The Big Bang How franchising became an economic powerhouse the world over

For the 25th anniversary of Entrepreneur's Franchise 500®, we asked franchising veteran David J. Kaufmann for his perspective on how franchising has changed the economy and opportunities for entrepreneurs over the past quarter-century. Among his accomplishments, Kaufmann, senior partner at law firm Kaufmann, Feiner, Yamin, Gildin & Robbins LLP in New York City, is author of the New York Franchise Act. He and his firm represent some of America's largest and best-known franchisors. Here are his thoughts:

The year was 1980.
Dallas, M*A*S*H and Three's Company ruled the television airwaves. People were boogieing (how's that for a 1980 word?) to Billy Joel's new release, It's Still Rock and Roll to Me. Jimmy Carter was president; Ronald Reagan only a candidate. The phrase "word processing" was largely unknown, as most folks were still banging out documents on their IBM electric typewriters. And Entrepreneur magazine published its first Franchise 500® ranking of the nation's leading franchisors, the first ever in the industry.

How far franchising's come since then! Defying the law of both physics and business cycles-that everything that goes up must inevitably come down-franchising over the past 25 years kept accelerating upward, dominating certain industries entirely (such as guest lodging, real estate brokerage, quick-serve restaurants and convenience stores), while propelling itself to the forefront of not only the American economy, but increasingly, the global economy as well.

In 1980, the Department of Commerce estimated franchising's total gross revenues at $350 billion. In 1985, that rose to $529 billion. And now? According to the International Franchise Association (IFA), franchising companies and their franchisees account for $1 trillion in annual U.S. retail sales-an astonishing 40 percent of all retail sales in this country-and employ more than 8 million people, which is more than 7 percent of total nonagricultural employment in the United States. These sources reveal that 1,500 business-format franchise networks operate more than 320,000 franchised units in the United States. Approximately one in every 12 retail establishments is a franchised business. Including both U.S. and foreign restaurants, McDonald's alone serves 47 million customers daily at its 30,000-plus restaurants, which employ 1.5 million people and earn a total of $41 billion annually.

Reality affirms what the statisticians tell us. Every time you install brakes or mufflers at Midas Auto Service Experts or Meineke Car Care Center; every time you dine at quick-service restaurants such as Pizza Hut and "casual" restaurants such as Denny's and Johnny Rockets; every time you buy or sell a house through Century 21, Coldwell Banker or ERA (these three franchised real estate brokerage networks alone, subsidiaries of Cendant Corp., account for a remarkable 25 percent of all residential purchases and sales in this country); every time you have your taxes prepared at a retail storefront such as H&R Block or Jackson Hewitt Tax Service; every time you seek or list a job at a personnel agency; every time you enroll your child at the local branch of a nationwide tutoring service such as Sylvan Learning Centers; and every time your office is cleaned by an outside janitorial service, the odds are extraordinarily high that you're doing business with a franchised establishment.

It's funny, because prior to the late 1950s and the '60s, franchising was virtually nonexistent. Before then, mostly auto manufacturers, soft-drink bottlers and gas station dealers used the franchise format on a regular basis as a prime vehicle for marketing and distributing their goods. In those decades, however, the giants entered the scene. 7-Eleven, Baskin-Robbins, Burger King, Dunkin' Donuts, Holiday Inn, H&R Block, KFC, McDonald's-they all geared up and franchised during this period.

But their true explosive growth came in the 25 years since Entrepreneur published its first Franchise 500® issue. That 1980 listing showed McDonald's had 1,576 company-owned and 4,173 franchised restaurants for a total of 5,749 restaurants. This year's Franchise 500® reveals that McDonald's operated 8,065 company-owned restaurants. It franchised another 22,116, for a total of more than 30,000 McDonald's restaurants-more than tripling the network's size in 25 years. (You could have done worse than to invest $10,000 in McDonald's stock in 1980-today, it would be worth close to $200,000.)

And what about this year's top-ranked franchisor in Entrepreneur's Franchise 500® listing, Subway? In 1980, according to Entrepreneur's first survey, the Subway network featured a grand total of 150 restaurants-16 company-owned, 134 franchised. Today? More than 15,000 U.S. restaurants, all but one franchised, for an astonishing 25-year growth rate close to 10,000 percent.

"Obviously, we've grown an awful lot," says Subway's founder and chair, Fred DeLuca, who started the chain when he was 17 years old because he needed money for college. With a loan from a family friend, DeLuca opened a submarine sandwich shop in Bridgeport, Connecticut, in 1965. "What's benefited us is that, before getting into franchising, we were in the business of running company stores for eight years and were able to develop a really good system of controls and great systems of operation. That system of controls-along with having a good basic business concept-has helped our franchisees to advance quickly. They themselves wind up expanding. Maybe 60 percent to 70 percent of our stores every year for the longest time have been opened by existing franchisees who have expanded."

World Conqueror

Franchising's explosive growth in the United States has proved sufficiently groundbreaking itself. But now factor in an element that was virtually nonexistent when Entrepreneur published its first Franchise 500� in 1980: the globalization of American franchise networks. The IFA notes that over the past decade, almost half of all units established by U.S. franchisors were opened outside of this country.

About 500 U.S. franchise networks now have a global presence. McDonald's, now in 119 countries (in 1980, that figure was 28), features more than 10,000 foreign franchises; 7-Eleven, more than 18,000; Yum! Brands Inc. (A&W, KFC, Long John Silver's, Pizza Hut, Taco Bell), more than 11,000; and InterContinental Hotels Group (Holiday Inn and InterContinental Hotels & Resorts), 832.

Indeed, when the Soviet Union crumbled and the Iron Curtain fell in the late 1980s, it was American franchisors-principally in the quick-serve restaurant and guest-lodging sectors-who led the American economic foray into Eastern Europe. And those with really good memories will recall that in 1989, when the Soviet Union was coming apart and Boris Yeltsin was sealed off and isolated in the Russian White House in the midst of a power struggle, he and his supporters were sustained not by blini and borscht, but by Pizza Hut pizzas. (It helps to recall that Pizza Hut has had a presence in the Soviet Union and, following its demise, Russia since the mid-1980s.)

How do you account for franchising's stunning success and explosive growth? The answer is relatively simple and has always been the cornerstone of franchising's compelling attraction: Americans' love of recognized brands. Increasingly, foreign citizens have the same predilection. McDonald's Big Mac tastes the same in Maine as it does in California; the restaurants look the same in Arkansas as they do in Ohio (or, for that matter, Tokyo); and the logo is the same throughout the United States and around the globe.

Lasting Success
The benefits of franchising for franchisees are best reflected in the units' longevity. While the average rate of failure for new businesses is 65 percent within five years of inception, a recent study prepared by the IFA reveals that only 3 to 11 percent of franchised units (varying by industry segment) suffer "turnover" in any given year ("turnover" defined as closure of the unit or sale to a nonfranchised purchaser). And even these low figures may be inflated, since often a franchised unit may be closed or sold for reasons other than "failure," such as death or retirement. In a survey conducted by The Gallup Organization in 1997, 92 percent of all franchise owners reported they consider their franchises to be either somewhat or very successful, and 65 percent said they would repeat the investment in the same franchise if they were given the chance.

As franchising has flourished since the first Franchise 500� in 1980, so too have franchisors and franchisees. Virtually every franchise system began with the vision of a strong-willed entrepreneur who tirelessly worked to perfect his or her product, service, systems and name recognition. The legends include Ray Kroc of McDonald's; Kemmons Wilson of Holiday Inn; Art Bartlett and Marsh Fisher of Century 21; and Colonel Harland Sanders of KFC (who, at the age of 65, began the KFC chain by traveling the landscape with broilers, tubs of spices, chickens and other cooking gear in his car and serving dinner to prospective franchisees who paid a royalty of a nickel per chicken). With the exception of Bartlett, these pioneers are all gone. The trend over the past 25 years is for mature franchisors to be acquired by megacorporations.

Yum! Brands Inc., parent of A&W, KFC, Long John Silver's, Pizza Hut and Taco Bell, operates nearly 33,000 restaurants in more than 100 countries, racking up systemwide sales of more than $24 billion. Avis Rent A Car, Budget Rent A Car, Century 21, Coldwell Banker, Days Inns, ERA, Howard Johnson, Ramada, Super 8-national and international brands known to virtually everyone-are all owned by a single entity, Cendant Corp. Burger King was acquired by Pillsbury Corp., which in turn was acquired in 1989 by the British conglomerate Grand Metropolitan PLC (now Diageo PLC), which in 2002 divested the chain to conglomerate Texas Pacific Group. In the late 1980s, Holiday Inn was acquired by another British conglomerate, Bass PLC.

At around the same time, Blockbuster Inc. acquired Major Video, while Allied Domecq PLC acquired Baskin-Robbins and Dunkin' Donuts. Even Warren Buffet's Berkshire Hathaway got into the franchise game, acquiring a large stake in Dairy Queen within the past decade. (Editor's note: In the interest of full disclosure, the author's law firm serves as franchise counsel to Cendant Corp., Holiday Inn and Yum! Brands.)

While franchisors were growing, franchisees were as well. Although franchising's roots could be traced to the grant of an individual franchise to one entrepreneur possessing no prior knowledge of or experience in the subject industry (sometimes colloquially referred to as mom-and-pop operators), over the past decade, many of America's oldest and largest franchisors have not followed that paradigm.

Instead, they find it far more efficient and profitable for all concerned to largely restrict the grant of franchises to sophisticated corporations or to existing franchisees whose experience, profitability and mastery of the franchisor's system strongly suggest future success. Recent reports suggest that the top 50 American restaurant franchisees in terms of U.S. sales collectively own and operate more than 7,500 units; somewhere between 20 to 36 percent (depending on whose figures you refer to) of all franchisees own more than one franchised unit; and such multi-unit franchisees own more than half of all franchised units throughout the United States.

We Can All Get Along

As franchising has grown, as franchisors have grown, and as franchisees have grown, something remarkable has happened-the conflict often so prevalent between franchisors and their franchisees throughout the 1970s and '80s appears largely to have subsided, perhaps reflecting each party's maturation. "There's been a big change," says DeLuca. "It's been quite positive, and it revolves around a great deal of communication between franchisors and franchisees. I remember 25 years ago, the idea of having a franchise advisory council was pretty novel for a lot of companies; the idea of actually getting some advice from a franchisee seemed foreign. Now it's pretty common, and systems work best when there's a strong involvement with the franchisees."

Amy Sherwood, vice president of public relations at Yum! Brands, says, "We realize the only way to achieve our goals and aggressively expand our business is through a strong partnership with our franchisees. One of the very first things we did as we formed our company in 1997 was to invite Jackie Trujillo, a KFC and Taco Bell franchisee, to join our board of directors. We make sure our franchisees have direct involvement and a voice in all we do and make a point to listen to their input as part of our decision-making process."

McDonald's chair James Cantalupo echoes the sentiment. "McDonald's founder Ray Kroc used to say, when referring to our relationship with our franchisees, 'None of us is as good as all of us.' Ray considered these businessmen and businesswomen to be the heart and soul of our company. Much of our worldwide growth in our nearly 50-year history is due to our collaborative working relationship with our franchise partners."

Indeed, Matthew Shay, executive vice president and general counsel of the IFA, observes that "the most significant development in franchising over the past 25 years is the achievement of the dream envisioned by one of franchising's pioneers, Bill Rosenberg [founder of Dunkin' Donuts and the IFA]: franchisors and franchisees working collaboratively for the betterment of the entire franchise community. In recent years, there has been significant progress toward achieving that dream, reflected in the services and programs offered by the IFA as well as by individual initiatives undertaken by many franchise systems."

Even the federal government notes how relationships between franchisors and their franchisees have markedly improved. "The biggest change I've seen in franchising since I came to this job [in 1987] is the growing realization on the part of franchisors that they share a common interest with their franchisees, and [consequently], in their being straightforward and transparent," says Eileen Harrington, associate director for the FTC's Division of Marketing Practices, who has served as the federal government's principal regulator of the franchise arena for the past 17 years. "There's been a real maturation in the way business is done and in the quality of the relationships between franchisors and franchisees in many, many systems."

A New Day

Certainly, federal and state franchise laws and regulations are largely responsible for facilitating franchising's explosive growth and success over the past 25 years. Many folks forget that, by the late 1960s and '70s, the words "franchise" and "fraud" had almost become synonymous.

What happened was simple. As franchising exploded on the scene in the 1950s and '60s, story after story appeared in newspapers and magazines about how franchisors and franchisees were growing wealthy in this burgeoning arena. That's when the criminal community-including organized crime-jumped in on the action. Tens of thousands of people nationwide collectively lost millions of dollars through criminal franchise enterprises-enterprises which, by using slick brochures and outright fraud, sold phantom, nonexistent franchises to hapless victims.

Indeed, the situation was so bad that, just a year before Entrepreneur published its first Franchise 500® edition, even 60 Minutes did a "takedown" piece on franchising, featuring a scam perpetrated by an outfit known as "Wild Bill's Family Restaurants," the principals of which were ultimately indicted by a federal grand jury.

California took the lead in fighting against franchise fraud, enacting its revolutionary Franchise Investment Law in 1971. It required a franchisor to register itself and its franchise disclosure document and to distribute that document to prospective franchisees prior to accepting their money or signing any contract, lest the franchisor expose itself to both criminal and civil liability. Other key states have also followed suit-Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington and Wisconsin.

In fact, as Entrepreneur was publishing its first Franchise 500® edition, I, then special deputy attorney general of New York, was putting the finishing touches on New York's franchise statute, the New York Franchise Act, which was enacted in 1980. Also at the time of Entrepreneur's first Franchise 500®, the seminal FTC Franchise Rule was promulgated, requiring franchisors nationwide to engage in the disclosure protocol pioneered by California (but unaccompanied by state franchise law registration requirements).

The goal of these federal and state franchise laws was to eradicate fraud and to eliminate criminals and organized crime from the franchise arena. And guess what? It worked. Due to the diligent enforcement of these laws by federal and state regulators-who, at the same time, grew increasingly aware of the legitimate franchisor community's needs and wants-there hasn't been a major franchise scandal in this country in decades. Not that there haven't been improprieties, mind you, but no large-scale and massive fraud visited by a criminal franchisor.

And franchisors recognize the laws' effectiveness. "Probably the best thing I've seen is a requirement of having a disclosure document for franchising," says Subway's DeLuca. "It helps to clarify and spell out the details of the relationships, so there's less likelihood of miscommunication or confusion. The fact that everybody gets a disclosure document is really important."

Harrington certainly notices the change at the FTC. "We see fewer things going wrong, less deception, certainly a lot less outright fraud in connection with franchising," she says. "We see a lot of fraud in connection with the sale of business opportunities, but not in franchising. The environment is a lot cleaner than it was."

Even crusading New York Attorney General Eliot Spitzer, who almost single-handedly took on massive Wall Street fraud and deception last year, notes the contrast between the slew of corporate fraud that's come to light of late (Enron Corp., Global Crossing Ltd., WorldCom Inc.) and franchising's relatively clean slate. "Interestingly, many of the protections we are now building into the traditional securities marketplace have been in place for a great number of years in the franchise marketplace," he observes. "And that may explain why, in recent years, we have seen fewer scandals in franchising."

So, yes, it's been quite a run for franchising since Entrepreneur published its first Franchise 500® edition. Meteoric growth, consolidation of both franchisors and franchisees, the maturation of relationships between them, and the still-growing public demand for franchising's brands (and the products and services sold under those brands) have yielded a situation where rarely a day goes by that any of us-either in the United States or most of the industrialized world-does not encounter or frequent a franchised establishment on a daily basis.

Bright Days Ahead

If you think franchising is exciting today, just wait until you see what the next 25 years may hold.

So what lies ahead for franchising over the next 25 years? Continued growth, consolidation and maturation of both franchisors and franchisees, plus some dramatic new developments, including:

• Expansion of multibranding: One franchised unit sells many branded products or services. Yum! Brands Inc.-owner of A&W, KFC, Long John Silver's, Pizza Hut and Taco Bell-features more than 2,000 multibrand restaurants worldwide, generating over $2 billion in annual sales.

• Growth in urban markets: The Department of Commerce Minority Business Development Agency predicts minority populations will contribute 44 to 70 percent of the total increase in U.S. purchasing power until 2045.

• Business segments turning to franchising for the first time: These include hospitals, health-care providers, investment advisors, the retail bedding industry and specialized health-care facilities (such as detox clinics and weight-loss centers).

• New franchisors catering to the large and aging baby boomer population: Think home health-care services and products, estate-planning advice, daily living aids, in-hospital patient advocate services and rehabilitation services.

• A continued increase in franchises that meet the needs of children of working moms: Expect more day-care offerings; specialized classes (from cooking to sports); tutoring and test preparation; and one-stop shopping for teens and preteens featuring clothing, accessories, electronics, music, video and computer programs all in one place.

Even the way franchises are offered and the way franchising is regulated are about to undergo a revolution. The federal government's key franchise regulation, the FTC Franchise Rule, is about to be revised for the first time since its promulgation 25 years ago. Following years of study and public comment conducted under the leadership of the FTC's Eileen Harrington and Steven Toporoff, the new FTC Franchise Rule will feature expanded disclosure based on the current state-ordained Uniform Franchise Offering Circular format, clarification that the Franchise Rule doesn't apply to pure international transactions, and new exemptions relieving franchisors from having to engage in disclosure with sophisticated franchisees. And, in conjunction with the state administrators who serve on the North American Securities Administrators Association Franchise Project Group, the federal and state governments will soon clear the way for franchise disclosure to be effected almost exclusively through electronic communications-e-mail, franchisor Web sites, CD-ROM and the like. We are fast approaching the day when franchisors will meet new franchisees for the first time either when their contracts are being signed or even later, at the first training session for new franchisees.

Want to see the future right now? Then look to California. Under the leadership of California Corporations Commissioner Demetrios Boutris and deputy commissioner Timothy LeBas, California is already implementing two future trends. Go to www.corp.ca.gov, click on "California Electronic Access to Securities Information" (Cal-EAS), and you can view and download virtually all California's franchise filings-disclosure documents, notices of exemption, administrative orders and more. Soon to come: California adopting a "risk-based" franchise registration review protocol, which gives closer scrutiny to start-up or problematic franchisors seeking registration than to mature, reputable and well-established franchisors.