domingo, 23 de octubre de 2016

The franchisor's dilemma: when granting a franchise and when opening a company-owned store

Every franchise network has its own stores and its franchised stores. There are two main reasons for choosing this combination:

a- the franchisor needs to have its own stores in which monitor new trends and test new products before passing them to the franchisees

b- the territories are different and the franchises do not always perform the same return on investment, suggesting that it is necessary to have a criterion for the granting of a franchise that allows the franchisee earn enough money and pay royalties.

We must always have in mind that the real deal is that the franchisor can collect royalties of many franchises for a long time. This is what shows the power of the concept and the brand. And not charging initial fees or selling goods, which can be done through a mere distribution channel.

For every dollar billed in a franchise store, 5 cents are for the franchisor. Thi is what some call the "credit card model", probably the best business ever invented in the history of business.

So, in which territory a franchisor should open a company-store and in which should grant a franchise?

There are territories in which profits are great, and in other territories profits are small.

As a general rule, if the territory generates little or great money, should be left to a franchisor's company-owned store. And franchises should be granted in territories in which the franchisee will be able to earn enough money to grow and pay royalties.

When the territory generates little money, to grant a franchise can be a great irresponsibility. Usually, poor generation is due more to the side of expenses than to the side of revenues. In a Shopping Mall for example, a store can bill very well, but the costs of being there use to be unreasonably high, so profits will be small. In return, millions of people will see the brand logo, so this could be considered as a communicational investment for the franchisor.

And when the territory generates a lot of money, why would you grant a franchise?

Instead, there is a wide strip of returns that can be exploited by entrepreneurs who purchase a franchise, earn money and pay royalties.

How do we measure that strip?

I will use a numerical method based on some commonly used metrics.

We start considering ROI (return on investment), defined as:

ROI = profit / total assets (1)

There are several critera to calculate the variables at play. Once the franchise business model has been run for the territory, having done the corresponding assumptions of revenues and expenses, and having arrived to a P&L (projected income statement for the franchise in the territory and along the duration of the franchise contract), my definitions are as follows:

profit = accumulated after tax profit at the end of the contract period

total assets = total initial investment + accumulated investment during the contract period + final inventory of goods (if applicable), which I consider equal to the initial inventory of goods that had to be bought to start the franchise operation

Along with these definitions, we are assuming that the premises in which the franchise operates is rented and is not a part of total assets, although it is part of total assets all the improvements that the franchisee makes in it, considered in the initial and ongoing investment.

Now, in the formula (1) we can multiply and divide by "sales" without altering the equation:

ROI = (profit/sales) x (sales/total assets) (2)

What appears as "sales" in the above equation are the franchise cumulative revenues at the end of the contract.

Equation (2) is the equation of a hyperbola.


profit/ sales = margin (3)


sales/total assets = asset turnover (4)

This give us the opportunity to consider the existence of "isoroi", ie ROI curves where ROI remains constant as a result of multiplying different combinations of "margin" and "asset turnover".

In this example, along the red "isoroi", ROI keeps the constant value of 182% and, at the point that we emphasize, that value is obtained by multiplying the "margin" of 16.18% by the "asset turnover" of 11.25. Different combinations may be made for the ROI value remains constant at 182%.

The green curve corresponds to a ROI of 200% and the blue curve to a ROI of 120%.

Then, depending on the final margin and asset turnover of our projected and accumulated business model's P&L at the end of the contract, we can define three areas in the chart above:

a- the area that exists above the green "isoroi", corresponding to franchises with highest ROIs

b- the area that exists below the blue "isoroi", corresponding to franchises with lower ROIs

c- the area between the green and the blue "isoroi", which we may call of "intermediate ROIs" for this franchise

Considering this chart for its business model, the franchisor should grant franchises in the area "c" and should start its company-owned stores in the areas "a" and "b".

The chart also allows a rationalization of the business model that the franchisor offers to the the franchisee. Given a certain range in which we want the franchises to operate, we can adjust the asset turnover to obtain the desired ROI, working on initial and ongoing investment, and optimizing franchise sales through the development of new revenue drivers.

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