Franchises

How to Choose the Best Structure for Your Franchise Company

How to Choose the Best Structure for Your Franchise Company
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The following excerpt is from Mark Siebert's book Franchise Your Business. Buy it now from Amazon Barnes & Noble | iTunes

Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever -- franchising. Siebert shares decades of experience, insights, and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, Siebert explains the different ways you can structure your franchise operations and offers pros and cons for each.

When creating your franchise plan, one of the first things you'll need to do will be to choose one or more structures under which you'll offer franchises. The choice of franchise structure will impact a number of variables that will further define your franchise organization—targeted franchisee, support requirements, staffing, and cost structure -- so you shouldn't enter into it without some forethought and financial modeling.

Understand that when it comes to franchise structure, there's no standard naming convention. For instance, what we call an “area representative” structure is referred to in some organizations as an “area developer” strategy and in others as “master franchising.” Here's our shorthand definitions for quick reference:

Single-unit or individual franchising involves granting a single franchise to a franchisee for just one business operation. While the franchi­sor may choose to award more than one franchise to some of its franchisees, they're typically sold individually and not as part of a multi-unit territorial grant. Perhaps the most prominent example of a company that grew primarily through single-unit franchising is McDonald’s.

Conversion franchising is a variation of single-unit franchising that involves granting a franchise to an operator who's already running a similar business. Conversion franchises are generally sold with preferential terms, often involving reduced fees, based on the fact that the franchisee has an established business and clientele and/or requires less training and/or support. Many of the largest real estate franchisors, including Century 21 and RE/MAX, initially had a strong emphasis on conversion franchising.

Area development franchising involves the sale of development rights to a territory in which the area developer is given the exclusive right to open and operate a (usually) pre-established number of individual franchises on a (generally) pre-defined opening schedule. While all area developers sign contracts that would make them multi-unit operators, not all multi-unit operators are area developers—some may instead be individual franchisees who acquired additional units without the benefit of an area development contract. Many large franchisors in the food-service arena (like Burger King, Pizza Hut, and KFC) have relied heavily on area development franchising, and some, like Panera Bread, McAlister’s Deli, and Buffalo Wild Wings, now focus exclusively on area developers.

Subfranchising (also called master franchising) involves a grant of the right to sell individual franchises in a specified territory along with the obligation to provide some level of support and service to those individual franchises in return for a shared-fee arrangement with the franchisor. In a subfranchise relationship, the master franchisee enters into contracts directly with franchisees. Subfranchising is often reserved for international markets (where it is also referred to as master licensing, just to make things more confusing), where many of the most prominent franchisors use it regardless of their domestic structure -- at least in some markets.

Area representative franchising is a variation of the subfranchise arrange­ment. While the roles of each party are largely identical, in an area representative relationship, the franchisor (not the master franchisee) enters into the franchise agreement with the indi­vidual franchisee, allowing them a greater degree of contractual control. Area representative franchising has been used successfully by fast-growing franchisors such as Subway, Quiznos, Jani-King, The UPS Store, and Massage Envy.

For most new franchisors, individual franchising is the safest bet. Individual franchises are generally easier to sell and can often be the best way to gain an understanding of the support you'll need to provide your franchisees to help ensure their success. Individual franchising offers the greatest control over your franchise operations, as well as which franchisees you'll allow to open additional franchises, as you can predicate it on their performance with their existing location(s).

If you're currently operating in a highly fragmented market, conversion franchising may be worth considering -- especially if you can demonstrate true incremental value to your franchise candidate (remember, you will be asking someone who is already operating in your industry to pay you an additional fee). In conversion franchising, prospects are usually easily identified, reducing marketing costs substantially. Prospects generally have established business relationships and thus begin paying their royalties sooner. Conversion franchisees may require less training and initial support than startup franchisees and are also easier to qualify because you can evaluate their existing operations.

However, conversion franchising presents a number of challenges. As entrepreneurs, these franchisees can be more resistant to the controls imposed by the franchise system. Typically, the best operators (those you would most like to convert) are the least likely to see the value of your offering, while the worst operators (who are likely struggling for a reason, and thus should probably be avoided) will be your most eager candidates. Moreover, if a particular conversion franchisee doesn't work out, the post-termination, noncompetition agreements that might otherwise come into play will be much more difficult to enforce (if they can be enforced at all).

Area development franchising continues to be the favored method of expansion of many brick-and-mortar businesses. As a franchisor, you work with a limited number of more sophisticated franchisees, allowing you to allocate less time and fewer resources to unit inspection and franchisee support. Area development contracts can also minimize territorial disputes. And, of course, each sale of an area development contract will, at least in theory, result in multiple store openings.

But like other strategies, area development has its disadvantages. As a franchisor, you'll need to recruit franchisees from a much smaller pool of candidates, as area developers must be better capitalized than individual franchisees. And if you look to area developers of other brands, you'll find that the competition for these prospects is intense.

If one of the reasons you're turning to franchising is that you feel your business will perform better with an owner-operator, area development franchising may not be the best route, as these area developers will be hiring managers of their own. Likewise, if your business doesn't provide the incremental returns that will allow the area developer to create the infrastructure to manage multiple units, this strategy probably isn't appropriate.

It's also worth noting that a substantial percentage of area development contracts go unfulfilled—by some estimates, more than 50 percent—not to mention those contracts that don't get fulfilled according to the agreed-upon development schedule. And if the contract isn't fulfilled, the franchisor often needs to get lawyers involved to regain the rights to sell franchises in that territory.

Subfranchising and area representative franchising are both known for helping franchisors accelerate their growth. But while subfranchising and area representative franchising provide the fastest growth, they also have some of the most substantial disadvantages. First and foremost is that the area representative is entitled to a portion of the franchise fee and the royalty on an ongoing basis. And while they'll be providing services in return for these fees, they'll also be entitled to a return on their investment -- thereby decreasing franchisor profitability as a percentage of revenues.

Without question, area representative franchising is the most complex form of franchising in the U.S. Not only does the franchisor need to establish support structures for individual franchise operators, but it must also develop detailed operations standards and training programs for its area representatives. For that reason, we rarely recommend this structure for a new franchisor, particularly if the franchisor’s management team doesn't have a strong background in franchising.

In deciding which structure (or structures) to employ, you should take a number of factors into account:

  • What speed of growth is required to meet your goals?
  • What is your return at the unit level?
  • How much support can you provide to your franchisees?
  • Does your business lend itself to passive ownership?
  • Are you able to cluster units effectively?
  • How fragmented is the competitive market?
  • What is the degree of competition for your targeted franchisee?
  • What is your value position for your targeted franchisee?

Ultimately, you want to choose a strategy in which you can support your franchise owners effectively and at a reasonable cost. The best strategies will achieve this goal while ensuring that quality remains high, the risk of litigation is minimized, and the chances of franchisee success are optimized.