DC Strategy on the daunting task of choosing the right franchise

According to DC Strategy , prospective franchisees are faced with a daunting task: what sector should I get into and how do I assess the risks, benefits, opportunities and potential for any particular product or service offering promoted by a franchisor? With franchise opportunities under virtually every category in the Yellow Pages, it pays to set some criteria in your evaluation of a particular market segment before you actually start examining the franchisor's documentation.

To a large extent, the choice of a product or service that is 'on trend' and playing into a growing market will typically derive greater longer-term value in both profit and goodwill than those segments that are maturing, in decline, or will attract substantial competition because of relatively low barriers of entry. The reality is that some excellent owner-operators are working in extremely tough and competitive environments that are not reaping the rewards, while other franchise owners who are contributing perhaps less time and effort have, by a shrewd choice or just plain dumb luck, chosen a segment that is outperforming the rest of the market.

Just like investing in real estate or the share market, the choice of the segment, product or service is going to have a substantial impact on the value of your franchise business. This is in the same way that careful selection of location and geographic markets will drive varying performances in the real estate market, and choice of company and sector in the share market will produce varying degrees of success – even within a bull market.

To organise the process of selecting the franchise that’s right for you, it is worthwhile addressing the following key issues early in the business selection process:

Sector

This is potentially the most important discrimination you will make. In reading the newspapers and talking to your friends, relatives and business colleagues, what trends do you see emerging with the potential to grow significantly over the next 10 years?

All sectors start by emerging, progressing towards maturity, and then into decline, and there are substantial financial opportunities at every stage of this cycle. However, in going through this journey, not every product or service bears the same time frame. Hindsight is a wonderful management tool and it can offer some excellent examples of products or services that have ranged from fads to long-term trends.

A great example of a fad, or more accurately a product with a very short business cycle, was the 'pick’n’pay' confectionary business in which consumers were confronted with 50 different confectionery items in acrylic containers and a small spade to shovel your choice into a bag and pay at the cash register. At one stage during the 1990s, there was a pick’n’pay confectionary store in almost every major shopping centre in Australia. And yet, within three to four years of their emergence, they have virtually disappeared from the marketplace.

An example of sectors with longer-term trends are: health care, aged care, child development and children’s products and services, food, hair and beauty, leisure, fitness and wellbeing. It is obvious that many trends are driven by demographics, as well as economic cycles.

Supply and demand

Scarcity of supply can drive demand and increase margins and, therefore, profitability. An excellent example is the current and potentially continuing shortage of tradespeople available to perform even the most rudimentary of trade services.

As the supply of skilled tradespeople dries up, those remaining or those looking to enter the sector, have an opportunity of pricing their service to the degree of demand created by limited choice of suppliers. As a result, trade-type franchises – ranging from mowing and garden care through to appliance servicing – are experiencing the effects of a growing economy and more spending on services and home improvements.

Geography

Bernard Salt in his book The Big Shift clearly shows that Australia is changing. If we take a global view, many new markets are emerging opportunities. If one has a propensity to move locally or internationally, looking to the future could mean that this is an ideal time to take a more national or global view of how you will spend the next five years of your life.

Just as a career move to a new city or another country may be part of a longer-term plan, is it appropriate to consider geography when looking for a business opportunity? For example, while we see continued Asian immigration to Australia, there is a growing trend of Chinese-Australians who are moving back to China to pursue commercial opportunities emerging as a result of the nation's progress.

The phenomena that turned southern California and Florida into lifestyle and retirement meccas is also driving change in Australia. The 'sunbelt drift' is attracting Australians into the southeast corner of Queensland and northern New South Wales, as well as from smaller rural communities into larger rural communities, cities and coastal towns. Don’t, however, fall into the trap of seeing a tree change or a sea change as being an opportunity to have a more relaxed lifestyle.

Establishing a business in emerging markets – often competing with lifestylers willing to discount their products and services to simply generate revenue for beer money during semi-retirement – will find you working harder in your first two or three years of establishing a new business than you could have possibly imagined as a paid employee.

Which franchise is right for me?

Having decided on the sector, the product or service, and the region you wish to reside in, the question is how to discriminate between the opportunities that may be available in that region? The following points may prove useful in finding the opportunity with the best scope for growth and profits.

Brand

Brand is probably the single most important part of any franchise network and is critical for a prospective franchisee to consider.

The 'look and feel' of the brand will be an indicator of its appeal in the marketplace, and will either reflect its current status or be a major indicator to its potential in the future. Not every great brand will start off being well known.

Excellent examples of emerging brands are Trampoline, Grill’d and Healthy Habits . These businesses have spent considerable money in their brand strategy as a precursor to franchising. The obvious example of a stellar brand that has emerged in the last five years is Boost Juice , which offers an excellent example of how a brand strategy can significantly enhance growth on both a national and international scale.

At the other end of the spectrum are businesses that have been in the market for many years. These are typically magnets for consumers because they offer franchises or licences of a dominant brand. They include Australia Post, Telstra, Caltex and ANZ .

Big brands are easy to spot and offer a relatively safe decision on the branding front. Smaller emerging brands offer substantial upside potential, but a judgment needs to be made: do they have their branding and brand strategy well executed, and will they maintain it in the future? A conversation with the franchisor about their brand strategy and the evolution of the brand is a worthwhile discussion to have.

Marketing

Not to be confused with the brand, the marketing process involves those activities that, when combined, bring people to your doorstep. Many retail businesses in shopping centres often contain their marketing to the immediate vicinity of the shopfront.

Their marketing is a mix of merchandising and marketing materials at point of sale. In these circumstances, you may find that the marketing budget is quite modest and represents a very small percentage of retail sales.

This almost invariably will require locations within high traffic, such as shopping centres. In some ways, the network is dependent on these centres to provide traffic.

Alternatively, business-to-business brands, such as Pack & Send, have a much more focused marketing approach that may be more dependent on targeted cold calling or door knocking to specific potential customers, rather than a broader advertising campaign. Service businesses, such as Fernwood Women’s Health Clubs , use a combination of billboard advertising and prominent physical location, coupled with localised marketing – aimed at their specific female demographic – to achieve visitations and sales. As can be seen, every good franchise should have a specific marketing strategy that is focused on their highest value consumer segment, and that understands how marketing and advertising dollars are translated into revenue. Good franchise systems understand the importance of marketing, and its role in supporting the brand, as well as supporting sales. If the marketing collateral doesn’t motivate you to respond, then this franchise should be crossed off your list.

People

Great franchises are built with passionate, motivated principals, staff and franchise owners. Therefore, if the people who own and manage the franchise inspire you, there is a good chance that they are a quality team with the ability to succeed. The franchise owner-operators are the face of the franchise and a visit to franchisees will tell you a great deal about the future potential of the brand.

If you meet franchise owners who look more like Homer Simpson and his good friend Barney, or who present as though they’ve been pulled backwards through a hedge, then this should tell you something about the future direction of the franchise.

There is little doubt that the calibre of the people in both the management and franchise network will dictate the future potential, so if you wish to soar with the eagles, make sure you are not joining a flock of turkeys.

Pricing policies

Pricing is probably the most poorly understood element of business today.

Many people confuse low prices with value-for-money, or consider that the business with the cheapest price will always persevere in the marketplace. Nothing could be further from the truth.

The fact is most businesses that have a focus on low prices are often the first to go out of business. They are not appealing to the majority of today’s consumers who are looking for value-for-money. This value translates into both the environment in which the business is located and the level of service (both tangible and intangible) that the client or customer receives in the process of doing business with the organisation. Many of the big brands that promote themselves as 'price competitive' are actually comforting the consumer with the knowledge that lower prices elsewhere will be matched. In reality, they are enjoying price and margin differentials greater than many of their smaller competitors.

What these retailers have understood is that price is the sole driver of decision-making, with a relatively small number of ‘bottom feeding’ consumers who, because of this single discriminator, will have little loyalty to a brand. For this reason, organisations that choose pricing strategies that support a quality presentation, a pleasant environment and good staff, are often rewarded with not only more generous pricing opportunities than their competitors, but better margins and overall sales volume.

In reviewing the pricing strategies of prospective franchisors, become part of the shopping experience. Decide whether you would be comfortable doing business with that organisation, and rank potential franchisors on your perception of their pricing and value-for-money offer.

This becomes another interesting topic for discussion with the franchisor as you come to know more about the franchisor's price positioning philosophy and the future direction of the pricing equation.

Product supply

The first question to ask is whether the franchisor is in fact a supplier of any goods or services to the franchisee. This is required to be disclosed in the franchise disclosure document, but a discussion of supply-side arrangements will be enormously valuable in understanding the dynamics of the relationship between the franchisor and you.

While it may not be well known, the majority of franchise systems do not have direct supply arrangements with their franchise owner-operators. While this is not necessarily a feature of good franchising, and is often brought about by the dynamics of the particular industry, there is no discriminator that demonstrates that franchisors with supply-side relationships are better for franchisees than franchise systems that do not supply franchisees.

However, the nature of the supply arrangement is important to understand. For example, a franchise system such as Hairhouse Warehouse has a major focus on negotiating purchasing arrangements from a raft of suppliers for the benefit of its franchised owner-operators. The effort that an organisation applies to the supply-side relationship will give you an insight into how the franchisor supports the franchisee.

Questions of supply of products and services should not just be focused on day-to-day products that are sold to consumers, but should also extend to the mechanics of the fit out of locations during the establishment of the franchise. What are the policies the franchisor has regarding the fit out of the location? Is there a margin the franchisor makes, or a rebate received from the shopfitter?

While there are several reasons why a margin or rebate may be incorporated into a fit out, it is important to understand – if there is such an arrangement – how it is calculated. How does it fit into the value equation for the franchisee and franchisor?

These supply arrangements will help to evaluate your degree of comfort with the franchisor and the way a specific business model is designed to operate. Naturally, supply arrangements that are focused on enhancing the margins, and therefore profits, of the franchisee are an attractive platform on which to build good franchisee relations down the track.

Franchisee satisfaction

Every franchisor gets the franchisees they deserve. Therefore, just as some say you should take a good look at your prospective mother-in-law (or father-in-law) before you propose to your life partner, the prospective franchisee should have a good look at the relationship that existing franchise owners have with their franchisor. This will allow you to gain an understanding of levels of franchisee satisfaction when comparing several networks in the same sector, and will be beneficial in helping you determine if your choice of sector was indeed correct.

If franchise owners are doing well in a number of franchise networks in the same sector then your choice of sector is likely to be a good one in terms of its current performance. On the other hand, a consistency of marginal or poor performance across a majority of franchisees in all franchise systems in the sector often demonstrates a sector under pressure.

The vast majority of franchisees are quite candid about their views of their business and the franchisor, and understand that their responses will have a major bearing on your decision-making process. Franchisees that express overall satisfaction with their relationship with the franchisor, and their decision to get into that particular franchise, are indicators of a relatively healthy sector and a relatively healthy franchisor/franchisee relationship, and therefore relatively competent franchised management and infrastructure.

However, just as one swallow does not make a spring, do not rely on one or two good reports – especially if you were directed to have your discussion with specific franchisees. In fact, a question of the franchisor, or some of his or her franchisees, should be “who is your most unhappy franchisee, and why?” It will be worthwhile to spend a little time talking to this particular individual to make an assessment of whether it is the franchisee or the system that is left wanting.

Value proposition

The ultimate test of a franchise, and the single biggest discriminator, will be the answers to the following two questions:

1. How much money do I have to put on the table?

2. How much money will I make?

The answers to these two questions are absolutely seminal to your future. The return on invested capital (ROI), which more accurately in an owner-operated franchise arrangement is ROIT (return on investment and time), will provide you with an understanding of what’s in it for you. It will also go a long way towards determining if this particular franchise is as good as it gets.

A franchisee can get by with a poor relationship with his or her franchisor, and a difficult and demanding workload, if he or she is making good money. The income of an owner-operator is the primary driver of franchisee satisfaction and the biggest single driver of the ability of a franchisee to maximise the value of the investment in a franchise.

Don’t be confused - operating any business is hard work and a good franchise system should require you to be more diligent and perhaps work harder than you may necessarily like. Don’t be attracted to any franchise that uses the word ‘lifestyle’ in its promotional literature or jargon. The best way to have a ‘lifestyle’ is to make a mountain of cash from the operation of a successful franchise business in which you work hard, and then sell for a small fortune, and enjoy your lifestyle from the fruits of your labour – not during your labour.

Many sunbelt drifters have been lured to the Sunshine State with the thought of afternoons playing golf or catching mudcrabs. They often have only two things in common – good suntans and small profits.

Therefore, be prepared to work at least 50 hours a week and compare ROIT. If you happen to find extraordinary ROIT in a business that requires no effort, let me know and I will apply for that franchise as well!

Growth

The potential to increase the revenue and the profits of a particular franchise, turning it into a bigger and bigger business year-by-year, is an important discriminator between franchise systems.

Many of the pointers to growth are indicated above, and a prospective franchisee needs to understand how scaleable the business may be.

For example, a personal exertion franchise that requires you to do all the labour is limited by the number of hours that you can spend at your particular franchise. If, however, a franchise has the opportunity to grow by leveraging the number of units that you might operate, or the number of employees that you can apply to manage growth of customers and sales, then your ability as a manager will be the real measure of future growth, rather than a structural feature of the franchise.

Even personal exertion franchises can have substantial potential for growth. An excellent example is the Drytron carpet cleaning franchise, which originally launched as a Man-in-a-Van, but now features a majority of its franchised owner-operators running several vehicles and operating from a centralised call centre. The most successful Drytron franchisee now operates seven vehicles and has a substantial revenue base and a very valuable business.

As a franchise grows, we often see the scale of the business grow. Franchise systems, such as Autobarn and Forty Winks , have grown the size of their stores from several hundred square metres to locations that are now two, three or four times the floor space. As a consequence, they generate three to four times the revenue and profitability of their early stores.

In considering growth potential it is important to understand that all growth, especially growth in profitability, will attract competition. Selecting a franchise system that has no competition is only relevant if you have a plan to exit before competition starts to intensify to a point where sales or profits are eroded. Therefore, understanding that every product or service will go through a cycle needs to be a factor in your consideration.

Exit potential

Ultimately, the value of every business is crystallised when the franchisee sells his or her business. This is typically the culmination of years of work, but is often not taken into consideration in the decision-making process when selecting a particular franchisor. As it can make the difference of hundreds of thousands of dollars over say a five to seven year period, then it must be a major consideration. Before they decide to choose a particular franchise opportunity, every prospective franchise owner should ask the question: who will buy my franchise and why?

Often, the very reasons that attracted you to a particular franchise are the same reasons why a prospective buyer may purchase a franchise – provided that the competitive landscape and the conditions of the marketplace have not changed substantially. On the other hand, a franchise that, over the years, will attract substantial competition may move from being a valuable business to one that faces a heavy competitive environment. This may prove unattractive to a potential purchaser and, therefore, depress the price.

Do not discount the fact that, when getting into business, the capital that you have outlaid to establish your franchise may be more than a potential purchaser may wish to pay for it at the point at which you decide to sell.

Factors that influence this may be the term remaining on any lease, or the requirement by either the landlord or the franchisor to refit the location to bring it up to the standard required to meet the then current competitive environment. A business that looks run down will have a similar effect on price to the appeal of a dilapidated house that needs repainting, refurbishing and new landscaping.

The biggest driver of the value of a business will be consistent improvement in sales and profits and excellent accounting records that clearly demonstrate the history of growth of the business. If you decide to cheat the taxman by stripping the cash register each week, do not expect to get a dividend on your investment when sale time comes. Often, a short-term mentality of 'cash in hand' will translate into less capital gain in the future.

David Stavropoulos, Tax Partner at Deacons, says: “Tax legislation provides generous tax concessions to correctly structured franchise owners that can mean a discount of up to 75 per cent on capital gains tax, and the opportunity to invest the proceeds of a franchise sale in low-taxed superannuation funds." This can mean substantial differences in the retirement savings of franchisees that look to focus on maximising profitability and have the record keeping to prove it.

On a final note, plan your exit during the year before you offer your business to the market to maximise the profitability and growth of the business. Just as an Olympian makes that final effort on their run to the finish line, so a business owner looking to take the maximum gold from the marathon effort of operating a franchised business should maximise the profit in the year prior to offering the business for sale.

This will help achieve the maximum value prize – and that’s as good as it gets.

Read about buying a franchise and running a franchise.