10 tips on shaping a franchise model for profitability

By Sarah Stowe | 05 Apr 2016 View comments

Put your franchise on the road to profit with some simple steps. Image: positiverealestate.com.auFranchising in Australia has become an essential part of the fabric of small business, with nearly 1,200 franchise brands operating more than 70,000 outlets, according to the Franchising Australia 2014 survey.

Entrepreneurial small business owners frequently look to franchising as a method of growing their businesses, contributing to the ongoing growth of the sector with new brands constantly entering the market.

However, not all new franchise brands survive more than a few years. Many factors, such as a lack of working capital, poor structure or lack of planning,  that contribute to the failure of any small business are also present in the failure of start-up franchisors. However one factor unique to franchising is the relationship between franchisor viability and franchisee profitability.

In other words, if franchisees aren’t profitable, their franchisors are unlikely to survive.

This highlights the mutually-dependent relationship of franchising. While a franchisor might not be impacted by one unprofitable franchisee here or there, if the entire network is unprofitable, the franchisor will soon follow into financial oblivion.

Structuring the business model for franchisee profitability is essential for the long-term success and viability of the network.

Here are 10 tips to structure a franchise model to improve franchisee profitability:

1. Determine a viable royalty

Ongoing royalties paid by franchisees generally fit into one of two categories – either a fixed regular amount, or a percentage of the franchisees’ turnover. (There are other types of royalties, including a hybrid of the fixed and percentage amounts, but most franchisors will pick one of these two methods).

If the franchisor picks a royalty amount that is too high, it will adversely impact franchisee profitability. The best way to approach the choice of royalty amount is to retrospectively apply it to all pilot and company-owned outlets first to see if they could still be profitable after paying the royalty and for the remaining profits to provide a sufficient return to the operator to justify the initial investment.

2. Keep the entry cost affordable

Start-up franchisors often risk over-pricing their franchise on the basis that they need to recover all or most of their franchising preparation costs from their first franchisees.

The difficulty with this approach is that it unneccessarily inflates the franchisee’s initial investment, which means increased borrowings, greater debt repayments and interest charges, and potentially lower overall profitability for the franchisee.

3. Align the royalty with the service provided

When deciding the ongoing royalty to be charged to franchisees, new franchisors are often yet to determine the nature and frequency of field support to be provided to franchisees. This usually means that franchisor support services are determined by the royalty’s ability to pay for them, rather than determined by the operational needs of the business.

If the operational needs of the business require a high level of support, then a higher fee may be justified (subject to the business model’s capacity to pay).

4. Create royalty incentives

Start-up franchisors give little, if any thought, to creating structural performance incentives for their franchisees via their choice of royalty.

Franchisors who charge a royalty based on a franchisee’s turnover could consider a declining percentage linked to franchisees’ increasing turnover, so that the more franchisees sell, the more they keep for themselves.

Similarly, fixed-fee systems could also create declining royalty incentives based on performance benchmarks other than sales, such as customer counts, service frequency, staff headcount..

5. Require franchisee business plans

One way to structure for franchisee profitability is to require franchisees to create a business plan that outlines their path to profitability before they have even begun operating their businesses. Once approved, this plan then forms the basis of the franchisor’s ongoing support and keeps the franchisee honest and accountable to his or her own aspirations.

6. Monitor franchisees’ debt

How a franchisee funds the acquisition of a franchise can be material to long-term success and profitability. If a franchisee has borrowed to buy the franchise, the franchisor should monitor the business-related debt to ensure that it is being repaid, and that the loan principal is actually being reduced. If the loan principal appears to be increasing, rather that decreasing, this can (among other things) indicate a lack of profitability in the franchisee’s business.

7. Align loan repayment timeframe, retail lease and franchise term

Linked with monitoring the franchisee’s debt level, the franchisor should also monitor that the franchisee makes principal and interest payments to zero the balance of their loan by the end of the initial franchise term, which for many retail franchises will also coincide with the term of the retail lease.

This provides a realistic reflection of interest costs (which affect profitability) compared to loans repaid over longer periods, including timeframes greater than the franchisee’s operation of the actual business.

8. Assess training competencies

To improve franchisee profitability, franchisors should also ensure that the franchisee is actually competent to run their business before allowing them to commence trading.

Franchisee training that does not include any ongoing or final competency assessment risks producing franchisees who have completed their training program, but still do not yet have the skills to run a profitable business. Testing competencies means that franchisees who need extra training should be able to receive it before their lack of skill jeopardises their business’ viability and profitability.

9. Create systemised sales and costs reporting

Franchisors that use a royalty calculated as a percentage of turnover will generally have a system to monitor franchisees’ sales, whereas franchisors who charge set amount royalties may have no sales monitoring systems at all.

To maximise the ability to improve franchisee profitability, franchisors should not only have visibility over franchisees’ revenues, but also visibility over their costs.

This can be best achieved by creating highly integrated sales and administration systems which capture transactions as they occur, and which automatically report to the franchisor at appropriate intervals.

Not only should this system capture sales information, but it should also capture costs across a range of standardised expense categories common to all franchisees so that the franchisor can establish meaningful benchmarks of performance variables across the network.

10. Provide profit coaching

Based on a comprehensive analysis of the benchmarking data gleaned through automated reporting of revenue and costs throughout the network, highlighted above, franchisors should be able to guide their franchisees to greater levels of profitability by identifying revenue opportunities and ways to minimise costs.

Where franchisors work with their franchisees to increase franchisee profitability, they help enhance the value proposition of the franchise relationship to one where the cost of the royalties may pale in comparison to the rewards the franchisees receive.

These 10 tips to structure a model for franchisee profitability are particularly useful to start-up franchisors, however established franchisors could also consider the extent to which they can adopt some or all of these principles into their existing models.

Given the mutually dependent relationship between franchisee profitability and franchisor viability, these tips and other structural and tactical considerations can serve a franchisor’s long-term interests by ensuring that their franchisees earn sustainable profits.