Make sure you know where youÕre going
Different Growth Strategies Can Lead To Very Different
Destinations
In the previous article, we looked at Òcookie cutterÓ
businesses. These are businesses that are self-contained economic units. Restaurants,
retail outlets, day care centers, bowling alleys and movie theaters are some
obvious examples. Each unit has a limit to its growth – physical
capacity, production capacity, geography, hours in a day, legal limits on hours
of operation, etc.
Franchising is a business model and strategic decision, not
a financing method. This distinction is often missed by the first-time
entrepreneur.
The conventional wisdom goes something like this:
IÕm going to start a franchise because I can grow my
business with other peopleÕs money.
The franchisees will be responsible funding each outlet. That letÕs me
grow quickly and reduces my risk. On top of that, the up-front franchise fee is
all profit and will help cover some to my corporate overhead. To me, thatÕs
obviously much more attractive, and more rewarding, than slowly building a
chain of company-owned stores.
From the outside looking in, those are reasonable
observations, but they are way off the mark.
First and foremost, if you choose the franchise structure, your
business is selling franchises, not running a chain of restaurants [or
whatever the self-contained economic unit is]. Before a franchisee is going to fund her outlet, she has to
be convinced that she wants to buy a franchise, and of all the available
franchises, yours is the right one for her.
You donÕt franchise by hanging up a shingle. YouÕve got to develop a marketing plan
that brings you to the attention of potential franchisees. YouÕve got to manage
a sales process that converts the prospective franchisee into your franchisee.
This all takes time, money and staffing.
Oh, by the way, thereÕs got to be some substance to you as a
company, as a credible franchisor. You need operations manuals; training
programs and trainers; and site selection expertise and methodology, among
other things. You need extensive legal work to properly establish your
companyÕs ability to franchise, and to make sure you comply with the laws
within any geographic area in which you want to sell a franchise.
You will need to find initial franchisees who are willing to
make an extraordinary leap of faith to buy a franchise from you. You will need to meter your efforts
because significant growth cannot be achieved until successful franchisees can
be pointed to as models for what the prospective franchisee can become. Again,
these take time, money and staffing.
About that franchise fee – if your franchisee
solicitation program breaks even through the collection of those fees, you will
be lucky.
Of course, all of this is for naught, unless your
franchisees are successful over a long period of time. Again, the appearance of ÒfreeÓ money
from franchise royalties is also a myth.
A good franchisor with successful franchisees will be spending a lot of
money making its franchisees more successful. Franchisees really are expecting, and demand, services for
their royalties, or they wonÕt renew their franchise agreements.
Franchising is not a panacea for growing a business
rapidly. One set of challenges is
being replace by another.
As compared to franchising, building a chain of
company-owned outlets is less complex and you have greater control. The offset
is that the capital requirements are much greater and growth is likely to be
slower.
Regarding control, you donÕt really ÒcontrolÓ a
franchisee. Yes, they will sign a
franchise agreement. Yes, that
agreement proscribes certain ways that things will be done. BUT, there is no
guarantee that the franchisee will comply to the letter of the agreement as you
intended it.
Certainly you can influence compliance by inspecting the
franchisee and auditing its practices, but if they arenÕt compliant, what can
you do? You can turn your lawyers loose and maybe the conflict will be resolved
in 3 years, but in the meantime, what has happened? Your other franchisees will
certainly be aware of this battle between you and one of their peers. Time and money have been diverted.
Alternatively, with a company-owned facility, staffed by
your employees, you can require performance of a certain type. Non-compliant employees will be terminated. Things will be done as you intend them
or immediate action can be taken to rectify problems.
As I hope youÕve seen, these are two entirely different
businesses, that only share external traits, but are very different in terms of
their actual operation. The
funding requirements are also different.
Each path has to have at least one company-owned operation
at the beginning. Beyond that though, the next steps are situation-specific.
Some franchisors have launched franchising after a single unit is up and
operating. I wouldnÕt recommend that, but it has been done.
For the company-owned chain to grow, investors have to be
convinced that the individual economic unit generates the kind of cash flow
that is appropriate to the investment and that the units can be replicated with
success. Those issues may be
resolved with only two outlets, but itÕs likely to take more than that to
remove sufficient risk that significant investment will be available on
attractive returns.
The potential investor in a franchise will need to be
convinced that you can predictably attract enough franchisees that the
financial performance of the franchise system will yield the financial results
that will lead to an attractive exit for that investor. In this case, you need
to invent the cookie, implement it and then get others to buy the recipe and
make their own cookie. What do you
as franchisor need to do to get to that point, where growth capital is
available, and available on acceptable terms?
In the case of the company-owned chain, you can control the
rate at which you build infrastructure, and its breadth and depth. You control rates of growth, and
thereby cash requirements. The development of infrastructure will not be a primary
driver in an investorÕs perception of your risk. The people Òat corporateÓ will
play important roles, but they will be more supportive in nature. Success or failure will be measured by
the success and failure of the operating units.
In a franchising environment, it is almost 180 degrees out
of sync with that. The corporate
capabilities are what will determine success and failure. First, there will have to be a critical
mass of people and capability so that you are viewed as a credible franchisor who
can provide the necessary support and services that can attract franchisees.
These capabilities must be available before you can get your first
franchisee. You may be able to
contract out some of these capabilities, but youÕll still have to oversee the
contractorÕs delivery of those services.
The previously mentioned marketing and sales plans for
securing franchisees will need to be developed and proven to be replicable. The
perceived risk of the franchise business centers on your ability to sell franchises.
Fund raising is a function of perceived risk and potential
reward.
In my opinion, the initial investment in a company-owned
chain will be viewed as less risky than franchising, from an investorÕs
perspective. The path to proving
the business model is more direct and under your control. In a franchise, a large portion of the
initial capital will go into infrastructure, and success is less easily
measured.
Offsetting this is the knowledge that the overall capital
requirements of a chain of company-owned outlets will ultimately dwarf those of
a franchisor; the potential reward is likely to be perceived as lower as well.
Another benefit of the company-owned facility is that you
will have several funding options.
In some cases it is possible to grow by funding each single outlet as a
standalone enterprise. Investors
can be sought for a single restaurant, for example. You might set up a limited partnership so that your company
is the general partner and the investors will get some defined return on their
investment. This has the benefit
of isolating the amount of capital needed. It also preserves your equity in your business. By the way, this is usually a
transitional strategy until the perceived risk has been adequately reduced so
that significant investment into your company on reasonable terms is available.
Some people start businesses that have these characteristics
as a lifestyle choice. They enjoy
the business itself and they run it to achieve an acceptable level of income
and a certain quality of life. Growth, or building a chain is not high on their
priority list.
Still, when the first unit is a success, thereÕs inevitably
an urge to do it again, and when thatÕs successful, do it one more time, and so
on and so on. This needs to be done with forethought as well. Otherwise, you may end up in a place
you never intended.
One of the reasons your first outlet is successful is
because you are personally involved.
If you open up other units, your efforts will be diluted over multiple
outlets, and you will have to manage the people who are doing the job you used
to do. Will those people bring the same passion and involvement to the
business? Probably not.
In addition, the complexity of managing the entire business
will increase as the square of the number of outlets. While you may secure
volume discounts from your vendors since you will be increasing your orders,
the cash flow implications may be daunting. The size of your payables may rise to uncomfortable
levels. Your vendor may be more
aggressive in his collection procedures since you represent a larger liability
to him.
If you try to run multiple businesses the same way you ran
just one, it is highly likely that the wheels will come off the tracks. If you accommodate these new demands by
adding people, you may be increasing expenses without a corresponding
improvement in margins.
If these things were to occur, your enjoyment of your job
would decline; your income may fall, not rise; and the quality of your
lifestyle may deteriorate. ThatÕs
not what you had in mind, is it.
None of these growth strategies is right or wrong. They are just inherently different, and
are likely to lead to different destinations. These alternatives should be
analyzed before one is selected. Thinking ahead can make all the difference.
Frank Demmler is Associate Teaching
Professor of Entrepreneurship at the Donald H. Jones Center for
Entrepreneurship at the Tepper School of Business at Carnegie Mellon
University. Previously he was president & CEO of the Future Fund, general
partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the
Western Pennsylvania Adventure Capital Fund, as well as vice president, venture
development, for The Enterprise Corporation of Pittsburgh. An archive of this
series of articles can be found at my website.