OPTIONS FOR GROWING A FRANCHISE SYSTEM
FranchisingAuthor :
Edward (Ned) LevittEdward (Ned) Levitt is a senior partner of Gowling Lafleur Henderson LLP, Toronto, Canada, and co-chair of its franchise law national practice group. He served as General Counsel to the Canadian Franchise Association from 2000 to 2007 and, as a member of the Ontario Franchise Sector Working Team, was instrumental in the creation of Ontario’s franchise legislation. Among his many publications is Canadian Franchise Legislation published by Butterworths/LexisNexis. Mr. Levitt can be reached at 416-862-3628 or ned.levitt@gowlings.com
Growth is the very essence of franchising. It is a more efficient method of distributing products or services than other methods because of its ability to quickly grow the business throughout broader geographical territories. Many of the issues in a franchise expansion will be the same, whether or not the expansion is from large cities to small towns, from region to region within a province, from province to province or from one country to another. While growth will fuel the financial success of a franchise system, it can also lead to its demise. Many post-mortems on failed franchises reveal that failure was caused by mistakes made in expansion, which were readily foreseeable and avoidable.
Timing and speed
Timing is a constant issue in franchising. Starting a franchise program before the business concept has been adequately developed can be a mistake from which the franchisor never recovers. Expanding too quickly can stretch financial and human resources to the extent a franchisor cannot adequately manage what it sells. Choosing a complex expansion vehicle, such as master franchising, before the franchisor has learned what is needed to effectively franchise the particular business can ultimately bring down the entire business.
The franchisor must grow its head office infrastructure in a manner that keeps pace with the expansion of the franchise system and add new capabilities as required. For example, a small franchise system will allow for easy communication between the franchisor and franchisees. As the number of franchisees increase, the all-important communications capability within the system must grow also, by creating websites and intranets, as well as adding technical staff. Remember, these support services are not established overnight, nor is it fiscally responsible for the franchisor to overspend on facilities and capabilities not yet required by the franchise system.
Once the fundamentals are in place and opportunities arise, the successful franchisor can wisely and aggressively seize expansion opportunities. Subsequently, after a period of rapid growth, most franchise systems will benefit from and grow stronger with a period of consolidation and intentional restructuring in order to ready itself for the next phase of expansion a pattern that should be followed throughout the growth cycle of a franchise system.
Expansion vehicles
The franchisor can grow his/her system in a number of ways. Each method carries with it its own set of advantages and disadvantages. Within each vehicle type, there are different approaches that can be taken and hybrids can be constructed to suit the franchisor's particular needs.
Direct franchising
Granting franchises directly to franchisees will, in almost all circumstances, be the first expansion method a franchisor will choose. In direct franchising, the franchisor shoulders the entire burden of selling franchises and supporting franchisees. As a franchisor looks to expand in more distant markets, other expansion vehicles become more appealing and, at times, absolutely essential.
Development arrangements
Multi-unit franchises, area development arrangements and territorial development arrangements all refer to situations where a single franchisee is given the right to open two or more franchises in a given territory. In time, some franchisees will acquire multiple units, as they become more prosperous. Sometimes franchisees acquire multiple units by operation of rights of first refusal, originally gran¬ted to the franchisee for additional units within areas contiguous to the franchisee's original territory. Often, rights of first refusal are granted by the franchisor as inducements to sell franchises. However, one school of thought considers the granting of rights of first refusal dangerous, and should not be done unti1 the franchisee proves himself/herself to be capable and trustworthy. Otherwise, the franchisor is permitting the unit franchisee to become a multi-unit franchisee solely because another party is interested in purchasing a franchise. The granting of multiple franchises to the same franchisee should never be done unless the franchisee's fundamentals are strong.
A cautious approach should always be taken when considering granting to one franchisee the right to open multiple units in a system. Multi-unit franchisees are usually financially stronger and more sophisticated business people. This can be an advantage in good times and a disadvantage when trouble arises - as such, a franchisee will be a more formidable adversary and a more demanding customer. Area or territorial development arrangements will be most advantageous where the area or territorial franchisee has deep knowledge and extensive connections in a market more distant from the markets in which the franchisor is already present.
Master franchising
When done properly and timed correctly, master franchising can be one of the most effective means of expanding a franchise network. This is particularly so for those going into foreign markets (although it can be advantageous in province-wide and national expansions, as well). Nevertheless, it remains one of the least understood and most poorly implemented expansion strategies in franchising. It is even difficult to arrive at a consensus on the definition of master franchising—it is used to describe many arrangements, including sales agencies, multi-unit agreements with no sub-franchising rights and arrangements by which the franchisor grants exclusive rights for the development of the system within the territory to the master franchisee with the right to sub-franchise.
The problems resulting from expanding too quickly and too soon will exist with or without master franchising, but will be made worse and the consequences will be much more serious when master franchising is chosen as an expansion vehicle too early in the franchise system's development. One of the key benefits for a unit franchisee is the knowledge gained from an experienced franchisor in running the type of business being franchised. Similarly, the success of a master franchisee is often rooted in the franchisor's experience in running a successful franchise system.
Choosing a master franchisee
While choosing the best unit franchisees is challenging, it often pales in comparison to the difficulties in appointing good master franchisees.
Usually, mistakes are made as a result of insufficient time and effort taken to thoroughly investigate, not only the master's financial capability, but also his/her personality strengths, weaknesses and business philosophies. Too often, a candidate is chosen based just on some prior business success, (and therefore, can finance the franchise expansion and perhaps more importantly write a sizeable cheque for the front-end franchise fee for the territorial rights), without regarding how he/she might 'fit' with the franchisor's goals. In these situations, master rights are viewed too much as investments by both parties.
On the other hand, fatal errors have been made in selecting master franchisees who do not have sufficient financial resources to weather the initial difficulties encountered in establishing the franchise system in the new territory. The franchisor may have forgotten how long it took before the system initially became self-financing or, more likely, he/she may underestimate how long it takes someone else to get sufficient revenues flowing in that particular region. Often, the master franchisee cannot perform at the same productive and efficient level as the franchisor, and the franchisor is better off planning for a more mediocre performance from a master franchisee.
The territory
Most master franchising arrangements provide that the rights are gran¬ted, often on an exclusive basis, for a specific territory. Understandably, master franchisees frequently attempt to negotiate the broadest possible territorial rights. However, one of the most common mistakes made by franchisors is to grant exclusive rights to territories which are far too large, with the consequences that the territory remains underdeveloped and/or the franchisor realizes much less from the territory than would have been the case had the one large territory been broken up into smaller territories. Sometimes, this occurs because the franchisor lacks the knowledge of the system's potential in the territory, and sometimes, it occurs because the franchisor feels it would be easier and more cost-effective to deal with just one master franchisee in a larger area. While there is some validity to these considerations, the franchisor will most often have a stronger—and arguably an ultimately more profitable system if territories can be kept as small as possible.
Having more master franchisees in one country or region allows the franchisor more maneuvering room, if a master franchisee fails or per¬forms inadequately. One of the other master franchisees in the area can either temporarily or permanently move in to fill the void. It also lessens the chance of a particular master franchisee 'biting off more than he can chew. The franchisor is able to exert more control or have more influence over the performance and conduct of a number of less-powerful master franchisees rather than one very powerful master franchisee.
However, if a franchisor still wants to deal with only one master franchisee in a country or region, careful drafting of the master franchise agreement can help to limit potential problems. For example, the franchisor can grant the master franchisee a smaller initial territory, which will increase in size as he/she proves his/her competency and commitment. Also, the franchisor may impose performance quotas, which will allow him/her to reduce the size of the territory, if performance is not up to par in the future.
Timing and speed
Timing is a constant issue in franchising. Starting a franchise program before the business concept has been adequately developed can be a mistake from which the franchisor never recovers. Expanding too quickly can stretch financial and human resources to the extent a franchisor cannot adequately manage what it sells. Choosing a complex expansion vehicle, such as master franchising, before the franchisor has learned what is needed to effectively franchise the particular business can ultimately bring down the entire business.
The franchisor must grow its head office infrastructure in a manner that keeps pace with the expansion of the franchise system and add new capabilities as required. For example, a small franchise system will allow for easy communication between the franchisor and franchisees. As the number of franchisees increase, the all-important communications capability within the system must grow also, by creating websites and intranets, as well as adding technical staff. Remember, these support services are not established overnight, nor is it fiscally responsible for the franchisor to overspend on facilities and capabilities not yet required by the franchise system.
Once the fundamentals are in place and opportunities arise, the successful franchisor can wisely and aggressively seize expansion opportunities. Subsequently, after a period of rapid growth, most franchise systems will benefit from and grow stronger with a period of consolidation and intentional restructuring in order to ready itself for the next phase of expansion a pattern that should be followed throughout the growth cycle of a franchise system.
Expansion vehicles
The franchisor can grow his/her system in a number of ways. Each method carries with it its own set of advantages and disadvantages. Within each vehicle type, there are different approaches that can be taken and hybrids can be constructed to suit the franchisor's particular needs.
Direct franchising
Granting franchises directly to franchisees will, in almost all circumstances, be the first expansion method a franchisor will choose. In direct franchising, the franchisor shoulders the entire burden of selling franchises and supporting franchisees. As a franchisor looks to expand in more distant markets, other expansion vehicles become more appealing and, at times, absolutely essential.
Development arrangements
Multi-unit franchises, area development arrangements and territorial development arrangements all refer to situations where a single franchisee is given the right to open two or more franchises in a given territory. In time, some franchisees will acquire multiple units, as they become more prosperous. Sometimes franchisees acquire multiple units by operation of rights of first refusal, originally gran¬ted to the franchisee for additional units within areas contiguous to the franchisee's original territory. Often, rights of first refusal are granted by the franchisor as inducements to sell franchises. However, one school of thought considers the granting of rights of first refusal dangerous, and should not be done unti1 the franchisee proves himself/herself to be capable and trustworthy. Otherwise, the franchisor is permitting the unit franchisee to become a multi-unit franchisee solely because another party is interested in purchasing a franchise. The granting of multiple franchises to the same franchisee should never be done unless the franchisee's fundamentals are strong.
A cautious approach should always be taken when considering granting to one franchisee the right to open multiple units in a system. Multi-unit franchisees are usually financially stronger and more sophisticated business people. This can be an advantage in good times and a disadvantage when trouble arises - as such, a franchisee will be a more formidable adversary and a more demanding customer. Area or territorial development arrangements will be most advantageous where the area or territorial franchisee has deep knowledge and extensive connections in a market more distant from the markets in which the franchisor is already present.
Master franchising
When done properly and timed correctly, master franchising can be one of the most effective means of expanding a franchise network. This is particularly so for those going into foreign markets (although it can be advantageous in province-wide and national expansions, as well). Nevertheless, it remains one of the least understood and most poorly implemented expansion strategies in franchising. It is even difficult to arrive at a consensus on the definition of master franchising—it is used to describe many arrangements, including sales agencies, multi-unit agreements with no sub-franchising rights and arrangements by which the franchisor grants exclusive rights for the development of the system within the territory to the master franchisee with the right to sub-franchise.
The problems resulting from expanding too quickly and too soon will exist with or without master franchising, but will be made worse and the consequences will be much more serious when master franchising is chosen as an expansion vehicle too early in the franchise system's development. One of the key benefits for a unit franchisee is the knowledge gained from an experienced franchisor in running the type of business being franchised. Similarly, the success of a master franchisee is often rooted in the franchisor's experience in running a successful franchise system.
Choosing a master franchisee
While choosing the best unit franchisees is challenging, it often pales in comparison to the difficulties in appointing good master franchisees.
Usually, mistakes are made as a result of insufficient time and effort taken to thoroughly investigate, not only the master's financial capability, but also his/her personality strengths, weaknesses and business philosophies. Too often, a candidate is chosen based just on some prior business success, (and therefore, can finance the franchise expansion and perhaps more importantly write a sizeable cheque for the front-end franchise fee for the territorial rights), without regarding how he/she might 'fit' with the franchisor's goals. In these situations, master rights are viewed too much as investments by both parties.
On the other hand, fatal errors have been made in selecting master franchisees who do not have sufficient financial resources to weather the initial difficulties encountered in establishing the franchise system in the new territory. The franchisor may have forgotten how long it took before the system initially became self-financing or, more likely, he/she may underestimate how long it takes someone else to get sufficient revenues flowing in that particular region. Often, the master franchisee cannot perform at the same productive and efficient level as the franchisor, and the franchisor is better off planning for a more mediocre performance from a master franchisee.
The territory
Most master franchising arrangements provide that the rights are gran¬ted, often on an exclusive basis, for a specific territory. Understandably, master franchisees frequently attempt to negotiate the broadest possible territorial rights. However, one of the most common mistakes made by franchisors is to grant exclusive rights to territories which are far too large, with the consequences that the territory remains underdeveloped and/or the franchisor realizes much less from the territory than would have been the case had the one large territory been broken up into smaller territories. Sometimes, this occurs because the franchisor lacks the knowledge of the system's potential in the territory, and sometimes, it occurs because the franchisor feels it would be easier and more cost-effective to deal with just one master franchisee in a larger area. While there is some validity to these considerations, the franchisor will most often have a stronger—and arguably an ultimately more profitable system if territories can be kept as small as possible.
Having more master franchisees in one country or region allows the franchisor more maneuvering room, if a master franchisee fails or per¬forms inadequately. One of the other master franchisees in the area can either temporarily or permanently move in to fill the void. It also lessens the chance of a particular master franchisee 'biting off more than he can chew. The franchisor is able to exert more control or have more influence over the performance and conduct of a number of less-powerful master franchisees rather than one very powerful master franchisee.
However, if a franchisor still wants to deal with only one master franchisee in a country or region, careful drafting of the master franchise agreement can help to limit potential problems. For example, the franchisor can grant the master franchisee a smaller initial territory, which will increase in size as he/she proves his/her competency and commitment. Also, the franchisor may impose performance quotas, which will allow him/her to reduce the size of the territory, if performance is not up to par in the future.