From the November 2003 issue of Entrepreneur

They have built two of the best-known and most successful businesses in the food and beverage industry. Their brands have become household names in America, rivaling longer-established companies. They've delivered large profit margins in an industry where margins are historically tight and competition is extremely fierce. They've brought their companies overseas, and now there are new words for their products in Japanese, Hindi and even more exotic languages.

But Fred DeLuca, founder of sandwich supremo Subway, and Howard Schultz, founder of coffee conglomerate Starbucks, each did it his way. Indeed, their roads to profit diverged on one key point: Schultz has kept his chain company-owned, while DeLuca has built his corporation through franchising. (In fact, Subway retains only one company-owned store.) In both cases, the decision to franchise or to remain company-owned was perhaps the critical element in building the business. And in both cases, the decision paid off. Earlier this year, Subway, which DeLuca founded in 1965 with a $1,000 loan, opened store No. 18,000. The sub chain now has more outlets in the United States than McDonald's, yet it has continued to post growth rates higher than most other food and beverage chains. It has also opened outlets in more than 70 countries. For its part, since its founding in 1971, Starbucks has grown into a company with over 7,000 outlets worldwide and sales topping $2 billion per year. In an exclusive interview with Entrepreneur, DeLuca and Schultz explain why they chose the roads they did, examine the advantages and disadvantages of their strategies, and consider whether other entrepreneurs should emulate their paths.

How and why did you first decide to franchise or not?
Fred DeLuca: When we first started the company, I didn't have any thoughts of franchising. We just had company-owned stores. But we quickly saw that company-owned stores that were not close to company headquarters didn't run as well-management of these stores seemed less dedicated and less entrepreneurial. So we figured we had to create a system in which all the stores would be like the ones close to company headquarters, where managers had the feeling of being very invested in the company's performance, of really caring about the company's success. We thought that the best way to make store managers really care about Subway's success, and have that kind of unique entrepreneurial spirit, was to franchise.

Howard Schultz: We believed very early on that people's interaction with the Starbucks experience was going to determine the success of the brand. The culture and values of how we related to our customers, which is reflected in how the company relates to our [employees], would determine our success. And we thought the best way to have those kinds of universal values was to build around company-owned stores and then to provide stock options to every employee, to give them a financial and psychological stake in the company. We thought the best way to get to those values would be to have all the employees working for us. [As a result,] Starbucks has the lowest employee turnover of any food and beverage company.

I always viewed franchising as a way to get access to capital, because you're using other people's money to grow, essentially. And we were dealing with a premium product-something that can be hard to learn, that you have to explain to the customer, that requires an educated staff. It would have been hard to provide the level of sensitivity to customers and knowledge of the product needed to create those Starbucks values if we franchised. You can be just as entrepreneurial and experimental in a company-owned model.

Company-Owned Growth Vs. Franchising

What do you see as the advantages and the disadvantages of the model that you chose?
Schultz: There are a lot of advantages to the company-owned model. You can create universal company values. You can read the marketplace and turn on a dime. As a company-owned business, we can do that. But if you're a franchised company, it's hard to make quick adjustments because there's an extra level of people in the business [the franchisees] that you have to basically pass all the decisions through. And that can make these kinds of transitions harder.

Being company-owned also allows you to find significant new revenue sources without having to worry whether they might compete with your franchisees' businesses. We've created a major new revenue source recently by selling bags of Starbucks coffee, bottled Starbucks coffee drinks and Starbucks ice cream in supermarkets. But imagine if we were a franchise. It would be difficult to sell products in supermarkets because most franchisees probably would see that as competition and not like it. In a franchise situation, there are a lot of prohibitions on territoriality and exclusivity. We don't have those problems, so we can open up many stores in an area quickly and even sometimes cannibalize our own business.

DeLuca: When you're invested in your own business, you're going to run it better. When people are financially responsible for whether their store succeeds, they're going to have that kind of entrepreneurial spirit that's harder to get if headquarters is running things. If you have company-owned stores, you make 100 percent of the profit from each one, but you have less entrepreneurial spirit.

Franchising also lets you expand to more places more rapidly. It's true that, with company-owned stores, you can more easily saturate a large city or make quick changes, because you don't have to worry about territoriality or going through the process of finding hundreds of franchisees in one city, which can be hard-you just open as many stores as you can in the city. So when we enter a new big-city market like Chicago or someplace equivalent, it's hard at first for us to get famous and build the reputation and build the business because we can't just open so many outlets so easily. But franchising makes it easier to open in a lot of markets simultaneously, because the investment that you need as a company to expand geographically isn't as great and because we're a relatively cheap company to get a franchise in. People in a wide range of areas can afford a Subway franchise.

How do you keep your company entrepreneurial and keep people in the company experimenting, given your different models?
DeLuca: There may be a perception that, with franchises, they're all the same, so that limits the ability to experiment. But that's not true. We've always kept two slots open on the menu of each Subway franchise-slots that franchisees can use to come up with their own sandwich ideas. And actually, franchising is the best way to keep things entrepreneurial, to keep people experimenting, if you can tap into franchisees' ideas.

We do this by allowing a lot of franchisee influence over marketing and other company decisions. Subway's marketing is totally franchisee-driven. A national board of franchisees makes decisions on our national advertising, and local boards make decisions on local advertising. So these local boards are out there finding interesting local ideas, and then they can send those on to the national board. It allows ideas to bubble to the surface locally and then be implemented nationally. The "Jared" campaign [Subway's national advertising campaign featuring Jared, a man who lost a considerable amount of weight eating Subway sandwiches] didn't come from company headquarters. Some franchisees in the Chicago area saw a story in an Indiana paper about a guy named Jared, who'd lost a ton of weight eating Subway subs, and they contacted him. He became part of their campaign and then part of our national campaign.

Schultz: In a company-owned business, you might not have the kind of local owners that you have in franchising, but as a manager, you have to come up with ways to encourage entrepreneurship. We do that with [stock] options, which works. Frappuccino was invented by one of our store managers. We've gotten big, but we've stayed small-keeping our intimacy with our staff and customers.

Coffee Talk
As of August 2003, Starbucks had more than 7,000 retail locations worldwide.
Starbucks plans to open approximately 1,300 new stores worldwide in fiscal year 2004.
Nearly 25 million customers worldwide visit Starbucks each week.
Starbucks is named after the first mate in Herman Melville's Moby Dick.
The first Starbucks store was founded in 1971 in Seattle's Pike Place Market.
The Starbucks Foundation has awarded more than 650 grants totaling $6.5 million to literacy, schools and community-based organizations across North America since 1997.

 

How to Grow Like Subway and Starbucks

What advice would you give entrepreneurs who are building their businesses? Who should use your model? Who should use the other model?
Schultz: There is no one business strategy that works for everyone. But if you're going to build a company-owned model in a business where you need rapid growth, it's very important for an entrepreneur to understand that growth is going to cover up problems for a while. Growth can be seductive, but you need to stay ahead of the growth curve, anticipating the day growth might slow down. In a growth business, you can't play catch-up. While the business is still growing, you need to hire people who've been through rapid growth and slowdown before, who already have experience with other companies. Many entrepreneurs don't understand the value of hiring [experienced] people from outside [the company] while you're still growing. You can't build a 50-story building if the foundation is weak.

DeLuca: I think that if you're going to use franchising as the route for your company, it's important to make the franchise inexpensive enough that it's accessible to a wide range of people, so that people in all parts of the country could afford to buy and run a franchise. Our franchises cost much less to buy into than [those of] many of our competitors. [Subway franchises usually cost between $86,000 and $213,000. By comparison, McDonald's franchises cost $489,900 to $1.5 million, while KFC franchises cost $1 million to $1.7 million.] That's how you can expand. Even in this relatively weak economy, our applications for franchises have been up significantly. But if you want a business that depends on quickly saturating the market in big cities, maybe you want to keep some of it company-owned.

What are your short-term and long-term strategies for your respective companies?
DeLuca: We're trying to establish more of a presence overseas. [DeLuca spoke to Entrepreneur from Amsterdam, Netherlands, where he spends part of his time.] We have expanded to many countries, but we don't have great market penetration in a lot of them. We're not a household name in Europe or Asia yet, the way we are in the United States. So that's a goal. We don't really change our menu that much when we franchise overseas, though of course there are some differences internationally. It's more an issue of getting more stores in the market so we get better-known.

Schultz: We fully believe that we can have 15,000 Starbucks stores outside America and 10,000 in North America. We still have less than 7 percent of the coffee consumption in America, but we're having a big impact on people who drink traditional coffee brands. People are leaving those brands for us. China could be a huge growth market; we've had tremendous success at our stores there. The word saturation is not even in our vocabulary.

Sandwich Central
There are approximately 19,500 Subway restaurants worldwide.
Subway plans to have 30,000 locations by 2010.
Turkey sandwiches are Subway's best-selling menu item.
Subway estimates that approximately 2,000 Subway sandwiches are made every minute.
Fred DeLuca founded Subway in 1965 in Bridgeport, Connecticut, when he was just 17 years old.
Learn more about Subway franchise opportunitiesin our Franchise Zone.

Joshua Kurlantzick is a writer in Washington, DC.