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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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Staff reporter for Blue MauMau