[IMGCAP(1)]Businesses with expansion plans, and especially those that might be franchised, inevitably face a critical decision that can greatly impact the future direction of the enterprise and its prospects for longer-term success. How should the business grow?

For the franchise-able business, the choice often boils down to whether to pursue future growth of the enterprise organically, that is, by financing expansion internally and/or with investor capital, or by franchising the company’s successful business model. Both have advantages and disadvantages.

This article will explore some of the advantages and disadvantages associated with growing a hypothetical restaurant chain by adding company stores versus franchising the concept to unaffiliated third parties.

Advantages of Franchising
• No capital invested in individual units. Franchisors can achieve a superior return on invested capital by avoiding the high cost of building and equipping individual restaurant units (which is the responsibility of the franchisee). The franchisor typically receives royalties from its franchisees, often 3 percent to 6 percent of franchised unit revenues, with a minimal capital investment. Upfront expenses that a franchisor routinely incurs to help a franchisee select a site, build it, train the franchisee, and open the franchise are commonly offset by the initial franchise fee charged. By contrast, corporate-owned restaurant units typically require a substantial upfront capital investment (which can exceed $1 million per unit in freestanding locations) and an ongoing capital commitment for staffing and support. Franchising eliminates the need for large per-unit capital commitments and can facilitate much faster chain growth for small to mid-sized companies looking to grow rapidly.

• Franchisees have significant incentive to run better restaurants than corporately hired managers. It is not uncommon in the restaurant industry to see sales and operating profits improve after a company-owned restaurant is sold to a franchisee. While this is not always the case, the typical franchisee is a hands-on manager, with a large vested interest, both economic and emotional, in the success of his or her business. A committed franchisee’s restaurants will often have higher-quality food, superior customer service and higher sales volume. However, care should be taken to choose franchisees carefully. Restricting the number of restaurants that a new franchisee can own is very important, until unit success has been demonstrated. Like most business owners, only some franchisees will have the wherewithal and skill set to become effective multi-unit owners and operators.

• Avoids some of the complexities and liabilities of operating in different states and countries. Local laws and sales taxes can vary widely by state. Compliance with local labor laws can be cumbersome and expensive, and can result in significant liability if not complied with fully. The typical franchise agreement places the burden of understanding and fully complying with local labor and other laws on the franchisee.

• Franchisees often contribute business ideas and experience to the franchisor. Again, the committed franchisee has a substantial vested interest in the success of its franchise and the enterprise as a whole. For that reason, franchisees are incentivized to contribute business ideas and expertise to the franchise. For example, some successful new menu additions, even at large chains such as McDonalds, were developed by their franchisees.

Disadvantages of Franchising
• Legal compliance and disclosure requirements. Businesses that sell franchises are compelled by federal and state laws to provide significant information, by written disclosures, to prospective investors and franchisees, prior to entering into a franchise agreement with the prospect. Complying with these laws can be an expensive and cumbersome process. Franchisors are also typically required to provide audited annual financial statements as part of the disclosure documentation. Financial performance information is sometimes difficult to obtain from franchisees.

• Substandard company stores can be shut down more quickly. If a company-owned store is suffering from substandard management or achieving unacceptable financial results, it can be shut down, or management changed, very quickly. By contrast, “bad” or troublesome franchisees can be difficult to remove from the franchise system, even if the franchise agreement is well-structured. Removal can be a long and expensive legal process, and the reputation of the franchise can suffer in the interim. These risks can be mitigated if the franchisor is disciplined in evaluating and selecting new franchisees, and if the franchisor develops and adheres to a formal removal process involving several cross-functional areas within the enterprise (executive, finance, franchise, operations).

• Less control. Well-structured franchise agreements and detailed franchise operating standards afford the franchisor significant control and protections with respect to the vast majority of the franchisees that comply. However, recognizing that franchisees are independent third parties who own and operate their own stores under agreement with the franchisor, the owner of company stores clearly has greater control over the operation of owned units and its own employees who operate them.

• Increased litigation risks. Franchisees who feel that a franchisor has not treated them fairly (which occurs with increasing frequency if the franchisee’s business is struggling) often resort to litigation for redress of perceived wrongs inflicted by the franchisor. By contrast, the company store owner does not face this same prospective problem.

A Blended Approach - “Hybrids”
A third approach to enterprise growth, referred to here as the “hybrid” approach, has been used with increasing frequency in recent years. Under this approach, the business owner continues to grow the enterprise by adding company-owned units but also franchises units to independent third parties. While the intent is to marry the best of both worlds, hybrid growth is not without its own challenges.

Franchisors who also own company stores can use those units as test kitchens, training facilities and/or demonstration units. Refinements to the processes that make the franchise unique can be tested before rolling them out to franchisees. For example, new computer hardware and point-of-sale systems can be tested before franchisees are required to modify existing systems. The franchisor can also test new menu offerings, recipe changes, and promotional items and specials before decisions are made to implement changes system-wide. These initiatives, conducted at the franchisor’s expense, can save franchisees a substantial amount of money by being proven before rollout.

Notwithstanding the foregoing, franchisees sometimes feel that the franchisor is not paying enough attention to all of the franchisee’s needs if it appears that the franchisor is devoting too much of its energy and resources to operating company stores.

Some franchisees believe that franchisors that operate company stores do so in direct competition with the franchisees. Allegations of unfair competitive practices can occur, for instance, if the franchisor opens and operates company stores at locations in close proximity to franchisees’ places of business.

Choosing the best path for enterprise growth is a multi-faceted decision that is best made in consultation with the business owner’s legal, accounting, tax, marketing and financial advisors.

William V. McRae, III, Esq., an attorney with Chamberlain Hrdlicka White Williams and Aughtry, has practiced law in Atlanta for over 25 years, conducting a diverse transactional practice focused on franchising, business transactions and estate planning. He represents both franchisors and franchisees, and particularly enjoys assisting startup franchisors with the launch of new business brands. For more information, visit www.Chamberlainlaw.com.

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