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© 1985-2010, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
Author Lloyd Tarbutton states the first chain concept began early, around 200 B.C. in China. The franchise concept perhaps started even earlier when rickshaw drivers were granted routes, the earliest form of a protected territory.
Credit for the first company to franchise in a more traditional business sense is the Singer Sewing Machine Company. In the 1850’s, short of cash, the young company could not afford salaried salesmen. It established a network of franchised dealers instead. The dealers paid an upfront fee for territorial rights and $65 for all sewing machines purchased for resale.
This was the first example of what is called a product franchise where distribution and sales of a product line are primary. In a business format franchise, like McDonalds, the look (trade dress) and uniformity of all business operations is specified. In a business format franchise, a franchiser supplies techniques, or other intellectual property assets (such as the brand) and various services, instead of complete products. The business format franchise, like McDonalds, may provide production and distribution services, and resembles a product franchise. However, its primary role is careful development and control of marketing strategies.
In 1898, two other young companies, General Motors and Ford Motor Company, also lacked capital to open retail outlets. Instead of capital, they used a network of franchised product dealers to buy, sell and repair automobiles. Henry Ford’s assembly line mass production techniques transformed a high-priced luxury item, into a cars that was affordable for everyone. His assembly line mass production techniques were applied in other industries. This accounts for America’s meteoric rise to become the world’s number one economy, a position it enjoys to this day, but even that is slipping away.
One year later, in 1899, two attorneys, Thomas and Whitehead, obtained a free, perpetual license with a simple 600-word contract, to sell a beverage known as Coca-Cola in bottles. Invented in 1886 by John Pemberton, Coca-Cola was sold in soda fountains until the attorneys promised to to achieve even greater distribution and reach an entirely different consumer base by opening a bottling plant. Just like the McDonalds franchise chain that arose decades later, their optimistic vision was not shared or embraced by Asa Chandler, the founder of Coca-Cola. He decided to keep the focus of Coca-Cola’s energy on the exploding growth in soda fountain distribution. Chandler was also wary of the emerging bottling business with its attendant health and safety issues. He believed if the attorneys were lucky enough to succeed, his company would sell a lot of the proprietary syrup at $1 per gallon. If not, the attorneys would be out of business with no down side to the Coca-Cola Company. Chandler thought he had the classic win-win strategy in his pocket.
In 1901, without the capital to establish their own bottling plant, the attorneys came up with an innovative solution. They awarded product franchises for bottling plants also based on assembly line mass production techniques. Even though the Thomas-Whitehead partnership (like most partnerships) shattered within a year, their idea was a huge success. By 1919 there were 1,000 franchised Coca-Cola bottlers. Thomas and Whitehead created the bottling franchise prototype that brought Coca-Cola to the masses.
Harlin Sanders, born in Indiana, wore many different hats, including practicing law in Little Rock, Arkansas, where no law degree was required at the time. The time spent arguing legal matters produced another talent that parlayed into another job – being an actor. In addition to attorney and actor, his other jobs included railroad fireman, street car conductor, steamboat ferry operator, selling insurance and tires, A chance encounter with Standard Oil Company led to an entirely new career – ownership of a service station.
In the Depression of the 1930’s, Harlin Sanders operated his Standard Oil gas station in Corbin, Kentucky. The main petroleum industry players operated company-owned gas stations, but quickly converted to the franchise model in the 1930’s to escape a national tax on company-owned locations. Franchise ownership also proved to be a quicker way to repond to price changes by independent gas stations. Franchise owners could make instant decisions.
To earn a little extra money Sanders served meals to hungry travelers in a converted back room kitchen of his gas station. He used a 15 square foot storage room that only had room for a table and six chairs. After his tasty chicken became legendary in the region, Governor Ruby Laffon made him an honorary Kentucky Colonel in recognition of his contribution to Kentucky’s cuisine. With this significant boost, the Colonel closed his gas pumps and proceeded to open a 142-seat restaurant featuring his moist and tasty finger-lickin’chicken.
In the early 1950’s, he turned down a $164,000 offer for his restaurant. Things were going so well the Colonel anticipated a prosperous retirement a few years away, funded by the increasing profits from his eatery. Then, in 1955 his business was destroyed by construction of a new Interstate highway that took all traffic seven miles west of his restaurant. The Colonel had to auction his property. The same day, he received his first retirement income – a social security check for $105. At the age of 66, the Colonel from Kentucky knew he couldn’t rely on social security. He began to think seriously about franchising.
In 1956, retired and bust, the Colonel traveled the long highways of Kentucky, Indiana and Ohio. Being a good salesman, he persuaded restaurant owners to sample his chicken. If they were interested after the meal, he taught them his cooking techniques in exchange for a royalty of five cents for all birds cooked using his methods. Business boomed at these restaurants after the Colonel’s instruction. Soon, people began approaching the Colonel, eager to open an outlet. The Colonel’s traveling came to an end. He managed the new franchise company with his wife from their home in Shelbyville.
Initially, all KFC franchises were full-service restaurants. Then, the Colonel’s daughter, Margaret, formulated the vision of the “Nothing But Chicken To Go” model. The Colonel, initially skeptical of the plan, gave Margaret exclusive KFC rights in Florida as a present on her 47th birthday. A year later the first stand-alone, take-away KFC was born. The less overhead, less square footage and higher income locations set the standard for future KFC’s. Much more profit could be made selling buckets of chicken at a low price, than from extensive menus, large locations and managing numerous employees. Full-service KFC’s were converted to take-aways, and the investment required to open the new KFC model was considerably less. This stimulated demand for KFC franchises.
By 1960, there were 200 franchised KFC outlets earning $100,000 per year. By 1963 this number climbed to 600 franchised outlets earning $300,000 per year. At the 600 outlet mark, the Colonel managed his growing franchise empire from an office he built behind his home, with 17 full and part-time employees. By 1980 the KFC chain mushroomed to 6,000 franchised outlets. Today there are over 10,000 KFC locations.
In 1940, no resident of San Bernardino, California dreamed the new McDonalds hamburger stand would be the genesis of a franchise chain that would change the eating habits and perceptions of customers throughout the world. Inspired by Henry Ford’s assembly line, brothers Dick and Mac McDonald, were the first to apply his mass production techniques to a service business. The outstanding results of their prototype catapulted the brothers to a level of wealth and prosperity they’d never dreamed of. They lived in a large estate overlooking the San Bernardino valley, earned $70,000-plus a year, a huge amount in those days, and owned two Cadillac luxury sedans. The McDonald brothers were happy and entirely content with their lifestyle. They had absolutely no aspirations or inclination for franchising.
Then paths crossed when an astute salesman named Ray Kroc visited their location in 1954. He wanted to see why a small hamburger stand ordered eight of his company’s milk shake multimixers, capable of blending five milk shakes at one time. Why, Kroc wondered, did such a small establishment need to produce forty milk shakes at a time? He found the McDonald brothers doing a remarkable business selling only hamburgers, french fries, and milk shakes.
Kroc, an outside-the-box thinker, was very impressed with the San Bernardino prototype and realized its potential for franchising. He sold the McDonald brothers, who did not share his franchise vision, on charging him with franchise responsibilities. As Kroc would later say, salesmanship is “the gentle art of letting the customer have it your way.”
After further refinements to the business model that included charting procedures, defining recipes and establishing uniform standards, Kroc achieved a level of standardization, trade dress and brand appeal that would create fortunes for the company and its future franchise partners. He opened the first of the chain of McDonalds restaurants on April 15, 1955, in Des Plaines, Illinois. On that first day, Kroc’s restaurant had sales of $366.12, less than a twentieth of the average daily sales of a McDonald’s restaurant today. By 1957 there were 37 locations; in 1959 the number increased to 100; by 1971 the chain numbered 2,500 locations. McDonalds went on to become the world’s largest chain of fast-food restaurants with over 31,000 locations in 120 countries worldwide. For information on how to buy a McDonalds franchise, applying for a franchise, obtaining the McDonalds FDD and details about the McDonalds franchise program, visit the McDonalds Franchise page of our website.
While franchising allowed chains like McDonalds and KFC to grow to thousands of locations by the early 1970’s, other chains that elected to go the company-owned, company-financed expansion route posted less than enthusiastic results. For example, the IN-N-OUT burger chain, started in 1948 but 25-years later only had only a dozen locations by 1973. Compare this performance to late ar-rival Burger King, which started franchising in 1961, and grew to 800 locations in 10-years by 1971. Fast forward to 2002 when Five Guys Burgers started franchising. In their first 10-year span, they developed a chain of 1,000 franchises open and another 1,500 under development by 2012.
These later chains did not try to preempt the leader, McDonalds, as the Mighty Mac owns the word “burgers” in the customer’s mind. Instead, they adopted classical ways to position themselves against the leader. Burger King, for example, realized early on it had to settle for being number two. So it attacked the Big Mac where it was weak, on two fronts, in classic number two competitive style. Its “Broiled, Not Fried” and “Have It Your Way” campaigns were a huge success. McDonalds could not economically replace all its fryers with broilers. Unfortunately, the success years fed Burger King’s ego and it changed gears, trying to act like it was number one – with predictably disastrous results: seven CEO’s in 11 years, franchisee and shareholder dissent, etc. But that, as they say, is another story.
McDonalds, besides its ubiquity, constantly demonstrates it’s strategic planning ability. Consider McCafé, the brainchild of Charlie Bell, the late McDonald’s President-CEO. He opened the first McCafés more than 20 years ago in his native Australia, then took the concept international when he moved to McDonalds U.S.A. Visitors to a McCafé find 11 kinds of coffee and tea, hot chocolate and mineral water.
McDonalds realized it’s initial market for McCafé was overseas, and the concept is in 33 countries so far. McCafés are all over Australia (406), ramping up fast in Germany (306) and just starting in Japan. Fifteen McCafes debuted in and around Tokyo in late August of 2007. About one in every four McDonalds in Germany includes a McCafé area. Five hundred McCafés are planned in Germany by 2008, and between 600 and 700 by 2011.
In Germany, McCafé is the market leader in coffee shops. Its biggest competitor, Starbucks, opened in Berlin in 2002 and now has 98 outlets, less than a third the current number of McCafes.
It was only a question of time before McDonalds decided its McCafé concept was ready for the U.S. market. McDonald’s is now pushing a nationwide expansion of the McCafe band name. The stratgegy was adding its espresso coffee drinks at existing McDonald’s restaurants across the U.S., so a Big Mac and a latte can be ordered at the same time. After all, a customer has to order some kind of beverage to go with their meal, and beverages are where the real profit is made. So the line extension made sense here. The expansion of the McCafe concept signaled the Mighty Mac’s desire to pursue the $12 billion specialty coffee market segment and grab a piece of the $60 billion coffee industry. By the end of March, 2009, McDonalds announced more than 7,000 (a little more than half) of U.S. McDonalds restaurants are selling the espresso-based drinks that include hot mochas, cappuccinos and lattes as well as iced coffees and mochas. The Mighty Mac says it is on tract to meet its mid-2009 deadline to have them in all U.S. restaurants. The next phase will be adding smoothies and frappes to the beverage mix. According to McDonald’s CEO Jim Skinner the McDonald’s goal is to become a “beverage destination.” Probably a very over ambitious goal – see McPizza and McKids discussed next.
Even the mighty giants make mistakes. McDonalds added McPizza to the menu board in the late 1980’s and early 1990’s, falling into a classic line extension trap (“we’re known for burgers, so let’s extend our brand to pizza.”) Probably sounded like a good idea at the Board meeting, but customers were not impressed. “How can a burger place know anything about making a good pizza” was the likely mental reaction when seeing McPizza on the menu board. McDonalds owned “burgers,” not “pizza” in the mind of customers. Customers will give you what made you famous, but no more. McDonalds finally realized this and abandoned McPizza. But it still had a crush on pizza, and we all know how difficult it is to give up a crush, even when we’ve been slapped in the face countless times. The Mighty Mac acquired the 182-restaurant Donato’s pizza chain in 1999. A different brand selling pizzas was definitely a better strategic move. But in 2003, McDonalds sold controlling interest in Donato’s back to the original founder, Jim Grote, for an undisclosed sum. The Mighty Mac wanted to refocus on its core business. As then CEO Jim Cantalupo remarked, the sale was consistent with their new priority to “do fewer things better.” Good idea.
And yet another failed line-extension attempt. In 1987 McDonalds launched its McKids clothing line, sold through Sears, Roebuck & Company. Sears dropped the line in 1991 after sales never hit projections. Wal-Mart picked up the McKids line in 1997, but dropped it in 2003. Lesson: trying to do more things better doesn’t work; go back to your basics and focus.
By the late 1960’s the success of business format franchise companies including KFC and McDonalds were well known and hailed in the press. KFC is credited with creating hundreds of millionaires through its franchise program, and McDonalds produced at least as many of the new wealthy. All this success legitimized franchising and fueled the fantasies of aspiring as well as existing entrepreneurs. Adding fuel to this fire was the growing impact franchising has on the U.S. economy, now accounting for over 40% of all retail sales.
Franchise companies sell the concept of a powerful formula they have developed, along with a catchy name, uniform operating standards, and ongoing, as-needed support. For an initial franchise fee plus ongoing royalty payments, the franchise owner receives instruction in the company’s proven business system, assistance in selecting a site, and help building a duplicate of the successful prototype. Initial training is provided, along with varying forms of ongoing consultation and advice. Over time, economies of scale develop, enabling volume purchasing power and extensive media advertising.
The fast-food chains – including the McDonalds and Kentucky Fried Chicken – symbolize the explosive growth potential of the franchise model. Companies can expand from a single location to dozens within a few years. And hundreds (even thousands) within a decade. This mega-growth is possible because franchise owners provide all expansion capital, assume all operating and management responsibilities, and shoulder virtually all risk. Franchising is expansion using “OPM” (Other People’s Money).
In addition to being a most economical way to open identical units quickly across the country, franchising offers substantial and highly profitable revenue streams. These are usually initial franchise fees as well as ongoing royalty payments. Sell ten franchises with an initial franchise fee of $40,000 and the company makes a quick $400,000 in revenue. Sell twenty and revenue jumps to $800,000.
On the expense side of the equation, a franchise company only needs a limited number of personnel to sell franchises and then provide initial training and ongoing assistance. Most of this work is at the initial stages – training and helping the new franchise owner get up and running. As franchise owners learn how to operate the business, they require less and less attention. Yet they continue to pay an ever-increasing sum to the parent company as a royalty (the second revenue stream) based on a percentage of their growing, gross sales. This places franchise companies in the enviable position of earning more and more, for having to do less and less.
A study of the disparity in profitability between operating company owned vs. franchised locations by a mature fast-food franchise company discloses the bottom line franchise profitability advantage:
No. of Units 1,550 restaurants
Revenues $1.69 billion
Expenses $1.42 billion
Pre-Tax Profit $270 million (16%)
vs. Operating the Franchise Company
No. of Units 4,550 franchises
Revenues $486 million (royalties, etc. paid to the franchise company)
Expenses $ 78 million (incurred operating the franchise company)
Pre-Tax Profit $408 million (84%)
Operating 1,550 company owned restaurants, the company begins with much greater revenues ($1.69 billion), but ends up with significantly less, both in total dollar profit ($270 million) and margin. The royalty, franchise fees and other revenues generated by its 4,650 franchise owners and resuls in $408 million in bottom-line profit for the franchise division.
To the business community the message about franchise profitability is loud and clear. Why assume the debt, administrative headaches and ongoing cost of operating company-owned locations that make 16% profit, when more money can be earned at 84% profit? On top of this, on the franchise side only a fraction of personnel are required, utilizing only brain cells to provide management consulting advice. Jack In The Box was entirely company-owned until 1980 when it saw the franchise light. The chain now has over 1,000 units. Increasingly, business owners are jumping ship with their company owned locations, selling them to franchise owner-operators. They’re getting out of the trenches and becoming highly-paid generals overseeing their franchise soldiers.
Two major reasons for the franchise profitability disparity were mentioned. First, franchise companies find themselves in the enviable position of earning more for doing less because most of their work is finished after the franchise owner is trained and matures a bit in operating the business. Second, a franchise company can manage a large number of franchised locations with a skeleton team of training and support personnel, and few significant operating expenses.
For example, in 1963, Colonel Sanders managed 600 franchised locations from a home office built in the back of his home. He employed 17 full and part-time persons. Kumon U.S.A., Inc., a learning center franchise with over 900 operating locations, is able to fulfill its management responsibilities with 9 persons (source: Kumon’s 1998 Uniform Franchise Offering Circular). Another fast-food player, Carl’s Jr. has a management team of 19 individuals managing its 1,000 = plus quick service franchised restaurants (source: Carl’s Jr. 2000 Franchise Offering Circular).
Not to be outdone, the Mighty McDonalds has a franchise department with only 50 persons overseeing more than 25,000 franchised locations. Comparing franchised vs. company-owned, it takes more than 850 employees to run the Mac’s 6,500 company-owned restaurants. Quite a difference in people power and administrative headaches. This explains the trend with many franchise firms, including McDonalds, in altering their dual-distribution strategy. They are selling off company-owned outlets as “turnkey” franchises, using a healthy multiplier of gross sales or net profits to determine the selling price, and focusing on the more lucrative, franchise management consulting side of operations.
What a franchise company does is provide management consulting advice on an as needed, diminishing basis. Management consulting firms in general have very high profit margins due to low operating expenses and no cost of goods sold. These advantages are compounded even further in a franchise environment. Initial franchise fees, for example, tend to be highly profitable. A company charging an initial franchise fee of $40,000 only needs to sell 20 franchises to generate an immediate $800,000 in income, with comparatively limited marketing expenses. As franchise owners open and learn business operations, the increasing stream of continuing royalty payments over a 10 to 20 year period creates an lucrative annuity that vastly exceeds the amount of the up-front initial franchise fees.
In the fast food industry, for example, a franchised restaurant generating only $500,000 in sales (less than one-fourth the sales of a typical McDonalds restaurant) pays the franchise company a 5% royalty of $25,000 per year. Over 20 years, that amounts to a staggering $500,000 for each and every franchise in the network. And this total is likely to be much higher given yearly increases in sales volumes as well as C.P.I. (consumer price increase) adjustments over the 20-year period. So, franchise companies enter into millionaire (or quasi-millionaire) financial relationships with each and every franchise member brought into the network.
Considerations other than franchise profitability also factor into the decision to use what is called “dual distribution” – the penetration of markets by a mix of both company owned and franchised units. The company owned units test ideas, build market demand and brand awareness, while developing system-wide standards and uniformity. The franchise owned units lead to rapid market penetration as well as innovation.
Some of the best, new product lines and ideas in many franchise chains originate from their franchise operators, such as the Filet-O-Fish, Big Mac and Ronald McDonald in the McDonalds chain. And the Bucket of Chicken by KFC’s first franchise owner, Pete Harman. A dual distribution strategy produces a whole that is greater than the sum of its individual parts, allowing the entire network to quickly adapt to opportunities as well as threats.
Large, established franchise chains are heeding the message as well. Refranchising and conversion franchising are strategies increasingly utilized by the big players in the franchise industry. 7-Eleven, a franchise chain operating more than 31,500 company owned and franchised stores worldwide, decided to become fully franchised in the U.S. It implemented a franchise conversion program in 2002 to sell all U.S company-owned stores as turnkey franchises. Yum! Brands, which operates and franchises KFC, Pizza Hut and Taco Bell announced in December, 2007 it will reduce its company owned restaurants by 50% in the U.S. by 2010 by refranchising them. For several years, Yum has been selling off hundreds of its U.S. restaurants to franchise owners. Refranchising improves profit margins because the company collects more in franchise fees and royalties without having to operate the units. The new franchise owners also pay for the value of an existing unit with an established track record and customer base, which can be a very substantial amount, running into hundreds of thousands or (in the case of major players) millions of dollars. In April of 2008, CKE Restaurants, Inc., which operates Carl’s Jr. and Hardees restaurants, announced a strategic refranchising program. It quicky jump started this program by selling more than 60 of its company owned restaurants as franchises. For persons interested in a McDonalds franchise investment, the most frequently used option is buying a company owned McDonalds or an existing franchise that’s up for sale by a franchise operator. In late 2007, McDonalds announced plans to sell 21% of its 7,000 company-owned McDonalds restaurants as turnkey franchises over a three-year period.
One day, sub sandwich shops like Subway and Quiznos are operating comfortably in their $21.2 billion non-burger sandwich market. Then along comes a sudden wake up call: Domino’s Pizza announces plans to roll out a line of four oven-baked sandwiches for delivery with (or even without) pizzas from its 5,000-plus U.S. locations. Overnight Domino’s becomes the largest sandwich delivery company in the nation. By the end of 2008 Domino’s announces national side-by-side tasting tests – the pizza chain’s sandwiches taste better than Subway’s. According to Domino’s CEO David Brandon, “. . .the margin of victory was overwhelming even to us.” In a sour economy where pizza sales are not growing, the pizza chains look for another menu item that will. Pizza Hut began delivering baked pasta dishes as well as pizza five months before Domino’s jumped into the fray. It also delivers sandwiches regionally. Only half of Quizno’s locations deliver, but that percentage is expected to quickly jump to two-thirds by the end of 2008. With McDonalds, Burger King and Wendys selling salads and chicken, Subway and Dunkin Donuts trying pizza and Arbys venturing into deli sandwiches and toasted subs, it’s become a free for all. And Domino’s says it’s not stopping at subs.
With the blessings of corporate, an Subway area developer is opening the first of the series of Subway Cafes – an upscale sandwich and coffee shop concept that aims to compete with Starbucks, just as McDonalds McCafes are doing quite successfully. Starbucks entered the fray in 2008, announcing a better-for-you breakfast in an effort to pump up flagging sales and hopefully capture market share from McDonalds, IHOP and other breakfast food chains. “Food has been our Achilles’ heel,” said CEO Howard Schultz. He called the better-for-you breakfast part of the company’s evolving health and wellness program, a “billion-dollar” idea. The hush-hush program (its secret code name was Morning Source) was also in response to rising customer complaints about calorie content and health risks of traditional food offerings at Starbucks – like doughnuts, muffins and scones.
Unfortunately, McDonalds CEO Jim Skinner revealed another Achilles’ heel on Starbucks’ other foot. Because the Starbucks format makes food preparation difficult, Skinner isn’t worried Starbucks will take breakfast business away from the Mighty Mac. In comparison, McCafes continue to land body blows on Starbucks’ market share. Started as an international idea in the late 1980’s and greatly exceeding expectations, McCafes are coming home to roust. McDonald’s has already opened McCafé coffee bar offerings in half of its 14,000 U.S. locations and is on target to bring this to 100% in the U.S. by the end of 2009. Franchise owners are happy with the product and customer response, and even happier that McDonalds is footing 40% of the $75,000 system improvement fee. Just what Starbucks doesn’t need at a time when it had to close 600 U.S. locations as many cash-strapped consumers hesitate to shell out $4 for their java fix. It’s a free-for-all and everyone is slugging it out.
Howard Schultz of Starbucks may have to reach even deeper into his bag of strategic plans. Don’t count him out. He’s the man who met the small chain of stores in Seattle that sold only roasted coffee beans by the pound. Schultz took a trip to Italy, returned and sold the Starbucks founders on the idea of grinding those beans and offering customers fresh brewed coffee along with Lattes, Espresso and other Italian favorites. A simple cloning idea and rest of Starbucks’ phenomenal growth is history.
McCafe vs. Starbucks Update
If McDonalds was hoping to bite into Starbucks’ business segment, it hasn’t worked – at least so far. “There aren’t too many people who meet for business meetings in McDonald’s,” said an investment manager whose company holds shares in both firms.
But bottom line: in the last 24 months, McDonalds coffee business has grown from 2 percent of sales to 5 percent of sales. The dynamic appears to be the tradeoff between quality (Starbucks leads in this category) and value (McDonalds leads here). Starbucks’ large iced coffee sells for $2.65 in downtown Los Angeles. The one from McDonald’s is slightly bigger and sells for $2.19.
For some cost-savings franchise tips, including a budget for franchising a business and reducing franchise development costs, click this link.
© 1982-2008, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
A company planning to franchise must realize it is entering a new business, offering an entirely different service (training & support) to entirely new customers (business owner-operators). This new business requires different skills, abilities and expertise. In the new business of franchising, it is critical to develop effective evaluation, documentation, mentoring, training and consulting skills. Since these new skills are rarely present within existing personnel, an outside franchise expert is needed to train existing personnel and plan the transition. The first step involves determining whether or not a business can franchise, and if so, what needs to be developed. Next, strategic franchise planning is necessary to create a “blueprint” for successful expansion efforts. Experience shows that, just like a building, the foundation developed at the beginning will create lasting consequences affecting the relative success (or failure) of the entire venture. Legal (franchise disclosure document, franchise agreements) and operational documents (franchise operations manual, franchise training program) are prepared and drafted and finally a franchise registration process is required in some 14 states, depending on which state(s) the company sells franchises. These phases are discussed below.
An indispensable step before any franchise development program gets underway is an analysis of the concept and business model. Has the concept been sufficiently proven in the marketplace? How profitable are existing prototypes or company-owned outlets? Franchising will not solve existing problems, it will only intensify them – and usually at a serious cost to franchise investors. Franchising is not a way to raise capital, get rich quickly or expand a business with existing problems.
There must be sufficient profitability in the business model so that royalty and other payments can be made and leave the franchise investor with a sufficient profit. With a franchise feasibility analysis, a determination can be made about:
(a) whether franchising or licensing expansion ideas should be pursued, postponed or abandoned; and
(b) assuming a positive result in (a), what needs to be fine-tuned or developed from scratch for the franchise program.
Besides determining if and when the business can franchise, the analysis should also include providing guidance and direction so as much of the groundwork as possible can be done by existing personnel. This has proven to be a very effective approach and significantly reduces franchise development costs. If the feasibility analysis is positive, the other phases discussed below follow.
My decades of experience in the franchise industry lets me share a valuable insight about franchise feasibility studies. Too many companies leap into franchising without doing a franchise feasibility study, or if one is done it is performed by a franchise consultant or group that tells everyone good news – they’re all “franchise-able.” Most franchise feasibility studies I’ve done either identify areas that need attention before franchising makes any sense or tell the client to forget about it and pursue other growth options.
A successful franchise development program begins with a solid plan – a foundation for franchising. The long-term goal is to establish balanced, integrated, successful business relationships with qualified individuals who support the company’s goals and image. Creating an enduring relationship requires a comprehensive strategy that addresses all aspects of the franchise endeavor.
Often there is little or no strategic planning with new companies entering the franchise industry. This is because they only utilize the services of a franchise consulting firm or franchise attorney, where little or no attention is paid to strategic planning issues. Instead, these firms draft “boilerplate” documents based on a questionnaire completed by the client. The client, who knows nothing about franchising a business, apparently is charged with making all strategic decisions. The boilerplate documents are presented, along with an invoice and a handshake. These are hardly the ingredients for success in the new business of franchising.
If the company has engaged in sound strategic planning then the franchise documents are easy. At a legal mininum, a company needs:
1. Franchise Disclosure Document
2. Training Program Curriculum
3. Franchise Operations Manual
4. Franchise Registration Application filed in certain states
The Franchise Operations Manual
Franchise operations manuals and training programs are developed, often from scratch, to impart business operating skills to the franchise owner as well as ensure uniformity of products and services. The franchise operations manual and training program curriculum must be drafted with a special focus. Certain topics, chapters and policies routinely covered in manuals for a company-owned chain, for example, are entirely inappropriate in a franchise environment, creating significant liability (lawsuit) issues for the franchise division.
I regularly find franchise operations manuals drafted by consultants containing inappropriate chapters or topics. Not knowing where the bullets come from in franchise litigation, they proceed blindly ahead using “boilerplate” manuals where most (but, unfortunately not all) instances of “ice cream” are changed to “tax returns.” Ongoing support during the franchise relationship needs to be carefully considered, structured and reflected in the operations manuals.
Deciding who will write the franchise operations manual is a relatively simple question to answer, yet many new franchise companies also fall into a trap here. Bewildered by the complexities of franchising a business, with its special legal requirements, franchise operations manuals, training programs, etc., they “delegate responsibility.” The recepient is usually a high-priced franchise consultant who produces the operations manual and sometimes even the legal documents.
Putting aside the practicing law without a license issue on the legal documents, does using someone to write your franchise operations manual who knows literally nothing about your business, ever make any sense?
The best practice approach, developed over almost three decades of writing, editing and reviewing hundreds of franchise operations manuals is based on a simple, common sense notion. Let the true expert in your business write the operations manual. And who is that expert? It’s usually the founder of the business or a handful of select personnel who know the business inside and out. It’s true, an outside franchise expert should be involved in the process. But the expert’s role should be limited strictly to a planning and editing capacity – helping develop the overall Table of Contents, giving samples of writing styles and techniques, then reviewing each chapter after it’s drafted by you or your management team.
This approach produces a professional, easy to use and update franchise operations manual that will make a positive impression on prospective buyers. It also ensures the most efficient use of resources and talent, so you write the franchise operations manual instead of paying a consultant $20,000 or more for what is a relatively simple task.
For more information, including three steps for writing a franchise operations manual visit our Franchise Operations Manual page.
Franchise Disclosure Documents – FDD
The Franchise Disclosure Document (FDD), which is similar to a securities – stock offering prospectus, is prepared and registered with various regulatory agencies to comply with applicable federal and state laws. This document can contain thousands of discrete disclosures within its twenty-three chapters and attached exhibits, and obviously needs to be prepared by a franchise attorney. This is definitely not the time to try using do-it-yourself franchise kits – unless the idea of spending $200,000 or more defending a franchise lawsuit is appealing.
My three decades of experience has demonstrated that in order for a franchise company to get off to a good start, a heavy emphasis should be placed on strategic franchise planning to manage the future franchise effort and address the franchise relationship. Then, before the franchise program begins, management needs training in how to effectively operate a franchise organization. At a minimum, the following programs should be in place before franchise marketing efforts begin:
1. Franchise Lead Processing System (sm):
Key considerations for all franchise companies engaged in franchise marketing are the careful screening of franchise applicants and using the right media. Only the cream should be offered the privilege of joining the franchise network. Eliminating unworthy applicants at the interviewing stage is far easier than waiting for them to develop into a headache later on. An examination of franchise networks having troublesome franchise owners (who often mature into a future lawsuit) shows a lack of planning and attention to this relatively simple concept.
Before franchise marketing efforts start, a company should adopt a customized Franchise Lead Processing System that includes instructing key personnel in:
(1) adopting the proper organizational structure;
(2) defining profile characteristics of the “best” franchise owners;
(3) developing effective interviewing techniques, procedures and checklists;
(4) using a series of tests and other measures to ensure that inappropriate candidates are disqualified before joining the franchise network;
(5) detecting (and avoiding) red flags that arise in the marketing – interviewing phase; and
(6) adopting the appropriate media plan, schedule and budget.
One client engaged our firm to develop a more effective franchise marketing strategy. Although they spent a lot of money in various media, quality leads were lacking and they hadn’t sold franchises. An analysis showed their franchise strategy was rooted in traditional strategic thinking – trying to outperform rivals and hopefully grab a share of existing demand. This wasn’t happening. We recommended an alternate, blue ocean strategy. In a blue ocean strategy, new market space is identified. The new market space we identified was a market segment they never thought was feasible. By adopting this blue ocean strategy, they were able to create new, uncontested market space and franchise sales grew quickly. In many cases the only way to beat the competition is to stop trying to beat the competition. Competing in a traditional way within limited terrain and the need to beat a competitor is fighting it out in a red ocean that only turns very bloody.
2. Franchise Marketing 101
Many new franchise conpanies who use a traditional law firm to enter franchising discover they have difficulty selling franchises. That’s because attorneys are not schooled or experienced in the art of franchise marketing. One mistake is attempting to compete head-to-head against large, established chains. The inevitable result – failure. With over 3,000-plus franchise companies spending hundreds of millions on advertising, the only way to score big is not to act big. Rather, franchise marketing program must be selective, concentrating on narrow targets. In a word, a company needs to position itself in a highly competitive arena. Using the experience and knowledge gained by hundreds of other franchise companies to guide your advertising decisions, our franchise marketing workshops show how to do this and avoid advertising blunders that have cost other companies tens of thousands of dollars.
3. Legal Compliance Program (sm):
A franchise lawsuit can result if inconsistent or misleading communications occur when a franchise is first sold. Most of the legal risk is franchising centers around what happens during the marketing cycle: the twenty-three chapters of disclosures in the franchise disclosure document as well as who said what, and when. Defending any franchise lawsuit, even a frivolous one, can be huge. The quicksand of litigation swallows up time and money without limit. The cost of getting involved in even a “small” franchise lawsuit can quickly exceed $100,000 within a couple months. Exposure can run into the millions.
Although one study of franchise disclosure documents indicated 27 percent of franchise companies have a history of franchise litigation (slightly greater than 1 in 4), the real percentage is much greater and probably north of 50 percent. This is because only pending litigation and final judgments must be disclosed in franchise disclosure documents. Most franchise litigation cases (like other litigation cases) are settled, so they’re only required to be in the franchise disclosure document from the time they’re filed until settled. After that, they vanish without a trace. And whether the chances of getting sued in a franchise lawsuit and getting embroiled in franchise litigation is greater than 1 in 2 or 1 in 4, who wants to get involved in a time-consuming, stressful and very expensive mess?
For all of these reasons, using franchise brokers is definitely NOT recommended. Their off-the-cuff statements made to “close a deal” make the franchise organization (and the personal assets of its officers) liable for applicable federal or state franchise law violations. This also explains why the overwhelming majority of successful franchise companies set up their own in-house franchise marketing department so that actions and statements made during the franchise marketing cycle can be monitored and controlled within the framework of a Franchise Sales Control System (sm).
4. Franchise Sales Control System (sm):
Franchise Sales Control is the other half of a compliance equation. Franchise compliance specifies rules and expectations. Franchise sales control is the way to detect gaps and inconsistencies by comparing the reality of business practices to the rules of the compliance program. When detected, the causes of the gaps are identified and corrected before jeopardizing the franchise program. A Franchise Sales Control System is designed with this goal. It should include a host of feedback mechanisms that monitor performance and retrieve pertinent information for review by management personnel. Use properly, this increases the effectiveness of franchise marketing efforts. The more important benefit is greatly reducing the chance of sales personnel deviating from required procedures in selling franchises. Finally, a well-designed Franchise Sales Control System has another benefit. It creates a complete back up file for every franchise sold. These files will qualify as business record evidence in the event a future franchise dispute ever takes place. The files also satisfy the legal requirement of various states that franchise companies maintain a complete set of books, records and accounts of franchise sales. Since most of the legal risk in franchising arises during the marketing cycle, a comprehensive Franchise Sales Control System is the company’s best protection against the quicksand of litigation.
5. Managing Franchise Relations:
As franchises are sold, the communication lines that develop between the parties will have a major impact on the success or failure of the ongoing franchise relationship. Controlling who is allowed to join the network through the steps outlined above is the critical first step. Once inside the franchise network, franchise owners must be taught to realize they are members of a team, each working for the benefit of the entire network. Developing an awareness of this early in the relationship and implementing a franchise feedback system has a number of important benefits. It creates a positive attitude among franchise owners. This encourages positive behavior, like passing on innovative ideas, paying royalty payments on time, etc. In the long run, it nips franchise relationship problems in the bud.
© 1990-2009, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
This differences between franchising vs. licensing has moved to its own page. Go to the Franchise vs. License page of our franchise website.
©1990-2008, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved
Evaluating franchise attorneys and evaluating franchise consultants can seem a daunting task. But the firm a company selects to assist its entry into franchising, refine existing franchise efforts or make franchise investment decisions will have profound consequences. Fees paid to one or both of these providers usually represent the cost to franchise a business. While asking for a list of “references” is one approach (and when is anyone ever dumb enough to provide a bad reference?) there are more objective criteria that are not dependent on selectively disseminated information. By addressing the nine Franchise Questions, topics and subcategories of information discussed below, you will eliminate virtually 95% of the individuals or firms you are considering. Then efforts can concentrate on evaluating the 5% cream of the crop that truly merit consideration:
A. FRANCHISE EXPERT:
The #1 factor in evaluating so-called expertise – are the principals really franchise experts? There are objective criteria to determine this:
(1) Have they qualified and been allowed to testify as a franchise expert in court and arbitration proceedings? Being involved as a franchise expert in the franchise litigation process gives a sensitivity and radar for avoiding future franchise problems.
(2) How many books on franchising have been written by the principals?
(3) How many franchise articles have been published in journals or magazines?
(4) What is their franchise teaching experience? (see topics E and F below)
(5) What is their depth of experience in the franchise industry? (see next topic below)
B. EXPERIENCE IN THE FRANCHISE INDUSTRY:
(1) Length of time the firm has operated exclusively in the franchise industry?
(2) Experience on both sides of the franchise fence – working with franchise companies (franchisors) as well as with individual investors (franchisees) who have purchased a franchise?
(3) Past experience principals have owning and operating a franchised business? This factor is absolutely critical. If the principals have owned and operated a successful franchise, they bring a unique perspective and radar for avoiding future franchise relationship problems from disgruntled franchise owners.
C. COMPREHENSIVE TRAINING & ONGOING SERVICES; CONTROL SYSTEMS:
(1) Can (and will) the firm train your personnel how to operate and manage the new franchise company? Remember, you’re entering an entirely different business, one requiring new skills and abilities. If this topic is not addressed in detail, you might as well earmark the franchise fees received when you sell franchises for a future franchise litigation war chest;
(2) Will the firm help you review and update operational (franchise operations manual) and legal documentation (franchise offering circular) on an ongoing basis?
(3) Has the firm developed, and will they help you put into place, franchise marketing, sales control and legal compliance programs during the critical implementation (start-up) phase of your franchise program?
The existence of these programs is essential to ensure only the cream of franchise applicants are allowed to enter the network. A welcome byproduct is also creating a series of documented files should a dispute arise in the future. Most of the legal risk in franchising occurs during the franchise marketing cycle when franchises are sold. Unfortunately, many franchise companies have no documentation of who said what – not a good place to be if a future dispute arises. If your company’s done a good job here with these programs, then you’ve eliminated most of the risk.
D. LEGAL EAGLES: FRANCHISE ATTORNEYS
(1) Is the law practice devoted 100% exclusively to franchise law – and for how long?
(2) Total number of franchise disclosure documents(formerly called franchise offering circulars) drafted and reviewed?
(3) Experience filing franchise registrations and working with state examiners in all 14-plus franchise registration states?
(4) Experience representing franchise companies as well as persons buying a franchise?
(5) Experience owning and operating a successful franchise? Knowing both sides of the fence is a tremendous asset. Subjective factors, such as being a member of the American Bar Association’s Forum Committee on Franchising, for example, are of little value. Membership in a franchise committee or franchise association only means the franchise attorney pays a yearly membership fee, usually with the motivating purpose being tax deductible travel expenses and learning about subjects they don’t know very well. A franchise attorney with an MBA is especially helpful to address both the business and legal aspects of the industry. You can do a Google search with “MBA franchise attorney” as a search term and narrow the field considerably.
E. ACADEMIC: UNIVERSITY & COLLEGE
Experience teaching franchise courses at graduate and undergraduate university levels?
F. ACADEMIC: PROFESSIONAL
Experience teaching franchise courses to franchise attorneys and general practice attorneys?
G. BLEND OF BUSINESS & LEGAL SKILLS:
Specialist franchise attorneys and law firms produce tight legal agreements (sometimes overly so, leading to future franchise relationship problems) and usually adequate franchise disclosure documents. Setting aside the overly tight contract issues, the problem is most franchise attorneys – franchise lawyers are not capable of making sound, strategic business decisions and providing practical, ongoing advice. That’s not what they do – their focus is drafting legal documents. It also explains why they tell you to find someone to write your franchise operations manual and provide franchise planning advice. It’s also why they give you an FDD “questionnaire” to complete. Instead of customized strategic franchise planning, you get a cut and paste FDD. Some franchise consultants, on the other hand, have good business sense and planning skills, but lack the requisite legal skills. Remember the famous definition of a consultant – a person in between jobs. Questions:
(1) Does the firm have the proper blend of business savvy and in-house franchise legal expertise? It’s always a big cost-savings plus if the franchise attorney also has an MBA. As mentioned above, do a Google search with these twin attributes (“franchise attorney MBA”) and narrow the field to the select few to consider. This approach also eliminates the need to hire a separate franchise consultant charging $20,000 to $30,000 or more for strategic franchise planning and writing your operations manual.
(2) Can the firm produce good legal documentation (franchise disclosure documents) and help you edit (or create on your own) consistent operational documents like the franchise operations manual, training program, etc. If your franchise agreement says “x” but your franchise operations manual or advertising materials say “y” about the same issue, be prepared to pay hefty franchise litigation fees and deal with franchise litigation attorneys in the future.
(3) Can the firm provide competent and practical ongoing advice in critical areas like effective franchise marketing, media decisions, interviewing franchise buyers, implementing a franchise advisory council, adopting the best franchise organizational structure, etc? Ask most franchise attorneys (and franchise consultants) what is the best franchise organizational structure to adopt and 99% will say an LLC or a corporation. That answer entirely misses the point and shows their lack of knowledge about this topic. Mistakes made in these areas can easily cost the franchise company tens, if not hundreds of thousands of dollars.
(4) Can the firm train your management team in how to operate a franchise company so you don’t have to budget and absorb the overhead associated with permanent franchise staff? The new business of franchising is paved with legal and business pitfalls. Doing it right, from the very beginning, will save your company a lot of headaches down the road.
(5) Will the firm be there to provide business and legal guidance, as well as answering questions that arise in the critical first phase where franchise prospects are interviewed and franchises are sold, trained and opened? One new franchise company president remarked “I’d call the attorney and he’d tell me to call the franchise consultant. I’d be talking to the franchise consultant and midway into the call, she’d say this was a legal issue and to call the franchise attorney. It drove us crazy.”
H. CONTRACT FAIRNESS:
Does the firm give you an option of choosing between:
(a) an hourly rate and;
(b) a flat contract amount, where you don’t have to worry about accumulated hours and an unknown total amount?
I. RED FLAGS – BEWARE OF ANY OF THE FOLLOWING:
• Combination teams where one entity does one part of the project and another the other part. For example, a consulting firm does franchise planning, and operational documentation, while an attorney “they know very well” writes the FDD legal documentation. Often a combination approach arises when a company hires a franchise attorney without an MBA and franchise ownership experience. The attorney ultimately tells the client they need a “franchise consultant” for franchise planning and to write their franchise operations manual. Thus another person or firm enters the picture, often charging as much as the franchise attorney and the franchise budget quickly doubles.
• Or, a variant of the above, a company (usually a franchise consulting firm) that says they will do everything, including the legal FDD, state franchise registration filing, etc. But, in the “fine print” of its contract, they require your attorney (who you obviously have to pay) to review and approve everything they do because the company (it says) is not rendering legal advice. Actually, by providing documents that affect legal rights, they are rendering legal advice, but in an illegal manner. It’s called the unauthorized practice of law. You end up paying two attorneys – yours and theirs. Besides the expense, it sets you up for future franchise problems. Who does their attorney represent? The franchise packaging group, of course, and definitely not you. He or she is typically a recent law school graduate who hasn’t figured out what they’re doing is illegal and could cause them to lose their license to practice law. Besides that, they represent the franchise consulting group, whose interest is to churn as many franchise packages per year as possible. You end up with a bad franchise disclosure document and sloppy franchise operations manuals. To save time, the franchise agreement gets watered down so it’s easier to push through some franchise registration states. Some of the “t’s” may be crossed and some of the “i’s” dotted, but not most of them. The end product are documents that set you up for future franchise litigation difficulties. Spending a couple hundred thousand in a franchise lawsuit these days can happen in just a few months.
• Firms that advise you to franchise your business, and they’ve never seen your business! You’d be surprised how often this happens.
• Firms that do a franchise feasibility study for clients and tell every one of them they have what it takes to franchise.
• Firms that say they’ll write a franchise operations manual for your company. How someone, who knows absolutely nothing about your business, could ever come close to anything but a mediocre product at best, is a frightening thought. The use of boilerplate manuals produced by consulting groups is yet another future litigation time bomb. You are the true expert in your business. With competent guidance, writing samples and editing, you’ll be able to produce professional and workable franchise operations manuals and save yourself $20,0000. Learn how by visiting our informative page Writing Franchise Operations Manuals.
• Pricing quotes that seem exceedingly high or low (especially “do-it-yourself” fill-in-the-blank franchise kits). For an informative discussion about franchise kits, franchise templates, etc. visit our writing your franchise operations manual page.
• If you are buying a franchise, BEWARE of any attorney recommended by the franchise company. Even worse, beware of franchise companies who say you don’t need to use an attorney. There are a number of these online.
• Firms (or individuals) that have EVER been sued for fraud, misrepresentation, the unauthorized practice of law or violating any franchise law. For a very informative article read Francorp Attorneys Walk Out Over Illegal Practice of Law.
DON’T FORGET TO ASK THIS CRITICAL QUESTION!!