Creative Developments in Franchising:

Date: NOV 14th, 2007

Topic: Industry Experts

By: Lori Karpman, President & CEO, Lori Karpman & Associates Ltd.

The term “Franchising” as generally understood, describes a very specific and defined business model. Over the past few years this standard definition has been modified and re-defined sometimes, beyond recognition. This is due to the fact that as new business opportunities arise, new business models have to be created to accommodate them. As well, creative strategies and strategic alliances have become a new way of doing business in today’s industry. The traditional model, where an initial franchise fee is paid and royalties and advertising fees are remitted regularly is no longer the standard practice. In fact, one emerging model is a hybrid of many of the traditional features coupled with some new and novel practices adopted from the wholesale and supply chain model of the retail industry. Franchisors are finding creative ways of designing their “business in a box” to make their systems more efficient, easier to operate and a better investment option for prospects. While there are several new styles emerging, I have chosen to discuss one progressive model in this article that I have become quite fond of creating myself. This model borrows many of the elements of a distribution style system whereby the franchisor becomes the main supplier of products to it franchisees and the financial structure is completely revisited. The day to day operations remain unchanged but on the whole, the chain becomes healthier, more profitable and results in faster overall growth.

The traditional franchise model has franchisees paying an Initial Franchise Fee and perhaps, an additional Training Fee at the outset. These fees represent the right to use the Trade Mark(s) and System, and a re-imbursement to the franchisor of the expense of putting the franchisee into business. Contrary to popular belief (of franchisees that is…..), this Initial Franchise Fee is not a profit making centre for the franchisor. The franchisor incurs tremendous expense in evaluating the prospect, site selection, coordinating the turn key process of preparing the franchisee to be an operator, construction coordination (where applicable), training, and all associated legal costs. The Training Fee may be charged separately in some systems and may be offered by a third party professional service. This element has remained pretty much unchanged. The costs and procedures of starting a new business remain the same in any business model. Some franchisors have attempted to do away with the Franchise Fee portion of the Initial Investment altogether reasoning that it will open the prospect pool and be one less barrier to entry. It is also a surefire way to guarantee that the franchisee’s money will be applied towards working capital for development of the business in the start-up phase.  I caution against this strategy however as the Franchise Fee acts a prospect qualifier. If there is no fee to get in, there is no corresponding loss to get out. The franchisees in this situation will be less committed as they have invested less and do not have the same commitment financially or psychologically to succeed. Furthermore, as a franchisor, you desperately need this income stream to fund and provide the necessary cash flow for continued operations. Remember-the money is a re-imbursement of expenses, not profit.

Where the major structural changes occur are in the ongoing financial commitments. In the standard model, franchisees generally pay a certain percentage of their gross weekly/monthly sales as royalties, and a smaller percentage as advertising fees/contributions. Often, there is an additional local store marketing component. In this new model, royalty fees are abolished and replaced with a mark-up on product fees as they are purchased (from the franchisor, or franchisor designated supplier) by the franchisee as their inventory. Essentially royalties are built into the cost of goods sold. There are multitudes of creative ways that the financial model has been restructured to suit the needs of each individual system. The franchisor becomes the system’s biggest (and sometimes only) supplier of product so it is integrally involved in the supply chain and has control itself, or can have control of it through a third party. The franchisor may sell the finished product, raw materials, or even just manage the relationship of the chain of supply.  Vertical integration it is called. So how does the franchisor make money in this scenario? The franchisor derives its revenues from the sales of product into its system. Instead of making money on the product as it goes out of the system (i.e.: royalties), it generates its revenue on the products as they go in. The franchisor is remunerated either by the supplier directly, or by the franchisees as the products are purchased as inventory. The franchisor has made previous arrangements with each supplier and the franchisor’s “share” of the purchase price of each item is factored into the franchisees cost. On a pre-determined basis, generally monthly, the franchisor receives a cheque from the supplier for its share of the total purchases. If it is warehousing the merchandise, it will be paid when the franchisees purchase from them. In this case, the franchisor generally charges an administration and warehousing fee as well. On top of this, there are generally volume rebates and the like that are compensable from the supplier. Essentially, it is a distribution style model in many ways. In a distribution model, each party takes their share of the purchase price as the product moves through the channel. It works particularly well in franchising since the key to success in franchising is product consistency, and the franchisor is best placed to ensure that. So for a host of financial and operational reasons, a distribution model is an excellent choice for a franchise system.

One of the most appealing reasons to structure a system this way from the franchisor’s perspective is the steady cash flow. Having been a franchisor myself, I know the drudgery of having to collect royalties. Having been a master franchisee, I understand the monthly reconciliations and calculations. With this system, the franchisor is being compensated as merchandise is purchased and the franchisee receives it with royalties all factored into his cost.  There is no monthly cheque writing or debit to his bank account. There is less accounting and paperwork on both sides. The franchisor has a steady cash flow and is being paid regularly as the franchisees are purchasing regularly. The monthly collection process that is the bain of every franchise relationship is now being eradicated. The other benefit of this method not to be overlooked by any means, is the operational ability to monitor the inventory and cost levels of each franchise.  By moving towards a supply chain management model you not only eliminate the “contentious” part of the franchise relationship but create a better financial and operational model that builds a healthier and more profitable system, unit by unit. Furthermore, by ensuring a continuous cash flow, the franchisor has the funds it needs to pour into continued research and development, human resources, or whatever initiatives are necessary to move the entire system forward and keep it growing. It is not at the mercy of its monthly collections or the whim of franchisees who, by their nature, use the franchisor for financing when funds are tight.

The biggest concern I hear from prospects coming to me having investigated a system of this ilk, is that the franchisor will take advantage of its position and charge higher prices for the products or, not pass on rebates that they receive from suppliers. I must first note that supplier and volume rebates are legitimate sources of revenue to a franchisor. A franchisor cannot not live by royalties alone! As long as the franchisor is honest about the fact that they obtain rebates and they keep them, the practice is legal and legitimate. The funds received are used for the benefit of the system to fund the franchisor’s continued research and development; new projects etc and are essential to its continued growth. Franchisees need to be made aware of this fact and understand how the funds are used. Often though, franchisors will pass on promotional opportunities to the franchisees. It is after all in their interest for each franchisee to have a healthy bottom line. Successful existing franchisees sell new franchises. Sales begin from the inside out. Franchisors that lose sight of this and attempt to make high margins per product at the expense of their franchisees quickly see their overall product sales decline, bottom line unit results falter and sales of new units stall. The best salesman is a happy, profitable franchisee. As long as the franchisor is not abusing the model for its own financial gain, the model works in the best interest of all involved.

Typically, franchisors do not actually handle any merchandise but have set up buying programs with suppliers. Franchisees benefit from the volume buying power of the group. The franchisor receives a percentage of the sales volume from each supplier as remuneration. In addition there may be advertising dollars contributed by suppliers to the benefit of the system which may be passed on to the franchisor in the form of a cooperative advertising budget, or the creation of marketing materials etc. One example of an excellent system is the following: a centralized purchasing system whereby the franchisees purchase their entire inventory through the franchisor’s central office. The orders are then placed with the individual suppliers by the franchisor and delivered to each franchisee’s location directly. This allows the franchisor to monitor each franchisee’s inventory level and helps them to control costs, a vital part of operational support. Inventory management is probably one of the least understood business principles and one of the most important in financial health. Providing this form of assistance to the franchisees is invaluable to their, and ultimately the whole system’s, success.

Insofar as marketing is concerned, each system is different and this can be handled in a multitude of ways. Many continue with the traditional percentage of sales calculation. What seems to be emerging though is a fixed monthly contribution to a regional and/or national fund and a local store commitment. This is very highly dependant however on the nature of the system and the product, service or geographical territory to be covered. Fixed contributions allow the parties to know in advance what their financial commitments are and avoid the monthly calculations eradicated by the supply chain model on product purchases. Even in traditional royalty based systems I am seeing a move towards this fixed monthly fee format. There should be however, a local store requirement based on sales regardless of the model chosen. In my opinion, this local advertising requirement should always be hefty. As is true in a traditional franchise system, the franchisor is required to provide all the tools necessary to assist the franchisee in developing their business. There should always be a database of material to use for local marketing efforts. I always recommend a mandatory local store marketing requirement but as a franchisor you still must provide some form of national brand awareness campaign.

From every other perspective the traditional model remains in tact. These hybrid systems provide a superior level of operational support needed to ensure success. In all other respects however, all the other rules of franchising apply. The principle is still in tact, consistency is the key. This model ensures product consistency by giving the franchisor complete control over the supply chain. Allowing suppliers to participate in the overall growth and success of a system has proven to be very beneficial. My experience has been that suppliers are very happy to perform this service for franchisors and to offer very competitive prices and additional services to assist the franchisors in tracking, reporting and controlling the activity of their franchisees. They have become most useful allies in the overall success of many brands.

For the franchisor, it is a welcome reprieve from the accounting nightmare of weekly sales and royalty reports, calculations and reminder calls. Everything is paid up front and all squared before the franchisee ever gets the merchandise. This reduces one, if not, the most, contentious areas of the franchise business. By removing an obstacle, you create an environment that fosters communication and that can only be good. For the franchisee, it is an operational model that greatly diminishes the complexity of owning a business by allowing the franchisor to provide input into its inventory management process, and hence, cost control and bottom line results. From both perspectives it ensures a quality product is being delivered to the end user at the best possible price. It ensures the franchisor a continuous cash flow from which to fund its continued growth and development. The benefits are far reaching. 

I have seen a few variations of this model over the past few years. This model can even be combined with other forms of business models such a licensing and incorporated into other legal business structures such as limited partnerships and joint ventures. As more and more business opportunities come to market, creative strategies will have to be developed to accommodate them. And with each new hybrid comes the opportunity to create outstanding operational results!

Lori Karpman & Associates Ltd., is a full service strategic management consulting, marketing and law firm. To reach Lori Karpman: 1-888-888-3183, lori@lorikarpman.com, www.lorikarpman.com.