Notes on The Advantages of Franchising
Three Categories of Advantages
Franchising provides a better mechanism for selecting and offering incentives to outlet operators than salaried employees
Franchising offers an efficient mechanism for obtaining human and financial resources for rapid firm growth
Franchising offers a lucrative business model, generating financial returns at relatively low risk
Selecting And Offering Incentives To Outlet Operators
Effective selection of operators
Adverse selection — the tendency of people with lesser abilities to put themselves forward as candidates for jobs more often than the overall population
Expensive and time-consuming for firms to find who actually has the needed skills and abilities
Better Incentives for Operators
Shirking — where a person does not put forth maximal effort because his/her compensation will be the same regardless of how hard s/he works
If a franchisee shirks, the franchisee’s sales and profits fall
Franchisees have stronger incentives to innovate than a salaried employee — the Big Mac, Filet-O-Fish examples
Franchisees have an incentive to set a high pace for work among their employees
Franchisees have an incentive to keep materials and labor costs down
Comparative Outcomes and Evidence
In one study, average sales in franchised restaurants were 82% higher than in nonfranchised restaurants
In another study, shift managers in company-owned outlets made 9% more than shift managers in franchised outlets
What About Bonuses And Stock Options?
Beneficial, but not as good as franchising
Stock options encourage outlet managers to make very risky decisions
Bonuses encourage outlet managers to focus on the short-term only
Using Franchising Improves Environmental Scanning
Franchisees communicate directly with headquarters, not through layers of hierarchy
Speed
Distortion
Franchisees are more likely to tell the truth than managers of company-owned outlets
Politics
Overall Lessons Related to Incentives
Rely on franchising rather than company-owned outlets when it is difficult and expensive to select people to operate outlets; franchising provides an inexpensive and effective solution to selection problems
Rely on franchising rather than company-owned outlets when outlet managers have an incentive to shirk or when you want local market adaptation; franchising is very effective in these situations
Ethical and practical implications: franchising aligns incentives locally and reduces agency problems but may reduce centralized control
Obtaining Resources for Rapid Growth
Subway case snapshot: Subway grew from 16 stores in 1974 to 150 stores in 1980
The accompanying chart shows growth and volume; exact numbers vary over time
Why seek growth?
Build brand name
Obtain supplies through bulk purchasing
Recover fixed costs, such as new recipes
Fill good locations before the competition does
Capital acquisition
Franchisees pay a franchise fee and a royalty
Franchisees pay start-up costs such as setting up a store and buying inventory
Allows franchisor to avoid taking on a lot of debt
Passive investors, information asymmetry, moral hazard
Passive investors often view young firms as too risky
Information asymmetry — passive investors have less information about the entrepreneur’s abilities and ethics than does the entrepreneur
Moral hazard — risk that the entrepreneur will act in ways that harm the passive investor without the investor realizing it
Franchisees have much more information about a business and thus face less risk than do passive investors
Other considerations about capital
Many firms are hard to finance because they have limited tangible assets
More efficient to sell franchises than to go public to raise funds, also keep control
Lose control when using venture capital
91% of franchisors chose to franchise at least in part because it allowed them to maintain control of their firms
Human resource acquisition
Establishing and operating outlets is time consuming
Franchising allows a firm’s management to specialize in identifying, selecting, and training franchisees
Franchisees have the responsibility of hiring and supervising employees
Capital resources matrix and how firms pick franchisees
A 2x2 matrix: Capital resources High vs Low; Managerial expertise High vs Low
I: Highly desirable potential franchisees (High capital, High managerial expertise)
II: Acceptable to capital scarce franchisors (Low capital, High managerial expertise)
III: Acceptable to manager scarce franchisors (High capital, Low managerial expertise)
IV: Undesirable potential franchisees (Low capital, Low managerial expertise)
Qualifying to be a Panera Bread Franchisee
Experience as a multi-unit restaurant operator
Recognition as a top restaurant operator
Net worth of $7.5 million
Liquid assets of $3 million
Infrastructure and resources to meet our development schedule
Real estate experience in the market to be developed
Total commitment to the development of the Panera Bread brand
Cultural fit and a passion for fresh bread
Source: Panera Bread franchise criteria
Overall Lessons Related to Resources
Rely on franchising rather than company-owned outlets when you want to grow your business quickly
Rely on franchising rather than company-owned outlets when you want to overcome financial and human resource constraints on the growth of your firm
A Lucrative Business Model
Risk sharing: Franchisee capital is at risk
Franchisors often buy back successful outlets and leave lesser outlets as franchises
Earn royalty on sales rather than profits
Geographic expansion provides diversification
Limit legal liability and insurance costs
A Lucrative Business Model — ROI
Return on investment (ROI) has 3 components:
Revenues divided by Amount of capital invested
plus Costs of generating revenues
Revenues are lower, but capital and costs are much lower
Net effect is higher ROI
Does not necessarily maximize Revenue
The formal equation:
Overall Lessons Related to the Business Model
Rely on franchising rather than company-owned outlets when you want to minimize risk
Rely on franchising rather than company-owned outlets when you want to generate high return on investment. By cutting investment and operating costs, franchising generates a high ROI
Summary
Franchising offers three main categories of advantages:
Franchising provides a better mechanism for selecting and offering incentives to outlet operators
Franchising offers an efficient mechanism for obtaining human and financial resources for rapid firm growth
Franchising offers a lucrative business model, generating financial returns at relatively low risk
Firms must weigh these advantages relative to franchising’s disadvantages when making decisions about how to grow the business
Three Categories of Advantages
Franchising provides a better mechanism for selecting and offering incentives to outlet operators than salaried employees. Franchising aligns incentives, reduces agency problems, and offers a cost-effective solution to selection challenges, especially when identifying skilled outlet operators is difficult.
Franchising offers an efficient mechanism for obtaining human and financial resources for rapid firm growth. Franchising allows firms to grow rapidly by leveraging franchisee capital and human resources, overcoming financial and human resource constraints.
Franchising offers a lucrative business model, generating financial returns at relatively low risk. Franchising minimizes risk, generates high returns on investment (ROI) by reducing investment and operating costs, and is particularly advantageous for geographic expansion and diversification.
Selecting And Offering Incentives To Outlet Operators
Effective selection of operators: Franchising simplifies operator selection by shifting the onus to franchisees, who, driven by profit incentives, are more likely to identify and train suitable staff.
Adverse selection — the tendency of people with lesser abilities to put themselves forward as candidates for jobs more often than the overall population. Franchising mitigates adverse selection by transferring the responsibility of selection to franchisees, who are incentivized to choose capable operators for their own profitability.
Expensive and time-consuming for firms to find who actually has the needed skills and abilities. Franchising reduces the costs and time associated with identifying skilled operators, streamlining the selection process.
Better Incentives for Operators
Shirking — where a person does not put forth maximal effort because his/her compensation will be the same regardless of how hard s/he works. Franchisees are motivated to prevent shirking due to the direct impact on their profits.
If a franchisee shirks, the franchisee’s sales and profits fall. Unlike salaried managers, franchisees directly suffer from reduced sales and profits, enhancing their commitment.
Franchisees have stronger incentives to innovate than a salaried employee — the Big Mac, Filet-O-Fish examples. Franchisees are more motivated to innovate due to the potential for increased profits.
Franchisees have an incentive to set a high pace for work among their employees. Franchisees are encouraged to maintain a high work pace to maximize productivity and profits.
Franchisees have an incentive to keep materials and labor costs down. Franchisees are strongly motivated to minimize costs to increase their earnings.
Comparative Outcomes and Evidence
In one study, average sales in franchised restaurants were 82% higher than in nonfranchised restaurants. Franchised restaurants outperformed nonfranchised ones in terms of average sales.
In another study, shift managers in company-owned outlets made 9% more than shift managers in franchised outlets. Shift managers in company-owned outlets earned slightly more compared to those in franchised outlets.
What About Bonuses And Stock Options?
Beneficial, but not as good as franchising. Bonuses and stock options can be effective, but franchising typically offers superior alignment of incentives.
Stock options encourage outlet managers to make very risky decisions. Stock options might incentivize managers to take undue risks to boost short-term stock prices.
Bonuses encourage outlet managers to focus on the short-term only. Bonuses can drive managers to prioritize immediate gains over long-term sustainability.
Using Franchising Improves Environmental Scanning
Franchisees communicate directly with headquarters, not through layers of hierarchy. Franchising enhances environmental scanning by facilitating direct communication.
Speed: Franchising speeds up communication, allowing for quicker responses to market changes.
Distortion: Franchising reduces distortion of information, providing headquarters with more accurate data.
Franchisees are more likely to tell the truth than managers of company-owned outlets. Franchisees are more candid in their feedback due to their stake in the business.
Politics: Franchising reduces the influence of internal politics on information flow.
Overall Lessons Related to Incentives
Rely on franchising rather than company-owned outlets when it is difficult and expensive to select people to operate outlets; franchising provides an inexpensive and effective solution to selection problems
Rely on franchising rather than company-owned outlets when outlet managers have an incentive to shirk or when you want local market adaptation; franchising is very effective in these situations
Ethical and practical implications: franchising aligns incentives locally and reduces agency problems but may reduce centralized control. Franchising aligns incentives and reduces agency problems while potentially diminishing centralized control.
Obtaining Resources for Rapid Growth
Subway case snapshot: Subway grew from 16 stores in 1974 to 150 stores in 1980. Subway's expansion demonstrates the growth potential of franchising.
The accompanying chart shows growth and volume; exact numbers vary over time
Why seek growth?
Build brand name: Rapid growth enhances brand recognition and market presence.
Obtain supplies through bulk purchasing: Expanding operations allows for economies of scale in purchasing.
Recover fixed costs, such as new recipes: Growth helps in spreading fixed costs over a larger sales base.
Fill good locations before the competition does: Rapid expansion secures prime locations ahead of competitors.
Capital acquisition
Franchisees pay a franchise fee and a royalty. Franchisees contribute capital through initial fees and ongoing royalties.
Franchisees pay start-up costs such as setting up a store and buying inventory. Franchisees cover the expenses of establishing and equipping their outlets.
Allows franchisor to avoid taking on a lot of debt. Franchising enables franchisors to limit debt by utilizing franchisee investments.
Passive investors, information asymmetry, moral hazard
Passive investors often view young firms as too risky. Passive investors may perceive young firms as high-risk ventures.
Information asymmetry — passive investors have less information about the entrepreneur’s abilities and ethics than does the entrepreneur. Information asymmetry increases the risk for passive investors due to limited insight into the entrepreneur.
Moral hazard — risk that the entrepreneur will act in ways that harm the passive investor without the investor realizing it. Moral hazard poses a risk that entrepreneurs may act against investors' interests without detection.
Franchisees have much more information about a business and thus face less risk than do passive investors. Franchisees are better informed and face reduced risk compared to passive investors.
Other considerations about capital
Many firms are hard to finance because they have limited tangible assets. Firms with limited tangible assets often struggle to secure financing.
More efficient to sell franchises than to go public to raise funds, also keep control. Franchising can be more efficient than going public for raising capital while maintaining control.
Lose control when using venture capital. Utilizing venture capital may lead to a loss of control over the firm.
91% of franchisors chose to franchise at least in part because it allowed them to maintain control of their firms. Franchising is often chosen to retain control over the business.
Human resource acquisition
Establishing and operating outlets is time consuming. Setting up and managing outlets demands significant time investment.
Franchising allows a firm’s management to specialize in identifying, selecting, and training franchisees. Franchising enables firms to focus on franchisee recruitment and training.
Franchisees have the responsibility of hiring and supervising employees. Franchisees are responsible for managing outlet staff.
Capital resources matrix and how firms pick franchisees
A 2x2 matrix: Capital resources High vs Low; Managerial expertise High vs Low
I: Highly desirable potential franchisees (High capital, High managerial expertise). Ideal franchisees possess both substantial capital and managerial skills.
II: Acceptable to capital scarce franchisors (Low capital, High managerial expertise). Franchisees with strong managerial skills but limited capital may be suitable.
III: Acceptable to manager scarce franchisors (High capital, Low managerial expertise). Franchisees with significant capital but less managerial expertise may be considered.
IV: Undesirable potential franchisees (Low capital, Low managerial expertise). Franchisees lacking both capital and managerial skills are generally undesirable.
Qualifying to be a Panera Bread Franchisee
Experience as a multi-unit restaurant operator
Recognition as a top restaurant operator
Net worth of $7.5 million
Liquid assets of $3 million
Infrastructure and resources to meet our development schedule
Real estate experience in the market to be developed
Total commitment to the development of the Panera Bread brand
Cultural fit and a passion for fresh bread
Source: Panera Bread franchise criteria
Overall Lessons Related to Resources
Rely on franchising rather than company-owned outlets when you want to grow your business quickly
Rely on franchising rather than company-owned outlets when you want to overcome financial and human resource constraints on the growth of your firm
A Lucrative Business Model
Risk sharing: Franchisee capital is at risk. Franchisees share in the financial risks.
Franchisors often buy back successful outlets and leave lesser outlets as franchises. Franchisors may repurchase successful franchises while retaining underperforming ones.
Earn royalty on sales rather than profits. Franchisors generate revenue through royalties on sales.
Geographic expansion provides diversification. Expanding geographically diversifies the business.
Limit legal liability and insurance costs. Franchising can reduce legal liabilities and insurance expenses.
A Lucrative Business Model — ROI
Return on investment (ROI) has 3 components:-
Revenues divided by Amount of capital invested
plus Costs of generating revenues
Revenues are lower, but capital and costs are much lower
Net effect is higher ROI
Does not necessarily maximize Revenue
The formal equation:
Overall Lessons Related to the Business Model
Rely on franchising rather than company-owned outlets when you want to minimize risk
Rely on franchising rather than company-owned outlets when you want to generate high return on investment. By cutting investment and operating costs, franchising generates a high ROI
Summary
Franchising offers three main categories of advantages:-
Franchising provides a better mechanism for selecting and offering incentives to outlet operators
Franchising offers an efficient mechanism for obtaining human and financial resources for rapid firm growth
Franchising offers a lucrative business model, generating financial returns at relatively low risk
Firms must weigh these advantages relative to franchising’s disadvantages when making decisions about how to grow the business