Franchise Investments: How to Analyze Them – Part 1

AB Podcast Nick Bibby AND Bruce Shaefer 01162008 Part 1 (AllBusiness.com’s Chris Bjorklund interviews Nick Bibby and Bruce Shaefer.)

Chris Bjorklund: You’re listening to the AllBusiness podcast. I’m Chris Bjorklund. If you’re getting this through iTunes and RSS feed or an online streaming-media player, you can hear interviews with other experts at AllBusiness.com.

Bjorklund: Franchising is a huge industry in the United States, full of both opportunities and rip-offs. AllBusiness has asked two experts in the franchising field to give you an overview of the general categories of franchising and explain what to consider before you make this type of financial investment. Nick Bibby is a nationally recognized franchising consultant with the Bibby Group. Bruce Shaefer has a private law practice in New York City and has more than 30 years of experience in the field. He is the founder and president of Franchise Valuations Ltd. So just how big is the industry now?

Nick Bibby: Let’s just talk about base numbers for a second. I’m sure Bruce will make this as detailed as we could have it. Franchising has today approximately 100 different industry segments, and by segment I am referring to a focus or a business. Like pizza, dry cleaning, computer repair. And out of those 100 segments today, we have approximately 3,500 different offerings across all of those different segments and on an annual basis we are growing by at least another 100 concepts a year. So franchising continues to evolve and to grow in greater proportions each coming year and shows no sign of reversing itself.

Bjorklund: Bruce, what about you? Do you have some data on that too?

Bruce Shaefer: I do and it may astound some people to know that franchising accounts for more than 40 percent of all retail sales in the United States. In fact, one out of every 12 retail establishments in the year 2001, the last time they collected the data, was part of a franchising network. There were, as another example, 767,483 franchise businesses operating and employing 9.7 million workers producing an output of $625 billion. And that should give somebody an idea of just how huge this is as a segment of the American economy. The leading areas of franchising are things like fast food, automotive aftermarket, commercial cleaning, retail products and services, business services, retail food, lodging, of course, hotels and motels are all subject to franchises. For people to take a look at franchising, they have to be aware of just how huge and all pervasive it has become in this country.

Bjorklund: Nick, why are so many people attracted to this type of investment, this way of doing business?

Bibby: That’s a good question. The bottom line is that overall franchising has proven itself as a vehicle for growth and profitability both for franchisors and franchisees and I would say that that is true across all levels of investment, whether it’s a first-time buyer looking to buy a single unit, meaning one location within a given franchise system, or whether that person is looking for a larger-scale investment in terms of signing on for multiples of restaurant locations in a city or even buying an entire region or at the largest level. And then we’ll break all of this down and Bruce will offer a lot in terms of perspective is that these investment levels go up but even ending at the ultimate, which would be the acquisition of an entire franchise system, which is certainly not what I am offering up as someone who’s coming in to franchising for the first, but for a very senior-level investor or firm looking for a major investment piece. So it covers all bases is what I am saying, Chris.

Bjorklund: Can we talk about sort of the general categories of franchising? I mean, what if I just wanted to go in and buy one, what’s that called?

Bibby: Well, that would be the acquisition of a single-unit franchise and that’s where the bulk of purchases are made. Those would be people primarily and Bruce certainly may have a different take on this but I think this is reasonably accurate, most people coming into franchising for the first time have been downsized, they have been retired, they have taken an early retirement, they are looking for a switch in career and it is a very logical path to business ownership for the first-time entrepreneur. Because generally, if you acquire or purchase a quality franchise--and believe me, there are many nonquality franchises--but if you do proper due diligence and you acquire a quality franchise, you are buying a known commodity where your risk is certainly to be lowered compared to an independent investment where there is no experience beforehand.

Bjorklund: Bruce, does a single-unit franchise, does it mean you get a guaranteed territory?

Shaefer: Well, sometimes it does and the custom or the more prevalent behavior now is leaning toward giving only the actual site of the store as their territory. What I mean is that many years ago it was commonplace if not completely uniform that people would get what’s called an exclusive territory. It was usually mapped out, say, a circumference of 3, 5, 10 miles from the site. But lately too many franchise systems have taken to refusing to give any exclusive territory and have simply allowed a franchisee the particular site that they get. That has resulted actually in a substantial amount of litigation, for some reason primarily focusing on Burger Kings. There are a lot of federal cases where people have sought to sue Burger King for putting a second operation within what they deemed their necessary territory because they did not get the contractually designed territory and the court has pretty much rejected it. You pretty much get that which you agreed to in your contract or franchise agreement so if there is an exclusive territory--and if there is, it has to be disclosed in the franchise agreement--then you have that guarantee. If not, then there is no concept of encroachment because the franchisor has the right to open as many units as they think will compete economically. And just following up on one thing that Nick said in terms of the marketplace, a lot of these franchises are being sold to people who had been downsized, as he said, and in many instances what they are doing is buying themselves a job. I remember about seven or eight years ago, in the middle of New York state, the area between New York City and Albany, a tremendous amount of people there used to work for IBM and then IBM closed them down and bought them all out and literally hundreds of the people that received buyouts were looking to buy franchises because they wanted to effectively assure themselves a job where they could not get fired again and figured if they were the boss that would give them the ultimate protection.

Bjorklund: Moving up the ladder, let us say we are interested in more than a single-unit franchise. What would be the next level?

Shaefer: Well the next level up are called mostly unit operators and they may be what are called area developers or they may be just franchisees that continued to acquire several other units. The old concept of franchisees being just mom-and-pop operators is really giving way because just as a franchise system offers a franchisee economies of scale, multiple-unit operators have their own economies of scale within their system so that it seems that the current trend is going toward more and more real business multiple-unit operators going around and buying up mom-and-pop operators simply because they have the good management that could be applied to many units instead of just one. Now there is something called an area developer that does not necessarily go out and buy up other operations but usually has a schedule with milestones that have to be met. In other words, the area development agreement will say, “You have to open 20 stores within the next three years and you have to open six by a certain date and the following six by a subsequent certain date.” And if the area developer fails to meet the schedule, they can lose either a portion of the rights or sometimes they can be terminated out of their franchise operations. So it is in an area--I hate to use the word area twice--but area developers is an area where you are using a more sophisticated and more substantially financial operator who is going to commit to opening many units within the specific time frame and it is substantially different than the downsized people who are just looking to generally buy a single unit to assure themselves of employment.

Bjorklund: I would imagine that the more units that you’re buying up, whether it’s area and regional or just the entire franchise, there is increasing complexity to the deal, so to speak.

Shaefer: There is increasing complexity to the deal but it’s sort of like riding a bicycle. Once you learn to do it, you can apply the same measures to six units that you can to one unit. And from six to 60 it then becomes more an administrative problem than an operations problem to make sure that you have systems in place that not only watches the store as they say but watches all the stores. So in the multiple-unit area it’s just applying the skills, the experience, the know-how, all that has been learned from trial and error and basically applying it over and over to the cookie-cutter sort of operation. Whereas, as Nick was saying, in the occasional item of a franchisor being bought, then you have a different sort of analysis and business scope because you may have an operation that needs to be turned around because when a franchisee buys a unit, they are basically buying the know-how and goodwill that a franchisor has already basically established by going through their own trial and error whereas when you buy a franchise system, if it’s in the error rather than in the trial portion, you need a rather sophisticated businessperson with great franchise experience, somebody like Nick to know how to either turn the system around or, if it’s not in trouble, how to expand and enhance it so that it becomes larger and even more profitable than when you purchased it.

Bjorklund: Nick, can you help us with the idea of the kind of homework you need to do regardless of the size of the franchise that you’re thinking of investing in? What kind of background research should you start with?

Bibby: Let me take off with that with one word that Bruce just used because it’s applicable across spectrums except that at different levels and the word is different levels of sophistication. The first-time franchise buyer has first got to determine whether or not franchising is a logical personal fit for them going into business. Because buying a franchise for the first time as a single-unit operation requires that one follows the system. And if you’re not able or willing to follow the franchisor’s system, you’re never going to be happy, therefore probably not successful in owning that business. So for the first-time buyer, which I think are the preponderance of probably the folks who are going to be listening to this podcast, the decision must be made that buying a franchise is a logical personal step beyond the logical financial step. So I think first, level one, buying a franchise, number one, is a factor that should be weighed against personal preferences, skills sets and pocketbook but all of those have to come into play. Now, the next question, which is actually the question you were asking is, “What about franchisee’s due diligence?” And I will tell you unequivocally and it’s a shame and I cannot tell you why it’s so--I can guess as to why it’s so--but unfortunately I will report to you that probably no more than one out of four buyers ever perform any type of serious due diligence, meaning examining, analyzing the investment before they sign up to buy the franchise. In most cases it’s long after the franchise agreement is signed, after the business is opened that the surprises are found out, which never needed to be surprises but people are, I guess, loathe to work on something that they’d rather believe in what is being sold.

Bjorklund: Right. Well they may also be enamored with the idea of the promise of a great income and all those things that, you know, are attractive about owning your business and being in control of your life and retiring earlier, whatever that the salespeople of the franchises are saying.

Bibby: Well that’s tremendously good insight on your part because that is exactly why I believe that so few people perform their due diligence. It’s simply easier to believe what is being said as opposed to comparing what is said to that which is written in the offering circular and the franchise agreement. And unfortunately when you introduce the concept of franchise brokerage, the brokers have to sell the franchise and therefore earn a commission and there is really very little to be known about what is said in those conversations and that is why it is so important and critically incumbent upon the buyer to perform due diligence. And let me add one other thought to that--because we’re only just scratching the surface here--talking about the initial or single-unit purchase. The problem, if the buyer elects to perform due diligence, if it’s the first time that they are purchasing a franchise, their hands are terribly tied because they don’t know how to perform. Now they could hire a Bruce Shaefer, they could hire a Nick Bibby, they could hire a host of people to help them and those helps are all scattered throughout the internet but they first have to make the decision that the help is required. So it’s not like one, two, three, I fell off the bike and somebody would lift me up. If somebody’s got to put the tires on the bicycle, pump them up and show you how to change the gears, do you hear me? And so, it’s not a simple thing. Buying a franchise is perceived as perhaps a simple thing but in fact it does require--it demands that you do it right. It demands some serious analysis and thought.

Bjorklund: Experts Nick Bibby and Bruce Shaefer will continue talking about investing in franchises in part two of this podcast, which is posted in the AllBusiness podcast library. I’m Chris Bjorklund. Thanks for listening.