The average franchise license agreement term is almost 15 years.[1] Choosing the right franchise and choosing the right franchisee are very difficult. Clearly, creating the best business format with the highest potential, as described in earlier chapters, is an important start. But there are no perfect selection methods, and monitoring behavior and performance for both franchisor and franchisee becomes a high priority. But, because of the need to make sure partners are meeting each other’s expectations, they sometimes miss superior performance. The most astute franchisor monitoring, control, and feedback loops are important aspects of a high-quality and evolving SDS. Remember that both you and the franchisor will be creating and refining the physical aspects of the SDS while also working out the appropriate business operations and control mechanisms. With tangible and intangible assets working in concert, you greatly increase the chance of success for your franchise.
An employee or partner could misrepresent his or her true abilities or simply be misunderstood by the employer. Also, you cannot know for certain if an employee, agent, or partner is working effectively and productively or is shirking. The same dynamic can be at work when the potential franchisee is investigating the purchase and operation of a franchise. The pervasive but unsophisticated view of franchising is that the franchisor alone bears the risk of choosing the wrong franchisee and monitoring a franchisee to prevent shirking. There is also substantial risk of the franchisor misrepresenting itself or being less than responsible. Selection and monitoring of your partner are particularly important problems in franchising because system growth almost certainly forces roles to evolve. If you are the right franchisee to own and operate one store, it doesn’t mean you are the right person for two or three stores. Furthermore, even the finest franchisee operator is imperfect and can benefit from the kinds of monitoring systems that go beyond policing and that share information. Again, the same is true for a franchisor. A franchise system of 100 stores is much more personal and much less complex than a system with 1,000 stores. Therefore, selection and monitoring challenges are conjoined in franchising.[1]
Designing a system of internal controls to promote desired behavior, establishing a means of monitoring behavior, and creating both formal and informal feedback loops between the entrepreneur and agents are key elements in minimizing the impact of imperfect choices of partners and shirking operators. The reality is that there are no perfect partners and therefore no perfect franchisors or franchisees. Most franchisors put monitoring systems in place to make sure the franchisees perform according to the business format and then pay the correct amount of royalties. The larger and possibly more important question is, Can the system of monitoring provide a positive benefit to a franchise system? By the same token, if a well-designed monitoring system detects underperformance, can it also identify superior performance?
Many companies choose franchising as a growth vehicle because of its ability to minimize the risks of poorly chosen and underperforming managers. Franchising minimizes these risks, among others, because the goals of the franchisor and franchisee are more congruent than those found in an employer/employee relationship. Because franchisees share the wealth with franchisors through the profits of the business, there is less incentive for them to shirk in the same manner as an employee might. For example, if an employee steals $1.00 by putting payment from a customer in her or his pocket instead of ringing it up on the cash register, the employer loses the entire $1.00. The same action by a franchisee results in the franchisor losing only the royalty percentage of the $1.00, usually between 5 percent and 8 percent. In other words, some element of ownership is transferred from the franchisor to franchisees. Furthermore, because franchisees usually invest a significant portion of their personal wealth into the franchise relationship, they generally have more to lose than the franchisor if their individual unit should fail. So, franchisees have less incentive to misrepresent their abilities to the franchisor than do prospective employees.
While incentives are better aligned between franchisee and franchisor than between employee and employer, they are still not exact. For example, consider the financial goals of the two parties: Franchisors earn their profits primarily through royalty payments and therefore have an incentive to maximize systemwide sales. Franchisees are motivated by net profits and therefore have incentive to maximize profit through both revenue enhancing and cost-saving measures. The classic example of this franchisor–franchisee incongruity occurs when the franchisor wants to promote a discount while franchisees are concerned that the discount will erode profits. As a consequence, even in a well-established franchise system, all advertisements are qualified with the small print, “Only at participating stores.” Therefore, franchising does not eliminate the need for monitoring and controlling operational systems. Internal controls and monitoring are essential to protect the interests of the franchisee, the franchisor, and the system as a whole.
The inconsistency between the financial goals of the franchisor and the franchisee leads to two specific behaviors that require monitoring and control: free riding and shirking. Free riding happens when a franchisee takes advantage of a lack of monitoring by gaining benefits from the system without paying his fair share. This can be a big problem in franchise system advertising. If a franchisee doesn’t spend his locally required advertising, he “rides free” on the brand. Classic shirking is using a lower quality of beef in a hamburger to save cost. Both free riding and shirking insidiously deteriorate the brand.
Franchising is a negotiated relationship in which franchisors and franchisees must live with some degree of flexibility regarding each other’s performance. In essence, the franchisee and franchisor create a “tolerance zone” unique to their relationship, an informal performance standard on many dimensions. No party to any relationship behaves perfectly all the time, so strict interpretation of the license agreement is usually a prelude to legal action. In our experience an hour spent in almost any franchisee outlet will uncover numerous breaches of the license agreement that could result in legal action. By the same token, a franchisee who strictly interprets the license agreement can easily highlight franchisor breaches. The result is a litigious environment that serves no one.
The tolerance zone is defined by a series of services that franchisors provide franchisees. In our professional lives as franchisors and franchisees, we have spent much time understanding the nature of the dealings between franchisor and franchisee that are most important to maximizing the relationship. The following list represents the franchisee’s perception of dealings with the franchisor that constitute the tolerance zone.[2] Many people make the mistake of thinking all they need to do is watch sales and profits, and they can rest assured the system is healthy.
Access to franchisor management
Accounting systems
Credit policies of the franchisor and in franchisor negotiated contracts
Equipment
Fair dealings in the relationship
Financial management assistance
Inventory assistance
Local advertising
Management systems
Market information
National advertising
New store development
New product development
Support in operations
Problem-solving assistance
Promotions
Purchasing
Training
From this pool of services, franchisees prioritize two major categories of interaction with the franchisor: operations and marketing. Within each of the operations and marketing umbrella categories, franchisees further articulate which individual interactions have the least tolerance from franchisees. See Table 5-1 for specific interactions on which you should focus your monitoring systems.
The franchisor monitors franchisees in a number of ways. Franchisees have high expectations of franchisors in dealings regarding the support of their store operations and support of franchisee marketing of the franchise. The message to franchisors is to prioritize your efforts in these categories, and franchisees will be forgiving when you perform less well in other areas.
Understanding what is most important to franchisees, franchisors should work towards building their monitoring systems with operations and marketing parameters in mind. Concentrating on these issues will build a monitoring and control system that engenders a tolerant and sharing long-term relationship. Ultimately, franchisees and franchisor begin to understand their own tolerance zone that will create goodwill from both sides.
Table 5-1. The Tolerance Zone and Prioritizing Operations and Marketing
Highly Sensitive Tolerance Zone Services |
|---|
Operations Interaction |
|
Marketing Interaction |
|
Internal controls are a system of checks and balances put into place by the franchisor to promote specific appropriate behaviors and to discourage inappropriate ones. Effective internal controls are often expensive to design and implement, but are normally a one-time investment that provide significant return to the organization over its lifetime. Entrepreneurs who are considering becoming a franchisor to grow their business must consider the types of internal controls they wish to implement, because the decision will affect the way the franchise agreement is drafted. Eric Karp, a noted franchisee attorney, believes, “The content of the franchise contract will greatly influence the control the franchisor has over which monitoring methods are to be used and the degree to which franchisees must adhere to recommendations made by the franchisor.”[3] The franchise contract is the place for the franchisor to articulate exactly what is expected of the franchisee and how the franchisor intends to ensure that its expectations are met. These expectations generally fall into one of two categories: execution of the SDS and financial reporting.
Companies work to build brands and trademarks because they communicate to potential customers the promise of a certain level of product or service quality. Customers come to rely on these promises, and failure to fulfill them erodes brand equity. Accordingly, ensuring that the SDS is executed properly is a means of protecting brand equity (see TIP 5-1).
There are several different schools of thought about how to choose the right franchisee. Some franchisors maintain that they are not interested in franchisees with related prior experience because they might bring the bad habits from other organizations to their own business. Other franchisors maintain that prior related business experience is essential to ensuring that the franchisees can be successful in the business. Allied Domecq vice president for retailing states, “While there is not universal agreement on whether a franchisee must have experience in the field of the franchise, franchisors generally look for overall business experience.”[4]
For the new franchise, the place to start in choosing franchisees is by recruiting would-be entrepreneurs who are comfortable in an operating role and who have some experience in marketing. Established franchisors should analyze the most successful franchisees in the system and use the data to develop a prospective franchisee profile. The startup franchisor can discuss franchisee selection with existing successful franchisors, but ultimately they begin by being selected by those drawn to their offering. Frankly, most new franchisors are resource starved, and a “hot prospect” with a franchisee fee can be most alluring. Still, franchisors can immediately establish a process for collection and review of profile data. Eventually, a successful operation becomes more selective. Then, you can consider the potential franchisee’s ability to execute the SDS relative to the requirements of the franchisee profile you’ve developed. Asking the right questions beforehand can save a considerable amount of trouble later, because a failing franchisee needs a significant amount of time and attention.
An initial control for addressing issues related to the execution of the SDS is requiring that franchisees, per the franchise contract, follow the current operations manuals and subsequently updated manuals. These updated manuals are the result of recurring feedback loops consisting of regular interactions between franchisees and the franchisor, and then between the franchisor and the entire system of franchisees. In the best franchise systems this interaction is a formal process. Both positive and negative information is evaluated and integrated, with constant iterative feedback, between the field and the franchisor. This is the most effective and fluid mechanism for ensuring that realistic and real-time changes are created and executed into the system. This iterative process creates a responsibility for the franchisor to painstakingly document all of the procedures required for properly running the operation. Furthermore, the franchisor must communicate to the franchisee, in the franchise contract, that updates to existing operations manuals may be required at the discretion of the franchisor. Failure to adequately document the franchise operations as they develop will make preparing effective operations manuals that can protect the SDS a monumental task. Additionally, the franchisor who pays attention to the development of the system and meticulously documents that development will have a far easier time transferring excellence than will the less diligent franchisor. When your system’s SDS is documented in such a fashion, achieving scale becomes a significantly more manageable process. The result is more successful franchisees, a more stable franchise system, and enhanced shareholder value.
Developing the Operations Manual. The operations manual captures the fundamental tasks of the SDS. It serves as both an information resource and a training tool. It must be well organized and written in clear terms, and the information it provides must be kept up to date and accurate.
When you are developing your SDS, document all functions, changes, and reasons for changes.
Write a manual for executing the SDS in the first location, detailing the actions required to deliver the goods and services.
Keep in mind that the franchisor will have to train new franchisees and that the manual is an extension of that training.
Use professional trainers and writers to work together to produce the operations manual.
Produce the operations manual in a binder that allows for frequent and rugged use and easy page changes.
Multiple tools exist for monitoring store operations. They include, but are not limited to,
Field support
External service audits
Peer review
Analytical tools
Customer feedback
Typically, these techniques are used together to monitor franchisee behavior. These are tools to execute the monitoring and feedback requirements. The tolerance zone tells us to focus the attention of these techniques in marketing and operations areas. We cannot stress enough that monitoring includes rewarding superior performance as well as controlling underperformance.
Many franchised organizations use field support personnel to act as a liaison between the franchisor and franchisee. Their main responsibilities include communicating the needs of the franchisees to the company and ensuring that company policies are upheld by franchisees. Franchise field support personnel often function like district or regional managers in a non-franchise company, but with less direct enforcement authority. Acting in this capacity, field personnel are responsible for evaluating franchisees, identifying potential problems, and implementing any necessary corrective actions. Alternatively, field support personnel may serve an internal audit function, regularly inspecting individual store operations against a set of specified criteria. When the field support function is designed in this manner, franchises usually operate with a rating system designed to communicate to franchisees how they are performing relative to company standards. These standards usually start with revenue comparisons in detailed segments. General Nutrition Centers offers product category comparisons. Friendly’s Restaurants helps franchisees compare day part revenue. Expense standards focus on variable cost-line items, especially labor cost. At Jiffy Lube, each location’s labor hours per car are shared nationally. A franchisee whose comparables fall below minimum requirements is given time and support to improve performance. A franchisee who fails to improve risks having his or her franchise agreement terminated.
Regardless of the capacity in which they serve, field support personnel are most effective in monitoring franchisee activities when there is a high ratio of personnel to franchised stores. However, the greater the number of field support personnel on the payroll, the more expensive this monitoring technique becomes. There needs to be a balance of people and policies and formal and informal governance structures. The quality of the relationship between the franchisee and the field support personnel, as measured by the franchisee, dramatically enhances the functioning of operational synergy in the system. Not surprisingly, franchisees rate franchisors more favorably when they perceive a high degree of communications with field support personnel.
To address the rising expense of monitoring, franchisors can also use external audit services or peer review methods, contracting with an outside agency to evaluate franchisee operations. Organizations offering such services can generally achieve economies of scale, making them less expensive on a contractual basis than they would be if performed by the franchisor. An example of such a service is “mystery shopping.” With mystery shoppers, the company with whom you have contracted the service is briefed on the criteria upon which the franchisee is to be evaluated and given a description of what is expected for each criteria. A representative of the company then visits a franchised unit posing as a customer, typically without the franchisee’s prior knowledge. After the visit is completed, an evaluation of the visit is prepared and submitted to the franchisor. Although mystery shopping can be an effective means of evaluating a typical customer experience, it is limited as an overall monitoring tool. Its limitations relate to the subjective nature of the mystery shopper’s opinion and the limited view he or she has of the operations as a whole. A complete evaluation would require access to back-end operations like inventory control and production, which is not feasible.
A more thorough and cost-effective means of evaluating franchisee operations is a system of peer review. A peer review is conducted by and between franchisees in the same franchise system. Results are confidential and not shared with the franchisor. Franchisees visit locations, work in the operation, review the back office, and interview employees and customers. Consider the Jack in the Box incident in which a breakout of e. coli bacteria sickened several customers. The entire system suffered as a result of the incident, not just the individual franchisee, because customers rely on the brand name, not the local entrepreneur, for assurances of quality. This incident highlights that a single franchisee’s peers will in fact be affected by such negative events. Because franchisees have a vested interest in each other’s performance, a program of peer review can be an effective means for monitoring franchise behavior. This method also eliminates the problem of limited access afforded to the mystery shopper, who is not able to evaluate back-end operations.
The franchise contract can be used to defer some of the monitoring costs. Many franchisors do this. As a matter of course the International Franchise Association recommends that franchisors support the establishment of a “franchise advisory council” (FAC). The franchisee association helps build a line of communication with the franchisor. Many FACs help establish the criteria for both minimum and exceptional performance.
Franchisor performance expectations are a powerful and relatively inexpensive monitoring tool. Franchisors can develop a set of performance expectations based on the performance of their own company stores. For example, in the fast-food restaurant industry the franchising company has a complete understanding of what food costs and labor costs should be as a percentage of sales. Franchise company personnel can compare actual franchisee results to these expectations and develop “exception” reports. Any store falling outside the parameters set for expected performance is highlighted for further investigation. Using analytical tools in combination with field support can be a means for stretching a franchise company’s monitoring budget and ensuring that it is addressing problem areas rather than policing stores that show no evidence of performance issues.
However, managing (or monitoring) by exception also means investigating the franchise operation that appears to be a superior performer. For example, why might a franchisee report lower than normal labor expense? At MacDonald’s a franchisee did just that. Investigation revealed a specialized intercom system for the drive-through that increased productivity. Eventually, this new intercom system became standard operating procedure in all restaurants, and labor cost was reduced for the entire system, saving millions of dollars. In the ideal system, innovative work flow, specialized tools, and incentives systems developed by a franchisee can be analyzed by the franchisor and exported to the rest of the franchise system. The performance model is then modified to establish an enhanced standard.
Probably the best way to monitor a franchisee’s performance is to ask customers whether they are being well served. Current customers can provide a wealth of information regarding how well a store is meeting expectations and reasons for their satisfaction or dissatisfaction. Quantitative customer ratings are an excellent tool for tracking how well a franchisee is serving the needs of the customer and where opportunities for increasing service levels might lie.
In addition to soliciting feedback from existing customers, you should also contact potential customers, that is, secondary and tertiary markets. Surveying customers who fit the description of the primary target audience, but who do not currently frequent the franchise in their local area, may provide useful information regarding franchises performance. If the feedback results in the identification of actionable issues, then communicating to potential customers that their concerns have been addressed may help increase the customer base for franchisees in the area. In addition to monitoring and control development, customer surveys are an important marketing and advertising tool, because the customer is the heart of all SDSs.
Financial controls are typically designed to protect the financial interests of the franchisor. Because franchisor compensation is usually based on a percentage of sales, ensuring that all sales are reported is a key element to protecting the company’s financial interest. The most basic concern of franchisors is therefore efficient reporting of sales. The process of collecting financial data enables you to establish a more thorough monitoring and control system.
One advantage of having a broad-based information technology monitoring system is that with it you can capture every aspect of the business, from sales to inventory, to marketing, to labor hours, in an easily aggregated, understandable, and transferable form. The best way for you to capitalize on such an information system is to set parameters both positive and negative, above and below which the controller will organize an exceptions list of variances that will help focus the auditing process on the line items or stores that fall outside the accepted parameters.
Several means for controlling financial reporting by franchisees exists. They include but are not limited to
Centralized point-of-sale systems
Financial reporting
Financial audits
The most basic function of the point-of-sale system is to capture sales data. Ancillary functions may include collecting inventory data as well as numerous other inputs, such as employee information and customer and marketing data. For example, at Jiffy Lube the customer’s name and address plus vehicle-specific information (year, make, model, and mileage) are all captured when the service is rendered and recorded. At the same time, the employees who worked on the vehicle can be tracked and productivity can be measured. Inventory controls include calculating the correlation of oil filters used and gallons of used oil extracted from the vehicle.
Point-of-sale systems can range in sophistication from wide area network (WAN)-based systems to manual cash registers with a journal tape. The more sophisticated the system, the more difficult it is for franchisees to misreport sales information. Electronic data capture that sends information to the franchisor is likely to minimize both unintentional and intentional reporting errors by the franchisee. If the franchise grows to the point where this complex type of system is required, this is a sign of success and value. When you draft the franchise contract, you should plan for the use and modification of such a system in the future. If the need for a more sophisticated system should arise, what type of power will you have to force franchisees to adopt it, and who will pay for its implementation? Another consideration when drafting the franchise contract is what access you have to franchisee financial data. You’ll want to consider the following questions:
How often do franchisees have to report sales?
In what format must the reports be?
What type of supporting documentation must franchisees provide?
Does the franchisor have the right to perform sales audits?
Using analytical tools, such as budgets and forecasts, to monitor franchisees’ financial reporting is a highly cost-effective monitoring tool. Budgets and forecasts make a good benchmark against which you can compare actual financial results. Significant deviations between the budget and actual results can identify stores that may warrant closer attention and investigation.
Franchisors must bear in mind, however, that comparing actual results to expectations is a worthwhile exercise only when those expectations are realistic. Just as company stores are an incubator for developing the SDS, they can also serve as a laboratory for developing expectations for financial performance (see TIP 5-2). Company stores can serve as a baseline for expectations, but differences between the baseline and the franchise in terms of the markets served, size of store, labor markets, and so on must be included in the forecasts developed; excluding these variables will clearly cause any forecasts to be unrealistic and relatively useless as a monitoring tool.
Another way to ensure that franchisees accurately report their financial performance is to reserve the right to conduct an external audit. Hiring external auditors to audit the financial statements of each individual franchisee is too expensive to be used as the sole monitoring tool for financial reporting. However, it is a highly effective means of investigating a franchisee that you expect is inaccurately reporting his or her financial results. When drafting the franchise contract, include the right to require an audit and require that franchisees comply with the requests for information made by the external auditors.
Monitoring and controlling franchisee behavior emphasizes the aspects of the franchisor–franchisee relationship in which the goals of the two parties are seemingly inconsistent. However, these inconsistencies are minor in comparison to what the two parties have in common. The best interests of both the franchisor and franchisee are served when brand equity is built and the end customer is better served. As a result, it is important for both parties to abandon the “us against them” mentality and instead work together to strengthen the system. Communication between the two parties is essential to create a strong working relationship; this seemingly simple mechanism will often separate great success from immediate failure.
Franchisors such as the Great American Cookie Company (GACC) and Kampgrounds of America (KOA) recognize that franchisees know customers in a way that the franchisor never could. These franchisors have tried to understand and integrate into the system the ideas provided by franchisees by working closely with franchisee groups. For example, the franchise association for KOA for years had been requesting that the company adopt a central reservations system supported by a toll-free telephone number and had consistently been denied by the franchisor. When rival camps implemented such systems, KOA was in a position of playing catch up. When the toll-free telephone system was finally implemented, it was an immediate success. An August 1997 Success Magazine article states that, “KOA is one of a growing number of franchisors that are giving serious attention to franchisee groups, turning to them for ideas on everything from packaging to rewriting their franchise agreement.”
In another example of listening to franchisees, the Great American Cookie Company was able to substantially increase its brownie sales. Franchisees alerted the home office that there was a packaging problem. The brownies, which are topped with a thick layer of frosting, were served in bags. Customers complained that the bags made the brownies too messy to eat. When the company switched to serving the brownies in boxes, sales increased.
Some franchisors won’t assist franchisees in forming an association. They’re afraid of a union mentality. In both situations the key feedback came from a franchisee association. The CEO of the Great American Cookie Company FAC indicated, “There is a perceived threat to the franchisor that the association has a bank account and money that can be used as a war chest (to sue the franchisor in a dispute). We keep reassuring each other. If you look at what we have in the bank and what they have, there is not even a comparison.” The CEO of the franchise association agrees. The biggest benefit of the FAC is the teamwork and being able to work with franchisees towards a common goal. By helping franchisees organize a franchise advisory council and taking it seriously, franchisors can tap into a great resource. Furthermore, by creating an atmosphere of cooperation, franchisors can prevent the potential lawsuits that can result when the relationship is adversarial.
The relationship between the franchisor and franchisee is a delicate one. As a result, franchisors must strike a balance between policing franchisee behavior to protect their own interests and partnering with franchisees to improve the system as a whole. The more that franchisees are treated as true partners, the less likely behaviors such as shirking and free riding will exist. The infrastructure implemented to manage the franchise relationship should be one that promotes desired behavior and facilitates communication, thereby minimizing the need for monitoring and control. Before proceeding onto the next aspect of an SDS—marketing—we’d like to leave you with some pearls of wisdom (see TIP 5-3) that mirror the ground covered in this chapter on how to maintain a strong franchisor–franchisee relationship.