick Bisio (op. cit., p.162) explains: "You start by forming a corporation. That corporation issues stock and sets up a retirement plan. Then, the corporation hires you. As a new employee, you roll all or part of your retirement funds into your new employer´s retirement plan and then instruct the retirement plan to purchase stock in the corporation. At this point, the business is now funded with private equity and the stock in the business is legally owned by your retirement plan. Best of all, you are investing pre-tax dollars . . . (This area of law, known as ERISA) is complex and it is important. . . to ensure the IRS is comfortable. There are organizations that specialize in this type of funding vehicle and they are listed in the resource section at www.educatedfranchisee.com."

Commitment

    Committing to a franchise is in some respects similar to committing to a marriage. It is at any rate a life-changing decision.  Taking the right decision avoids another life-changing event, viz. divorce. Franchise divorce can be an amiable parting of the ways, or can turn into as fierce a battle as, unfortunately, hostile matrimonial ones do.

    In Europe for a couple to live together for some years before marriage is not unusual. Most couples do not take it quite as far as a Swiss entrepreneur who founded, among other businesses, a successful consulting company in Zurich. He was particularly good at long range planning – always had been. Upon finding an apartment with his then girlfriend when both were 18, he told her that if their living together worked out, he thought they should marry at 35. True to his word, when they turned 35, after a mere 17 years of living together, he promptly married her. 

    This approach might be a little extreme for “living together” with a prospective franchise. Here “living together” means getting a job at one of the franchise locations. One can spend, say, a summer working there. You should be able to find a franchise operator who likes the idea of getting a highly motivated employee, willing and wanting to do every possible job there for less than the normal wage. You are doing your due diligence – and getting paid for it – and he has an employee who will be an extra set of eyes and ears to give him feedback on various aspects of his business. After working a variety of jobs for a couple of months there, you will have a much better idea of whether this franchise is the right lifetime partner for you.

II. As a Franchisor

Comments on Developing a Franchise System

    Franchising is one way of rapidly acquiring market share. Growing your sales team, either with salaried employees or through reps working on a commission basis is another. If your product line, or services, are suited for “putting people into their own business,” – true for most of what is bought and sold – than franchising may well be worth considering.

    Instead of paying your salesmen a salary or a commission, they pay you an entry fee and on-going royalties. Surely that is a better business model? Theoretically, yes, but there is a significant downside. Hiring (and firing) salesmen, especially on a commission basis, is pretty straightforward. You give them some training and turn them loose, with, of course, on-going support. Some will work out, some not. Over time, you get a team in place of people who are successful at selling for you. The others have fallen by the wayside. Efficiently managing this process is hardly a no-brainer, but it is not rocket science either.

    Developing a winning franchise system is another story entirely. Doing so requires a major strategic effort. What will the business model be? For example, people tend to think that McDonalds is in the hamburger business. That is only half true. The franchisees are in the hamburger business. McDonalds Corporation is in the real estate business. McDonalds wants its franchisees to be very successful selling hamburgers – so that they can pay high rents for the prime commercial real estate from which the franchisee operates. The reason is that in many cases McDonalds Corporation owns that real estate.

    Even after a good concept is successfully launched, managing growth is tricky.  If it is too fast, it will sap the support to existing franchisees.

Beginning the Research

Three "Starter" Websites and Three Books

"Starter" websites

    These three websites were also recommended as for prospective franchisees, naturally perusing them here from a different perspective.

    1) Franchise Foundations is the firm of Kevin Murphy. He is a franchise attorney, J.D. University of San Francisco, who also has an MBA in international business from San Francisco State University. His firm, , has offices in San Francisco and Singapore. The website has solid content, including good articles about international franchising, licensing vs. franchising (beware the horrendous consequences of the "license trap" in the U.S.) and writing an Operations Manual. He is opposed to delegating that work. The real expert in the business, viz. the founder, should do the bulk of the writing, not an expensive franchise consultant (or attorney) who does not know the nuts and bolts of the business. Naturally the document should be reviewed, but that is another matter entirely from writing it from scratch. The site has solid content, including a series of good articles at "Buying a Franchise."

    2) International Franchise Association should be examined.

    3) AAFD, the American Association of Franchises and Dealers, has apparently awarded only nine or ten companies its  Fair Franchising Seal. Why so few, and would it be worth the effort to meet the requirements for the seal for your franchise?

    Three books to consider are:

    1)The Economics of Franchising by Roger D. Blair and Francine Lafontaine, Cambridge University Press, 2005, ca. $50.00.

    2) International Franchising - 3rd edition, Alexander S. Konigsberg, Juris Publishing Inc., 2008, 625 pages, $175.00

    3) International Franchising - (same title, different work!), edited by Dennis Campbell. The two looseleaf volumes comprise 1800 pages; they are a standard legal reference for the 48 primary franchising countries. The second edition is dated August, 2011 and may be purchased at Juris Publishing Inc., $325.

    To treat the first two in more detail, on Amazon.com there is a good review by Stephen C. Long of The Economics of Franchising. An excerpt follows:

            “The U.S. Government quit collecting data on franchising in 1986. The franchise industry has, for the most part, done a poor job of collecting good data. Blair and Lafontaine collect the data, such as it is, which has been reliably produced on franchising since 1986 and reveal four prevalent myths in franchising . . .  (Bridges comment: an egregious case of data manipulation is that for franchisee failure rates. Franchisors will go to great lengths to minimize this statistic and have come up with some imaginative "bobs and weaves" over the decades to do so.)

            This book will be helpful for the person . . . responsible for creating the economic model, i.e., the initial franchise fee, royalty fees and advertising fees. The book won't be much help without a background of college-level introductory macro- and microeconomics. A basic knowledge of calculus will enable you to follow the analyses but isn't critical to understanding the conclusions. The book also critically analyzes the economic issues, which impact franchisor-franchisee tensions.”

    International Franchising by Alexander Konigsberg is well described, including showing its complete table of contents and a brief biography of the author, on the website of Juris Publishing Inc. (linked above). An excerpt follows:

            "(The book) is an in-depth examination of . . . international franchising. Designed for use by the franchise attorney or professional, it is the preeminent work for the (internationally minded) franchisor. . . This work, besides exploring the legal and related business factors . . . offers strategy and analysis regarding the different commercial alternatives or vehicles available to the franchisor (direct franchising, master franchising, development agreements, joint ventures and test-period agreements) and how to avoid and deal with some of the inherent difficulties... Appendices provide important. . . information. . ."

Appendix I – The Origins of Franchising

    The origins of franchising go back to the landed aristocracy in the Middle Ages. Peasants and serfs were granted hunting and fishing rights, and the right to conduct business, for instance at a market or fair, within the aristocrat’s domain. These rights and the rules and obligations associated with them became a part of European Common Law.  

    The impetus for franchising as we know it today came from the U.S. Isaac M. Singer (1811-1875) is credited with developing the first significant franchising system there. Singer, originally an actor, had invented improvements on the existing sewing machine. By the early 1850s his improved model was successful. However he faced two major problems. First, he did not have the funds to increase production. Second, one needed training to be able to use his sewing machines, and the normal retailers were not set up to provide it. Without training, people were understandably reluctant to buy.

    Singer’s innovative solution was to change the business model for distribution. He sold a license that granted the rights to sell his sewing machine in a specific geographical area. The licensee in turn committed to provide the necessary training. The licensing fees provided Singer the funds for increasing production.¹ A few small companies followed suit

    The next major company to achieve massive success with a franchising system was Coca Cola, founded by John S. Pemberton's (1831- 1888). The company sold syrup concentrate to bottlers who were granted an exclusive territory. Like Singer, Coca Cola also had a strong international orientation, rapidly setting up an international network of bottlers with its franchising system. 

    Another early American example is the Western Union telegraphs system, which was franchised (licensed) to the different railroad companies that operated it. Franchising really came to prominence in the U.S. in the food and restaurant industry in the 1920s and 1930s. The forerunners of McDonalds include A&W Root Beer (1921), White Castle (hamburgers, 1923), Maid Rite (1927) and Howard Johnson restaurants (1932). (The dates refer to the year the company started franchising, typically just a year or two after it was founded.) The first service business to be franchised in the U.S. was Arthur Murray Dance Studios (1938/39).

    The development of the U.S. interstate highway system after World War II led to a franchising boom. Fast food restaurants, diners and motel chains followed the interstate, just as in a previous epoch businesses had followed the expansion of the railroad system. The real breakthrough is credited to the success of McDonalds, which spawned untold imitators.

    In 1954 a milk shake mixer salesman became impressed with a hamburger stand in San Bernardino, California. The stand was operated by the McDonald brothers, who had developed a food preparation system that let them produce high volume quickly, with consistent quality – and at a low cost. The milk shake salesman, Ray Kroc (1902-1984) convinced the brothers to hire him as their licensing agent. Ray Kroc began selling franchises in Chicago, and in 1961 bought out the brothers. Today (2010) there are over 30,000 McDonalds worldwide.

    Although the significance of franchising has been steadily increasing in Europe, its greatest impact has been in the U.S. The accounting firm Price Waterhouse Coopers conducted a study that was made public by the International Franchising Association in 2004. In that study franchises were estimated to have employed almost 9.8 million people in the U.S. in 2001. However such national data are always to be viewed with caution. Another U.S. study, for 2010, gives the figure of 7.8 million employed, with over 780,000 franchise outlets accounting for $740 billion in sales. There have been estimates that franchise systems account for almost half of all retail sales in the U.S.²

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