Measuring the Health of a Franchise System

Area Developer asked Darrell Johnson, president and CEO of FRANdata, what a multi-unit developer should look for when evaluating franchise opportunities. In a wide-ranging interview, Johnson sorts out the massive amount of available information into four basic categories and provides a tutorial-and dozens of relevant questions-on how to think things through when searching for the best brand to suit your business (and personal) needs. Most of the information he discusses is available if you know where to look and who to ask. And the categories of information are

1. The concept
2. The franchisor
3. The franchisees
4. The franchisor-franchisee relationship.

The health of a franchise system is affected at each of these four levels. And while each category contains key information that can cause an investment to be wildly or moderately successful (or wildly or moderately unsuccessful), Johnson says the franchisee-franchisor relationship is the most important, the foundation on which the investment rises or falls.

"You can have a really good brand name. You can have a really successful, experienced, smart franchisor. You can have some good franchisees who are making money and have been in the system for quite a while. And you can be, as a new player coming into it, highly likely to be unsuccessful if the franchisor-franchisee relationship is not a good one," says Johnson.

This does happen a lot, he says. "Sometimes it happens just from neglect, from not paying attention, sometimes it happens from changes over time." But it does happen, even to the best operators, for a number of different reasons. Let's begin at the top.

In this article, Johnson tackles how to judge the health of a franchise system from a multi-unit operator's perspective: a perspective that includes previous franchise success; a knowledge of either franchising or the specific industry, or both; sufficient financial resources; and the savvy to know what to look for, where to look for it, and how to evaluate it. Yet no matter how well informed or experienced a multi-unit operator or area developer may be, there's always more to learn.

"They're in the game," says Johnson. "The question is: What are the things they should look at if they're trying to evaluate another franchise system?"

I. The Concept Level

Johnson begins with a quick review of the basics, reminding even the most experienced among us that 1) franchising is a business model, not an industry, and 2) while the aspects of applying this business model differ in minor ways from industry to industry, the general characteristics of how to evaluate a franchise system remain the same throughout.

What franchising represents, he says, is that one company has created a brand or concept and has put some controls, processes, and operations around it. Thus, in evaluating a franchise system, the first questions to ask are: What is the brand or concept worth? What is its uniqueness? How valuable is it as a separate brand or concept?

"As a multi-unit operator looking at the health of a particular franchise system, one has to look at the concept itself," says Johnson, "and what are the aspects of that one can pull information together about and understand." Johnson, who raises more good questions in an hour than most franchisees ask in a lifetime, fires away with the following queries that multi-unit operators - or anyone considering a franchise - should ask themselves before signing on the dotted line.

What differences does it have relative to other brands or concepts competing in that space? How old is it? How well-known? How much advertising money has the franchise system as a whole invested in creating a brand image? How competitive is that particular space? For a young system, or relatively new brand, how do they plan on addressing these questions?

Before launching another volley of questions, Johnson reminds us that it's not just how many franchise competitors a brand has, but how many competitors it has in total, how competitive that concept is in its entire industry.

"What has this particular brand done in the way of creating that uniqueness? How is it competing? Are their competitors big, strong, financially powerful? Are they regional, national, or are they just local? Do they have an established market share? Is this particular brand focused locally, regionally, nationally?

"What factors are out there that could affect that brand either positively or negatively? Is it part of the current rage of, say, health trends, where it's low-carb-diet related? Is it a trend that's hot today and will go away tomorrow? Is it involved in building-maintenance services, where maybe there are some chemical or toxic issues? Did it get in the news as a byproduct of somebody nationally that happened to be using it and became famous themselves?"

Any of those factors, he says, could be the key to success or failure. Some of them, he says, are controlled completely by the franchisor that owns the brand, while others are external. These include the amount of competition, litigation, and other events occurring in the marketplace that affect the value of the brand, either positively or negatively. Finding answers to these questions and more is what goes into evaluating the system at the concept level.

II. The Franchisor Level

That covers the basics of the first level, the concept or brand. Time for the next level: the franchisor. First, says Johnson, the franchisor is distinguished from the brand it represents in several ways. Two primary ways are management experience and finances.

The franchisor represents some degree of management experience and know-how about running a business in that industry, he says. In evaluating the strength of management experience, there are two sides to consider:

a) How experienced is that management team running any business in that industry? If they're operating fast food, do they know how fast food really works? Or did they just come into it and say, "We know how to manage companies, so we're running this one."

b) The second aspect of the management experience relates to franchising. They may be really good at running a fast food operation, but they may have very little, if any, experience running a franchising operation. Franchising requires different sets of skills. "To what extent a management team has balance between those two is an important consideration in looking at a franchisor," says Johnson.

Looking at finances, he asks, how financially strong and stable is the franchisor? What is the staying power of that franchise system? If a multi-unit operator is considering investing in that franchise system, does it have deep pockets or shallow pockets? Is it making money? Is it not making money? And what is it making money on? Where are its revenues coming from?

One would normally expect the source of a franchisor's revenues to be the royalties that franchisees pay. In fact, franchisors can get revenues from a number of different sources, says Johnson. A franchisor could be a company that does franchising on the side, and their main business happens to either be in that same industry or in an ancillary type of business, with franchising an add-on component. "In the context of how important the royalty streams are and what other sources of revenue they're getting, if you're looking on an equal basis, I would much rather be dealing with a franchisor that is totally dependent on royalty incomes," he says.

"They may be making a lot of money; that may be a good thing. They may have a lot of capital; that may be a good thing," says Johnson. But, he cautions, if they're getting their revenues from sources other than franchising, it could potentially be a distraction. "It's important to understand not just whether the franchisor is profitable or not, but what their financial strength is and where it's coming from."

Another indicator to consider at the franchisor level is the number of franchised units compared with the number of company-owned units. While this can play out many different ways, what it definitely says is that the franchisor has revenues coming from their own operations in the same business as the franchisees. On the other hand, a franchisor that has no company units may be better able to focus all of their time and attention on their franchise units.

"Neither of these is an implication of being good or bad, but it's helpful in understanding what's motivating the franchisor," says Johnson. "In some instances, that could be considered a good thing because it tells me, as a potential investor, they know how the game works, they're actually running them themselves." On the other hand, he says, it could be a potential threat because they could invade your territory with company-owned stores and cannibalize your business.

"These things can be traded off. I'm not giving an indication if certain of these factors are good or bad, because that's really the facts and circumstances around a particular franchise system. But these are the things that need to be looked at," he says.

III. The Franchisee Level

At the franchisee level, Johnson begins with two important aspects for a multi-unit operator to consider in evaluating the health of a franchise system. Both involve the franchisees already in that system.

The first has to do with the type of franchisee in the system (see sidebar). The franchisor, of course, has established certain types of characteristics they're looking for in a franchisee: a certain amount of net worth, a certain amount of experience, a certain size. Perhaps they want multi-unit or single-unit operators more, or perhaps area developers; people experienced in different brands, or people who have lived entirely in that industry.

Second, what is the mix of franchisees? What are their backgrounds? Are they young people early in their careers? Senior citizens at the end of their careers? "What's the mix of franchisees out there in that system?" Johnson asks. "Because those are your partners that you're going to be playing with."

A very important, related aspect, which he says any multi-unit owner can appreciate, has to do with best practices. If you're comparing a franchisee-run business to a chain store that has hundreds of stores in the same industry, e.g., a Home Depot vs. a True Value franchise, you have only your own information to learn from. Home Depot has hundreds of stores with operating data that they can use and compare. Since your only outside source of information is the other franchisees, the extent to which they're willing to share best practices will affect the success of your stores.

"If I look at those other franchisees and say, 'They're not my kind of people,' or 'They're not playing well together'; if they don't get along, if they don't talk well together, then I may know less about how to run that business because they have a learning curve that I don't," says Johnson. "What role does the franchisor have in information sharing? Is there a franchisee association? What were the investment requirements when they came in? Does that line up with the type of business unit that I want to be involved in?"

The actual performance of franchisees in a system can be measured several different ways, he says. Turnover data is one of them. Data are disclosed on the number of stores or units that were closed, and on the number of units that changed hands, for example. There also are SBA loss statistics by franchise system.

"Clearly, over time, if you see a successful system, you're going to see there's not a lot of turnover, not a lot going on with changes of control," he says. If there is, he adds, it could be for positive reasons, such as an older system with generational transfers, or when a multi-unit operator on an expansion path buys profitable single units from other franchisees. In these cases, change of control is a good sign, especially for a multi-unit owner considering buying into that system.

As with nearly all indicators, the why of this statistic often is more important than the statistic itself. While no single factor by itself can lead a multi-unit operator to a bullet-proof conclusion, taken together they do add up to a coherent picture. By examining each one on its own and building an aggregate impression, you can form a more complete picture and draw meaningful investment conclusions.

Another interesting indicator for a system, says Johnson, is the number of multi-unit operators in the franchisee mix. "If a franchisee wasn't making money at his first unit, if he wasn't happy with it, he would probably never get around to having a second unit. Why would you do that? He's making an economic decision. To the extent that there are more multi-units, on its own could be a positive indicator."

But wait, there's more. When it comes to statistics it's never black or white, so a duly diligent multi-unit operator must dig deeper. Some franchise systems may sell only multiple units or area development rights, while some other concepts may be more or less conducive to multiple ownership. "You have to be careful," says Johnson. "It's not a standalone indicator. The fact that there aren't multi-unit operators there may not be a bad thing. It may be just a business model decision the franchisor made."

The change in the number of units year over year is another indicator at the franchisee level, says Johnson. Say you're looking at hair salons from a competitive standpoint. The brand you're looking at is growing at a 3% unit growth rate, but their competitors have been growing at 10%. That may not be a good thing. Yet although this may seem a clear indicator, it shows only the relative success (or lack) of unit growth. Guess what? Dig deeper. When judging the health of a franchise, no piece of data should be isolated from its overall system context.

Say a franchisor has been growing at a 30% or 50% unit growth clip for 3 or 4 years in a row, says Johnson. "My guess is that they're going to start having some problems with units. Because if they've reached a size where they wanted to grow from 100 to 200 units in a short period of time, you have to look pretty carefully at how they found additional franchisees. Did they lower their standards to get more prospective franchisees in the door because they just wanted to grow units? If so, you're going to start seeing some turnover challenges a couple years later. Did the franchisor expand its staff to provide the support an expanding franchisee base would need?"

So in tying together the franchisee side of these indicators, essentially what the data reveals is what kind of franchisee profile is represented in that system, and how successful have they been?

In answer to the last question, Johnson says success also can be somewhat measured by earnings claims (Item 19), which about one in five franchisors disclose. However, he notes, earnings claims still have some "maturing" to do.

"Earnings claim is a huge misnomer. Typically reported are revenues for a group of franchised or company-owned units, and maybe some cost information. It rarely has anything to do with earnings. But the times they are a-changing," he says. "More franchisors are making some type of earnings claim disclosures, and on the heels of that trend will be more consistency in what is reported."

IV. The Franchisee-Franchisor Relationship

As Johnson noted, the franchisor-franchisee relationship is the most crucial of the four categories for a multi-unit operator to consider when evaluating the health of a franchise system for investment purposes. Do they have a relationship-driven culture? Do they have a national accounts system that drives business to local units?

"Oftentimes, we think of the franchisor-franchisee relationship as defined by an operating manual," he says. "I can have an ops manual that is either really poorly written or extremely well written, and neither one of them necessarily ensures that you, as a new franchisee, are going to succeed. It's what happens when you hit the problems, when something happens that you weren't anticipating, when you have issues that come up: that defines the franchisor-franchisee relationship."

Johnson says this often comes down to the level of operational support the franchisor provides, such as help in the site selection process at the front end. Do they provide demographic help to find the right site that fits the profile of the customers they are trying to attract to that site? Do they help in the pre-opening challenges, the inevitable speed bumps that occur along the way? Do they stay in after the fact, or provide support for the learning curve necessary to understand how they do business? Explain what the culture is in that particular franchise system and make sure new operators get it right? Does the franchise agreement have impact policies that help protect a franchisee's territory?

On the non-operational side, he asks, do they provide financial services? To what extent do they facilitate access to supplies, to the product you're selling, to the products you need in order to sell, or to the equipment you need? How turnkey do they get in helping a new franchisee run their business? Are they involved on the procurement side? On the flip side, he says, are they making money from the procurement side? Do they have a lot of proprietary items you must buy that they're profiting from? Returning to the franchisor level for a moment, do their financial statements indicate they are making a lot of money on that?

"All of these things tie together," says Johnson, "but in the franchisor-franchisee relationship these are issues that are likely either to create conflicts or have people saying, 'Hey, this really works well!'"

On the money side, are they providing financial support, either by providing loans or making accommodations to defer a down payment or initial investment requirement over time, in order to make sure new operators have working capital? Do they make any accommodations at all?

Again, dig deeper, advises Johnson. "It isn't necessarily a bad thing that they don't, but it's a good thing if they do, typically." On the other hand, he asks, are they making a lot of money (again, back to the franchisor side) by providing financing to franchisees and charging a hefty margin for it?

It could be they aren't providing any financing directly, but they help facilitate access to financing. For instance, being on the SBA's Franchise Registry makes access to SBA funds more streamlined. Does the franchisor provide a package a prospective franchisee can take to the bank that tells all about the system, including why it's a good system measured against its competitors or peer group, and why it's financially healthy? "Do they do anything in that regard, or do they just say 'Go figure it out yourself,'" he asks.

How Does It All Add Up?

"I can look at any franchise system based on these four standards and make some pretty good judgments, any one of which could come out as being fairly low-rated, if you were to put it on a scale. As long as the others are able to overcome it, then I think things can work," says Johnson.

"Probably the least likely to be one that doesn't work is the franchisor-franchisee relationship. If that's weak long term, it creates a lot of problems. There's a lot of wasted motion just dealing with what the franchisor should have done but didn't do, or is doing and shouldn't do." Or, conversely on the franchisee side, a mix of strong-headed franchisees may try to force the franchisor to do things that don't make good business sense. Again, a lot of wasted motion.

"It can flow either way," says Johnson, "but in the end you have to have some sense of the dynamic going on between the franchisor and franchisee in order to have a sense of how attractive that particular franchise system is when you're looking at it from a multi-unit perspective."

Finally there is no single directional indicator that says: If it looks like this, then that's good or bad. But looked at in context it's important to consider and understand them all, says Johnson. "If you open up each one in the four categories, and some of the indicators in those categories, you can start going a lot deeper into any one of them." Good digging!

- Eddy Goldberg is a business and technology writer from Amherst, MA.