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.