Shane Pt 3: Common Mistakes by New Franchisors
CLEVELAND, Ohio – Professor Scott Shane finishes his three-part interview explaining the common mistakes of new franchisors, and how franchisors need to understand and manage built-in conflicts of the franchise model.
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 Company. For the benefit of franchisor executives, private equity firm leaders and even franchisees, Shane illuminates the building blocks of a franchise model and the economic drivers of strategy.
BMM: What are some common mistakes that new franchisor start-ups make?
SS: One of them is that young franchisors don't really understand the economics of franchising, particularly the issues that relate to conflicts between franchisors and franchisees: That the system has structural issues that mean franchisors and franchisees have different goals. There will be conflict in their franchise systems.
BMM: So no matter how nice a guy the franchisor leader might think he is or wants to be, there are conflicts of interests built into the system.
SS: What people [franchisor founders and leaders] do is essentially convince themselves: "Unlike everybody else in the industry, I'm a saint. Therefore, I won't have conflict."
What they really should be saying is, "Look, there's something that happens when a franchisor adopts strategies to try to maximize a franchise's revenues at the outlet [to receive more royalty payments to the franchisor], while the franchisee makes money off profits, their revenues minus costs." That means that there will be conflict. The franchisor needs to figure out systems to deal with it. The lack of knowledge about the economics of franchising I think is one of the problems.
The other thing that a lot of franchisors lack understanding about is how only a few franchisors make a successful franchise system out of their business.
When people are franchising, they start with a good [independent] business. And then they think, "Okay, I'm going to franchise it." What they don't realize is that if a business doesn't get the franchising essentials right, they will make a mess of it.
A lot of franchisors don't do it right. They've actually taken what was a good, solid business and put franchising on top of it. The reason they later develop problems and are unsuccessful is that they underestimated how hard it is to build a successful system and how few franchisors do it successfully.
BMM: If someone has had a profitable business for ten years, they already are way more successful than the average start-up, who has long gone by the wayside. Are you saying that when an established business begins franchising, that the business is again in danger of going belly up at the same high failure rate as start-ups?
SS: When someone franchises their business, there is no guarantee that just because there was a successful business they will have a successful franchise. Only about one out of four franchise systems will successfully stay around over a ten-year period. An entrepreneur could have a successful restaurant, having run it for ten years. It's fine. And then they think, "Oh, I can certainly build a successful franchise out of it." They don't realize that the chance of building a successful franchise out of the original framework is one in four. There are many bad decisions that might keep a franchisor from building a successful franchise system.
The distractions of building a franchise system, and if it is not working, the efforts of trying to cope, will not help. Franchising can hurt most underlying good businesses and can cause those businesses to be less profitable and more likely to fail than would have been the case if they just had continued to run the business without ever thinking of franchising it.
BMM: Are there franchise models that minimize earnings conflicts between franchisors and franchisees? I suppose franchisors that receive royalties from a franchised store's profits may minimize that conflict. On the other hand, you wonder how much less in royalties a franchisor might receive by doing so.
SS: If you changed the model from royalty based on sales to royalty based on something else, like profit, you might minimize the conflict that you had with your franchisees, but that would come at a cost of something else.
One of the problems is that there are almost always tradeoffs that will be made, strategically. One way to better deal with this is to say, "I know I'm going to end up in conflict with my franchisees because I'm trying to maximize sales and they are trying to maximize profits and at some point that's going to cause a conflict, I'd better write a good contract. I'd better have a good lawyer write a good contract that will put me in a good position when that conflict emerges because it's going to emerge."
The franchisor could have a terrible franchise contract and lose terribly in a court case. They need to anticipate what reality is and then design accordingly.
There are other things to think about. Does the franchisor want to adopt a particular business tactic if it anticipates that the initiative will cause problems with the franchises?
BMM: Speaking of franchisor-franchisee conflict, a few months ago talk-show host Oprah Winfrey announced that Kentucky Fried Chicken was providing free grilled chicken coupons. Unfortunately, grilled chicken supplies ran out. Some KFC franchises would not honor the coupons. Quiznos has also had a similar coupon problem. Some franchisees at the beginning of the year would not honor a national coupon campaign. Customers were irate.
SS: Think about the logic of why there is conflict: I'm a franchisor and I get royalties as a percentage of sales. If I can find a way to increase sales by 10 percent, I'm going to make more money, right? And so, what do I do? I give out coupons. That encourages more people to go to the outlets so that there will be more sales.
The problem is that a coupon adds costs to the franchisee. The added sales that a given franchisee gets could be smaller than the cost that they have had to add to the "buy two, get one free" promotion. So for them, the coupon drives down profits, while at the same time it drives the franchisor's profits up.
The question a franchisor needs to ask is — is it worth doing? That's the kind of thing that they should understand the economic impact of before making a decision.
BMM: There is a lot of research, 2 X 2 grids, charts and footnotes in your book to provide support to your points. It's not the sort of book to curl up with.
SS: If anyone can think of a franchising model without thinking too hard, it's unlikely that the franchise system will be very successful. Leaders need to think about how to design a franchise business. It's going to be a deeper read than The Five Most Important People I Met in Running a Business. I read both kinds of books. I will tell you that some are more important and more valuable than others. But these are not necessarily the ones that I would pick to read on the beach.
BMM: Yes, but I hear that the author of The Five Most Important People I Met is negotiating a big blockbuster movie deal with Hollywood even as we speak. Seriously though, I found From Ice Cream to the Internet a fascinating read. I suspect that many executives and entrepreneurs involved or thinking of becoming involved in franchising will as well.
Make sure to read the rest of the series:
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Related Reading:
- Biggest Factors in Start-Up Survival by Scott Shane
- Blue MauMau's book review of Scott Shane's From Ice Cream to the Internet: Using Franchising to Drive the Growth and Profits of Your Company
- Scott Shane: Costly Myths of Entrepreneurship
- Are Entrepreneurs Made or Born?
- Franchise topic:
- Enter Your Own Tag:
Any more coming down the line?
franchise your business. This issue goes to the heart of whether what you are thinking of doing is really franchising or just a rip off masquerading as a franchise.
Definitionally - substantive versus superficial - a franchise is a relationship model that has been vetted for reasonable mutual profitability potential.
If the model you are selling is configured to provide profitability for the franchisees and you don't builld in rip off mechanisms, or have the integrity to forego the rip off mechanisms that are found in every franchise agreement today, then you have a franchise. Everything else is a rip off, a scam.
When competent due diligence is being done on a potential franchise investment, one looks very sharply at the profit potential configuration and then to the franchises's history of providing that to the franchisees in real terms. In a newer franchise with little or no history, you have less to look at, so the investment risk is much higher and you have to look for other things to see whether this higher risk profile can be handled by this particular inverstor.
Part of the problem is that people thinking of franchising a business are sold by the consultants on the enormous cash flow potentials that can be extracted in a franchise relationship. The many ways in which a hungry franchisor can extract extraneous royalty streams from its frachisees are like a cleansed killing field lying before your relatively safe ambush position. As the investors emerge from the woods, you can - if you are so inclined - just mow 'em down.
In an essentially ethical configuration with a rational long view franchisor, one needn't spend a lot of time worrying about the trouble graphs between the term of years and the grounds for termination clauses. You will in a normal contract have plenty of ammunition to use on miscreant franchisees. You need to be able to rationalize your franchise agreement portfolio to keep it relatively current with the market and with the legal requirements. Ten years is an outside time limit on a "rational" franchise term configured in this manner.
If you have a "real" model to franchise and you are not a thief, your franchisees will sell them for you and they will also renew if the terms under the new agreements are not confiscatory. If your brand has no value at end of term, regardless of the reason for it, your franchise will have come to the end of its useful relationship life and no contract provisions can save it unless your franchisees have slave mentalities.
Richard Solomon, FranchiseRemedies.com, has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School
Mr. Solomon has missed the point. The chart isn't focused on helping an entrepreneur decide whether to franchise a business. It obviously is an illustration to help business architects understand and manage the interplay of forces and their implications to all parities when building franchise structures -- in this case creating franchise agreements.
Speaking of which, did you also notice how each industry has a different average contract term? Any thoughts on why certain industries are more concerned with franchise opportunism and want longer term limits?
I have seen 20, 15 and 10 year terms where churning existed in industries where 5 year terms didn’t produce churning. And vice versa.
I considered premature exits as being the style of the individual franchisors whatever their preferred term. It is a good question worthy of expansion so please do tell ….
The most common mistake by newbie franchisors is that they don't do and what we scream for franchisees to do. Find out what it is really all about.
But going back to the title here, 'Common mistakes by new franchisors'; how about selection? I realize here we are have taken the topic to the structure of agreements however, new franchisors tend to want to swim before they can paddle and when they fall for poor selection they tend to drown. Selection obviously being franchisee selection but also, advisers, locations and personnel.
based upon the research of Dr. Timothy Bates of Wayne State University and our own franchise development experience. We wrote about it, and that was one of the very first articles on my home web site.
Why New Franchises Fail
There are real mechanical reasons for new franchisor failure that we addressed in addition to recognition of the fact that franchising does not change the attrition rates of business start ups in most instances.
Many years later even the IFA quit telling people that franchising makes a critical difference in survival likelihood, but, unfortunately, many of its members continue to this day trying to sell that outrageous falsehood.
It is so unfortunate that franchise investors continue to try to make do without the insights of people like Scott Shane and the others who have known these bitter truths and could have saved them from losing their total investments.
The only thing that will actually be effective in cleaning up franchise selling fraud is drying up the sucker pool through education about not trying to outwit the experts who are out there working their emotions and their mental vulnerabilities to the end that they get fleeced.
When I designate something a FranWhack, it is this kind of insight that makes a terrible franchise offering so utterly unworthy of investment and makes that insight readily available to franchise investors. No frachise investor need ever get fleeced by bozo franchise offerings that he simply cannot see through.
Richard Solomon, FranchiseRemedies.com, has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School
This is the question, asked or not asked, that tends to differentiate the systems that live long past the 10 year mark and those that fail. And still there is a balance that must be maintained.
Franchisors who have an absolute focus on increasing franchisor royalty from franchisees without reasonable and fair concern as to the negative impact that may have on franchisee profit set themselves on a path to a fragile future that includes increased conflict and franchising brand damage.
There are basically 2 approaches to growing franchisor royalty and in the highest performing systems both are pursued with a level of balance that compliments each other offering strength to the franchisor’s financial success which enhances the investment of the franchisees while also delivering a healthy return to franchisees.
The second approach is where the franchisor asks the question ‘is it worth it?’ on the basis that to grow royalty a franchisor’s alternative can be to produce a system where a reputation for producing a healthy franchisee return creates network growth. These are typically the franchising brands that can withstand scrutiny, they do grow and they last.
In very basic terms as an example and to be brief; a franchisor pursuing a 10% growth in royalty may choose to push franchisee gross revenue up [and too often to the detriment of franchisees] or a franchisor may choose to grow the network by 10% on the back of a reputation for producing successful franchisees.
I’m not suggesting it is a simple process to get to that position but it is a relatively simple philosophical difference that becomes evident in a franchisor’s business plan and the resulting reputation they choose.
There are other methods that may be utilized in many franchise systems to grow franchisor royalty and a healthy franchisee return while producing network growth through enhanced franchising brand reputation. In quality systems there is a definite correlation between standards, training, support, effective communication systems and performance and everyone’s net profit.
The problems facing naïve prospective franchisees is that poor and disastrous franchise models ride on the back of the franchising reputations created by quality franchise systems even though they are comparatively few. The industry and governments promote the success of the few and vaguely refers to what in reality is the mass of failures.
The other problem of course for naïve prospective franchisees who find themselves tied to a franchisor set on a short term path, whether out of ignorance or design, is that the relationship and financial woes go from conflict to mush worse than real nasty where franchisors eventually realize the end is inevitable and every penny counts.
This also explains why so many franchisors choose to wring every last cent out of a failed franchisee often ensuring the franchisee loses such assets as their homes and anything else they didn’t bother to consider when they first signed to a contract without performing and investing in effective, this is serious crap, due diligence.
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