Unraveling the Growing Complexity of Franchising Is No Simple Matter

This article originally appeared on Forbes.com.

An Explosion of Uses for the Model

The franchise model has been steadily expanding to include new entrants from various categories in business, the medical profession, financial services, and even the nonprofit sector. As each of these segments forays into the franchise arena, they bring the underlying complexities of their industries with them, providing new issues and challenges for the franchise model to experience, including: billing insurance companies and the government, obtaining various certifications and licensing requirements, and overcoming an extremely limited if not absent knowledge of the franchise model. Who is guiding these pioneers into franchising with strong, factual, and competent advice? As highlighted in the recent Entrepreneur Magazine article Can Colleges Teach People How to Franchise?, the presence of substantive education on the franchise model is virtually non-existent in the halls of academia. And sadly, many academics are ignorant of the differences, as evidenced by the comment from Timothy Baldwin from Indiana University in the article, Franchise Ownership or Management is Fundamentally No Different Than Other Forms of Management Leadership. If this were true we would not be seeing franchise failures from corporate leaders or financial firms that move into franchising. Thus, new entrants to the franchise community are generally relegated to a wide range of consultants sharing their experience and/or an attorney providing legal input. Will this be sufficient to prepare them for the challenges ahead?

New Segments Bring New Challenges

The ranks of franchisors have been growing steadily, with more than 300 new concepts a year entering the U.S. market since 2011, according to a recent Frandata report. While many of the entrants are “me too's,'” there are a growing number of new segments evolving, such as in the healthcare arena. While hamburgers and hotels have their own operational issues, medical billing for insurance reimbursement is a whole different level of complexity and certainly one the average franchisee candidate knows little or nothing about. “We realized for us to be successful using the franchise model we would need to provide a much richer onboarding process,” said HealthSource CEO Dr. Chris Tomshack. A new Healthsource franchisee must complete five weeks of pre-training before they are scheduled for the three-week onsite initial training program, and that's just to get them up and running. “We don't even allow franchisees to do their own billing for insurance until they reach $450,000 in revenues, then we take full responsibility for ensuring they are proficient before turning them loose.” Unless HealthSource could architect an effective path through this complexity, they would fail to extract maximum value from using the franchise model to expand their concept. Clearly, they have figured it out, now approaching 300 locations on board with steady year-on-year growth. Yet it's hard to imagine what questions remain to be answered.

The Lagging Legal and Regulatory Activities

It is generally understood that our legal and regulatory systems are lagging indicators of what's actually going on in society, and unfortunately, they tend to address only the problems that occur, often not providing long-term and efficacious solutions. As franchising expands into new arenas, there is little in the way of guideposts to frame the conversation regarding patient rights, confidentiality of financial records, privity of knowledge, and numerous other critical aspects of the growing segment-focused issues as they cascade through the franchise network. When the ranks of “franchisees” are growing with physicians, nurses, wealth managers, and other highly licensed and regulated individuals, it will certainly test the known bounds of franchising. Intersect this with the paucity of knowledge the courts, regulators, and many budding franchisors know about the franchise model and it may well be a recipe for some new and potentially significant issues, if not direct regulatory activity. Given the critically divergent goals the parties bring to a franchise agreement, we can anticipate some shift in the balance of the relationships.

The Shifting Goals of Franchisees

While I'm sure there are still plenty of individuals who buy a franchise in order to replace their corporate vocations, increasingly we are seeing a broader set of goals emerging. The influx of significant financial organizations into franchising is tipping the balance towards an investor model that looks surprisingly like a mini-franchisor. In fact, in some systems franchisees are becoming more powerful than the franchisor in terms of gross revenues, impact in the market, supply chain management, and even in their influence on the rest of the network. Keep in mind the franchisee keeps 90-plus percent of the revenue generated while the franchisor only draws a small percentage off the top, allowing them many multi-unit operators to amass strong treasure chests for expansion, whether within their native brand or with complimentary brands in the same market. When the franchisee is a private equity firm, there is little doubt their goals do not mirror those single-unit franchisees within the network. This level of influence could have a dramatic impact on the focus of the franchisor, with a ripple effect on support, marketing, training, and the other key pillars that underpin most franchise companies as franchisor goals move decidedly towards increasing overall valuations.

Valuation of Franchise Assets

Over the past decade the value of franchisors has been on the rise, with the clearest indicator being the higher and higher multiples of earnings being paid to acquire them. According to Bret Lowell at DLA Piper, a law firm deeply entrenched in this space, the current marketplace is a feeding frenzy. “There just aren't enough franchisors out there willing to sell. Thus, those that are for sale command a premium, which is driving up valuations. This shortage is also causing buyers to seek multiple-unit franchisees, and not just franchisors, to acquire.” As Bret states, the evidence of late indicates this appetite for acquisition is expanding into the franchisee ranks, with some significant multi-unit franchisee deals with strong values hitting the market. This should bode well for the myriad of aging “baby boomer” franchise owners increasingly thinking about liquidity. Whether a larger franchisee in their brand aggregating the space, or in a roll-up deal through a franchisor acquisition, it appears the valuations are increasing across the board. So how does one prepare to maximize the value of their franchise? I would suggest keeping Warren Buffet's comments in mind, "It's far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Simply put, making sure you are considered a “wonderful company” when the suitors come a callin' should be a top priority.

Simplification is a Pipe Dream

For decades franchising has been thought of as a simple model for rapid expansion using other people's money. The model today is anything but simple, given the expanding state regulatory penchant and the increase in new segments entering the arena and bringing in new challenges. Rapid expansion may be elusive given the exponential growth in the number of concepts on the market today versus just a few years ago. And the money coming into the market by individuals is increasingly being supplanted by Wall Street firms and middle market investors with significantly different goals. I'm afraid the “simple” train has left the station and isn't coming back anytime soon. The spotlight on the seemingly overnight success of a wide variety of concepts using the model successfully in the past will continue to draw me too's and a wider variety of new entrants that will test the known limits of the model as we know it today. This is an exciting time for true entrepreneurs, but anyone who expects a simple experience in franchising in the days ahead should be prepared for disappointment.