🍟 9/25/2023 – Updated Criteria To Evaluate Emerging Franchises

DEEP DIVE 

Updated Criteria: How to Evaluate Emerging Franchises

Well over a year ago, I wrote about my 5 criteria for an emerging franchise. Since then, I’ve learned quite a bit from speaking with more franchisees, franchisors, and other members of the franchise community.

I also recently spoke to the founder of a new business, who is intending to franchise it in the near future. The approach this founder is taking to franchising is a much more methodical and thought out, and will set them up for a higher likelihood of success because of it. 

With this in mind, here’s my updated criteria for how I evaluate emerging franchises (I’ll quickly review the original 5 criteria from the original post, and then discuss the additions. 

1. Return on Investment Potential

If a new brand is franchising, and they don’t have a quality return on investment, then move on to the next! Note that top franchises show the potential to return your initial investment in ~3 years, some even sooner.

And if a new franchise doesn’t disclose any performance representations in their Item 19, it is absolutely a major red flag. If your business is truly worth franchising and worth buying, why wouldn’t you disclose the performance of existing locations?

There are some early franchises that have been given misguided legal advice and are concerned with liability, but outside of those select few, 99 out of 100 new franchises that don’t share financials are doing that because the numbers aren’t pretty. 

2. Replicable Operations

Franchises with high growth potential aren’t complicated to operate. They are simple enough businesses where the franchisor can transfer the knowledge of how to run it in a reasonable amount of time in a franchise training environment.

Businesses that are complex operationally or require a very specific skill set, are added risk for a franchisee and the brand as a whole. 

3. Scalable + Malleable Supply Chain

For a franchisor to expand across the country via franchisees, they need to scale their supply chain so that zee’s can purchase inputs and still operate profitably. 

Beyond scaling, the supply chain has to be malleable as well, so that the quality of the product doesn’t vary from market to market.

This primarily applies to food franchises, but an example I think about is Cousins Maine Lobster, a food-truck franchise with 40+ locations. 

The concept started in Maine, where they source their lobster locally. But if you buy a franchise in Idaho, the question is not only can that franchisee source lobster profitably but will the product maintain the same quality that makes the original location so popular? 

I’m not saying I know the answer by the way, but it’s a good example of why a scalable and malleable supply chain are an important criteria. 

4 and 5. Brand Identity + Executive Team

Brand identity primarily comes down to the success of their online presence. Do they have impressive google reviews, yelp reviews, and/or social media followings? 

If a business/brand is loved, those are a few quantitative ways to measure it. If a business doesn’t have social media clout or google reviews, that doesn’t mean you should cross them off your list, just that you should determine why they don’t have digital attention

For the executive team, you should really be trying to figure out one thing: is the CEO capable of building a franchisor organization that can successfully support growth of the system?

Asking questions about how they plan to hire support staff as franchisees get onboarded, and what their org chart will look like along the way are good things to know.

6. Are they well capitalized?

Last week I mentioned how the median franchise only grows by ~4 locations per year, and the average brand today has about ~40 locations. Those are sobering statistics as many in the industry focus on the unit sales of brands and think that equates to success.

Given this, for an emerging franchise, I’d want to know that they have capital on their balance sheet to support growth as they ramp up their franchise system. 

Many franchises don’t have much capital at the beginning, and then they immediately buy into the hype that the only way to grow is through broker networks.

Unfortunately, some broker networks take as much as 90% of the franchise fee as commission – leaving next to nothing for the franchisor to reinvest into their business, nevermind the franchise owner who paid that franchise fee!

Then there are franchise sales organizations (FSO) that take as high as 35% of the royalties in perpetuity for the franchises they work with!

If I’m a franchisee, that’s a bad sign for the franchise system, as your franchisor will need that royalty revenue to continuously reinvest into the brand over the years. 

Thus, understanding the capitalization of an emerging franchise isn’t just about where they are today, it also should factor in their growth strategy. If they plan on using brokers, you better cross your fingers they can sustain growth until they hit royalty self-sufficiency. If they’re partnered with an FSO, you have every right to understand the nature of that contract, as it impacts their ability to invest in the brand as a whole. 

If you’re an early franchisee, you’re taking the biggest risk, so these are details you should never be afraid to ask about!

7. Is there a defensible business moat?

This question ties into the longevity of a franchise’s business model. If you’re an early franchisee buying into a new brand, you want to feel confident that this business will still be around over the coming decades. 

For instance, I recently spoke to Dan Reese, the CEO of Milkshake Factory. After learning about that franchise, I see a defensible business moat over decades for a few reasons:

  • Milkshakes will always be consumed, unless ice cream as a category disappears (incredibly unlikely)
  • They have an operational playbook that allows them to churn out a high volume of milkshakes that your typical ice cream shop could never do 
  • They have invested into so many different ingredients and recipe to create truly premium product that a mom & pop competitor would have a difficult time competing with 

Over time, as that franchise grows nationwide, the brand itself can become the moat, like many consumer facing businesses.

Some may still think Milkshake Factory is in a commodity business arena (I do not), but perhaps a more glaringly obvious moat is that of Uptown Cheapskate. The boutique clothing re-seller has developed proprietary technology that allows franchisees to accept an article of clothing from a consumer, accurately pay them a fair amount for it, inventory the SKU, and re-price it when it goes on the shelf. 

As more and more customers walk into their 200+ stores, the more data their technology system has, and the quicker, and more dialed in the business becomes. 

Mom & pop resellers simply can’t invest in a system like that, and more importantly they don’t have the scale to generate that level of data that finetunes the entire machine. 

In summary – look for a true moat!

8. Do they have a deeper mission?

To come full circle, this last criteria relates to the conversation I had with the founder of the business I mentioned at the beginning of this newsletter.

Without disclosing too much, the business has an incredibly positive impact on the environment and saving waste. 

As time goes on, being environmentally sustainable will be more and more a requirement for companies (although it already should be top of mind for everyone). It’s also worth mentioning that Gen-Z and future generations are already far more supportive of purpose driven companies.

It’s not necessarily a need to have, but it’s certainly a great addition if the franchise you’re buying into does have a greater purpose to communities. Not to knock fast-casual franchises, but there are dozens of brands out there with the mission of creating a healthier option for consumers. 

Most of those franchises are still pumping their smoothies and acai bowls with sugar, but the point is that it’s a crowded market with brands that have an undifferentiated mission statement. 

Ideally a brand has a unique mission statement that they actually back up with their business. In these cases, franchises are an amazing business model for these concepts as you can scale quicker and increase the positive impact exponentially. 

Hope you enjoyed the updated criteria – if there’s any questions, feel free to reply to this email. And if you’re interested in evaluating emerging franchises with a trusted advisor, book a free strategy session here!


FRANCHISE HEADLINES

McDonald’s raises fees for franchisees in first price hike in 30 years

McDonald’s franchisees who open new outposts in 2024 will have to pay an increased royalty fee of 5% — the first time in nearly three decades that the fast-food giant increased the fee, according to CNBC.

For the past 30-some years, a Golden Arches franchisee only had to cough up 4% royalty fees, a percentage of gross sales in addition to rent and other expenses such as payments towards the company’s mobile app.

These higher rates — which McDonald’s used to refer to as “service fees,” but will now call “royalty fees” — will only affect new franchisees, buyers of company-owned restaurants and relocated restaurants, according to an internal message reviewed by CNBC.

With Big Pizza Hut Purchase, Yum Franchisee Emerge Inc. Keeps Growing

Singh is the CEO of Emerge Inc., a franchisee of Pizza Hut, Taco Bell, KFC and Sonic Drive-In that in late August acquired another 36 Pizza Hut restaurants to bring the group’s unit count across all four brands to 169. He and Chief Operating Officer Mick Rosckowff began building Emerge’s portfolio in 2016 after Singh acquired nine KFC/Taco Bells in Houston and Beaumont, Texas, to go along with the seven Louisiana units he bought the year before.

Using their own capital and working with lending partners, they’ve eschewed private equity, which Singh said gives them the freedom to look beyond the P&L and purchase packages of stores that may have somewhat messy books but are solid operations. “Second-generation owners, they may not have the best record keeping, but we know the business. We can look at the top line, the leases, the real estate,” he explained. “There’s no board we have to go to. We’re long-term buyers.”

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