Corporatisation: A new dawn for franchising?

A review of the approximately 1,100 franchise systems known to be operating in Australia indicates that somewhere between 4-8% are operated or ultimately owned by publicly listed companies.

Franchise systems listed on the Australian Stock Exchange (ASX) include Gold Coast-based Retail Food Group (parent company of Donut King, Michel’s Patisserie, Café BB’s and Brumby’s Bakeries), Allied Brands (parent company of Awesome Water, Baskin Robbins, Villa & Hut and Kenny’s Cardiology) and even Harvey Norman.

Not all publicly listed franchisors are household names. Whereas Harvey Norman is a nationally recognised electrical and furniture retailer, the brands operated by Retail Food Group (RFG) are themselves better known among consumers than the parent company itself.

While an ASX listing might represent the pinnacle of franchising corporatisation, there are intermediate steps that franchisors take to get there, and in some cases, these steps are being mirrored by franchisees who are also corporatising themselves.

A business is born

Almost all franchise systems in operation today have started from humble origins, often with very little capital, but backed by the belief, energy and enthusiasm of the founder. The characteristics of the founder are often indistinguishable from the business itself in the early days, and the founder and the business are synonymous for many years as the franchise grows and develops.

Growth requires investment capital

As the business grows and the founder sees more potential, the business’ needs for capital increases. One solution is to franchise the business by attracting franchisees who are willing to pay for the set-up costs of their own business under the franchisor’s brand in anticipation of profiting from that brand.

But even with a growing number of stores or territories funded by franchisees, growing franchise networks still often have even greater capital requirements as they build and resource logistics and support infrastructure for franchisees in anticipation of future royalty income.

Additionally, growing franchisors may pursue a strategy of owning and operating their own sites or territories in order to secure a location or market share ahead of any competitors until such time as a franchisee can be found. As a result of attempting to maximise their market leverage, buying power, etc, growing franchisors can need even more capital than is being provided by new franchisees, and may look to private investors to take equity in the business.

Investment requires governance

By taking on external capital from investors who buy a slice of the business, growing franchisors then face an obligation to deliver returns to shareholders (often foregone by the founders during the early growth stage of the business as profits are constantly reinvested) and provide some transparency in the operation of the business.

At this stage, the entrepreneur founder of a franchise may learn for the first time that he or she can no longer treat the business as their personal fiefdom, and that a degree of corporate governance will be required by the investors to protect their interests.

Where franchisors take on private investors, the system will often form a board of directors to provide corporate governance and strategic oversight to the growing enterprise. (Some systems even establish advisory boards to perform the same function ahead of selling equity in the business in order to make themselves more attractive to investors).

Some investors, particularly those who wish to actively manage the risk of their investment, will insist on the formation of a board and a seat at the table before agreeing to invest. Others may take a more passive approach to their investment, and assess the quality of the board as a whole without necessarily demanding a seat for themselves. Either way, a growing franchise with investors is now subject to a level of scrutiny and a requirement to produce dividends and share growth that enterprises owned by the founder do not necessarily face.

Going public

By increasing its capital base further, a growing franchise can accelerate network growth and deliver a return on sweat equity to the entrepreneurial founders of the business who may have foregone profits and income during the formative years of the franchise. A public float of the franchise can substantially increase a company’s capital base above and beyond that provided by private investors, but comes at the cost of substantially increased reporting and governance requirements, as well as the initial cost of the float itself.

By going public, expectations of strong performance, share growth and regular dividends increase among shareholders, thus bringing even greater scrutiny to the operation of the franchise.

What does this mean for franchisees?

The upside of a franchisor’s corporatisation journey is that the franchisor has more funds to invest in growing the brand and providing improved support services to franchisees. The franchisor is able to introduce or upgrade IT systems, logistics, operations support, and more specialised support personnel. Additionally, franchisees (particularly of listed systems) may have access to more information about the performance of the franchisor through its ongoing disclosure obligations to the stock exchange than would otherwise be available to franchisees of a privately-owned system.

Where franchisors seek investment capital from private investors or via a public listing, franchisees may also have the chance to invest in their franchisor at corporate (rather than store or territory) level, and help shape the future of the organisation.

However, there can also be some downsides for franchisees in the corporatisation of their franchisor.

The first is that the franchisor’s requirement to deliver returns for shareholders (ie. investors) may outweigh the franchisors requirement to deliver returns for its stakeholders (ie. franchisees). Franchisees invest heavily in the future success of a brand, but do not have the same rights or entitlements as shareholders.

Indeed there is a natural competitive tension between the needs of shareholders and the needs of franchisees as the bulk of shareholder dividends are ultimately sourced from franchisees, but if franchisees are not resourced or supported properly, their performance will suffer and in turn, returns to shareholders may decline. In a corporatised franchise, franchisees are more likely to be viewed as sources of revenue than as business partners.

Another downside is that the level of corporate governance required by investors may drastically reduce the franchisor’s appetite for risk, which is often an asset to small growing businesses led by entrepreneurial founders. Even if the same risk appetite continues to exist after a franchisor has corporatised, the governance processes and internal bureaucracies these create could slow decision-making to the point where opportunities are missed. (In other words, the bigger the ship, the less manoeuvrable it becomes.)

Corporatisation may also mean that the founder and leader of the business takes a step back or steps down altogether. This can be quite significant in a franchise network as whether they admit it or not, franchisees buy equally into the leader of the franchise as they do in the brand. When the original leader no longer leads, franchisees experience uncertainty and may develop a fear of change.

There is also the risk of an outright change of ownership with a corresponding change in corporate direction (which again causes uncertainty for franchisees).

Additionally, franchisees may be affected by a perceived “impersonalisation” in the relationship with the franchisor as its staff are promoted, transferred and changed during and after the corporatisation process, which again gives rise to fears of change and uncertainty. This can be particularly unsettling for franchisees, whose franchise terms may be considerably longer than the tenure of their franchisor’s senior executives or support personnel, and who could be subject to a revolving door of franchisor operatives each bearing different strategies and tactics for working with franchisees and growing the brand. A perceived lack of continuity in franchisor personnel and the imposition of change for change’s sake can rapidly disillusion a franchisee, where for example, they may have had up to five different franchisor CEO’s during a 10-year period.

Franchisees are also corporatising

But the corporatisation of franchising is not a one-way street. In some cases, franchisees in the United States are themselves major corporations which own hundreds of outlets and are listed on the stock exchange in their own right.

The sheer size of the US population and its domestic demand for goods and services makes the corporatisation of franchisees at this level more visible and viable than in Australia, but corporatisation of franchisees is occurring here nonetheless.

While we do not have any publicly-listed franchisees currently trading on the stock exchange (though there was a 50-unit corporate franchisee that was listed on the ASX in the early to mid-2000s until it was privatised) we do have an increasing number of multiple-unit franchisees that are now operating mini corporations with much of the same corporate structure and private investment requirements of franchisors (similar to the corporatisation journey outlined above). Retail franchisees who own 10 or more outlets often have the same or better support infrastructure compared to franchisors of the same size, and usually have an appetite for growth with corresponding investment and governance requirements.

But perhaps an as yet little understood reason for the corporatisation of franchising at franchisee level is the steady increase in entry costs. This is particularly so for retail franchises which for a number of systems now approach $400,000 and above, and which threaten the “buy yourself a job” perception among first-time business owners on which the success of franchising has largely depended.

Indeed there are quite a few franchise systems where the investment level is considerably greater than $400,000 and in effect, these are largely beyond the reach of many “Mum and Dad” owner-operators who are the key to franchising’s success because their attention to detail, personal management and profit focus is what makes franchised businesses peform better than company-owned businesses.

There may come a time in the not too distant future where some franchise networks will be recruiting franchisees not from the Mum and Dads of Australia, but almost exclusively from the ranks of large private enterprises, or even public companies, as these may be the only ones with the asset backing and organisational capability to buy and operate certain franchises. When this happens, the corporatisation of franchising will have come full circle.

Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 18 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues.