Have you ever wondered why certain businesses are grown through franchising, while others are scaling themselves by creating creating corporate units? It seems easier to control your brand by growing a business with a unified ownership structure and the profit margin seems higher in expanding as a corporate unit. Corporate owned Starbucks made a 14% net profit in 2016, while ongoing royalty payable received by McDonalds from its franchisees was 4% of gross sales in the same period..
So why do people franchise instead of scaling the business?
A company is scalable if it is able to maintain, or even grow, its profit margins, while increasing its sales volume. Scalability describes a business’s ability to grow without being hampered by its structure or available resources.
One of the scarcest resources in a business is leadership talent. Many entrepreneurs lack the skill to grow their business beyond a size that they can personally control. During my career as an investment banker, most of our clients sold their businesses when they hit the ceiling of growing it without attracting or building a leadership team.
The greatest bottleneck for most businesses is the abilities of its leader. A company will only grow to the extent its leader can raise herself to working on her business while mentoring and or attracting talent to take her place. The leader has to elevate herself to become capable of mentoring good people or be an attractive employer who can entice and pay leaders who have already succeeded elsewhere.
In practice, few leaders are able to continually grow themselves and scale their businesses up into a Fortune size company. There are notable exceptions, such as Zuckerberg, Gates, Page and Bezos. The late Steve Jobs hit the ceiling as a CEO in the late eighties and had to go away and learn the skills he needed, before he could return to Apple ten years later and start turning it into a world-class company.
Building a business through franchising
Those that don’t have the skills, or the desire for the pressures, of building a BIG company, might opt instead for franchising their business. Being a franchisor will allow them to focus on recruiting training and servicing franchisees for a royalty stream and run a modest size corporate center that can be personally controlled well into the future. A franchisor business may become very profitable and can provide significant wealth, while serving up an easier lifestyle to its owner than being a Fortune CEO.
People also franchise businesses that are hard to scale. If a business is successful as a one-unit operation, but it is not scalable, then an alternative could be to create stand-alone units in non-competitive geographies where these entities would not cannibalize the original business. Franchising or licensing is a great way to do that.
Four reasons why a business was not scalable.
Over the years, I came across a vast a number of un-scalable businesses. The most typical reasons why growing the business was not feasible were the following:
Low operating margin
Scaling most businesses requires an infrastructure and the business will have to invest in layers of management, internal controls, marketing and financial controls, etc., each of which will cost overhead, reducing the operating margin of the operation. Unless the original business is able to generate doubly digit profit margins, it will not be able to carry the extra cost of the overhead required for the expansion.
Years ago, I sold a HVAC contractor company to a French multinational, that levied a 5% cost contribution charge to acquired entities, to amortize the group overhead to reflect the acquired businesses “cost of being part of the corporate group”. There were next to no productive services provided to the subsidiary for this cost. It was pure overhead.
Low margin businesses often need entrepreneurial management to make them viable. The business owner whose cash investment and often the livelihood of whose family members are at stake, will focus more intensely in making the business profitable and will likely be willing to work long hours and sacrifice leisure and family time. Sadly, “slave labor” is the only way to make some businesses profitable.
In 2008 I represented a DIY business franchisor that operated in several Central European countries. The founder of the business figured out a model to develop franchisees in rural towns, even villages where his was the only franchise business around. The franchisors financed the purchase of local properties and loaned inventories to over one hundred of these, in many cases, mom and pop franchisees, who had few local employment opportunities and were willing to work long hours and their networks to make these stores successful.
No obvious synergies
Most franchise groups provide some central services to their members, such as accounting, IT and marketing, but most often those are not essential to the franchisee or are not provided cost efficiently.
If there are no meaningful synergies between the units that could compensate for the extra overhead of expansion, than setting up in other geographies will dilute the operating margin of the expanding business and growth oriented shareholders and their boards will not support these deals.
Lack of valuable IPs
Developing intellectual properties allows a business to differentiate itself in the market and achieve higher margins. The franchising process will maintain the legal protection but may weaken control over such IPs, so owners of such IPs may prefer to keep them in a more controllable corporate environment. IP-supported higher margins give these businesses more scope to expanding directly.
Businesses that don’t own significant IPs, tend to differentiate themselves through branding and processes, which can be sufficiently attractive for franchisees to pay for. These processes if effective and documented thoroughly so that they can be easily implemented, may be sufficient to create a market for the franchise opportunity.
Scaling your business (whether corporate-owned or franchised)
The most successful franchisees occasionally end up becoming better at scaling their franchise businesses than the founders expanding the master businesses. Several years ago, we advised a successful bakery product master franchisee who had fallen out with its franchisor when their contract came up for renewal. Our client refused to agree to the doubling of royalty payments and instead decided to rebrand his business and start to compete with his former “master”. 3 years later our client’s rebranded business ended up overtaking the original franchisor.
Are you a “Traction®-company”? Is your company naturally scalable, thanks to its high operating margin, geographical synergies or intellectual property? If so, the Entrepreneurial Operating System® (EOS®) may be a simple and cost-effective solution to make rapid and sustainable growth happen.
However, EOS can help you even if you don’t have these attractive features, or if you are running a franchisee unit. Provided you have at least 10 employees, EOS can help you align your team around a vision, create a structure for disciplined execution and increase the health of your team in working together to elevate your operation and help you grow and open additional locations for the business.
Steve Preda is a licensed implementer of the Entrepreneurial Operating System® (EOS®). He is committed to helping business owners and CEOs triple their profit and triple their time off within 3 years.
Steve has over 25 years experience in Europe and the United States. He scaled and sold a market leading investment bank in Hungary and created and led the merger of a regional investment banking network (MACEE) with global network IMAP. He holds CPA, CFA and Investment Banking Licenses in the UK, Canada and the United States, respectively, and sat on the boards of several public and private European and US companies. He has two books published on Amazon and a podcast show: Succession Secrets.