There may be no better franchise illustration of the glory and costs of rapid growth than Boston Chicken. Boston Chicken opened its first restaurant in 1985. Eight years later, in November 1993, it was a franchisor and floated an initial public offering. Serving healthy food that actually tasted good in a fast, casual setting was a simple but compelling story. Besides, restaurant sales had shown consistent and impressive growth. But Boston Chicken (which later changed its name to Boston Markets) transformed itself into more of a real estate mortgage company than a restaurant franchise. Until the IPO, Boston Chicken had grown by way of individual franchisees who put up substantial amounts of their own money to open new stores. To accelerate expansion to a dizzying pace, the company signed up financed area developers (FADs). These folks put up 20 percent of the required development costs for a market, and the rest provided by loans from Boston Markets.

The capital market appetite for Boston Chicken seemed insatiable. In 1997 the company raised over $400 million in bond offerings and convertible debt. At the same time, those choice FADs were losing increasing amounts of money—$156.5 million in 1997 alone.

Did Boston Chicken grow too fast, or did it lose sight of the business format that made it a success in the first place? It was probably guilty on both counts. The growth strategy is always dependent on the religious devotion to the business model and store-level economics. Success can be turned into dramatic failure when you forget that.

Historically, an entrepreneur launches a successful single outlet. That success often motivates a desire to add new outlets. If the entrepreneur perceives the opportunity as considerable, the human and financial capital requirement is likely to be bigger than the currently available resources. There are many ways to secure capital for new outlet growth, and as we have discussed, franchising has proven to be a significant method. When a franchisor sells a franchise unit, she is securing both the capital and the talent of the franchise partner—the franchisee. The one-time, upfront franchise fee, ongoing royalties, and franchise management system creates a sharing arrangement between the franchisor and franchisee. Once success has been achieved with the initial rollout of a franchised unit, most franchisors begin to think along the lines of, “If we can have 10 units, why not 25; if 25, why not 50; if 50, why not 150?” and so on. This successive growth logic becomes self-fulfilling as more success leads to more success—but only if you run the stores right and make a profit.

Eventually, Boston Chicken filed for Chapter 11 bankruptcy, reemerging only after being purchased by the MacDonald’s Corporation.

The franchise risk profile template (FRPT), shown in Table 3-1, is a guide in the franchise environment to perform due diligence on a specific franchise. As a prospective franchisee, you can use this tool to evaluate the risk–return scenario. The template allows the franchisee to filter the prospective franchise and the franchisor to construct or modify the franchise so that it scores well and appeals to a larger segment of the prospective franchisee population. This guide has been constructed to help you make an initial assessment of the franchise’s strengths and weaknesses that will likely require further investigation. It is by no means meant to assess the overall potential of a franchise. Rather, it offers a perspective on the balance of risk and return that the franchisee requires. The FRTP is a mapping device, not a formula. We have segmented the FRTP by the business model–scaling hurdles that franchising addresses: administrative efficiency, risk management, and resource deconstraining. In the FRTP the level of market performance a franchise has achieved indicates the extent to which it has overcome the given hurdle.

A company that is lower on the risk scale will offer a lower average market return than a company that is higher on the scale. The higher risk franchise will clearly require the promise of an extremely large return to induce investment. You should consider the criteria in the FRTP before purchasing a franchise. Of course, franchisors should therefore consider these criteria when they make a franchise offering.

Even if you run a single store, you can’t do everything. But if you want to grow the business, you simply must delegate major responsibilities. The problem is that most entrepreneurs think they do things better than almost anyone else. Simply stated, the concept of agency asks, How does the business owner know that delegated tasks are performed exactly as he or she prefers? Once this question can be answered, then the business owner will attain administrative efficiency—a documented process of efficient and effective business operation. Administrative efficiency is the means by which agency problems are managed.

Most businesses grow to the point that the company-owned locations can no longer be managed cost effectively by the corporation. This is the point of zero or negative marginal return. Some additional mechanism for control must be implemented, with additional costs. This can be the trigger for a business to consider franchising.

Monitoring processes implemented through managers or operational and financial system controls are practical ways to monitor quality—but at what cost to the business in dollars, opportunity, or both? One of the biggest cost factors, for instance, occurs when organizations decide to manage and grow their business through the hierarchical use of assistant managers, managers, general managers, district managers, national managers, and so on. When this process of management is used in a corporate-owned chain of outlets, management performance becomes divorced from ownership.^[1] The level of performance may become suboptimal because managerial accountability is not directly linked to compensation. Because the outlet managers in a company-owned store do not directly reap the rewards, or suffer the consequences of their actions, the feedback mechanism that could reduce inappropriate management behaviors such as shirking or free riding is, in effect, rusty and relatively less effective.^[2] To correct this effect, the entrepreneur and/or the company’s management must incur high system-monitoring costs. This may solve the behavioral problems but restrict both the speed and the extent of growth.

Let’s refer back to the FRPT in Table 3-1 for a moment. Under Agency Concerns, we list outlet performance disclosed or discerned—the economics of the individual unit as a key indicator of an efficient system. In plain language, if the stores are profitable, then the franchisor system has, generally speaking, overcome agency issues. The second criteria, business format, allows you to understand whether profitability is a result of overcoming agency issues through a well-documented system or simply a case of the “rising tide” phenomenon. When a franchise offers something new to an accepting customer base, it may gain success because it was the first and maybe only such offering. Inefficiencies that become more apparent as the market develops and competition increases will deteriorate store-level economics. Boston Chicken is a prime example. In either case you would like to understand whether the system is moving in the right direction toward documentation and monitoring of the mechanisms that generate profits. The best way to discover the truth is to study the revenue growth in existing stores from quarter to quarter and examine how fast new stores reach and exceed breakeven. Asking the franchisor and existing franchisees direct questions is always a good idea!

The next criteria, franchise fee and royalty, is the mechanism that franchising uses to share the productive benefits of the relationship and therefore create the economic motivation for both parties to “act like owners.” The franchise fee and royalties are payments from the franchisee to the franchisor. The profit or loss from operating a store is the incentive for the franchisee. The partners share responsibilities and feel better that their goals are aligned through the profit incentive. Ownership induces behavior that is directly linked to the bottom line—positively or negatively. In order to better understand how franchise fees and royalties are determined, it is helpful to first look at the framework franchisees use in evaluating whether to buy a franchise or open their own business.

We can begin to manage the decision process surrounding a franchise opportunity by using the PDV exercise in Figure 3-1; this will help us understand the reality of pursuing a franchise by considering the income streams and discounted value of both franchise and standalone opportunities.

We are often asked, “Should I buy a franchise or develop my own store?” While PDV is a pretty straightforward formula, greater nuance is necessary to tease out the issues that affect the calculation.

Figure 3-1. PDV exercise.

“The present discounted value of an income stream” contains two key concepts—discount and income. The discount rate is the reduction in the future income based on the chance (expressed as a percentage) that we will not achieve expected results. A new business idea is often “discounted” up to 70 percent in pro forma financial statement analysis. The greater probability of success of a franchise lowers the discount rate for the franchise operation because a “proven” business model has less risk than a new concept (i.e., a new standalone operation). Because the success of a franchise rests, to some degree, on the development and beta testing of a business model, positive market response to this business model is what the franchisor is really “selling” when a franchise is sold. The discount rate could be half that of a standalone operation.

An additional benefit to franchising is economies of scale in marketing, purchasing, and property, plant, and equipment (PP&E), which translates into more efficient growth and faster solidification of the brand. In most cases, having a recognized franchise brand versus a new standalone brand results in greater income sooner.

Similar to the analysis franchisees conduct in assessing whether to pursue a franchise or standalone model, franchisors often ask, What should I charge for franchisee fee and royalty? The franchise fee is the one-time, upfront payment, and the royalty is paid as a percentage of sales as they occur over the term of the license agreement. The answer is to make the same PDV calculation as in Figure 3-1, but to interpret the results from a slightly differently perspective. If the PDV of the franchisee’s income stream is not greater than the PDV of the standalone operation, the concept is weak. If the PDV is greater, then we have a monetary value, which is essentially the difference between PDVs, to begin with and then to alter according to current market conditions. Hypothetically, if the franchise PDV is $1 million and the standalone PDV is $700,000, then the franchisor can reasonably charge a franchise fee plus royalty of $299,999 or less, depending on current market conditions. In the marketplace of franchise business opportunities there are presently approximately 4,200 franchises. The perceived strengths of the franchise and the respective costs of other business opportunities create the adjustments to the $299,999 difference between the franchise’s income stream and the outlet’s income stream.

Current market forces will of course naturally control how high a figure will be tolerated. The stronger the franchise is perceived to be, the closer to $299,999 can be charged. What part of the theoretical $299,999 should be franchise fee and what part should be royalty is generally the next question on the franchisor’s mind. Because the market does not supply perfect information, the prospective franchisee cannot know everything about a franchisor. However, in general, a higher franchise fee is a signal to the potential franchisee that the franchise is of high quality. For example, many home-cleaning franchises have a franchise fee of under $20,000, and Merry Maids is $32,500. Why? Such a difference in cost would signal the differentiated and higher quality aspects of the Merry Maids franchise. Which is better, a $10 bottle of wine or the $20 bottle? In reality, we don’t know which wine is better. But for many people, the price signals one as better than the other.

Some franchisors might attempt to charge a very high franchise fee to send a false signal of quality. The reality is that the market won’t sustain that fee if stores aren’t profitable.

The franchisee and franchisor are making the same bet that the franchise outlets will generate a faster-growing and more stable income stream than a chain of independent outlets. In general, although the perceived or actual strength of the operation will increase the royalty and franchise fee for the franchisor, it will also reduce the risk for the franchisee. You must remember that the marketplace is dynamic, and the PDV calculation must be reassessed often to monitor the marketplace. There are several risks to consider in pursuing a franchise as a business opportunity, but with the PDV exercise, you can gain a great deal of insight into the actual financial opportunity.

The next section of the FRPT relates size of the system to risk. Generally, the larger the system becomes, the larger are the economies of scale, the lower the costs, the higher the profits, and therefore the less risky is a franchise opportunity. For example, when a system has only four units, the media exposure and brand awareness that are generated—and that subsequently reinforce themselves over time—are entirely different from the exposure and brand strength of a system that has reached 1,000 units. When a significant size is reached, signals of strength and consequently reduced risk are sent to the market. These are real factors of lowered risk for the franchisee. As the next exercise demonstrates, these lowered risk factors not only increase the income but will also lower the discount rate for the franchisee. Total number and market placement of outlets is indicative of consumer acceptance and power in the marketplace. Profitability drives the need and motivation to grow a system, and growth makes profitability more feasible because of economies of scale. It is a virtuous economic cycle.

The FRPT links multiple market presence and market share as defining criteria for measuring market size. For example, a system that has 100 units spread across the country does not have the same market presence as a system that has 100 units in one geographic region. The concentration of outlets tends to create marketing economies of scale and increases administrative efficiency. Therefore, the system with dominant market share in a number of markets is the least risky.

Most franchisors make an attempt to operate stores. Some have proven to be quite good store operators. Radio Shack has 2.5 times as many company-owned stores as franchised stores.^[3] It pushes out geographically from its headquarters until the monitoring costs become too high or until it simply wants to grow faster than its available capital allows, and then it sells more franchises. Keeping in mind that the per-unit development cost for each new unit is identical for franchisor and franchisee, you must consider the capital requirements of the franchisor. For example, developing four corporate-owned units could be capital-prohibitive in comparison to developing one corporate unit and franchising the other three. In the former case, the required investment for development could be so high as to retard growth, whereas in the latter, the increase in cash flow may very well enable further expansion more quickly. Therefore, the franchisor seeks to implement franchises as a means of leveraging the concept and franchisee capital—a fundamental underpinning of franchising. TIP 3-2 illustrates the principle of balancing capital needs in a growing franchise system.

Thirteen percent of all outlets in franchise companies are company-owned stores. For every store that a franchisor develops, seven more franchised stores are built—a finding supported by our discussion of capital allocation. Refer to Figure 3-1 for the number of outlets criteria. The average franchise system’s investment capital (including franchisor and franchisee) can produce seven times the number of stores that a wholly owned independent chain can by leveraging the franchisor’s concept with the prospective franchisee’s capital. The franchisor has expanded the brand system by four units but has incurred direct investment costs for only one unit.

Once a company begins to expand in size, the principal administrative requirements shift to the franchisees. At what size, in terms of number of outlets owned, does the franchisee exceed her management capacity? Clearly, this is different for each system and indeed for each franchisee. But the smart franchisor is aware of the issue and monitors management capacity. Franchisees often invest a significant portion of their net worth in a single outlet. By doing so, they are not taking full advantage of the diversification benefits that can accrue through a diversified portfolio of outlets in different franchise systems. That diversification can occur by simply using the investment you would make in purchasing a franchise to instead purchase a portfolio of franchise company stocks. These franchisees leave themselves potentially exposed to a high level of franchisor-specific risk, just as an investor that holds only one sector of investments, or only one stock, faces similar risks of overspecification. In a frictionless market in which information sharing is seamless and instantaneous, no additional returns would be expected to compensate for what is, in effect, the self-inflicted pain of not diversifying when perfect information is possible.

However, the franchise market is far from frictionless, with limited buyers and sellers, large degrees of informational asymmetries, and constrained capital. Under these circumstances, it is conceivable that above-market rates of return need to be provided to franchisees to entice them to join the franchisor’s system. Therefore, franchisees are more likely to invest in those franchises that outperform the general corporate market. This suggests that younger systems may have to adjust their franchise fee and royalty down. In and of itself, this conclusion begs the question of which needs to come first: the chicken or the egg—quality franchisees or high-performance franchisors? The reality is that most systems are dynamic. Early franchisees are taking a bigger risk. If performance is exceptional, they attract high-quality people to the system.

Any organization’s attempt to grow will inevitably be hindered by a lack of capital. Franchising can meet the need to conserve capital while continuing to achieve growth.^[4] In a franchise context the capital influx from franchise fees reduces the need for the franchisor to raise money to grow,^[5] conserves the franchisor’s capital,^[6] and establishes a distribution network more quickly than does a chain of company-owned outlets.^[7] Franchisee capital is specifically earmarked by the franchisor for implementation of a rapid growth strategy.^[8] Entrepreneurs clearly perceive the opportunity for rapid growth and the acquisition of franchisee capital as important reasons to pursue franchising.^[9] The FRPT tracks the general use of franchisee capital contributions to the growth of the system and the financial health of the franchisor. The franchisor’s health is due in part to the health of the stores and in part to good management of resources.

The FRPT is our guide to franchisor-specific due diligence. Industry-standard documentation in franchising contains much of the information for due diligence and reveals extensive financial data. The Uniform Franchise Offering Circular (UFOC) and the license agreement can answer many of the questions raised by the FRPT. The first is government-mandated franchise disclosure. The second document is the contract between the franchisee and the franchisor, which is typically standardized within a franchise system.

The franchise relationship is characterized by a high degree of informational asymmetry. This means that the franchisor and the franchisee do not have access to the same knowledge about the strengths and weaknesses of the franchise. The Federal Trade Commission (FTC) does not require franchisors to disclose franchisee earnings, which tends to reinforce the franchisor’s ability to camouflage poor performance and to maintain a financial advantage (higher franchise fees and royalties) far longer than might prevail under more stringent disclosure rules. The FTC argues that a disclosure of average earnings would be as misleading as no disclosure at all, because such a wide range of earnings exists among franchisees that the average is relatively meaningless.^[10] Limited disclosure does not benefit all franchisors either, but it generates a “lemons” problem^[11] wherein good firms are pooled with bad firms and, unable to attract capital at reasonable rates, progressively disappear from the market. Franchisors can signal their superior quality, however, by building their brand through successful stores. By constructing the franchise concept with the FRM in mind, the franchisor will extract the most efficient system and highest returns and will stand out in the crowd of those who have chosen not to perform such due diligence in the shaping of their opportunity.

One of the key operating features of the franchise partnership is the license agreement, a document that codifies the relationship between franchisor and franchisee. Six sections of this document are relatively consistent throughout franchising and represent the core of the operating arrangement. Table 3-2 is a chart that describes the license agreement item, its overall impact, and the effect of that impact on your perception of the return potential as a franchisee (called a marketplace signal).

These license agreement features offer a realistic context in which to consider the specifics of the concept. They codify the economic relationship between the franchisor and franchisee and therefore affect the income stream that is used in the PDV calculation. They are also tools to differentiate a given franchise from another. For example, when the average advertising fee is $20,000 and yours is $100,000, the difference screams, “Why?” Your higher fee should correspond to higher quality, and you should be ready to communicate that advantage to franchisees.

These franchise dimensions are taken from 91 publicly traded franchisors that, as a cohort, have outperformed the S&P 500 over 10 of the last 11 years. They help us understand what to look for from existing franchisors and also provide a template for aspiring franchisors to reshape their opportunities. Some important interpretations include the following:

Franchisor wealth creation results from an intricate combination of key characteristics. Traditionally, this combination has centered on rich unit economics, an ability to transfer excellence, and the potential for economies of scale. However, the bond between franchisors and franchisees, as embodied in the license agreement and in the parties’ informal relationship, is of equal importance. Potential franchisors should understand that the details in the license agreement will shape the relationship with the franchisees. Franchisees in turn should use these details as a clear pathway to choosing a potential franchise.

Our general assumption has been growth through internally funded sources or through the introduction of franchisee capital. But public capital can serve as a supercharged catalyst for systemwide growth. Let’s explore the notion of public capitalization in further detail.

Because rapid growth is the goal, most franchise systems are continually seeking additional capital. When scale is achieved, the amount of acquired capital becomes increasingly important. Accessing capital through the public stock markets is a faster, if not the fastest, means of obtaining large amounts of capital. Some franchisors have not limited their capital to franchise fees and royalties. Many have used private equity, and approximately 250 of the total 4,200 franchisors have acquired public capital.

Our research compared the total shareholder return for public franchisors to the S&P 500 index for an 11-year period from January 1990 through December 2001. For 10 of those years, excluding 1999’s “irrational Internet exuberance,” public franchisors outperformed the S&P 500 in total return to shareholders.^[12] The wealth created by these “public” franchisors makes it apparent they’re doing something right. It is also clear that the public markets are an additional source of capital that can enable the explosive launch and growth that franchise entrepreneurs crave.

Public capital might allow the franchisor to lower the franchise fee. The effect is to accelerate growth because lower startup costs attract more franchisees. The franchisor can then back-load her income stream with a higher royalty. Royalties on sales directly tie success of the franchisor to the success of the franchisee. While this seems obvious to most of us, franchisors can lose sight of it. Boston Chicken got so caught up in growth that it forgot about its franchisees’ success. It actually derived more of its income from financing franchisee development and receiving interest on the loans than from royalties.

The sheer size of franchising in terms of number of stores, revenue generated in the United States, and its significant portion of the U.S. GDP is evidence enough of its success. Franchising accounts for more than a third of the annual retail sales in the United States; clearly, it is a successful wealth-creating vehicle.^[13] The capital marketplace would simply not support this pathway to entrepreneurship if return on investment did not warrant it. This chapter is the first clear documentation of both franchisee and franchisor wealth creation. The debate is advanced in favor of our argument that franchising, for all the stakeholders, is entrepreneurial in nature and fact.

Although the potential for wealth creation is clear, the road to success is fraught with details that can derail great opportunities. Here, we’ve provided substantial evidence that franchising as an entrepreneurial alliance can fulfill the promise of wealth creation. By examining the major components of the SDS in later chapters, we also show how the combination of these components can create sustainable competitive advantages for the franchise company.