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Balancing Company and Franchised Outlets

Thirteen percent of all outlets in franchise companies are company-owned stores. For every store that a franchisor develops, seven more franchised stores are built—a finding supported by our discussion of capital allocation. Refer to Figure 3-1 for the number of outlets criteria. The average franchise system’s investment capital (including franchisor and franchisee) can produce seven times the number of stores that a wholly owned independent chain can by leveraging the franchisor’s concept with the prospective franchisee’s capital. The franchisor has expanded the brand system by four units but has incurred direct investment costs for only one unit.

Once a company begins to expand in size, the principal administrative requirements shift to the franchisees. At what size, in terms of number of outlets owned, does the franchisee exceed her management capacity? Clearly, this is different for each system and indeed for each franchisee. But the smart franchisor is aware of the issue and monitors management capacity. Franchisees often invest a significant portion of their net worth in a single outlet. By doing so, they are not taking full advantage of the diversification benefits that can accrue through a diversified portfolio of outlets in different franchise systems. That diversification can occur by simply using the investment you would make in purchasing a franchise to instead purchase a portfolio of franchise company stocks. These franchisees leave themselves potentially exposed to a high level of franchisor-specific risk, just as an investor that holds only one sector of investments, or only one stock, faces similar risks of overspecification. In a frictionless market in which information sharing is seamless and instantaneous, no additional returns would be expected to compensate for what is, in effect, the self-inflicted pain of not diversifying when perfect information is possible.

However, the franchise market is far from frictionless, with limited buyers and sellers, large degrees of informational asymmetries, and constrained capital. Under these circumstances, it is conceivable that above-market rates of return need to be provided to franchisees to entice them to join the franchisor’s system. Therefore, franchisees are more likely to invest in those franchises that outperform the general corporate market. This suggests that younger systems may have to adjust their franchise fee and royalty down. In and of itself, this conclusion begs the question of which needs to come first: the chicken or the egg—quality franchisees or high-performance franchisors? The reality is that most systems are dynamic. Early franchisees are taking a bigger risk. If performance is exceptional, they attract high-quality people to the system.

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