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CLEVELAND, Ohio - Professor Scott Shane argues that franchisors often do not understand when to franchise or even what franchise structure best drives success. It's not just franchisors. Franchisees are typically unclear too, as they put hundreds of thousands or even millions into a franchise in the hopes that they and the chain will be successful. Shane, professor of entrepreneurial studies at Case Western Reserve University, venture capitalist, franchise consultant, author, and New York Times small business blogger, speaks with Blue MauMau about his book, From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Business.
For the benefit of franchisor executives, leaders of private equity firms who invest in franchising firms and even franchisees, Shane discusses what the academic world knows about economic patterns underlying successful franchising models. Shane illuminates for the practitioner the building blocks of a franchise model and the identification of drivers and value based on economic logic and research.
He begins by discussing the fundamental decision of whether or not to franchise: what businesses franchise well, what don't, and why.
This interview is part one of a series.
BMM: The title of your book, From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company, brings to mind the question of which type of business is better to franchise and why: An ice cream shop? Or an Internet-based franchise?
SS: Ice cream.
One of the points about the book is that as new industries merge, franchisors have moved into many of those industries. In certain sectors, franchisors don't do as well. One of the key issues for franchising is the need to have a geographic location, where somebody working hard on the ground affects the system. That person needs a territory that doesn't overlap with somebody else's territory in order for franchising to work well. One of the problems with Internet-based businesses is that geography is blown out of the water and so if you franchise to two franchisees and they're operating over the Internet, they will immediately be competing with each other all the time. That's going to cause a lot of problems. It's also the case that you probably don't need franchisees over the Internet because if you don't need a local person on the ground for the business model to work, then you don't need franchising.
BMM: Should a franchisor be concerned that maybe their Internet concept isn't the best way to go because franchisees will be very hard pressed to make any money?
SS: Exactly. In the short run a franchisor can make money by selling franchises to franchisees. But for the long run, to have an ongoing franchise system, franchisees will need to make money. So anything that destroys the ability for franchisees to generate profits makes for a bad franchise system.
It's very hard for franchisees to be successful with an online model, so it's hard for franchisors to be successful with that in the long run.
BMM: In one of your other books you discuss what sort of small businesses venture capitalists and angels want to invest in. My impression was, of course, underwriters of businesses like it when something is greatly needed, but can't be easily duplicated by competitors. If an entrepreneur found the cure for cancer, the start-up business would more easily find funding and take off. But the sense I have in franchising is that inventing the cure for cancer doesn't make a good franchise. In fact, you mentioned that ice cream, which seems like such a generic product, seems like a good franchise model. Ice cream is a pretty mature industry. Why ice cream?
SS: There are a couple things to keep in mind. One is that the typical franchise, like most small businesses, will not make huge amounts of money. To make a lot of money off franchising, you need to either be the franchisor, or you need to be a franchisee with a very large number of outlets, each of which is generating a small sum of money. The point here is that there are just lots of businesses out there, whether they're franchised or not, where people aren't going to make very much money. And the question is, in a set of businesses, why can you sometimes make a lot of money? One of the key things that any investor will always want to look at is the scalability of the business. If you have a cure for cancer, a lot of people around the world have the same disease and nobody wants to die. Once you've figured out the formula for the drug and you've got a strong patent on it, you will want to keep other people from duplicating that drug. That approach will make a business a lot of money.
Now franchising is a different kind of scale, which is that if you can come up with a good way to set up a bunch of retail outlets that serve customers and provide a product that those customers want in an inexpensive and efficient way, and you have a very good system behind what you're doing, you can scale that up too. So when you think about a chain like Wendy's or McDonald's, there's a lot of money that was created there, but it didn't come from the fact that there was one outlet. It came from the fact that you could scale the thing to be large. But a business isn't scalable for the long term in franchising unless it works for both the franchisor and franchisees.
The reason I chose ice cream over the Internet is that the Internet just doesn't work well for the franchising model. Not every ice cream shop will be successful, but an ice cream shop is much better at being scalable through franchising.
BMM: So you are saying that in either buying a franchise or in starting a franchise chain, it is good to look at more mature industries. And to also look at whether the franchise model truly brings out advantages of economies of scale.
SS: It's not necessarily the case that you should disregard the maturity of the industry, because the maturity of the industry matters for a set of reasons whether the business is franchised or not. If a business is really mature and there's very little demand, then . . . (hesitates)
BMM: I see. Just being in a mature industry doesn't necessarily lend itself to franchising. Buying a horse buggy whip franchise may have been all right in the nineteenth century, but it isn't such a great idea in today's world.
SS: Right, you're not going to be successful. If you are thinking of franchising a successful independent business, you want to ask if franchising is the right strategy to help grow the business.
Where this book is helpful is in making that franchise choice. If there's no demand for the product, like it's buggy whips in the era of cars, it doesn't matter if it's perfect for franchising or terrible for franchising. Whether you franchise it or not is not going to solve the fact that demand for the product is not there. But if there's demand for a product, and it's a good idea, and there's need by customers, if you franchise the business when franchising doesn't really fit the business model, you will destroy the value of your good idea.
BMM: Speaking about that horse buggy whip, what do you make of disruptive technologies that come in and replace an older industry? Take Blockbuster movie rental stores, for example. Those stores have been hit by one new innovation after another that are removing the need for a brick and mortar store — home delivery of DVDs, small DVD kiosks and now video streaming of movies through broadband Internet services.
SS: The best sectors for franchising in essence have an intersection between two things. One that varies over time and one that stays pretty constant over time. The thing that stays constant over time is whether the sector has the right characteristics for franchising. That is, it needs a local operator to be successful. You can routinize and train people to follow an operating system and produce products for service. The franchisor is able to constrain and manage the geographic location well that the franchisee gets. Things that were good in the 70's on that dimension will be good currently on that dimension. That doesn't change.
What changes over time is that the market gets saturated or people no longer want some products or services.
If we took fast food as an example, that is a sector in which the model of franchising works extremely well. The problem is that much of the world is now saturated with these outlets and you find it difficult to put them in a lot of places in the U.S. What that says is that maybe in some other countries, which haven't been completely saturated with this model, there might be opportunities. But it's not that franchising itself is no longer appropriate for fast food. It's just that it's hard to have fast food outlets whether company owned or franchised today compared to the 70's because the market is saturated.
BMM: How can you tell that a market is saturated? For example, you mentioned fast food and that there are a lot of quick service restaurants. But franchisor consultants and franchise sellers all the time market that ethnic fast food, such as Mexican, Chinese, or Japanese, is an underserved market and that it is the growing sector of the future. How do you get a feel that a market really is pretty saturated?
SS: There are two ways that you would gain your ability to sell something. One is that whatever it is is in greater demand than it used to be. One of the problems with food is that that's very difficult to do. I know Americans, every year we eat more calories, but it's not that many more calories than in the past. It's not as if you're selling personal digital assistants, which ten years ago, we didn't think we needed. Now everybody wants one, including ten-year-old kids.
In food-related businesses, there is not going to be much more demand for food. The other way you get it is when people substitute. And so you're not really saying, when you say Japanese or Chinese fast food, that people are going to eat more than they used to and that's why you're going to be able to sell. What is really being said is that a franchise chain is going to be able to sell consumers more Japanese food in place of the hamburgers that they used to eat.
There you would have data out there that shows whether that's actually true. Are people actually substituting eating Japanese food in place of eating hamburgers? And are there long-term trends that show that? The underlying reasons need to be explored: say, that there is demand for healthier food and therefore people are making these choices. But decisions need to be based on evidence and an understanding of the factors of why people are making that substitution, or your business isn't going to be successful.
BMM: Give me an idea of what you see as currently the best sectors or worst for franchising a business. Would meal preparation franchises be a bad investment since they are a new sector for franchising, while health care would be good since we have a population that is growing older and health care prices are rising higher than the rate of inflation?
SS: Here's the thing. If I were to draw a two-by-two matrix for you, and say, okay, what sector should you choose to franchise a business? On one dimension would be a good sector for having a business. On the other dimension, I would ask, but is it a good business to franchise? And then for a franchise business to be successful you want a business that is a good sector to be in and it's good for franchising.
Your question is focusing on the dimension of is it a good business for anyone to be in. Well, is it a good business for anyone to be in? What does growth look like? How have sales been in that industry over the past five years? Is it growing at one or two percent, or shrinking? Or, is it growing at 10 to 20 percent? You can look at government data. You can look at the data that's put out by the Small Business Administration or the Census Bureau. Or you can use private data sources to track it. You could figure out, okay, this is a good industry.
But then the other dimension is to identify which industry is good for franchising. I will tell you that one of the best indicators of that is to look historically at where have there been the most franchises. Those industries where there are the most franchises tend to be the ones that are best for franchising. So I would look for the intersection between growing industries and a large number of franchises.
Now the harder part of this is to actually know about which industries are growing because that changes over time. Some of this is actually quite difficult because there are industries where franchising actually tends to work pretty well like, say, shoe repair. If you had asked five years ago would that be a good industry to be in, you would have seen that the industry wasn't growing. Now, paradoxically, because of the recession, it's been a strong growth industry over the past two years because people are substituting repairing their shoes for buying new ones. So sometimes our ability to predict where industries are going is difficult.
Read the rest of the interview: