Deacons looks at franchise network expansion

Deacons recognises that the stunning success of franchising in Australia, and throughout the world, is a powerful testament to its proven credentials as an effective vehicle for business expansion. Australia, of course, has many viable and successful independent small businesses, but their capacity for building a network of outlets is limited by capital, infrastructure and management constraints. Franchising provides a strategy for rapid and wide geographic expansion without the proprietor having to provide capital to establish, or to directly manage, new outlets. For a successful small business with a proven concept and system, franchising may provide the only viable opportunity for sustained expansion.

McDonald’s is the obvious example of the power of franchising to enable a small business to develop into a big business. Needless to say, McDonald’s did not emerge fully formed. Its growth from a single successful and distinctive retail outlet is San Bernardino, California, in the late 1940s to a network of over 30,000 outlets in over 100 countries, is an impressive demonstration of the power of franchising to expand a network through cloned outlets. Australia’s 700-plus franchise systems, over 90 percent of which are Australian developed and owned, which operate through over 50,000 outlets and employ over 600,000 Australians in a sector which turns over in excess $80 billion annually, emphatically illustrate its network expansion credentials and economic, commercial and social significance.

The decision to franchise, by definition, commits the business proprietor to network expansion. A business proprietor who does not have the resources to grow the system beyond critical mass and the vision to develop the system into a significant commercial presence should not adopt franchising. While a franchisor adopts franchising for the opportunity it provides to expand a business, a franchisee adopts franchising for the opportunity it provides to enter a business sector through the franchisor’s proven concept and system, training and ongoing support. The franchisee’s investment is closely linked to an expanding network in which the benefits of brand recognition, economies of scale, concept development and goodwill are maximised. Both sides of the franchising equation – franchisor and franchisee – have a vested interest in network expansion which is driven by the unique synergy that emerges from marrying the proven systems and management expertise of the franchisor with the enterprise and initiative of the franchisee.

2. Expansion options

The original franchise model was direct single-unit franchising where the franchisor contracts directly with a franchisee to establish and operate a single franchised unit. This model combines direct control and supervision by the franchisor with hands-on proprietorship by the franchisee, who both owns and operates the outlet. This is the model invariably adopted by franchise systems in their start-up phase and indeed remains the most common model overall in Australian franchising today. However, with the increasing maturity of the franchise sector, new, different and more complex strategies have emerged to drive expansion and achieve efficiencies. Today the expanding franchise system has a number of expansion options through which the network may be developed:

• Converting independent operators to the franchise system;

• Contracting with sub-franchisors/master franchisees or area developers to develop the franchise system in a particular territory;

• Forming associations with compatible systems to share retail locations in co-branding arrangements;

• Granting additional outlets or territories to existing franchisees in multi-unit franchising arrangements;

• Developing additional compatible concepts which can be offered to existing and new franchisees in addition to or instead of the original concept in multiple-concept franchising arrangements;

• Merger with or acquisition of a competitor.

Whether network expansion is horizontal through increasing the number of outlets, or vertical through increasing the range of goods, services and concepts, franchising is a practical strategy. Whether expansion will be through traditional incremental growth, through harnessing the entrepreneurial initiative of franchisees via opportunities to build their business in multi-unit or multi-concept arrangements, or through developing the system in particular territories via arrangements with other companies, or through some combination or permutation thereof, will depend not on franchising theory but on practical solutions to the expansion challenge. The most successful systems are innovative, dynamic and responsive. Opportunities to split territories to acquire rights to compatible concepts within a system, and for ‘career progression’ for franchises through defined levels of franchisee participation, are among the initiatives increasingly adopted by Australian franchisors. Following are some of the most common expansion methods.

Conversion franchising involves a franchisor coming to an arrangement with an existing independent operator to join the franchise system. For the independent operator the loss of independence and payment of fees is far outweighed by the real benefits in joining the franchise system, including name and brand recognition, systems, technology, training, buying power, marketing and so on.

Multiple-unit franchising involves the franchisor granting to the franchisee the right to operate multiple business units. To some extent this is a surprising development. One of the factors in the success of franchising at its developmental stage was the franchisee’s ‘hands-on’ proprietorship. The franchisee was not simply an owner or investor, but the operator of the business, and that brought with it a level of commitment, initiative and passion that often distinguished him or her from a manger. Some franchise concepts remain better suited to the ‘mom and pop’ single-unit operator model, but better systems and technology have made multi-unit franchising a very viable option for maturing systems. In some cases the decision to allow multi-unit franchising has been driven by a desire or need to retain experienced and highly performing franchisees within the system that, without the opportunity to grow the business beyond the limits of a single-unit operation, may have chosen to leave the system. In other cases multi-unit franchising is adopted as a deliberate strategy to achieve rapid growth and increased market share.

Master franchising, or sub-franchising as it is also known, typically involves a franchisor establishing a relationship with another company to take on the franchisor’s rights and obligations in a particular territory.

Master franchising is often adopted as a strategy for accelerated network growth. The sub-franchisor/master franchisee usually brings to the company additional capital, management skills, and a day-to-day focus on business operations within the territory. This allows the franchisor to concentrate on such matters as group marketing programs, systems upgrading, product development, group purchasing, supplier relations, and other enhancements to the business. Given Australia’s geographic spread, providing appropriate national support and training to franchisees can be difficult for a franchise organisation, especially during its early expansion phase; i.e. before it has sufficient franchisee numbers to cost/justify employing support staff in each state or region. The sub-franchisor/master franchisee is actively involved in the business and shares the revenue stream with the franchisor. The success of the franchisor/sub-franchisor relationship is therefore very much dependent on the business offering sufficient revenue to enable each party to receive adequate reward for efforts and return on investment – in both the short and long-term.

Master franchising obviously creates a more complex legal and commercial tripartite scenario in which the respective rights and obligations of the master franchisor and the sub-franchisor, and the sharing of the initial and continuing fees paid by franchisees, must be carefully negotiated. The opportunity master franchising provides to further develop a network or to expand more rapidly, coupled with the sub-franchisor’s payment to acquire territorial rights, makes it an attractive option for a new franchise system. However, the advice of experienced franchisors and consultants should be heeded: master franchising is for the experienced franchisor, not the beginner. It requires strong systems, total commitment and a sub-franchisor with requisite business management experience, strong communication and leadership skills, sales and marketing experience as well as energy, urgency, enthusiasm, financial capacity and the same passion and commitment as the franchisor in relation to the system and the welfare and development of its franchisees.

Area development agreements involve the franchisor contracting with a company to itself develop and operate new outlets within a defined territory in line with specific targets. The area developer is, in effect, a multi-site franchisee within the defined territory. By contracting with a party with a proven capacity to develop new outlets, the franchisor may be able to accelerate the network development plan.

Area support agreements involve a party undertaking the franchisor’s training and other operational roles within a defined market area. If a franchisor has a capacity to develop new franchises but does not have local (on-the-ground) personnel to be able to provide full, ongoing support to franchisees, then the franchisor may wish to appoint a party as ‘area support consultant’. The basis of remuneration is likely to be oriented to franchisee performance, possibly a percentage of franchisee turnover. An area support consultant might come from the ranks of existing franchisees or, alternatively, be a highly skilled person perceived to have an appropriate track record and capacity to advise franchisees on day-to-day operational issues.

Co-branding is an integrated retailing concept that essentially consists of marketing several franchised products or services in the same location. It is an increasingly popular technique for expansion driven by shortage of prime retail locations, consumer convenience and demand, cost savings and leveraging of well-known brands in a synergistic arrangement. The pizza franchise in the premises of the convenience store franchise is an increasingly prominent example. Co-branding is a dynamic and relatively new mechanism for network expansion but unless the co-branded concepts are under the same ownership it gives rise to a number of commercial and legal complexities.

Multiple concept franchising is an increasingly common practice in particular industry sectors under which a successful franchise system develops further similar, but not competing, product lines. As a successful single product franchise matures the franchisor may offer additional franchises or additional services utilising its existing infrastructure. The classic Australian example is Jim’s Group , which started as Jim’s Mowing , but has now expanded to include 30 compatible – but not competing – home services, essentially using the same operating system.

Merger and acquisition may provide the best method of rapid expansion. Although Australia is rightly proud of the fact that per head of population it has more franchise systems than any other country (apart, of course, from the much smaller New Zealand sector), a downside of the statistic is that in some market areas there are too many smaller franchise systems competing with each other. A merger or acquisition in these circumstances gives the opportunity for improved economies of scale and the development beyond critical mass to a situation where sustained expansion can be launched. The challenge of merging cultures, systems, brands and so on should not be underestimated, but if met will benefit all stakeholders.

3. International expansion

Franchising has played a key role in the internationalisation of business. It is practiced today in every region of the world and to a greater or lesser but rapidly developing extent, in most countries. Much of the credit for the increasing global influence of franchising is due, at least in the first instance, to the well-known US fast food systems whose international expansion first alerted local entrepreneurs to the technique and power of the model and provided the catalyst for domestic franchise development. The Australian experience is typical. Franchising was virtually unknown until McDonald’s, Pizza Hut and KFC successfully entered Australia in the 1970s and brought it to prominence. While these systems remain very significant forces in Australia, there are now over 700 other franchise systems servicing most industry sectors. The 2002 Australian Franchising Survey records that over 90 percent of systems have been developed in Australia and that about a quarter of these have themselves expanded beyond Australia. A further 50 percent indicate that they plan international expansion. New Zealand is the most popular destination but Asia is rapidly growing in significance.

For a business that wishes to expand overseas, franchising offers distinct advantages over other methods of international growth. Cross border franchising of a successful business format with the right partner overcomes many of the cultural, language, technical, legal, political, employment and other problems that more conventional techniques for establishing a business abroad face. Local franchisees not only provide the capital for management of the system offshore, as they do in the home country, but their familiarity with language, culture, customs, practices, officials and so on create opportunities that may otherwise be closed.

A franchise system seeking to expand overseas has a number of entry options that must be assessed:

• Direct franchising

• Subsidiary or branch office

• Area development

• Master franchising

• Joint venture.

Direct franchising involves the franchisor franchising individual units directly from Australia into the foreign country without the intervention of a third party. It is effective only where the scope of the franchise offshore is small or where it can be effectively managed from the home country. Direct franchising from Australia to New Zealand is possible – the major New Zealand cities are closer for an Eastern states-based franchisor than Perth and language, culture, laws and so on are the same or very similar – but beyond the Tasman its scope for internationally expanding franchise systems is obviously limited.

A subsidiary or branch office involves the direct presence of the franchisor in the foreign country. Whether an Australian franchisor establishes a branch or subsidiary is dependent in the first instance on local entry requirements (an issue of decreasing significance following WTO liberalisation in the major trading nations) and then on tax and financial considerations. Apart from these factors a branch or subsidiary does not involve a local partner, which for most Australian franchise systems in most foreign markets, is a substantial disadvantage.

Area development involves a franchisor entering into a development agreement directly with an area developer in a foreign country to develop and operate all of the franchise outlets in that country, or a region within it. The franchisor has the advantage of a local ‘partner’ with local knowledge, and is required to deal only with one or a limited number of sophisticated franchisees. However, this is balanced by the difficulty in finding an appropriate developer, the considerable power of that developer and the consequences of its failure or unsatisfactory performance.

Master franchising involves the franchisor granting a master franchise to a sub-franchisor in the foreign country to operate or sub-franchise all franchise outlets in the country or a region within it. Master franchising is the most common form of international expansion for all franchise systems – Australian and foreign – because it offers a smaller financial and human resources commitment than other options, shifts most financial risk to the bus-franchisor and capitalises on the local knowledge of the sub-franchisor. It also offers the inducement of an upfront payment by the foreign party. As with other intermediary arrangements, it carries the risk of loss of control. Experienced franchisors report that selecting the right sub-franchisor is the single most important factor in determining the success of international master franchising.

A joint venture involves establishing a commercial presence in a foreign country with a local partner. The joint venture, usually a company, typically enters into an area development agreement or a master franchise agreement with the franchisor to operate or grant franchises in that country. A joint venture, as with master franchising, offers a local partner with local knowledge and in some countries may facilitate entry, and selection of the appropriate partner is crucial to the ultimate success of the venture. The main benefit of a joint venture is that risk is shared between the partners. For many systems this is seen as a disadvantage in comparison with the master franchise where responsibility to ongoing management is abdicated to the partner. However, the continuing and hands-on commitment of the franchisor in a foreign joint venture is viewed as increasingly attractive by the foreign partner, particularly in developing franchise sectors in the Asian region.

4. Challenges

The 1991 Report of the Australian Franchising Task Force (which led to the 1993 voluntary self-regulatory Franchising Code of Practice, since replaced in 1998 by the Mandatory Franchising Code of Conduct under the Trade Practices Act) identified the major reasons for the failure of franchise systems. Prominent among these were problems with network expansion:

• Under-capitalisation of the franchisor: On submissions received, it would appear that some franchisors entered into franchising without sufficient financial strength to be able to develop and support expansion, particularly in the first two years of operation, or until such time as the franchise system’s ongoing fees were able to sustain the franchisor.

• Too rapid expansion of the franchise system: Some franchisors, generally in order to overcome financial difficulties, have expanded the franchise system in a manner that has not been able to be sustained, depriving franchisees of imperative support and service.

• Poor product or service: Some franchise systems have commenced operation prior to a product or service being fully tested in the marketplace and have used franchisees as test marketers.

• Poor franchisee selection: This has been seen to be one of the major weaknesses of franchising to date. Whilst it is clear that all franchise systems from time to time select inappropriate franchisees, there is a tendency, particularly in small franchise systems, where capital is tight, to take people with the money, but who do not necessarily have the appropriate skills or personality for the franchise system.

These factors are, of course, related. Under-capitalisation leads to too rapid expansion to overcome financial pressures which in turn frequently involve poor franchisee selection. Without a proven business concept and system the survival of a franchise system is clearly threatened. A proven business concept and viable business format may provide initial success but under-capitalisation, too rapid expansion, poor franchisee selection and greed will place the franchise system under such stress that failure is virtually guaranteed. A downward spiral is well documented in most cases of franchise failure – financial pressures resulting from under-capitalisation or too rapid expansion or buying out inappropriate and under-performing franchisees leads to increasingly desperate measures to keep the system afloat, disregarding the interests of those already in the system or those prospective franchisees whose capital contributions offer the main hope of the company’s salvation.

Fortunately, examples of this ‘downward spiral’ are much rarer today. The growing maturity of the franchising sector and impact of the Franchising Code of Conduct have had a significant impact in discouraging inappropriate practices. However, the 1991 Report and the examples that led to its conclusions remain valid. There is clearly a significant cost to franchise expansion beyond the preparation of required disclosure documentation.

A franchisor’s ultimate rewards from a national franchise system do not come without substantial investment and franchising is, of course, used as a strategy for undercapitalised businesses to raise money to fund growth. But unless the initial franchisee fee is dedicated largely to supporting franchisees the system, the franchisor and the franchisees, are vulnerable. Fortunately, as franchising in Australia has matured and capital markets have become more sophisticated, it is easier for franchisors with proven concepts and systems to obtain external finance to fund growth, as well as list on the stock exchange.

With regard to franchise network expansion, the challenge for the aspiring franchisor is to replicate the prototype business concept in pilot operations that refine the system and demonstrate the concept is viable beyond the original location. Importantly, the system should be refined by the franchisor in its own operations and not from the experiences of franchisees.

For the newly established franchisor the challenge is to expand beyond critical mass – to the point where a sustainable network exists for the benefit of franchisor and franchisees. Resources must be available to the franchisor to train, support, service, advise and assist franchisees as well as to audit and enforce system compliance while communicating effectively with the network. Head office infrastructure and capabilities and field support activities will be prominent in this evolutionary phase.

For the established franchisor the challenge is to continually grow the system and expand the network in a sustainable and controlled manner, effectively managing issues such as the recruitment of suitable franchisees, finding suitable sites and making the transition from a ‘family’ to ‘corporate’ environment.

With increasing maturity the issue of network expansion conflict – encroachment – also arises. A franchise system utilising exclusive territories has by this stage faced the challenge of territorial allocation – too large and the expansion of the system through introducing new franchisees is foreclosed without buying them back, too small and franchisees cannot develop viable businesses. For systems approaching maturity the allocation of non-exclusive territories or sites does not solve the commercial issues, let alone potential legal issues. Generally ‘encroachment’ is through the opening of a competing unit of the same system within an existing franchisee’s perceived market, resulting in a reduction of sales for that franchisee. With the development of alternative channels of distribution encroachment can also occur through product and service encroachment as well as through territorial encroachment.

In product and service encroachment customers are lost from existing franchised units not because the franchisor has set up a substantially identical franchise, but through development of a system that allows the customer to obtain identical products and services by means other than visits to the local franchisee. Such encroachment can occur when a franchisor supplies the franchise product through supermarkets, mail-order, telemarketing or the internet. Irrespective of any legal consequences, encroachment poses real commercial challenges for which the mature franchise system must develop strategies to accommodate.

When international expansion is considered the standard domestic challenges are complicated and multiplied. Many Australian systems have already met these challenges and have successful networks overseas, but all would agree with the counsel of Professor Warren Pengilley:

“Take the maximum time possible imaginable for negotiation. Take the maximum time possible imaginable to comply with government requirements. Assess the maximum possible legal and other costs which will be payable. Then at least double all factors!”

5. Opportunities

While the challenges of network expansion should not be underestimated, neither should the opportunities.

In relation to local expansion, franchise systems established 30, 20, or even 10 years ago had the benefit of novelty, first mover advantage and less competition for franchisees and sites. However, they operated in an environment that despite regulatory reform was much less accepting of franchising than today. The pioneering work by franchisors, service providers, the FCA and its predecessors, and even by academics, has created an environment in which franchising is fully accepted, and valued, by society generally – consumers, governments, media, and business entrepreneurs, as well as prospective franchisees who can take some comfort from the new regulatory environment in Australia, which is now the most comprehensive in the franchising world.

Still, the transition from deregulated environment has not been without some pain for franchisors in terms of compliance costs and administration. From the prospective franchisee’s perspective, however, the introduction of the mandatory Franchising Code of Conduct, the prohibition of misleading and unconscionable conduct, and the active involvement of the ACCC in enforcing the new regulatory regime, provides franchisees with a much greater level of protection than their counterparts in other countries. The Code does not, and cannot, remove the commercial risk inherent in franchising, but enhanced protection through the provision of better information on which to make the decision whether or not to invest in a franchised business makes franchising an even more attractive proposition. Indeed, the increasing maturity of the franchising sector in terms of systems, participation, education, regulation and organisation has seen frequently negative media coverage replaced by overwhelmingly positive media and a lack of interest among financial institutions replaced by active involvement.

The continued growth and development of business format franchising will be driven by a number of factors: its close association with the rapidly developing services sector, its ability to exploit and service niche markets, the increasing demand for convenience and standardised quality, and the increasingly difficult business environment for independent small business operation. The ability of franchising to harness the power of brands, systems, infrastructure and networks ensure that it will become increasingly influential.

In relation to international expansion the opportunities are particularly exciting. The high standards of the Australian franchising sector – to some extent mandated by a rigorous regulatory regime but strongly supported by a mature and responsible sector – place Australian systems in good standing for international expansion. It is expected that over the next decade 70 percent of world trade will be generated in Asia, a massive market comprising over half the world’s population and in which franchising is generally at a developing stage. Australia is well placed geographically, through its engagement with the region and through its leadership in franchising, to play a leading role in the growth of franchising in the region.

6. Managing network expansion

Franchising delivers a uniform, standardised and consistent product. This is indeed one of its key strengths. The end result nonetheless disguises incredible diversity in the manner in which systems deliver this result. Franchising developed as a practical business solution to problems faced by companies in expanding their business operations. It is a practical commercial strategy – a method for replicating a business – and there is no single method of implementing it. As a consequence franchising today is characterised by great diversity as franchisors apply the basic business format franchise model in different ways. Successful franchisors build formats, devise systems and develop network expansion models that accommodate the unique characteristics of the business and prevailing market conditions.

FCA chairman Stephen Giles has suggested: “It is likely that franchising as a business method will need to be dismantled and reconstructed. It will be franchising techniques, not franchising, that will be relevant. Old formats may no longer be relevant or may not deliver the same competitive advantage.” Franchising harnesses the power of brands, systems, infrastructure and networks. The manner in which franchisors package these value drivers and replicate them in an expanding network is the essence of franchising.

Franchising prospers, and will continue to prosper, because it is continually reinventing itself. The management of this process is one of the most challenging, and most rewarding, that the commercial world can offer.

Read about buying a franchise and running a franchise.