How Will Wall Street's Meltdown Affect Small Business, in particular, Franchising in the U.S.?
Before I answer your question I think a bit of historical background is important. Our economy is where it is today because we chose not to learn from what we did in the past.
I remember after the bubble broke following the dot-com meltdown we were faced with similar questions. And we moved through those troubled times to what became one of the best environments for the growth of small business and certainly franchising. It is a fact of life in our economic marketplace that business cycles happen. Business cycles in the United States have always produced a beneficial cleansing although living through the corrections is always painful in the short term.
There are clearly differences between the two periods. Then we were faced with a marketplace that suspended its understanding that a slower burn rate was not the same as sustainable success. Enterprises that had little hope of ever producing profits were celebrated because of their innovation without regard to potential profitability. Our collective greed got in the way of sound business judgment. But keep in mind that those failures led to the birth of innovations in technology and services that we take for granted today.
This downturn is different but it has a similar cause. We chose to again suspend our understanding of economic realities and we got greedy. While the dot-com bust was a product of a new technology, the birth of the age of electronic commerce and applications, this is an event that finds its root in social engineering by Congress. Congress determined that it was our right, regardless of our economic status, to own a home. It pressured lenders to end what was called "redlining" in how they looked at borrowers. Congress created government sponsored agencies, which had ever-increasing lending capacity but also had ever-decreasing borrowing standards. People purchased homes they could not afford and could never pay for. Mortgage products were created with artificially low entry prices and that led to a secondary marketplace where these poorly structured loans were traded and vast profits were made. The result is the global mess we find ourselves in today and which many predicted five or more years ago. While it was likely too late even when it was proposed, McCain's bill in 2005 would have created an oversight requirement on Fannie and Freddie, that might have avoided the meltdown we are facing today. The suspension of any bipartisan efforts coupled with the huge pressure from campaign contributors, including those from Freddie and Fannie, are where we as voters should be focused during this current election cycle if we want a quick resolution to this current problem.
For franchising, this downturn will require a rethinking of our marketplace. For too long if you asked many franchisors "how is business" they would talk to you about franchise sales and their pipeline of candidates and commitments from multi-unit developers. For many, it was the growth of their franchise systems rather than the growth of their same store sales and franchisee bottom lines that were how they measured their performance. While the transition for many franchisors on how they measured the health of their businesses (from a growth in units to a growth in unit bottom line performance) will be difficult, it will be beneficial and indeed essential to long term recovery. Better to not lose locations because of poor performance than try to replace them has always been the right path to take in good times and in bad.
Credit is the fuel of our economy and certainly the lifeblood of franchise system growth and modernization. The credit market is going to be tight through most of 2009 and franchise sales for many franchisors will slow down dramatically. Those franchisees that choose to join stronger concepts (both established and new) and who are financially healthy enough to finance their entry into business with more capital and less debt will be fine. Franchising has always been somewhat counter-cyclical to Wall Street and when passive investments are challenged; investments into franchises are seen as a safe harbor. Franchisors are going to need to conform their franchise marketing to prospects so that they are more attractive to a different profile of franchisee then they may have been looking at in the past, if they want to continue to grow.
Loans will still be available but lenders will be looking for more secure opportunities, at likely higher equity requirements and possibly higher interest rates than they did in the past. The franchisees that will enter franchising in the near term will need to be economically stronger and the franchisors that grow will have to show a better performance as a system than their peers.
There will be some consolidation in existing franchise systems, as stronger franchisees will take advantage of the opportunity by purchasing existing franchises that are struggling. Long term this will have a beneficial impact for many franchise systems and franchisors need to re-work their strategies to take advantage of this trend.
For those franchise systems that sold multi-unit development rights to franchisees, many of them need to look quickly at their current pipelines and the growth obligations of their developers. Realistic projections are a necessity to work through this current cycle.
Cooperation and trust between franchisors and franchisees has always been important. As rapid changes to retail offerings, price points, suppliers and marketing will be required to remain competitive, those franchise systems that have historically had good levels of cooperation and trust will do better than those that have not. Communication is key to building trust and it will be essential for franchisors to actively work with their franchisees and their advisory councils in shortcutting tests and other beneficial changes. Modernizations or investments in physical changes will butt up against available capital and that will pose some challenges as well.
International expansion may seem like a growth opportunity for some franchisors who are seeing domestic opportunities slow down. Many of our clients are looking overseas but the smart franchisors will deal with the health of their domestic operations first as international expansion comes with its own set of strains.
Sales multiples for franchisors and franchisees looking to sell will drop from their historic highs and bargains will appear. Expect that some franchise systems will purchase their growth through acquisition of other systems, strategic buyers will look to take advantage of some of the bargains and at the same time, as the returns on Wall Street are challenged, capital will flow into the acquisition of franchisors by financial buyers. For those of us who deal with mergers and acquisitions, 2009 and 2010 should be very active.
Some franchisors will certainly get into trouble. There will likely be an increase in franchisee to franchisor litigation but that can be expected as same store sales come under stress in some systems. Franchisors may need to take action against franchisees for payment of royalties and other fees. But I believe strongly in the economics of franchising and think if there is an overall increase in business failures and bankruptcies in the general economy, the structure and nature of franchising offers a high level of protection.
Real estate will begin to free up as existing businesses close. Landlords will again start to offer build-out allowances and other inducements to keep their properties full. Rent in some markets will soften. This will create some opportunities for franchisors whose pipelines were already backed up looking for suitable sites.
The most important and again beneficial change of the slowdown in franchise sales may be the recognition by some franchisors that they need to focus on unit performance. Unit performance is important to sustain and grow a franchisor's bottom line when the system is not expanding.
MSA's practice has always been heavily weighted toward working with established franchisors and larger non-franchised business in strategic and tactical planning. Over the past year, that part of our practice has grown dramatically and continues to do so. Franchisors who were focused on new unit sales should for a while likely de-emphasize growth and put an increased effort into their existing unit performance. Once the marketplace in 2009 and 2010 returns to a more robust unit development posture, those franchise systems that have targeted their efforts toward improving their franchisees' bottom line will be extraordinary well positioned when franchise sales opportunities arise. Having the ability to present a solid Item 19 disclosure is going to be an important advantage to franchisors.
Finally, what about new franchise opportunities? Moving away from packaged development is essential for emerging franchisors. There are several consulting and law firms that have always understood how franchisors need to be developed and what makes franchisors sustainable in good times and bad. New and emerging franchises need strategic partners to help them decide if now is the time to franchise. They'll also need to know how to strategically and tactically develop the system. MSA actively competes with other franchise-consulting firms that understand these requirements, so we are not alone in understanding what is needed. Those of us in the professional services area of franchising will do fine during this period but anticipate a reduction in the number of "cookie cutter" franchise packagers and likely several weaker franchise sales brokerages over the next few years. That cleansing of some of the "bad" players will also be beneficial to franchising.
The bottom line is that franchising is truly the engine of economic growth today and its inherent structure, when executed well, makes it a relatively safe and sustainable investment for both franchisors and franchisees. Those that are nimble and understand how to make changes quickly to take advantage of the opportunities will do extremely well during and on the backside of this credit crunch. Those that continue to do business in 2009 and 2010 as they have in the past and continue to focus on system growth as a solution instead of focusing on unit performance will not.
Provided By Michael Seid, managing director of MSA (email@example.com)
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