What separates the great franchises from the mediocre? What makes some franchises hum like a finely tuned engine and others sound like a broken record? Our belief is that beyond all the systems, spreadsheets, and technologies, the fundamental success factor for franchises is an understanding that the franchisor–franchisee alliance is an intimate business relationship. This leads to our discussion of the dynamic relationship between franchisor and franchisees and the important role it plays above and beyond all the quantitative material and data that comprises the “potentially successful” franchise. Relational dynamics is the way in which the franchisee and franchisor interact to exploit opportunities, handle conflict, communicate about current operations, and plan for the future.
The subject of conflict in franchising is well documented in the press. Almost 50 percent of all franchisors are in a lawsuit at any given time. Thirty percent of franchisees are unhappy enough with the relationship to consider severing it. Conflict is not totally unhealthy for any business. Questioning, probing, arguing, and even fighting can sometimes produce very healthy results. Pizza Hut had dramatically contentious relations with its franchisees in the late 1970s that led to a revised license agreement and a successful new launch of its pizza-delivery program. However, when conflict reaches the courts, it drains time, talent, and money from a franchise system, and conflict at that level seldom results in a healthy relationship going forward.
Like several of our other topics, relational dynamics is a concept that can be separated into four individual parts but that can be fully appreciated only by the integration of all the parts working together in a dynamic fashion.
We briefly break down “relational dynamics” into its individual parts, and then present a case study that reflects the relative importance that each component below brings to a franchise system. The individual components of relational dynamics in franchising are:
Wealth Creation: A view by each player about how the franchise system will help them become wealthy or at least will provide a market ROI. For some people, this is simply an income stream or the accumulation of assets. For others, it includes wanting to be in the industry they are involved with, the product or service they provide, the people they serve, their role in the business, and the degree of control in decision making.
Communications: Franchising is a long-term contractual relationship facing many challenges because both people and markets change. Communication, both formal and informal, is at the core of a relationship flexible enough to last over time.
The Brand: How do the franchisor and franchisee value the brand and their collective role in maintaining and building it? When there is perceived fairness in brand building, role definition, and execution, then the relationship remains healthy.
Exit Costs: What happens when a franchisee becomes unhappy with the franchisor? He or she likely looks at the long-term value of the relationship versus the cost of exiting the relationship. That calculation is more measurable than you might expect.
Let’s look at each of these components more closely.
As we’ve stated numerous times throughout this book, one of the main reasons for becoming involved in franchising is wealth creation. With most license agreements averaging 15 years in length, we doubt anyone would become either a franchisor or a franchisee without the absolute expectation of creating long-term, sustainable wealth. In fact, of the more than 600 franchisees we surveyed, all of them expected the venture to create some personal wealth beyond their management salary. The trick, as if you could make it that simple, is to turn this great franchising idea into real wealth. Believe it or not, your success may rest not only on the quality of your product or service, but also on the quality of your partnerships with those you depend upon and those who depend on you.
The franchisee must make a series of investments in the franchise. The initial investment is disclosed in the United States through the Uniform Franchise Offering Circular (UFOC) and can range from a few thousand dollars to several million dollars. The operating results of the franchise are expected to provide a return on that investment. Often, over the life of a franchise agreement, reinvestment in property, plant, and equipment is required. Again, operating results need to support that additional investment.
When the operating results fall short, the franchisee tends to look to the franchisor for an explanation. Most systems have some under-performing stores. But when a significant minority of stores under-perform, the franchisees often lash out at the franchisor. There is a two-pronged focus of franchisee wrath. First, are the royalty payments too high and thus strangling profitability? Second, are the services provided by the franchisor appropriate and sufficient? Look at a franchisor’s balance sheet for royalties payable to get an indication of the health of the franchisee–franchisor relationship. If accounts receivables are rising and days receivable are increasing, there may be franchisee conflict brewing. When franchisees become pressed financially, the first bill extended is the royalty payment. Ultimately, the franchisor cannot survive without an overwhelming majority of franchisees that are making a market or better ROI. When financial return does not meet franchisee expectation, conflict ensues and changes to the relationship occur. A small number of outlets in trouble results in closure or franchisor acquisition. A large number of under-performing outlets affect royalties or services. Those changes can happen through renegotiation of the license agreement or in litigation. The market simply will not allow status quo with under-performing operating stores.
Franchisees as a group and each franchisee individually must find a way to manage their relationship with the franchisor, and vice versa. Not enough attention is paid to how partners, who commit to as many as 20 years of working together, will remain focused enough to protect the brand and be flexible enough to react to constantly changing market forces. It is this very ability to manage the franchise relationship in a dynamic way that keeps a system viable for the long run. Additionally, when the franchise relationship builds in mechanisms to adjust to market changes, the formal legal boundaries of the license agreement should not constrain competitive advantage. In other words, no contract can be written that anticipates every change that may occur over the course of a 20-year period. But when both the franchisor and franchisee are committed to communicate openly and believe there is equity in the relationship, then the appropriate adjustments can and will be made in manners that benefit both parties.
This is the essence of relational dynamics—making adjustments to the relationship in response to market demand that benefit both parties and enable them to reach their mutually dependent goals of wealth creation. The role and interpersonal skills of the franchisor’s field personnel is the key to the informal communications system in the franchise relationship. When franchisees believe their field support contact with the franchisor is clearly and accurately communicating, the level of conflict remains healthy. This is true even when the message is not one the franchisee wants to hear! Frequent and direct contact with the franchisee by trusted franchisor personnel is essential to a positive relational dynamic.
Informal communication is wrapped around a more formal system of contact that often includes
Written store reviews with clearly delineated expectations and performance feedback.
Advertising and promotional materials and strategy that is planned in advance and delivered to operating units.
Regional and national meetings to provide education and a venue for strategic planning with franchisee input.
Formalized business planning at the franchisee level with custom tools (such as customized electronic spreadsheet programs, store growth capital planning tools, human resource management support).
Training aids such as curriculum, videos, and certification.
Also important to franchisees is their assessment of the distribution of the revenue generated by the franchise. Franchising is a classic “relational exchange.” That is, the franchisee and franchisor both see their current income and future wealth as tied to the performance of their franchise partner. They equate preservation of the relationship with the fair distribution of the benefits generated by the relationship. Clearly, fair does not necessarily mean equal. Fairness, however, is subjectively assessed by a franchisee. If fairness is perceived to be absent in the distribution, then the franchisee will assess alternatives to the current relationship or start behaving badly.
The question of a franchise’s value rears its head in the discussion of relational dynamics in a different sense than it does when you are a prospective franchisor or franchisee first considering a franchise opportunity. From the relational dynamics perspective, the question of a franchise’s value is, Now that I am a party to this franchise relationship, what is the value of continuing to be so?—not, Should I do this at all?
That assessment to continue as a franchisee ultimately values the trademark or brand value that produces profits. How much it costs to exit the franchise relationship tells us a lot about how valuable the relationship is. There are always costs to exiting a business relationship. So, a franchisee says, “Am I unhappy enough to bear the expense of severing the relationship?” When franchisees see the trademark as able to grow and sustain value, they try to work through problems. However, if they see little value in the trademark at present or over time, then it’s fairly reasonable to contemplate leaving the system. There is evidence that if franchisees aren’t rewarded by the brand in the first 7 years of the relationship, then contemplation changes to action. It’s an interesting twist we call the “franchise seven-year itch.” As we soon discuss, one way to calculate the present and future value of your stake in the franchise is to determine your exit costs.
The franchise relationship is based upon the belief that the alliance will generate efficiencies resulting in greater returns to the participants than if they pursued similar opportunities independently. The franchisor and franchisee share a common trademark or brand, which is the embodiment of the value of the franchise relationship. The two must manage the part of their relationship that centers on this shared asset. If they understand the issues likely to cause conflict that erodes brand value, the partners can design and implement policies to control disagreement and to support the long-term relationship. The connection between forethought and real-time policy implementation enables more effective adjusts and supports the constant effort to prevent disruptions to the wealth stream whenever and however possible.
Either party may make the decision to exit the franchise relationship. This choice carries with it both direct and indirect costs. In this discussion we assume that the franchisee’s exit is followed by the decision to continue to operate as an independent. You could, of course, try to sell the franchise instead. This can be difficult if poor performance is the underlying cause of your dissatisfaction. The sale price would be significantly depressed. In either case—sale or exit to become an independent operation—understanding exit costs is essential to making a sound decision.
You should assess your exit costs while your relationships are strong, before conflict arises. As an integral part of a relational dynamics management process, assessing these costs will confirm your understanding of the value of the franchise. Based on this confirmation, you will see the value in managing and planning for conflict before it happens. Only in the worst situations will you have to put your knowledge of exit costs into action to terminate the relationship. In contrast, when returns meet expectations and you are ready to sell the franchise, exit cost knowledge will help you assess the value of your firm and establish a sale price.
Previous research has shown that dissatisfaction may arise in a conflict situation when the cost of remaining in the relationship exceeds the perceived cost of exit. These costs vary wildly by franchise, but the greater importance is not magnitude—it is the comparison of cost of exit and benefit of staying in the relationship. Conflict in the relationship usually comes from one or more of the categories we describe in Table 9-1 when they do not yield the benefits that the franchisee expects. Conflict generally arises for franchisees when they perceive diminished value from the very franchise concepts that were purported to make the system unique. Think of it this way: The value you receive from the franchisor would cost you something to replace if you weren’t a franchisee. The less value received from the franchisor, the less expensive it would be to leave the system. Therefore, perceived exit costs correlate with trademark value. Higher exit costs mean you think it will be expensive to replace the value received from the franchisor. If there is conflict with the franchisor and the exit costs are high, you’ll work harder to solve the conflict. This brand capital would be lost to the franchisee upon exit from the franchise relationship. In the simplest terms, the amount of loss that would be incurred is equal to the value of the brand capital.
To help determine the value of exit costs, we assessed the investments that franchisees often make and placed them into four categories: business format, expense, asset, and psychic. Table 9-1 categorizes several exit costs and describes the perceived effect of each cost.
The variables in the first category, business format, deal with the SDS, operating system, or training program. The business format variables dominate the exit cost calculation because these comprise the foundation of the franchise. The second category, expense, reflects what appears to be the direct expense associated with exit, such as legal fees. The third category is psychic costs—clearly, great personal psychological expenses are incurred by an entrepreneur as investments are made in the franchise relationship with other parties. The fourth category, the asset, deals with the costs of converting physical assets to avoid legal infringements on the rights of the franchise you have exited. Some of these exit costs are easier to quantify than others.
Table 9-1. Exit Cost Analysis
Perceived Exit Costs | Relationship Category | Cost Analysis |
|---|---|---|
Exiting will increase training cost. | Business Format | How many days of training do you currently receive from the franchisor? |
Exiting will require operating changes. | Business Format | Will you have to replace special/proprietary tools, equipment, or software? |
Company investment is unique to the relationship. | Business Format | Some of the services you receive from the franchisor are difficult or impossible to replace. How much will that increase the cost of delivering your product? |
Exiting will be costly in lost customer goodwill. | Business Format | The brand of the franchise generates sales. If you change the name of the business from the franchise name to an independent name, how much revenue will be lost? |
Exiting will be costly in finding alternative suppliers. | Expense | How will you buy your supplies as an independent versus a franchisee? You’ll no longer have access to national or regional supply contracts. |
Exiting will increase marketing budget. | Expense | You’ll have to advertise your new name and logo. Also, you’ll probably not have the marketing economies of the franchise system. How much will that increase your marketing budget? |
Exiting will be costly in legal expense. | Expense | A franchise license agreement is a contract that is not easily severed and almost always requires legal counsel. |
Company has invested time and energy into the relationship. | Psychic | Most franchisees report they have built informal relationships in the franchise system that provide benefits. What if these relationships were severed? What costs or lost opportunities might result? |
Exiting will be costly in store conversion. | Asset | Both external and internal signage has to be changed if you exit; this is the single biggest store conversion cost. |
Using this exit cost assessment as a framework for determining not only the actual costs of exit, but also of the value of the trademark presently and subsequently, will make the transition into a relational dynamics management process that is much simpler and standardized.
The relational dynamics management process of creating wealth, communicating goals and execution requirements, clearly defining roles in building brands, and assessing exit costs is another tool for solidifying the value of your franchise. Relationships are the vehicle that enable, empower, and support every other physical or financial effort. Once franchisee and franchisor understand that wealth creation is the common goal, everything else falls into place.
When reading about the Quick Lube Franchisee Company, you’ll see the manifestation of conflict in franchising on all four of the dimensions discussed in this chapter. While you are reading the case, we recommend keeping the following four concepts in mind. As a guide, we have provided the general definition of each category in italics and then a hint as to how you will see each in the case. Although the names of people and companies are fictitious, the events are a true depiction of the vastly complicated human and organizational interactions between a growing and profitable franchisee and a franchisor.
Wealth Creation: A view by each player about how the franchise system will help them become wealthy, or at least provide a market return on investment. The change in control of the franchisor almost always causes concern among franchisees. In this case study we see a franchisee who now wonders how the multiple roles of “Big Oil” will cause an unfocused approach to wealth creation for the franchisees.
Communications: Franchising, as a long-term contractual relationship, faces many challenges because both people and markets change. A relationship based on both formal and informal methods of communications is at the core of a relationship flexible enough to last over time. When there is trauma in the franchisor, the field support personnel have to go into high gear with communications. We see little of this from the new franchise owner. The franchisee, QLFC, panics and quickly seeks refuge in the courts.
Brand: How do the franchisor and franchisee value the brand and their collective role in maintaining and building it? When there is perceived fairness in brand-building role definition and execution, then the relationship remains healthy. The franchisor is suddenly the franchisee’s biggest supplier. This is a huge red flag for the franchisee: What brand is going to get promoted, Quick Lube or Big Oil? When there is brand confusion, the franchisees invariably feel stress. Unless there is absolute clarity from the franchisor, this stress is likely to elevate to negative conflict.
Exit Costs: What happens when a franchisee becomes unhappy with the franchisor? She likely looks at the long-term value of the relationship versus the cost of exiting the relationship. That calculation is more measurable than you might expect. A consequence of brand confusion is a lowering of exit costs. If the franchisee believes that the franchisor is diluting the brand (in this case with a supplier brand), then losing that brand and operating under another name is not a big hurdle. This case is a particularly good example of how brand concerns for a franchisee lead to dramatic action. A company with $30 million of revenue suing a multibillion-oil company is a David versus Goliath battle and not a completely rational action!
It had been a year since Huston, a major oil company, had bought 80 percent of Super Lube, Inc., the number one franchisor of quick lubrication and oil-change service centers in the United States, with 1,000 outlets. As a result of that takeover, Super Lube’s largest franchisee, QLFC, found itself in the position where its principal supplier, lead financing vehicle, and franchisor were the same entity. Was this an opportunity or a disaster? In April 1998 Frank Herget, founder, chairman, and CEO of QLFC, was faced with one of the most important decisions of his life.
Historical Background. Super Lube was the innovator of the quick-lube concept, serving the lube, motor oil, and filter needs of motorists in a specialized building with highly refined procedures. It was founded in March 1986 by Jeff Martin. Frank Herget was one of the four founding members of Martin’s management team. After a few years, Herget became frustrated with life at the franchisor’s headquarters in Dallas, Texas. He believed that the future of the Super Lube was in operating service centers. That put him at odds with founder, chairman, and CEO Jeff Martin, who was passionately committed to franchising service centers as fast as possible. Martin and Herget had known each other for a long time, so they sought a mutually acceptable way to resolve their differences. Their discussions quickly resulted in the decision that Herget would buy a company-owned service center in northern California by swapping his Super Lube founder’s stock valued at $64,000, which he had purchased originally for $13,000. Quick Lube Franchise Corporation was founded.
Early Success and Growth. Success in his first service center inspired growth. Eventually, QLFC controlled service-center development and operating rights to a geographic area covering parts of California and Washington with the potential for over 90 service centers. Herget’s long-term goal was to build QLFC into a big chain of Super Lube service centers that would have a public stock offering or merge with a larger company. See Table 9-2 for QLFC’s 10-year growth trend.
Table 9-2. QLFC’s 10-Year Growth
′89 | ′90 | ′91 | ′92 | ′93 | ′94 | ′95 | ′96 | ′97 | ′98 | |
|---|---|---|---|---|---|---|---|---|---|---|
Service Centers | 2 | 3 | 4 | 7 | 16 | 25 | 34 | 44 | 46 | 47 |
Sales ($ Mill.) | .5 | 1.6 | 2.1 | 3.8 | 8.5 | 15.5 | 19 | 27 | 28 | 30 |
Herget financed QLFC’s growth with both equity and debt (figures 9-2, 9-3a and 9-3b). Most of the additional equity came from former Super Lube employees who left the franchisor to join QLFC in senior management positions. They purchased stock in QLFC with cash realized by selling their stock in Super Lube. A key member of Herget’s team was Mark Roberts, who had been Super Lube’s CFO until 1993. He brought much needed financial sophistication to QLFC.
The primary debt requirement was for financing new service centers. In 1998 the average cost of land acquisition and construction had risen to $750,000 per service center from about $350,000 ten years earlier.
Growth was originally achieved through off-balance-sheet real estate partnerships. An Oregon bank lent about $4 million, and a Texas bank lent almost $3 million. However, rapid growth wasn’t possible until QLFC struck a deal with Huston Oil for $6.5 million of subordinated debt. The Huston debt was 8 percent interest-only for five years and then amortized on a straight-line basis in years six through ten. The real estate developed with the Huston financing was kept in the company. QLFC was contractually committed to purchasing Huston products. See Figures 9-3a and 9-3b for QLFC’s financial statements.
Super Lube’s Relationship with Its Franchisees. Despite bridge financing of $10 million at the end of 1992, followed by a successful IPO, Super Lube’s growth continued to outpace its ability to finance it. By the mid-1990s, Super Lube was in technical default to its debt holders. Huston struck a deal to acquire 80 percent of the company in a debt-restructuring scheme. However, during the time of Super Lube’s mounting financial problems and the subsequent Huston deal, franchisees grew increasingly discontented.
A franchise relationship is governed by a contract called a license agreement. As a business format franchise, a franchisor offers a franchisee the rights to engage in a business system by using the franchisor’s trade name, trademark, service marks, know-how, and method of doing business. The franchisee is contractually bound to a system of operation and to pay the franchisor a royalty in the form of a percentage of top-line sales.
The Super Lube license agreement called for the franchisor to perform product development and quality-assurance tasks. Super Lube had made a strategic decision early in its existence to sell franchises on the basis of area development agreements. These franchisees had grown to become a group of sophisticated, fully integrated companies. As the franchisees grew with multiple outlets and became increasingly self-reliant, the royalty became difficult to justify. When the franchisor failed to perform its contractually obligated tasks as its financial problems grew more burdensome by the mid-1990s, a franchisee revolt began to surface.
The Huston Era Begins. The new owner, Huston Oil, quickly moved to replace virtually the entire management team at Super Lube. The new CEO was previously a long-term employee of a K-Mart subsidiary. He took a hard-line position on how the franchise system would operate and insisted that Huston motor oil would be an important part of it. The first national convention after the Huston takeover was a disaster. The franchisees, already frustrated, were dismayed by the focus of the franchisor on motor oil sales instead of service center-level profitability.
Herget decided to make a thorough analysis of the historical relationship between QLFC and Super Lube. Three months of research and documentation led to QLFC calling for a meeting with Huston to review the findings and address concerns. The meeting was held at the franchisor’s offices with Herget and the franchisor’s CEO and executive vice president. Herget described the meeting:
The session amounted to a three-hour monologue by me, followed by Super Lube’s rejection of the past as relevant to the relationship. I was politely asked to trust that the future performance of the franchisor would be better and to treat the past as sunk cost. In response to my concern that Huston might have a conflict of interest in selling me product as well as being the franchisor and having an obligation to promote service center profitability, they answered that Huston bailed Super Lube out of a mess and the franchisees should be grateful, not combative.
Litigation. The QLFC board of directors received Herget’s report and told him to select a law firm and to pursue litigation against Huston. QLFC’s 3 months of research was supplied to the law firm. A suit against Huston was filed three months after the failed QLFC/Huston “summit.”
Huston denied the charges and filed a counter suit. Document search, depositions, and general legal maneuvering had been going on for about 3 months when QLFC’s attorneys received a call from Huston requesting a meeting. Herget immediately called a board meeting and prepared to make a recommendation for QLFC’s strategic plan.