How Much Should I Invest to Start a Franchise Company?
Why some fail and what can be done to help more new franchise systems succeed
Talk to any number of franchise brands at the IFA Convention with fewer than 100 franchisees or locations, and a troubling theme will emerge: An alarming number of them have not been able to grow as they expected. Some have stopped growing altogether; others have declined from peak numbers of franchisees or locations. Even more troubling are the large number that have ceased to exist and are no longer represented in the aisles at the IFA convention.
Compared to other industries, we find franchisors to be far more transparent with information, more open to giving advice and more likely to take a personal interest in the success of others.
Why, then, when so many passionate people have committed their lives to improving the condition of both franchising in general and franchisors in particular, do so many new and emerging franchisors struggle or fail?
Are these failures isolated incidents or examples of a franchisor failure epidemic? In 1998, business school professor Scott Shane studied the problem and published his results in an article titled MIT Sloan Management Review. He researched 157 companies in 27 industries that became franchisors between the years of 1981 and 1983. He looked at their progress after 12 years as a franchisor.
His conclusion was that 75% of these franchisors ceased to exist. Only 25% survived.
Are Shane’s findings still valid today?
Franchising is full of success stories where committed franchisors created scalable and profitable businesses, which will be around for the long haul, taking many franchisees along for the ride and adding more value to the brand than either party could have created separately.
But why is franchising so successful for some, while so many others struggle?
8 Mistakes That Can Lead to Failure
Most would-be franchisors have the wrong questions in mind when they begin thinking about expanding via franchising. They ask, “How do I launch a franchise system and what does it cost?” The question they should be asking themselves is, “What does it take to sustain the organization on royalties and continuing fees alone?”
There’s an entire industry of franchise attorneys and consultants who specialize in packaging and launching franchise systems. They cite amounts in the range of $100,000-$150,000 to to launch a franchise system including such things as writing an FDD, designing templated training programs, writing operations manuals, upgrading consumer websites and designing franchise sales processes, tools and systems. Inexperienced franchisors often take this at face value, assuming from that point forward the business will self-fund through the revenue generated by franchisee fees and eventually royalties. Many franchisors fail because they grossly underestimate how much capital it takes to get to royalty self-sufficiency.
Franchisors should plan on investing a best-case scenario of $500,000 to upwards of $2 million to take them from launch through the initial ramp-up to 50 franchisees or units; at that point, most franchisors will have crossed the threshold where royalties and recurring revenue are covering all of their operating costs. Those quoted amounts do not include the money owners or founders pull out of the business. If you plan on living off of your system, add that amount the the total needed.
We believe many new franchisors get into a circular situation where they start out with just enough capital to purchase the FDD and operations manual and a small ad budget to start recruiting franchisees, but not enough to sustain the franchisor through their growth curve. As they recruit franchisees, they either underestimate what’s needed or don’t have a clear roadmap for investing back into all those things an emerging franchise system needs: operations staff, developing training systems and coaching franchisees through the learning curve so that they, too, can become profitable.
2. Poor operations, training and support
Undercapitalization or franchisor inexperience leaves the franchisor with ill-conceived or under-developed training and operating systems, poor or ill-prepared operations and support, leading to breakdowns and low profit margins for franchisees, which in turn creates operational headaches for the franchisor and poor franchisee validation. If the franchisees are not making money and are unhappy, it becomes impossible to attract additional talented franchisees. This pushes the franchisor’s dream of “royalty self-sufficiency” further out into the future. Inevitably, the franchisor will find themselves at point No. 3.
3. Selling franchises to survive
When a franchisor is selling to survive, they make poor recruiting choices and accept franchisees who may be operationally unsound or a poor cultural fit for the business. Some franchisors start selling profitable company stores or territories to fund an unprofitable franchisor. All these add strain on cash flow and operations and diminish the franchisor’s likelihood of success. While this vicious cycle is predictable, they either fail to see it coming or to break from its clutches. After a couple of years, if franchisees aren’t making money, they will start listing their businesses for sale. This creates a situation where the franchisor loses good candidates to resales and collected slim transfer fees rather than larger franchise fees. Ab abundance of resales will spook strong candidates into investing in another, more stable franchise.
4. Lacking the skills and mindset of a successful franchisor
Too often, new franchisors relate to franchising as a distribution or growth strategy rather than a business unto itself. They may be excellent at running the operations of their core business but never acquire the skills necessary to become a successful franchisor. For instance, retail chains often run best when the key decisions are made by a small, central authority and then pushed out to the organization to be implemented. Franchising is more decentralized and requires more buy-in on the unit level than other models. The more centralized and less collaborative a franchisor becomes, the more franchisee-franchisor relationships suffer and become unworkable. To succeed as a franchisor, the chain must successfully transition its culture from that of a strong central authority where all decisions are made at the top to a more decentralized and empowerment culture where more decisions are made at street-level by the franchisee.
5. A ‘get rich quick’ mindset
Some franchisors get into franchising for the wrong reasons, chasing upfront franchise fees or area development fees for quick cash, thinking, “I can sell a widget for $20 or a franchise for $40,000! Or perhaps an area for $100,000! I choose franchising!”
They aren’t at all concerned with franchisee profitability. They have little to no operational expertise. They don’t know or care about how to make franchisees profitable. They aren’t concerned with the long-term viability of their brand. They want to sell as many franchises as possible and then dump the company before the operational problems hit the fan. We often see this in the weight-loss or with fitness concepts.
6. Running a sprint rather than a marathon
Many beginning franchisors enter franchising thinking they are going to be the next big thing in a few years and aren’t capitalized for the long haul. Franchising is a 7- to 10-year play. If would-be franchisors cannot wait the 7-10 years it takes to monetize their intellectual property, attain royalty-sufficiency and build significant momentum, they would be better served by opening more company-owned units or territories, which will offer them a better 3-year return on investment. Profitable franchisors are often are valued at 6-8X EBITDA instead of the typical 3X EBITDA of a typical small business, which is why smart, well-capitalized, patient franchisors enter franchising in the first place.
7. Overestimating value or demand
At Franchise Performance Group, we have a saying: “People don’t invest in franchises, they invest in results.” In other words, franchise candidates really don’t want a franchise, they want their lives, careers or investments to look a particular way. The franchise opportunity should be able to bridge the gap between where the candidate is and where they wish to be in the future. If you buy into this logic and consider the thousands of franchise offerings currently available, you will see that almost any outcome a franchise candidate could want can already be satisfied in the universe of current offerings. Bluntly speaking, the marketplace has more than enough franchisors and probably doesn’t need yours to improve or expand its breadth of potential outcomes.
However, the franchise-buying marketplace will always reward a business that is unique, profitable, enjoyable, difficult for competitors to copy and offers franchise candidates an acceptable, predictable and sustainable return for the long haul.
8. Being ill-prepared
Many franchisors come out before they are “franchise-ready.” Perhaps they haven’t proven they can replicate their success in other markets, and their unit-level economics are unpredictable or inadequate. They may have underdeveloped systems that are sufficient enough to get managers up to snuff, but not new franchisees. Many franchisors lack uniqueness and launch knockoffs in an already crowded space, hoping to ride the coattails of the category leaders. We often see this in categories such as residential services, food service and commercial cleaning.
An emerging franchisor can’t make too many mistakes recruiting the wrong candidates, choosing bad locations or ramping up franchisees slower than expected before franchisee validation suffers and the brand implodes. They have to come out of the blocks smoking, replicating the original model with results as good or better than the company units or territories that started it all. Franchise buyers typically don’t reward what they think is only a good idea; they rally behind great execution and predictable, positive outcomes.
Doing it right from Day One
During a recent IFA convention, we approached several franchisors in different industries that survived the start-up phase and had growing franchise systems with happy and profitable franchisees. They had all crossed the threshold where they were royalty-sufficient, meaning their existing royalty stream sustained the business. Their business could sustain itself if they failed to recruit another franchisee.
We asked them, “Knowing what you know now, if you wanted to launch your concept right and not be undercapitalized, how much should you have started with?” Their answers were very consistently between $1 million and $2 million. Not a single franchisor we know of invested less than $1mil. Not one.
We’ve worked with two franchise brands recently, both started by well-capitalized companies with deep pockets. Both owners had experience in franchising and set out from the beginning to build successful national brands. One, an IT franchise, has just passed the 50-territory mark and has made an almost $8 million investment to get to royalty self-sufficiency. The other, a groundbreaking music school franchise, has invested more than $15 million to scale their business to six schools and build out the infrastructure, systems and support structures needed to scale the business quickly. Franchisees’ revenues are up 40% over the last two years. The model is hitting their tipping point. They look and act bigger than they are. In other words, they’re built for long-term growth, and the company will grow into their excess capacity rather than continually stretching the organization or breaking it down.
When we took on Menchie’s as a client with 25 units, one of the first things CEO Amit Kleinberger did was assemble a roundtable summit with some of the top consulting minds in franchising: a legal expert, a top PR firm, a top marketing firm and our firm, which specializes in lead generation and franchise sales. Kleinberger made sure from the jump that Menchie’s was set up to win as a franchisor. Four short years later, Menchie’s is opening its 400th location, with almost 300 more in development. Menchie’s has brought on more than 100 franchisees each year for the last two years and is on course to become an iconic national brand.
How should you spend your money?
All sustainable franchise brands have already achieved royalty self-sufficiency. It’s the key milestone in a franchisor’s history.
The initial capital — from a best-case scenario of $500,000 to a more likely range of $1 million to $2 million — is pure investment, meaning none of it will be used to line the owner’s pockets. Expect 75% to be invested in infrastructure, including a larger and more experienced home office staff, better systems, better training and plugging any holes in the model. Franchisors, when operating correctly, will quickly employ a team of specialists, including:
VP of Operations: This person should be an expert in replicating the business model, accelerating new franchisees through the learning curve and maintaining brand integrity. They will build and manage a team of operational support personnel who will act as franchisees’ business consultant to identify areas of breakdown and bring in specialists where needed.
VP of Marketing: Someone in this role will provide the expertise in new customer acquisition, increasing customer frequency, increasing average customer transaction revenue, increasing customer retention and loyalty, and creating a brand identity.
VP/Director of Franchise Development: This expert will identify your value proposition as a franchise opportunity, craft your franchise sales process, tools, CRM, systems, maintain FTC compliance and recruit, train, and develop successful franchisees.
Director of Training: This person will work with the VP of Operations to craft learning systems for new franchisees, which will accelerate them through the learning curve and past break-even as quickly as possible.
CFO: The CFO will create, track and manage the franchisor’s financial plan, secure financing for franchisees’ initial capitalization and expansion, reduce the franchisor’s tax burden and manage budgets.
Founder/CEO: The leader sets the vision and long-term objectives, sets the culture and corporate values and acts as a control tower, making sure all internal and franchisee relationships remain workable, and must also marshal the resources necessary to allow these franchisor specialists to execute their “A game.”
Many new systems underestimate how important it is to hire skilled staff early in the process. Many franchisors jerry-rig such things as training by promoting a company manager or promote family who have no background in adult education principles and lacks understanding of how professionals from outside their industry learn new business models. The predictable outcome is a system where franchisees struggle rather than power through the learning curve and ramp up slowly.
Additionally, many franchisors hire outsourced franchise sales firms who have no commitment to the long-term health of the organization. These firms are paid a large percentage of the franchise fee revenue, and often a percentage of ongoing royalties as well, which further delays the franchisors’ ability to achieve royalty-self-sufficiency. Because banks and other potential investors evaluate the worth of the franchisor by the predictability of their recurring revenue streams, the franchisor finds out too late that they wiped out a significant portion of their equity value and credit worthiness the moment the ink was dry on their contract.
We recently spoke to the owners of a quick-service restaurant chain who signed a 10-year, no-cut deal with no performance guarantees with a franchise brokerage firm. The brokerage firm receives 30% of revenue and a percentage of royalties on franchisees recruited. The brokerage firm has not produced a fraction of what was promised. The chain needs an equity injection to keep going. Investors are balking because the franchise brokerage firm, rather than the franchisor, receives most of the value of the turnaround. This is a chain that might have grown to 200 units, but will most likely bleed out before they open 30 units.
There are excellent outsourced franchise partners out there, but there are also sharks. Check references. And never pay royalties.
Investing your first million
Your first $150,000 to $250,000 should be used to surround yourself with smart people to make sure your systems are tight and franchise-ready. Then allocate $250,000 for advertising for franchisees and a highly experienced franchisee recruiter. This $250,000 should come back in the form of franchise fee revenues, and the department should run at break-even within a year. Expect no deals for 4-6 months, and anticipate 6-12 franchisees over the next six months. If your initial franchisees ramp up strong and validate well, you can expect some rapid acceleration and exponential growth from there.
Allocate an additional $500,000 to bring in key personnel such as VP of Operations, training, field support, Director of Marketing and finance. It would be great to have an additional $500,000 to $1 million on the sidelines to draw from for brand refinements, round out the leadership team, and cover emergencies or breakdowns on the way to royalty self-sufficiency.
One of the greatest things the IFA has ever done was to compile the ICFE Study Guide, which is an amazingly dense mind-share of some of the most brilliant content experts in franchising. Most of what it takes to run a successful franchisor has been identified and flushed out in this study guide. It’s a great source of information to show new or would-be franchisors what is in their blind spots… what they don’t know that they don’t know.
We also recommend bringing in an experienced and successful franchise executive on retainer early on to help you evaluate your model and personnel and determine your readiness. Notice we said experienced and successful. Franchising is populated with many franchise executives who are merely “clingers” with weak track records.
We also recommend you attend the IFA conferences and events of local chapters to get a better grasp on what you need to be concerned about as a franchisor.
Launching your concept
A franchisor’s first inclination might be to bootstrap it, putting together a marginal program, hoping it is good enough to start and thinking, “When I have more money, I will do it right.”
Ask yourself this: If you were a smart franchise candidate, would you bet your farm on a company that was knowingly undercapitalized and didn’t have the resources to go with their A-game? Of course you wouldn’t. So, right out of the gate, an undercapitalized franchisor is set up to recruit B-level franchise candidates at best.
Is this how iconic brands are built? Is it any wonder bootstrapping franchisors and franchisees get chewed up in the marketplace?
Isn’t there a better way?
Assuming you don’t have normal credit lines or access to commercial loans to fund growth, private equity has entered franchising in a big way. If you are an emerging growth franchisor who has not attained royalty self-sufficiency, chances are your franchisor has little book value because you haven’t profitably monetized your intellectual property. The franchisor may not be credit-worthy, and may be worth less than the franchisors has already invested, since the franchisor’s book value is determined by its assets (and many franchisors don’t have many hard assets), EBITDA (emerging growth franchisors typically won’t have strong EBITDA), and long term predictability of their royalty streams (franchisee fee revenue is a “one time hit” and not sustainable. Private equity firms will often discount the value of the franchise fee revenue, the same way they would discount a one-time tax rebate. They will however assign some value to the predictable royalty revenue of new franchisees who are not open yet.
You are faced with a decision: Do I own 100% of something with predictably little value and long-term sustainability that is highly likely to fail OR do I own a smaller piece of something with great future potential that is better positioned to win? If you can live with the smaller piece of something with potentially greater value, you still stand to make out in the long run, and that might be the best decision for your company. Taking on a partner or private equity may be your best play.
Second, you have to ask yourself, “What type of experience am I looking for in a partner?” Partnerships and equity firms will offer you varied levels of involvement and experience depending on what they are looking for also. Many franchisors reading this may experience a knee-jerk reaction thinking, “I don’t want ‘the blue suits’ running my business and calling the shots!” But the right partner may also offer the franchisor a particular brand of genius they couldn’t afford to pay for right now… which may prove to be the missing ingredient to their overall winning formula. The right equity firm or financial partner may bring the A-game.
For instance, Franchise Performance Group operates a franchisor-growth equity firm called FPG Capital. FPG Capital makes investments in emerging growth franchisors and brings with it highly skilled experts and proven intellectual property in the areas of lead generation, franchise sales, franchisor leadership, strategic planning, technology, operations, organizational development and franchisee-franchisor relations. While we are highly hands-on and are not for everyone, an equity firm like ours simplifies the franchisor’s business by our taking over some of the critical day-to-day functions like franchise sales and adding the needed expertise to avoid pitfalls and ensure success.
We prefer to work in partnership with the existing leadership team, increase their capacity, and “turbo charge” their franchise program. Other equity firms look for operational control and bring in their own people. Others are completely hands off and track their investments through key performance criteria and monthly board meetings.
One of the pitches franchisors make to franchise candidates is “don’t go it alone. Buy into our experience. You will ramp up quicker and have a higher probability of success.” And on balance, they are right.
But as a franchisor, you might find the shoe is now on the other foot. Too many franchisors go it alone, undercapitalized, under-resourced, inexperienced as a franchisor, and making the same rookie mistakes as legions of franchisors before them, never fully monetizing their franchisor business model.
There are numerous equity firms and potential partners operating today in franchising. Start with knowing what your organization needs, structure an offer, and then search out one that meets your needs.
Franchising is unforgiving. Franchise candidates do not want to finance your learning curve as a franchisor. They are paying for expertise and experience, not just in how to sell products and services, but franchising itself. They do not want to bankroll your expansion capital with their franchise fees. They don’t wait for the people and tools you should have gone to the market with in the first place. They don’t want your B-game. Smart money won’t put their dollars there — inexperienced franchise candidates might. You will never build a meaningful, sustainable and profitable franchise brand leading a confederacy of naïve franchisees
The big payout for doing it right
If you were to contact a business broker and value your franchisor, if your EBITDA is under $500,000 you would hear your business valued at about 3-4 times EBITDA. However, if your EBITDA started cracking $1 million a year, that valuation would bump up to 6-8 times EBITDA.
Most franchisors don’t have 100 franchisees or units and never crack $500,000 in EBITDA. Often the difference between a 6-8 times EBITDA valuation and 3-4 times EBITDA valuation is the next 100 franchisees or units.
<$500,000 3-4X 0-$2 million >100
$6 million-$12 million+
Notice the increase in exponential increase in equity value when a franchisor climbs from under $500K in EBITDA to over $1mm. A small $500K increase in EBITDA will create $4-6 million dollars in equity because the multiplier is higher. As franchisors approach 500 units and franchisees (about the minimum number it takes to build national brand name recognition in the US), valuations can get into the 10X or higher.
The biggest barrier to blowing past the 100-franchisee or unit milestone is how successful the franchisor was in onboarding its first 25-50 units or franchisees.
To win in franchising, a franchisor needs three things:
1. A proven, replicated, predictable and highly polished business model.
2. Skills in how to recruit, train, develop and lead a team of high performance franchisees
3. A war chest of at least $1 million to cover expenses relating to smart growth Some franchisors will need to invest much more.
If your franchisor doesn’t have all three, more than likely you are already making one or more of the 8 Big Mistakes in this article. Luckily, there is time to right the ship while the ship is still seaworthy.