Should You Sell Franchises or Build a Chain?

(Franchise Buy) - By . Updated Feb 20, 2011

Just because a particular business can be franchised does not mean it should be franchised. Any business owner who is considering expansion would be well advised to assess whether franchising or company-owned expansion is a better alternative for growth before embarking on either strategy.

But what kinds of factors need to be taken into account? And how do you go about making the decision?

Perhaps the best way to start is by understanding the relative advantages of each path, and the myths that surround them.

The Advantages of Franchising 
Franchising, as a growth vehicle, has several distinct advantages over the alternative of company-owned expansion. In a nutshell, people turn to franchising for four reasons: capital, motivated management, speed of growth and reduced risk.

First of all, since the franchisee provides all the capital required to open and operate a unit, it allows you to grow using the resources of others. By growing using other people’s money, you’re virtually unfettered by capital when it comes to your ability to grow.

Moreover, since franchisees are highly motivated by the investment of their own money, combined with the fact that you’re usually compensated based on the top line (with royalties) instead of bottom line performance, you’ll probably have far fewer problems managing your growth. And since the addition of each new franchisee brings another “body” into the organization, you can also leverage off of the efforts of these franchisees when it comes to site selection, lease negotiations and other startup functions—allowing you to grow with fewer internal resources as well.

The combination of these factors provides you with another significant benefit: reduced risk. You can grow to hundreds or even thousands of units with a limited investment and without spending any of your own capital on unit expansion.

Debunking the Myths 
Franchising also harbors its share of misconceptions. The first and foremost among these misconceptions is that franchising is a legal minefield simply waiting to explode on some unsuspecting franchisor.

The fact of the matter is that franchising need not be any more litigious than any other endeavor and, in fact, may be considerably less so.

Let’s start with the disclaimer. America is a litigious society as a whole, with more lawyers and more lawsuits per capita than any other country on earth. Moreover, in America, anyone can sue anyone else for seemingly anything—including the coffee spilled on one’s lap—so there is no absolute proof against litigation.

That said, it is important to understand a few reasons why franchising is actually less prone to litigation.

First of all, the typical franchise contract is a very one-sided document. And, if written by an attorney who specializes in franchise law, it is likely to afford you a great deal of protection.

Over the years, the litigation centering on franchising seems to have come in waves. Some years ago, there were a number of cases involving the proper use of advertising funds. As decisions were reached and case law established, we saw fewer and fewer such lawsuits. Later, we saw several lawsuits on the issue of territorial encroachment. And again, as decisions were reached and case law established, fewer such lawsuits occurred. Why have these wavers subsided? Because the lawyers who specialize in franchising have followed these cases closely and have learned how to write clauses in their contracts that allow franchisors to avoid such litigation. The fact is, the franchise agreements that are written today afford you even more protection than those written a decade ago—as long as the right attorney is drafting the agreement.

The two issues that always remain ripe for litigation, of course, are violations of franchise law and fraud in the inducement of selling a franchise. But even these issues can be largely inoculated against. First and foremost, train all your people on franchise law and, of course, hire a good franchise attorney. Be sure everyone on your staff is scrupulous in their honesty. Mystery shop your sales force. And, of course, ask each and every franchisee in their closing interview about the sales process and any representations that were made. Many franchisors will use a written “closing checklist,” and some have gone as far as videotaping those interviews. And, lastly, institute a no tolerance policy if you do find any infractions.

On the upside, franchising affords you a significant “liability tradeoff.” In other words, when making a decision about franchising versus company-operations, you need to consider the litigation exposure you are avoiding as a part of this same equation.

Yes, as a franchisor, you gain some potential contractual liability with each franchise agreement you sign. Every time you sign any contract, of course, you’re obligated to live up to the letter of that document. And while these documents are one-sided, there is no denying the potential liability.

But consider the alternative of company-owned operations.

With company-owned operations, you have the liability for every lease you execute—whether it’s for equipment, a vehicle or a building. In franchising, that liability is the franchisee’s. With company-owned operations, you have the liability for every employee you hire—personal injury, sexual harassment, discrimination, employment law, crime in the workplace … the list goes on and on. Again, with franchising, that employment liability is largely that of the franchisee. The same holds largely true for customer liability—everything from breach of contract to personal injury.

To be clear, franchising may not stop someone from suing you, but if you have a well-written contract and a well-written operations manual (allowing you to avoid claims of negligence and inadvertent agency), the liability will likely be limited to the franchisee. Add to that other protections (such as the requirement of the franchisee to obtain insurance coverage and name the franchisor as the co-insured), and it becomes readily apparent that significantly more liability is associated with the growth of an equal number of company operations.

The second big myth in franchising involves control and the improved unit-level performance that some argue comes with it. Control advocates believe the ability to terminate employees at will is a big advantage, and, of course, with company operations, you can hire and fire at your own discretion. While you have a great deal of control over unit operations in a franchise, terminating a franchisee is certainly more difficult.

We would argue, however, that the ability to terminate does not equal improved unit operations or brand performance. Both independent studies and our own observations of franchisors have repeatedly shown that similarly-situated franchisee-operated sites typically outperform their company-owned counterparts in almost every imaginable category—from revenue to perceived cleanliness to customer satisfaction.

Why?

Two reasons: First, franchisees are highly motivated and take a pride of ownership that is difficult to instill in someone with nothing on the line. Their franchise is their business, and thus they usually keep it cleaner and run a tighter ship than their non-franchisee counterparts. Secondly, franchisees, by their nature, are often “lifers,” staying with the company sometimes for generations. Instead of constantly training and retraining and hoping for the best, franchisees develop a depth of knowledge and experience that is virtually impossible to replicate in a company-owned operation at the unit level.

But while franchisees not performing up to your standards can always be terminated, of course, the process can be slow. And if you have a franchisee living up to the letter of the contract and operations manual, termination will not be an option.

This is why the process of franchisee selection is so important to franchisors. If you choose the right franchisee, these issues likely never arise. Choose the wrong franchisee, and you may need to live with your mistake for years. See 'Finding the Right Franchisee.'

The Other Side of the Coin
Of course, franchising is not without its drawbacks.

First of all, as a franchisor, you will no longer be entitled to every dollar that goes to the bottom line. Franchisors typically receive a royalty that is a percentage of gross revenues. So as a franchisor, you do not share in profits. So while you would recognize 100 percent of your revenues if you owned the unit, your revenues as a franchisor might be limited to 4 to 10 percent of the unit’s revenues, plus perhaps some product sales, rebates and advertising fees.

Likewise, if the operating units were to generate profits in the 20 percent range and you required a 6 percent royalty, you might need to sell four or five franchises or more to achieve the same level of dollar profitability as you would with just one company-owned operation. So as expected, reduced risk (in the form of franchisee investment) results in reduced returns—at least at the unit level. Of course, franchising does allow for faster growth to offset these reduced unit level returns. But if you have the capital to adequately develop the markets you desire to penetrate without franchising, you may well be sacrificing total dollar returns—although your ROI would likely be higher through franchising.

The way in which franchisors are compensated is even more noticeable if you’re looking to demonstrate revenue growth. While revenue growth may not mean much to some companies, for public companies or companies considering going public, this metric can be important for valuation purposes.

Similarly, company-owned operations offer the other financial advantage of building the balance sheet. With franchising, the only assets built are franchise contracts and the “goodwill” associated with them. Company-operations, on the other hand, will build hard assets—which can also help from valuation purposes.

Likewise, it is important for you to have a personality that is well suited to franchising. Certain leadership styles (see 'Determine Your Leadership Style') are better-suited to franchising, and if you find you aren’t comfortable with the more open communications you will receive from franchisees, perhaps you may be better suited to a company-owned environment.

Should You Do Both? 
Lastly, for the company trying to choose a growth strategy, it is important to point out that it does not have to be a tradeoff between building assets and speed of growth. The vast majority of franchisors use both company-owned and franchised strategies in combination.

Some franchisors will choose to own and operate the best locations/markets while franchising secondary and tertiary markets. Others will choose to develop a company-own presence in their core marketplace and franchise in more distant markets. And some choose to treat company growth and franchise growth opportunistically.

Regardless of the strategy taken to integrate these two growth models, the combination of franchising and company-owned growth, for many companies, provides the best of both worlds.