FranchisingMktg 427 – Chapter 11

Learning Objectives

1. Define and understand Franchising2. Describe why an entrepreneurial individual would become a

franchisee rather than founding a new business – and what would make a candidate hesitate to join a franchising system.

3. Explain why a firm with a business model would opt for franchising rather than expanding by setting up its own branches run by employee managers.

4. Evaluate the biggest problems the franchisor faces once the business becomes clearly viable.

What is Franchising• Franchising – a marketing channel structure intended to convince

end-users that they are buying from a vertically integrated manufacturer when, in fact, they may be buying from a separately owned company.

• A franchise system masquerades as a company subsidiary. In reality, they are a category within the classic marketing structure of two firms, one supplying, the other performing downstream marketing channel flows.

• Franchisors – are upstream manufacturers of a product or originators of a service.

• Franchisees – separate companies that are downstream providers of marketing channel flows

What is Franchising• End users (customers of the franchisee) should believe they are

dealing with the franchisor’s subsidiary. Therefore, the franchisee assumes the identity of the franchisor, projecting itself as though it were the franchisor’s operation.

This deliberate loss of separate identity is a hallmark of franchising!

• To accomplish this loss of identity, the franchisee awards the franchisor category exclusivity (no competing brands in the product category).

• The franchisee purchases, via contract and by the payment of fees, the right to market the franchisors brand, using the methods, trademarks, names, products, know-how, production techniques and marketing techniques developed by the franchisor.

What is Franchising• Effectively, the franchisor develops and entire business

system, a business format, and licenses it to the franchisee to use in a given market area.

• By paying fees and signing the contract, the franchisee assumes the obligation to follow the franchisor’s methods. (By contract, the franchisee cedes a great deal of LEGITIMATE POWER to the franchisor.

• The franchisee is a separate business with its own balance sheet and income statement. They invest their own capital, run the business, and keep the profits or assume the losses.

• Franchisees own the business.

Why become a franchisee?• Failure rates for new businesses are high.• It takes time and resources to build a clientele.• Location decisions• Theme decisions• Size• Product Mix decisions and costing.... If you are planning to start a business, these are the most basic questions to ask and are often very difficult or time consuming to answer which can lead to being overwhelmed.

A franchising agreement is attracting to entrepreneurs facing such challenges.

Why become a franchisee?• In effect, you sell a piece of your independence to the

franchisor. In return, you purchase the services of a corporate backer, a coach, a problem solver.

• Franchisor personnel step in to assist you – they train you, work with you, share with you the franchisor’s formula, its business format. The business format should be a prepackaged solution to all your start-up problems. By paying a fee (usually in several parts, fixed and variable), you buy a license to exploit the format in a marketplace.

Why become a franchisee?• THE START-UP PACKAGE• Market survey and site selection• Facility design and layout (architectural and building services)• Lease negotiation advice• Financing advice• Operating manuals• Management training programs• Training the franchisee’s employees

• ON-GOING BENEFITS• Field supervision of your operation, including quality inspection• Management reports• Merchandising and promotional materials• Management and employee retraining• National advertising• Centralized planning• Market data and guidance• Auditing and record keeping• Group insurance plans

Why become a FRANCHISOR• Typically, a company with a concept, a brand and a business

format would desire tight control over its implementation.• Control to ensure that the brand image is being upheld and

proper sale and servicing of the product is being practiced.

• For the franchisor, the system is a way to acquire capital and management quickly and to harness the motivation and capability of an entrepreneur.

Why become a FRANCHISOR• Raising Financial and Managerial Capital to Grow Fast

1. Producers / Manufacturers are motivated to move quickly if: 2. They have a unique idea, to exploit it as fast as possible and gain

first-mover advantage.3. Competition is fragmented, with no strong brands4. They want to build a brand name before someone else does5. If there is a competitor, and they wish to grow large before the

competitor notices and tries to block them.

• Franchisees are a quick solution to alleviate financial problems.• The alternative is raising equity through capital markets. However,

many organizations go with the franchising route because their overriding objective is CONTROL. (it is easier to influence and/or control franchisees than board of directors)

Why become a FRANCHISOR• Harnessing the Entrepreneurial Spirit• Raising capital and finding management quickly are reasons start

out by franchising. Once launched, the reasons to continue to franchise revolve around harnessing the drive and capabilities of an entrepreneur with motivation.

• To simplify, there are two major ways a firm can motivate people.1. Monitoring them (making them employees, as to be able to

supervise them and apply sanctions and rewards)2. Make them residual claimants (profit sharing) – Residual claimants

do not need as much monitoring. They will work anyway out of desire for profit and fear of loss.

• “Franchising is way to cut down monitoring costs by making people into residual claimants”

Challenges facing the franchisor• SURVIVAL• Franchisors have very high failure rates. Various estimates have

it that some ¾ of the hundreds of franchisors launched in the 1980s in the U.S. survived fewer than ten years. Why?

1. Undifferentiated product mix2. Franchisors defrauding franchisees

• Which franchisors are more likely to survive?• Success forecasts success – the older the system, the more units

it has the higher chance of not going out of business. Evidence suggests that franchise systems that are at least four (4) years old have a sharply lower probability of failing than younger systems.

Challenges facing the franchisor• Which franchisors are more likely to survive? (Con’t)• Survival is more likely if the franchisor can attract a favorable

rating from a third party. For example, in the United States, the magazine Entrepreneur surveys franchisors, collecting information from them. Verifying information and adding judgments to compile proprietary ratings of hundreds of franchisors.

• Their rating is a good predictor of franchisor survival many years later.

Challenges facing the franchisor• Gaining and Keeping a Cooperative atmosphere• A critical issue in franchising is that franchisees see the

benefits they derive when the outlet is new. Once it is underway, they may question whether they are receiving continuing value in return for their royalties.

• Franchising’s inherent conflict between being one’s own boss and being almost a subsidiary becomes prominent once the business gains ground. Franchisors must respond by earning the franchisee’s continuing cooperation and goodwill.

Challenges facing the franchisor• Gaining and Keeping a Cooperative atmosphere• Franchisees are more cooperative when they sense a solid relationship

between themselves and their franchisor. Stronger bonds exist when:

1. Franchisees feel their franchisor encourages them to innovate (try new methods, develop ideas, solve problems)

2. Franchisees feel a team spirit among themselves, getting on well internally and taking an interest with each other.

3. Franchisees feel that good performance is recognized by a franchisor4. Franchisees feel the franchisor is fair, setting reasonable objectives

and not terminating franchisees without good reason5. Franchisees feel they control their own business, setting standards

and making decisions as they see fit. (Paradoxical; Exert influence without threatening the franchisee’s autonomy)

Challenges facing the franchisor• Inherent Goal Conflict

• A structural source of conflict build into every franchising system is the clash of goals between franchisee and franchisor. This clash is due to the difference between what each side puts into business and what each side gets out of it. For the franchisor, higher sales are always better. Higher sales means higher variable fees, therefore more income. This in turn enables more promotion, which raises brand equity.More brand equity increases the fees (fixed and variable) that can be

charged and enlarges the pool of prospective store managers and franchisees.

• Franchisors seek to maximize sales, while franchisees seek to maximize profits.

Challenges facing the franchisor• Inherent Goal Conflict (Con’t)

• Seeking to maximize system sales, franchisors are motivated to saturate a market area by authorizing new outlets. In the process, they often encroach on existing outlets and thereby cannibalize their own franchisees.

• One solution, is to offer new sites to existing nearby franchisees or to give them the right of first refusal to a new location near them. If there are economies of scale in operating multiple sites, the franchisee is in position to gain from them. (Multi-unit Franchisee)