Franchising Your Business to Achieve Sustainability

Michael Seid

Date

Apr 06, 2018

Franchising ensures that when we shop at a locally owned franchise, regardless of where we live or travel, we can trust that our brand expectations will be met. Over 120 separate industries use franchising for expansion today. Even your doctor may be conducting their practice as part of an established franchise system.

Franchising enables enterprising individuals to invest in branded franchise systems and, through hard work and the support of their franchisors, create equity in their business to benefit themselves and their families. The established methods of designing and supporting a franchise system enable independently owned and operated businesses to deliver a consistent, sustainable and replicable brand promise to their customers.

Whether in the clouds or in the strip center next to the grocery store, brands in every industry compete not only with the quality of their products and services, but on how well they deliver consistently on their brand promise. Brands sustain themselves based on how well they know what their consumers want, and how they innovate as consumers’ preferences change.

It is our ability to trust in a brand that makes franchising work. It is also – when franchisors don’t structure and support their systems properly and don't deliver on their brand promise to franchisees – why franchise systems frequently fail.

Examining the Causes of Franchise System Failure

It's estimated that around 300 new franchise systems start up each year, yet the total number of active franchisors does not seem to grow at that same pace. Yet many of the 300 emerging brands might not be offering franchises – or even exist – in three to five years. Why is this, when most active franchisor members of the International Franchise Association produce remarkable and sustainable growth?

When done right, franchising is a fabulously strong powerhouse for sustainable expansion and the creation of equity for both franchisor and franchisees. It is, therefore, important to understand why some franchisors fail or do not perform as expected.

Most companies that decide to explore franchising have done well enough locally to achieve some level of consumer success. It is their local success, and the interest of potential franchisees, that leads many business owners to the idea of franchising their businesses. Given the number of potential franchisors that approach MSA Worldwide for advice, the primary reason for franchise system failure is likely that many new franchisors enter into franchise development earlier than they should:

  • Many don't have sufficient resources to develop a proper franchise system or sustain their growth.
  • Some lack the unit economics necessary to support the required fees and still allow for a proper return on investment by the franchisee operator.
  • Often, the emerging franchisor’s main focus is on growing the brand with little real understanding of what it takes to support a franchise system.

Recruiting franchisees to join a franchise system is relatively easy. But while franchise system growth may be relatively easy, sustaining a franchise system is not. Achieving sustainability starts early in the planning stage, and shortcuts are anathema to sustainability.

MSA has worked hard to build our reputation through expertise and client performance, and is considered by the International Franchise Association to be “the leading strategic and tactical advisory firm in franchising.” While the core of our practice is the design and development of franchise systems for small companies, we're fortunate to also advise many of the largest franchised and non-franchised brands because. We also wrote Franchising for Dummies, recognized as the best-selling book on the subject.

What's alarming is how frequently, when we recommend to a potential client that they delay starting a franchise until they are better situated to establish a successful franchise system, we discover they have already found a franchise packaging firm or lawyer to create a franchise system for them. In tracking the progress of these new franchisors, the number that are no longer offering franchises or have started to lose their existing franchisees is quite high.

Such system failures are not unexpected – there are no legal requirements that a company must meet to become a franchisor, and that is a double-edged sword. Sometimes these franchisors can overcome obstacles because of their product/service offering or management capabilities, and survive to develop into great franchise programs. More often, though, those obstacles – evident at the start – create critical issues that time and proper planning could have prevented.

The Most Avoidable Mistake in Franchise Development

Based on our extensive experience in working with established franchisors, the single most avoidable mistake causing franchise system disruption is often baked into the system from the start: Not enough time and intellectual capital is spent in determining whether or not to franchise in the first place. Then, in an effort to keep down the cost of developing the franchise system and quickly offer franchises, these emerging franchisors avoid the hard work of properly developing the underlying system strategy by working with a franchise packaging boiler-room shop and rushing directly into the development of their franchise agreements.

There are myriad serious issues that need to be considered in designing any franchise system, and the decisions reached will be different for each franchisor, even within the same industry. Each company in some way or another is unique, due to culture, products/services, costs, franchisee profile, locations, competitive set (including maturity and density), pricing strategies, methods and style of customer service, even the reasons for becoming a franchisor. It is not sufficient for the offering documents to be attractive to franchisees, when the purpose of the franchise system is to sustain the growth and support provided to franchisees.

Working with Qualified Franchising Counsel

A body of law has grown up around franchising at both the federal and state level, and as it relates to wages, locally in some cities and states. Likely this is why many potential franchisors often start their exploration of franchising by working with their lawyers. But business lawyers view franchising through the regulatory lens first, and often fail to understand that while a Franchise Disclosure Document (FDD) is necessary to offer franchises, merely meeting the regulatory burden is not sufficient to become a successful and sustainable franchise system.

Most experienced franchise lawyers recommend that before developing the franchise legal documents, their client engages an experienced franchise consulting firm. Franchise law is fairly straightforward, but for the underlying legal agreements to be beneficial to both the franchisor and its future franchisees, good franchise lawyers require that the terms of the franchise offering be based on the client’s business realities and the requirements of operating a solid franchise system, and not simply on what some other franchisor has been doing.

Steps to Becoming a Sustainable Franchise System

1. Become Educated – Study up on franchising

In addition to reading Franchising for Dummies and Franchise Management for Dummies, there are articles, presentations and online courses you can take on the International Franchise Association’s (IFA) site at www.franchise.org. MSA Worldwide's website provides a franchise library of detailed articles. Becoming educated on franchising is essential before you start developing your franchise system.

2. Check Your Math – Exercise – Are you really a candidate for franchising?

Surprisingly, there is no financial threshold for legally franchising your business. You can even franchise a concept that has never existed. And securing a few initial franchisees is relatively easy, regardless of the concept or its economic performance. What is difficult is designing a sustainable franchise system that has the potential to grow. While you may ultimately want the assistance of a professional advisor to determine whether or not you are ready to begin to develop a franchise system, before you make that call, check the math yourself.

  • Start with the investment you made in developing your last location. Not just the capital costs; every penny you spent on construction, equipment, licenses, fees, grand opening marketing, professionals, inventory, deposits, insurance and working capital needed until you broke even. To that number, add some franchise-related costs, starting with franchise fee, staff salaries required during training, and the cost of staying in a hotel and living expenses during training. For the sake of discussion, if we assume an average franchise fee of $35,000 (and in the real world, average franchise fees don't matter) and add another $15,000 - $25,000 for other franchise-related incidentals, you have a rough and quick approximation of your franchisee’s initial investment, suitable for the purpose of checking your math.
  • Now take your most recently opened location (if that is going to be the basis of your franchise offering) and project a five-year financial performance for that location without any franchise-related costs. Don't forget to burden the location with the full cost of a unit manager, even if you operate your business without charging that to the location today. Back out depreciation and amortization, interest and taxes (EBITDA – earnings before interest, taxes, depreciation and amortization). From that number, deduct some franchise-related fees and costs including continuing royalty, brand fund contribution, licensing fees for your POS and IT system (if any), any increase in cost of goods based on income you may earn from the sale of inventory to franchisees, charges you may impose for a landing page on your website, etc. For the sake of this exercise alone, let’s assume that these continuing franchise-related costs are approximately 10% of the location’s gross sales.
  • Now calculate what your debt service on the initial investment would likely be if the franchise invested 25% of the required capital and borrowed the other 75% at approximately 6.25% interest. Based on this very rough, down and dirty calculation, you can assess the estimated cash flow and return on investment for the franchise. If the recast business cannot support the debt service and does not allow for a reasonable return on the franchisee’s cash investment (after the cost of the manager’s salary), then you are likely not a candidate for franchising.

If you are a candidate, congratulations!

If not, it doesn’t mean you should not still consider expanding your business; franchising is one method of growth, and you may still be a very viable candidate for expansion using another method.

3. Prepare for Franchise System Development – Document your operations

Before you start the design and development of your franchise system, prepare by capturing all of the information you will need in your franchise operations manuals and training program. These are an essential part of every franchise system, because it is through the manuals and training programs that you can set standards and evolve the business as required. The manuals and training program will also be essential to your lawyers, as there is a legal requirement to disclose information about each in your Franchise Disclosure Document.

In a franchise system the term “operations manual” is generally used to describe a series of manuals or a manual library. Each functional area in a franchise system, over time, will require a manual to define how you want your company to operate. For new franchisors, two manuals are usually essential – a Start-Up Manual and a Unit Operations Manual.

  • The Start-Up Manual takes your new franchisee from the site selection, development, and approval process through the opening of their business.
  • The Unit Operations Manual provides your new franchisee with the standards required by you the franchisor in operating their business, and other practices that you recommend but which may not be mandatory.

When capturing the information for your future manuals and training program, don't worry about the format or the franchise-related information as, in most instances, a professional manual writer and training developer will be providing you with assistance later on in the process.

Capturing all of the necessary information can be a daunting task, because when we do things routinely, we rarely need to think about each step. But this won’t be the case for your new franchisees and their staff; they won’t have your level of knowledge and experience. The manuals will be their reference guide, providing the information they need to operate their business to your standards.

  • A good consulting firm that also writes manuals will be of significant assistance in finalizing the information you gather into a manual; not only must your standards be clear, but manuals and training programs also need to avoid vicarious liability and claims of joint employment later on. In addition, where the franchise agreements refer to the manuals, a qualified consulting firm can verify that the necessary information is there and is accurate.

In addition to manuals and training programs, think ahead about what else your franchise system will likely need: architectural drawings, demographic information about where your units do best, the requirements of your supply chain, the adequacy of your IT/POS system, changes to your consumer website, etc. When it comes to human resource matters for your franchisees, remember that in franchising, the employees of the franchisee don't work for you, they work for the franchisee. In order to avoid joint-employment and vicarious liability concerns, in most instances you will not establish HR policies and practices for your franchisees.

Don’t spend any time yet on determining your franchise fees. Developing the franchise fees will come later, after you have determined the structure of your franchise program and how you will support your franchisees, have gathered information on the system economics for the franchisor and franchisee, have analyzed the market to determine system growth and geographical dispersion, and have determined how you want to position the franchise, among many other considerations. Your franchise consultant will assist you with these recommendations later on.

4. Engage Qualified Franchise Professionals

Take your time when choosing a professional advisor. Talk to franchising insiders you know to create a list of professional franchising advisors with a great reputation. While price is always a consideration, professional fees should never be the determining factor in developing your franchise system; the structure of your system and resulting legal documents have long-term and critical implications for whether you meet your goals for success. Select the best professionals; it will pay dividends in the long term.

If you don't know any franchising insiders, go to the International Franchise Association’s supplier section at www.franchise.org. You can also ask to be connected to the IFA membership department, and they may be able to recommend a member company that can assist you.

The first professional to connect with is a franchise consultant. The consultant is the firm that will assist you in designing and developing your franchise system. They will assess with you and your decision to franchise, determine your strategy and the terms of your franchise offering, work with your franchise lawyers in developing your legal documents, and most will also be able to write your manuals and assist you in structuring the marketing of your franchises.

The next professional to engage with is a qualified franchise lawyer. Most franchise consultants can provide several referrals, and are your best resource for selecting an attorney with enough experience to work with you. During the engagement, your consultant should recommend at least three franchise lawyers for you to interview.

It's important that you engage your lawyer directly, and don't allow the franchise consultant to prepare your agreements:

  • Since franchise consultants are not lawyers, it is illegal for them to practice law without a license, even if the franchise consultant has a lawyer on staff. That is called Corporate Practice of Law and is not allowed.
  • You need client confidentiality with your lawyer, and for that reason need to engage your lawyers directly.
  • A qualified franchise lawyer can provide a great deal of business advice when reviewing the franchise consultant’s recommendations.

Most franchise consultants look to qualified franchise lawyers to push back and question their recommendations, as there is frequently more than one way to do things in franchising. Just as the franchise consultant, in reviewing documents prepared by the lawyers, will question language inserted by the lawyers into the disclosure documents and agreements, a good franchise attorney may also make recommendations to changes to some of the strategies developed by your consultant. Good lawyers and consultants work as a team, and professionals enjoy the interplay when it benefits the clients.

Use Caution When Choosing Your Franchise Consultant

Unfortunately, there are currently three types of companies that call themselves “franchise consultants”:

1. Franchise Sales Brokers. Franchise Sales Brokers started to refer to themselves as “consultants” several years ago when “franchise broker” had picked up a relatively bad reputation. There are many good Franchise Sales Brokers; however, while some may offer development services, they are not a good source of development advice because their major income comes from selling franchises. Your goal is a sustainable franchise system that will reward you in the long term, whereas the Broker earns their income from commissions received by selling franchises quickly. This conflict of interest can be very damaging to your franchise system.

2. Franchise Packaging Firms. A Franchise Packaging Firm is a one-stop shop that provides you with everything including the legal documents. Some Packagers get around the fact that they are not lawyers by asking you to have your general attorney review the legal work their staff prepares and to sign off on the Packager’s work product. But since your general lawyer is not a specialist in franchising, the capability for them to do this type of review is generally outside their level of expertise.

Most Franchise Packaging Firms offer limited strategic services and, surprisingly, use this as a selling feature. Their claim is that to minimize your costs and development timeline, they won’t 'bother' you with any strategic documents, and instead will provide you with just a bullet-point presentation of their recommendations. Their message is that all franchises are basically the same and why waste a lot of time on strategy when, if you avoid the time strategic work takes, you can be selling franchises a few months earlier. But in reality, franchise systems are not fungible; each needs to be carefully designed.

Your lawyer would be relying on the Packager's business recommendations in drafting your disclosure document and franchise agreement; a bullet-point presentation is not adequate. Franchise Packagers' shortcuts can create significant problems for the franchisor long-term, because Packagers' recommendations are general and not focused on your particular brand or system. Many critical decisions, once made, can’t be fixed through simply editing your operations manual down the road. Strategic system design is essential, if you are going to succeed as a franchisor.

Packagers are also notorious for selling to you (directly or indirectly) services that most emerging franchisors do not need or want when they start their franchise program. Generally these services can also be provided by more specialized professionals, and often the Packager recommends firms that pay them commissions for the introduction, or may even have an ownership interest in the firms they are recommending to you.

3. Franchise Consultants. Professional Franchise Consultants act as the quarterback of the development process, ensuring uniformity of the franchise offering and system from franchisee recruitment through franchisee support, development of the legal documents to the drafting of manuals, training programs, field support materials, etc.

Franchise Consultants generally start every engagement with a client by assessing whether or not franchising is the proper expansion method for the company. In addition to properly advising a client about franchising, most professional franchise consulting firms have extensive experience in working with other methods of expansion. This capability enables them to look to the best interest of the client without considering that if they don't franchise, they may lose the assignment.

Professional consultants focus first on requirements for replicating the emerging franchisor's brand experience at the unit level. By first defining the brand experience that the company wants each consumer to experience, the consultant is able to determine what support services will need to be provided, based on a determination of the classes of franchisees that may be included in the franchise system. This begins the process of fine-tuning the classes of franchisees that may be included, and enables the consultant to run extensive financial models to ensure that the fees charged will be affordable to the franchisee while providing the franchise system with the revenue it requires to execute a consistent, sustainable, and replicable system.

Only after the requirements necessary to support the unit franchisee are determined, can the franchisor define the costs they will incur in providing those services. This enables them to develop the terms of the franchise including the fees, length of franchise term, manuals and training required, support necessary, other obligations of the franchisor, and each class of franchisee in the system. Out of this work comes a Gap Analysis to determine those elements that the franchisor may already have, those that need to be developed from scratch, and those that may exist at some level but which require modification or further development.

Finally the franchise consultant delivers, generally at several points in the engagement, their strategic recommendations for review and comment by the client. Once strategic recommendations are discussed and changes have been made, the final written scope of the franchise offering enables the emerging franchisor to visualize how their system will operate. This work product then goes to the lawyers for development of the franchisor's legal documents; to the manual and training professionals to begin development of manuals and training programs; to franchise recruitment professionals to develop the tactics necessary to successfully market the franchise opportunities; to web designers who will now know the classes of franchisees being targeted and the features of the system to highlight; to intranet providers as the needs of the system related to online manuals, training, supply chain, development and support will be known, etc.

Other outside professionals may be required or recommended whose work products, like the lawyers’, will be based on information provided by the franchise consultant. Professional franchise consultants will know several firms in each industry they have worked within the past, and will introduce them to you so that you can have a direct relationship with that provider, without any mark-up or profit motive by the consultant.

After all the pieces are in place, it's the role of the franchise consultant to remain for a time with the client to ensure they can effectively market and operate their franchise system, and sometimes to make adjustments to the strategy based on the real-world experience of the franchise system.

Don't Rush Development of Your Franchise System

The franchise development process can take up to six months to complete, and it may be another year before your first franchisee opens their first location and begins to pay you royalties. To achieve long-term success with your franchise system, it's essential that you take your time with the system development process.

A company that is insufficiently structured and managed cannot expect to prosper in the long term. It is important that you don’t rush, and that you take the time necessary to plan, so that you can become an effective franchisor able to support a growing franchise system. Shortcuts may allow you to offer franchises more quickly; but when you talk to experienced franchisors, they will tell you how expensive and disruptive those shortcuts were for their franchise systems. After all, you are investing in developing a system for the long haul – shortcuts that shortchange the process may be the most costly mistake any new franchisor can make.

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