Should your system refranchise? Here's the case against it
Over the last five years we have seen a proliferation of franchisors selling their corporate stores, which we commonly call “refranchising.” We have not seen many franchisors acquiring franchisee stores. This is a change from 10 years ago, when franchisors were anxious to re-acquire territories that were not being developed. Such active participation by franchisors seems to have waned.
There are exceptions; we have some successful franchise companies looking to acquire franchisee stores by exercising their right of first refusal or just acquiring outright. We also have seen franchisors acquiring troubled stores within their system to resolve franchisee issues.
There have been other interesting scenarios such as Burger King selling its right of first refusal in 20 states to Carrols Corp. In effect, the Burger King sale is a hybrid of refranchising. I think the term for this should be “substitute franchising.”
The earnings effect that refranchising provides to the franchisor is wonderful but short-lived. Because of the way the accounting rules work, corporate store sales are not extraordinary transactions but are sales of franchise rights in the ordinary course of business and result in a boost to revenue and earnings for the franchisor. This was the case for Applebee’s between 2010 and 2011. We also saw the same revenue boost for Jack in the Box and Yum Brands, which, in the subsequent years, saw double-digit or high-single-digit declines in corporate food service revenue, mainly as a result of a lack of refranchising.
What can be gleaned from these situations? Why should we be cautious of refranchising? Can a good case be built against refranchising? We advise you think hard before you get into an active refranchising program. Consider the following:
1. Short-Term Boost. Refranchising is a great short-term way to boost revenue and increase royalty flow. The problem is the increase is only short term because once that revenue boost has occurred, the royalties (which are never going to equal the revenue from the sale) are going to be depressed. Following the refranchising process, the ways to increase revenue are to increase the royalty income by higher same store sales, an increase in royalty rates, or new store openings. In today’s market, most franchise systems are experiencing flat same store sales, increasing royalty rates is very suspect because franchisees already feel the royalty rate is too high, and new store development for mature systems is slow.
2. No Proving Ground. Owning corporate stores is a valuable tool in successful chains. Corporate stores serve as a proving ground for new concepts, products, prototypes and remodels. In general, corporate stores serve as a way the franchisor can test new ideas and expenditures prior to rolling out a program to the franchise community. Always remember, the franchisee community is very suspect of changes until they see that the capital expenditures and changes will result in profitability and return on investment.
3. Partnership Perils. Franchisees like to have their franchisor side by side with them by owning and operating businesses versus just collecting royalties. A symbiotic relationship is created when the franchisee knows the franchisor has operational skin in the game.
4. Area Development Opps. Holding corporate stores in select areas may create opportunities to quickly develop various geographic areas and then, once these areas are developed, may create an even better strategy for selling to a well-funded franchisee.
5. Time and Effort. A refranchising process is time-consuming and can create a number of issues. Many times refranchising happens because the company has too much debt and needs to pay it down. This certainly was the case with DineEquity, where refranchising was made necessary by a high debt load. This trap is dangerous and can distort the operational decision for refranchising.
6. Talent Pool. A franchisor with corporate stores can develop a pool of strong operational talent that can be made available to the franchisees for development and growth of their stores.
7. Conflicts Inherent. The franchisor’s sale of corporate units to the franchisee community creates an inherent conflict. Franchisors look to get the highest sale multiple from the franchisee, and the higher price may result in more debt by the acquiring franchisee or just more capital investment. That in turn generates a lower rate of return on investment.
These are some of the reasons for holding corporate stores and not getting caught up in the refranchising game. I often hear from franchise executives and franchise lawyers that franchising is one type of business and corporate store operation is another type of business. I disagree. They are both businesses using the same concept. The key is the concept and utilizing all of its value.
What is a good mix of corporate stores to franchised stores? I have spoken with many franchisors, and there is no consensus. In my opinion, a good mix and one that reflects a vital system is somewhere in the neighborhood of 70 percent franchise stores to 30 percent corporate stores. While this is just my opinion, it is important to have enough corporate stores in essential markets to effectively understand the operational challenges and contribute to the process of growing profitability at the unit level.
Do not jump into an active refranchising program without careful thought. The key is to judiciously use refranchising to seed markets and help attract new franchisees that need a base from which to grow operating stores.
Dennis L. Monroe is a shareholder and chairman of Monroe Moxness Berg, a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation. He can be reached at email@example.com.