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More businesses than ever before are embracing franchising. So what exactly has prompted these organisations to deviate from the traditional business development path, and adopt franchising as a growth strategy? Rod Young provides some crucial direction for those considering franchising.

The Franchising Australia 2006 survey identified that approximately 1000 Australian businesses operate within the definition of franchising in the Trade Practices Act. Many franchisees have opted for franchising as a low risk enterprise, and by and large the vast majority of franchisees are successful. Many would-be franchisors have seen and read about the franchising success of McDonalds and KFC and other world-wide businesses such as Coca Cola, Pepsi, Ford, Toyota, Shell and BP. Each has built a massive enterprise through franchising.

Australian franchising icons such as Australia Post, Forty Winks, Bakers Delight, Boost Juice, Donut King, Hairhouse Warehouse, Dymocks, Cartridge World, Fernwood, Mortgage Choice, Cash Converters and Healthy Habits have been held up as shining examples of what franchising can do.

Over the past 20 years the growth in the number of franchising companies and their 60,000 franchised owner-operators make franchising a powerful magnet for those business owners keen to expand.

Does franchising make franchisors successful?

The reality is that while the majority of franchisees are making money, the performance of many of the 1000 franchisors is less clear. An understanding of how a franchisor generates revenue and profit is instructive.

A franchise network that has no company-operated outlets and is 100 percent franchised relies for its profitability on the sale of franchises and the ongoing royalty stream flowing from the successful operation of the franchises. In some cases, supply-side rebates and renewal fees after the initial franchise term help supplement revenue and profits for the franchisor.

The initial franchise fees can support the overheads of a franchisor and still create good profitability during the growth phase of the franchise. However, as a franchise system grows and market penetration approaches its peak, the reality is that new franchise sales will decline. It will grind to a sudden halt if existing franchisees do not validate the viability of the financial performance of the business.

Unless there is continued growth and a harmonious relationship with franchisees, cash flow generated from initial franchise fees will dry up and the franchisor must rely on ongoing income from the current franchise pool to maintain profitability. When franchisee viability is marginal, and the franchisor and franchisee relationship is strained, the income stream from ongoing royalties may come under stress, leaving the franchisor with a modest or even dwindling revenue stream and little prospect of further growth.

In a franchise network, ongoing franchise sales and therefore royalty growth are dependent on the early franchisees achieving profitability quickly with a reasonable degree of satisfaction about their decision to buy their franchise. Future franchise sales are heavily dependent on existing franchisees confirming to potential franchisees that the franchisor has a good system and the choice of that particular franchise is a wise decision.

Fully franchised networks need to deliver the promise of profitability early in each of their franchisees’ establishment periods, and grow to a significant number of franchised units before the franchise network can make decent profits (more than $1-2 million per annum) and create a worthwhile magnitude of enterprise value ($5-10 million) to make franchising worthwhile.

Many fully franchised networks are failing to reach critical mass and are not making decent profits or building worthwhile enterprise value from franchising because either the business is unprofitable, or the franchise system on which the franchise is to be based is poorly conceived and developed, or both.

Should franchising be considered?

The answer to this question is an emphatic “yes!”, but only after the business model is proven. There are several key signposts that can point a business owner in the right direction along the road to profitable franchising.

The following is a franchising checklist:

1. The business should be proven and profitable before franchising is considered.

2. At least two company-operated locations should be developed and operating profitably to prove the viability of the business model in multiple locations.

3. The businesses should be operated under management to test the operating and reporting systems.

4. The businesses should be returning at least 20% on capital invested.

5. The market in which the business plans to operate should support at least 20 business units.

The last point is important, as the mathematics of franchising will not support the investment of time and money and infrastructure necessary to develop a franchise system that cannot scale beyond at least 20 units.

Franchising does not mean abandoning the growth of a company-owned network. Every business should operate as many company-owned units as it can afford to finance and operate profitably. Ultimately, franchising should not replace the development of a company-operated network but be considered a growth strategy to complement it.

In a limited market like Australia where few networks grow beyond 200 units, the combination of a core of company-owned units supplemented by a network of franchised outlets is the ideal business structure. The operation of company-owned locations contribute critical cash flow and profitability, keep the franchisor close to the marketplace, and provide a fertile base to develop staff, train franchisees, trial new products and services, and innovate with new locations and presentation.

Franchising is both a sophisticated capital management plan and in today’s employment environment, it’s a key HR strategy to attract and retain motivated owner-operators at the customer end of a business.

Rod Young is executive Director of DC Strategy, and can be contacted at rod.young@dcstrategy.com

* The opinions expressed in this article are those of the author, and don’t necessarily reflect the opinions of DYNAMICBUSINESS.com or the publishers.

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