The new face of franchising

And as [Ned] Levitt notes…”they don’t have the depth of knowledge about that business to really take on the responsibility of all these children called ‘franchisees’ – how to raise them properly and help them make money.”

PROFIT magazine
December 1999 / January 2000

The new face of franchising
From cool concepts to creative financing methods, franchising offers hot new growth opportunities. It might even launch your next competitor
Charise Clark

Think of the symbols that best represent Canada: snow, hockey, bilingual cereal boxes and the maple leaf. Now, add franchising to the list.

Canada is the franchise capital of the world. According to some experts, the sector employs at least one million people and chalks up sales of $100 billion a year. Fully, 1,300 franchisors count nearly 64,000 outlets among their ranks, giving Canada more franchised units per capita than any place on the planet. Another 2,500 units will open this year.

But franchising is not only getting bigger, it’s getting better – and that has implications for all entrepreneurs. Today’s franchise is smarter than ever: a decade of corporate downsizing has injected the sector with thousands of experienced managers looking to run their own firms, and they’re taking advantage of a growing range of franchise concepts. Banks and venture capitalists are creating new financing schemes to fuel faster growth. Recent developments on the legal front promise to bring order to an industry known as much for controversy and dispute as for burgers and fries. Finally, consumers are increasingly driven by brand recognition – which franchises offer in spades. “It’s a wonderful time to be in franchising,” says Richard Cunningham, president of the Canadian Franchise Association.

In the tomorrow-is-too-late economy, that rare capacity for rapid growth and quick branding could make franchising your perfect business model – or the driving force behind your next competitor. To help you pinpoint the best opportunities (or biggest threats), PROFIT brings you the seven hottest trends in franchising.

BEYOND THE BURGER
Fax and printer supplies. Website design. Home healthcare, window cleaning and dollar stores. Growth industries all – and some of Canada’s hottest franchise concepts.

Franchising is fast shedding its fast-food image. Today, franchisors are selling concepts from tutoring and tanning salons to autoparts and casket retail. Canada’s fastest-growing franchise segment: consumer and business services, where the number of units is growing by more than 8% a year – double the rate of the franchise industry as a whole.

Franchisors are tapping the growing demand for help with household chores. Lawn care, maid services and house painting are particularly popular concepts, says Gord Metcalfe, president of Toronto-based Francon Consulting Ltd. Moreover, “They’re far less capital-intensive. Most of them are home-based, which cuts down on your equity requirement.” Whereas you might spend $1 million on a name-brand fast food outlet, you can start a landscaping or house-cleaning franchise on as little as $25,000.

Franchises offering business-to-business services, from accounting to website design, are also multiplying. “Government and big business are outsourcing more,” observes Toronto-based franchise lawyer Ned Levitt. “There are growing opportunities for [franchisors] to come up with a business concept that works.”

LEARNER AND KEENER
Still, foodservice represents 40% of all franchised units in Canada – and fast-food franchisors are fuelling the growth of express take-out concepts, from Tim Hortons drive thrus to spartan McDonald’s outlets with limited seating and menus.

Driving the express movement is more than the desire to profit from crammed consumer schedules. Smaller locations are easier to find than full-sized mall spaces or stand-alone properties. Lower rents or building costs mean reduced overheads. And express locations tend to attract a steadier stream of customers than larger outlets, which see top traffic at meal times.

Caz’s Gourment Fish & Chips is one franchisor that’s reaping the benefits of the express craze. Darrly Singer, vice-president of the Toronto-based firm, compares Caz’s 550-sq.-ft. midtown takeout store with its 2,800-sq.-ft. full-service restaurant in suburban Oakville, Ont. “At the end of the day, the net profit on the [midtown] store is the same as the Oakville store, although the Oakville store does substantially more in sales,” says Singer. “The overhead is that much greater in Oakville.”

BRAND NEW MONEY
Recognizing the rising stability of franchise operators, traditional financiers are creating new plans that make it easier for companies to acquire startup and growth capital.

Even those guardians of the status quo, the big banks, are offering a radical new scheme, lending money secured by cash flow – not hard assets – to existing franchisees in proven systems. “It allows the lender to provide financing for the [new] store based on the cash flow from the existing store plus the potential cash flow that should come from the second store,” says Ian Hamilton, senior manager of national franchising services for Bank of Montreal in Toronto. “It’s financing the good-will value in that first store. This may create much larger multi-unit franchisees in this country, and allow some of the larger systems to expand at a faster pace.”

Venture capitalists also are fuelling expansion. Traditionally, VCs buy equity and seats on the boards of investee firms. That’s never been attractive to the franchise business, where control is already split between the franchisee and franchisor. To increase their appeal, VCs are delivery new alternatives.

McCarvill Corp. of Toronto, for instance, now offers loans based on “gross revenue participation”: the VC purchases a percentage of the company’s gross revenue (say 4%) over a period of time known as the “head” (usually four years), plus a “tail” of about 0.75% for an additional eight years or so. The advantages: no control is relinquished, and the loan appears on the investee’s balance sheet as an asset – prepaid royalties- rather than a liability, making the company more attractive to other investors.

Although McCarvill launched the program in 1996, it has only recently opened it to franchising firms. More than $60 million is invested in 20 companies, including three franchisors and one multi-unit franchisee. Still, only established businesses can access these funds. McCarvill looks for companies that have been in business four to five years and have revenues of at least $8 million. Adds McCarvill vice-president John Eansor: “We put a lot of credence in the operator…strong management that has a demonstrated track record.”

What a budding franchisee to do? Caz’s Gourment Fish & Chips recently unveiled its “managing partner concept” to help expand its six-unit system by 50 locations over the next seven years. Adapted from a practice common among drugstore chains, the plan sees Caz’s buy a 51% interest in a new franchise – and pay half the startup costs – in return for 35% of profits for the duration of the franchise agreement.

Caz’s Singer says the MPC appeals to three types of potential franchisees: investors who don’t actually want to run the day-to-day operations of their franchise; those who lack the initial equity required for traditional franchises; and gun-shy purchasers worried about “getting screwed” by the franchisor. Singer says MPC is a win-wing proposition: “A franchise system will not work unless everyone is making money. We believe that from both an ethical and a business point of view.”

BRAND BUDDIES
More and more, franchisors are turning to their biggest strength – brand – to boost revenues. “Co-branding” is diversification, plain and simple: by merging two concepts under the same roof, a franchisor can overcome saturated markets and cut the risk of selling a single product.

One type of co-branding involves buying or launching a new product that shares the same corporate infrastructure as the franchisor’s existing concept; however, the products are not necessarily complementary or offered through the same storefronts. Calgary-based Comac Food Group offers a perfect example: to supplement its flagship GrabbaJabba coffeehouses, in 1997 Comac acquired the Canadian franchisor rights to Domino’s Pizza. “Merger and acquisition activity in franchising is very much on the rise,” says Toronto franchise lawyer John Sotos. “When you have a mature industry, there are a lot of synergies in complementary systems buying each other out so that they can share real estate and a lot of overhead costs.”

Another co-branding strategy sees two franchisors placing their locations side by side, if not selling each other’s products. The idea, of course, is to broaden the appeal of a franchisee through a wider range of products, plus gain brand exposure in locales where the franchisor is shut out.

Under one such arrangement, Yogen Fruz World-Wide Inc. of Markham, Ont. had its frozen yogurt sold through Country Style Donuts outlets, while some of Yogen Fruz’s office-tower food-court locations sold coffee and doughnuts from the Thornhill, Ont. –based company. “The thinking behind it was to extend our appeal, to have some additional business done early in the morning,” says Gerry Gordon, director of franchising and retail development for Yogen Fruz.

While the five-year experiment recently came to an end – Gordon says the food costs were too high – he insists the program was very successful. “It did for us what we wanted it to do,” Gordon explains. “It gave Yogen Fruz more representation in other outlets and raised our profile.”

LAW & ORDER PAPERS
If one thing plagues the franchising industry, it’s a reputation for sheltering unscrupulous franchisors who dupe franchisees into signing unfair and unprofitable contracts. And there’s not much to stop them. Only in Alberta are franchisors required to disclose their financial positions or the success of their franchisees. Franchise agreements can vary wildly, even within the same chain. Without he knowledge required to assess such agreements, untold franchisees are locked into bad deals that often result in them surrendering their businesses to the franchisors that sold them.

“The distortion between truth and reality in some cases is total,” says Sotos. “And that’s where regulation, which tends to eliminate the most obnoxious players, is helpful.”

Players on both sides of the franchising fence have been calling for legislation for decades. Progress has been slow, for the most Canadian of reasons: although a franchisor might operate across the country, legislation falls under provincial purview. At present, Alberta is the only province with legislation specifically devoted to franchising – a situation, by the way, that some have blamed for slowing the growth of franchising in that province.

But recently proposed legislation in Ontario – which is home to 56% of the country’s franchisors – could make the franchise sector a safer place to do business right across the country.

In December 1998, the Ontario government introduced Bill 93, its own franchise-governance proposals. The legislation provided for disclosure requirements for franchisors, demanded “fair dealing” on both sides in a franchise agreement, and gave the right of association to franchisees, who are often discouraged – or penalized – by franchisors for joining franchisee groups. A spring election call nixed the bill for now, but experts believe franchise legislation in Ontario – and elsewhere – is inevitable. “I know the interprovincial committee of commercial relations ministers has looked at franchising regulation,” says Sotos. “But I think everybody is looking to Ontario to take the lead.”

THE COMING OF COMPROMISE
In the absence of franchising legislation, Canada is seeing rampant litigation. Franchisees now bring some 5,000 lawsuits against franchisors each year – in Ontario alone. The presence of a small number of ill-intentioned franchisors only partly explains the level of conflict. Today’s better-educated franchisee is less likely to tolerate a crippling business arrangement. And as Levitt notes, growing numbers of well-meaning companies, pressured to expand, are franchising before they’re ready: “they don’t have the depth of knowledge about that business to really take on the responsibility of all these children called ‘franchisees’ – how to raise them properly and help them make money.”

However, more parties are using mediation to solve their problems. “Mediation is a growing trend in franchise disputes,” says Levitt, “since litigation is do damned expensive.”

While franchisees have the most to gain from the lower costs of mediation, franchisors like it, too. Ken Fong, vice-president and corporate counsel for McDonald’s Restaurant of Canada Ltd., points out that even if mediation doesn’t work out, it often leads to direct negotiation later. “ It’s a win-win for both sides,” says Fong. “It allows for creative solutions.”

CIVIL ACTIONS
Even with mediation, says Les Stewart, founder of the Canadian Association of Franchise Operators, the balance of power lies with franchisors. “Franchisors will mediate only if it’s in their interest to mediate,” says the former Nutrilawn franchisee. But another option in emerging: class proceedings acts in Ontario, B.C. and Quebec mean franchisees can launch class action suits. An extreme measure, for sure, but one that could rock the industry.

Class actions are valid only when the complaint is systemic, such as when a franchisor overcharges all its franchisees for supplies. While class actions let franchisees share legal costs, they’re all downside for the franchisors: lose a class action suit, and you have to settle with all participating franchisees. Canada has seen two franchisee-related class action suits so far – and, says Sotos, “There will be more.”

The rise of mediation and class action are just two indications that franchising is finally growing up. Not willing to settle for second-class business status, franchisors and franchisees alike are moving to give their industry more credibility – and greater profit potential.


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