FRANCHISING IS NOT THE “BE ALL TO END ALL”

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FRANCHISING IS NOT THE “BE ALL TO END ALL”

There are a lot of myths that surround franchising, many of which have been embraced by restaurant operators and institutional investors alike. Some of them are briefly and broadly described below.

Myth Number One – Franchising is capable of improving the cash flow for a company successfully operating a handful of restaurants.

Not so fast. Substantial legal expenses must be incurred to register as a franchisor. Since the liability and the expenses to defend in a lawsuit can be substantial, it would be foolhardy to proceed without proper legal advice. Registration requirements vary, state by state, so that research has to be done as well.

Secondarily, just in terms of the first franchise deal, expenses by the franchisor will be incurred, indeed should be incurred, to minimize the risk of failure. If the first franchisee stumbles, it’s case closed except for potential legal liability. Those supporting expenses to get the franchise effort off the ground will likely offset most, if not all, of the initial franchise fees.

Myth Number Two – Accepting the reality of the above, if five or ten franchised units can get going, generating, let’s say $1,000,000 per location, a 5% ongoing royalty would be $50,000 annually per unit, and $250-500k of recurring franchisee income becomes real money. Marketing contributions are on top of that, but presumably would be spent as promised.

Not so fast. If you’ve got 5-10 franchised locations, with more planned, you need a supporting cast to maximize the probability of franchisee success. While it is tempting to use your existing operating personnel to support initial franchisees, you can’t afford to distract the operating personnel at your company stores too much. In addition, sites must be approved, training must take place, marketing materials and programs must be created and provided, ongoing field supervision must take place. Salaries, automotive and travel expenses and employee benefits add up pretty quickly, and you don’t want to hire a second rate staff. So even 10 franchised locations, properly supported, are not going to generate a lot of incremental income for the franchisor. Our experience indicates that something like a minimum of $1M of annual expenses, with the handful of functions described above, to properly support a franchising effort. You can calculate for yourself how many units, at your AUV, to absorb that expense, and begin to look at “free cash flow”.

Myth Number Three – Accepting Myths One and Two, the “Asset Light”,“Free Cash Flow” is really exciting when a chain gets to be hundreds and thousands of units.

This assumption is not completely flawed, but is not as foolproof as often assumed. There are any number of large franchised systems where the franchisor allowed their franchisees to “twist in the wind”, as the former’s executives enriched themselves. Just one example: A number of years ago, I was a guest speaker at a Dunkin’ Donuts (to become Dunkin’ Brands) franchisee annual conference. That conference was sponsored by the franchisee Association, not the franchisor. It was crystal clear that the franchisees were suitably glum. Their sales had been flat to down for a number of years while Starbucks had been “eating their lunch” and breakfast too. Though stores that were fifteen or twenty years old were still profitable, there were very few new stores being built, predictably, because current economics didn’t justify it. In the meantime, the Company had bought back, over five years, over ONE BILLION DOLLARS of stock, to allow for stock options and to shrink the shares outstanding enough to show EPS progress. Wouldn’t it have been nice, appropriate and productive, if a couple of hundred million dollars less had spent to buy back stock at a fully priced valuation? It could have alternatively been spent on new product development, marketing, digital ordering technology, or even a renovation fund (at a low interest rate) for the physical updating of franchised stores. The system would have been healthier in the long run, but, as opposed to the franchisees who have signed twenty year franchise agreements and store leases, most of the executives will have cashed out and moved on. Franchised systems, to remain vibrant, have to be supported. Cash flow it is, but it’s not all “free”. Let’s call it “soft capex”.

Myth Number Four – The Apparent Ease of Duplication – Customers love it. If you build it “they will come”.

There are all kinds of reasons that success at one, or even a handful, of locations might not be indicative of broader appeal. To name just a few: the early location (s) might be unique, even in misunderstood ways. The owner’s personality and physical presence, including operating expertise, might be essential. The menu might not work as well elsewhere. Occupancy Expense and Capex at future locations could change the operating economics. New locations might not be adequately researched, from a demographic or logistical (traffic patterns, etc.) standpoint.

Myth Number Five – If it is profitable for the concept’s creator, and it is not too complex an operation, there is no reason it shouldn’t be just as profitable for a hard working franchisee.

Not exactly. The franchisee has to pay a royalty plus marketing fees plus “incidental” fees. That will very substantially reduce the return on investment for the franchisee. As described in Myth Number Six below, a concept should be generating close to 20% EBITDA at the store level to provide an above average long term economic return for the franchisee. An exception would be if the franchisee is willing to “work the store”, perhaps along with family members, therefore “buying a job”, so the operational salaries can be considered additional return on capital invested.

Myth Number Six – 5% Royalty, plus 1-2% local plus 1-2% brand marketing can be expected, pretty sweet for the franchisor, especially once the overhead is covered.

The restaurant franchising industry has come a long way. What was standard, affordable and acceptable by franchisees decades ago is not so easily in the cards today. We wrote over two years ago, referenced in the link:

https://www.liptonfinancialservices.com/2019/03/the-franchisor-franchisee-economic-relationship-this-is-not-your-fathers-world/

This is not your father’s restaurant industry. In a nutshell: if a franchised store is fortunate to be generating 17-18% store level EBITDA (BTW, depreciation is not free cash), that is before local G&A, which can easily run 2-3 points. Out of 15 points, before allowing for the depreciation “reserve” fund, the franchisee is not going to love rebating half of that back to the franchisor. Not unless there is a great deal of support provided. Once the partners have gotten to know each other, after the early passion has worn off, the franchisor and the franchisee had best become good, mutually responsible, friends. 20% store level EBITDA, or more, is better than 17-18%, and will help keep the romance in the relationship.

We could go on, and would be happy to do so, with any of our readers that would like to explore the above thoughts further.

Roger Lipton