As a B2B CFO I have worked with a lot of smaller growth companies and it’s always interesting to learn a new business model and see how an entrepreneur makes money. I am frequently asked "What are the most profitable businesses, or what is the best way to grow a business". As I see the proliferation of frozen yoghurt stores in my neighborhood, I thought it would be interesting to take a look at the franchise business model to see how it works. I have enlisted the help of Jim Deitz aka The Franchise Doctor. Jim has consulted on franchise operations for more than thirty years and is a recognized authority on creating, buying and selling franchises.
Franchising is typically the right to sell or distribute goods or services under license, using a common branding and advertising, while the franchisor retains a degree of control over operational procedures. I asked Jim how big the franchising business was. In fact, franchising accounts for 11 million jobs and at $1.3 trillion is just over 5% of national output. There were over 900,000 individual franchised establishments in 2005. Jim said that while Fast Food, Hotels and Automotive sectors are the most well known, there is a diverse range of business models from Janitorial, Hardware, Real Estate, Auto Rental, Learning, Personal Care, Schools, Construction and Maintenance.
For many franchisee investors (ZEEs) and potential franchisors (ZORs is franchise-speak for business owners who use franchising to expand their business), the costs and potential profitability are the key issues. Jim says that license fees can vary from $10K to over $50K, while annual royalties based off revenue will range up to 10%. Additional costs payable to a ZOR would include shared advertising fees of 3 or 4%, and often ZORs will source inventory and perishable supplies. Of course, any serious franchise operation will still involve the normal costs incurred by any start up business such as real estate, equipment and furnishing, payroll, promotion etc. This is why some franchise purchases can soar to $1.5 to $2 million to fund a turn-key operation like a McDonald's or Zaxby's store.
Do franchises really make any money? Is a ZOR just selling stores? Of course, there are horror stories, but the ideal model is that franchising offers a ZOR a fast, cost effective way to grow a successful business venture, and offers a ZEE a way to purchase a proven, turn-key business model that has predictable revenue streams. Jim points to Department of Commerce studies that show that 90% of franchised ventures survive for five years or more, while only 28% of independent start-ups are still going. Why would this be so?
There appear to be many reasons, but they center around working from a proven blue-print where the learning curve is dramatically shortened because the franchisor has already tuned the business model. Thus, Jim points out, that the investor gets a Coach who provides training, site selection, credible financial projections, financing assistance, instant branding, corporate R&D and advertising, and other benefits. Of course, the number one ingredient for success is entrepreneurial zeal. As in any business, the weak and uncommitted will not be able to survive for very long.
I was also curious about the benefits and costs to the business owner who has a successful business model, and is looking for growth. Jim Deitz explained that franchising can offer an entrepreneur a fast, efficient way to quickly grow a business. Franchising law is federal in nature and thus provides significant safeguards for business owners licensing their business ideas. Jim has worked with many new franchisors that have goals, capital and a realistic growth rate, and sees the critical aspects to success as having a profitable existing model, a system that can be documented and taught, broad appeal, the ability to replicate affordably with a branding package that can be trademarked. I also asked Jim why successful business owners couldn’t simply open additional branches themselves. It comes down to two factors: capital and talent. Expansion will be slow and steady when self funded due to capital limitations. In addition, finding, training and holding on to quality branch managers is always very difficult. Thus, franchising can help an owner expand quickly with little capital, be confident in the "management" of the franchised operation, and build residual income and market share. It’s not all perfect, of course, and there can be problems: quality of service, bad franchisees who cannot be fired, and considerable HQ attention is required for success. Building a larger enterprise, more quickly is also likely to result in improved Exit Planning strategies and gain the attention of Private Equity groups.
Clearly the franchising model should be considered for investing in or developing a proven business model.