What Makes Franchising a Good Investment?

Franchising is comprised of several entities to create a successful network. Typically, it includes franchisees (The owner of the franchise or Investor), the franchisor (The owner of the brand or intellectual property being licensed), and Suppliers to the franchise (Those supporting entities acting as vendors to the franchise system). In a well-oiled franchise, all three parties benefit and thrive from their involvement in the franchise network. Ray Kroc called the McDonald’s (MCD) franchise a three-legged stool which depended on these three entities to keep standing up. Generally, the franchise model offers potential investors in any one of these entities significant potential returns compounded with higher degrees of success at the operating unit level.

How so? From the franchisee’s perspective, the math is simple. First, franchised businesses are considerably less risky from a new business start-up standpoint and therefore are offered aggressive funding options that a traditional start up would not have available. Second, a solid franchise platform offers validation and consistent business practices which increase the likelihood that the new business works. Third, franchises are typically designed to offer a franchisee an ROI in a certain number of years depending on the business, if a franchise has proven it’s system, an investor should have details analytics, existing financial data and franchisees to build their business plan from. Finally, franchisees benefit from economies of scale on the marketing and supply side of the business where the group should be leveraging supplier and advertising discounts and scale as a franchise.

From the Franchisor’s perspective, the franchise system offers significant investment gains. First, the franchisee makes the investment in capital to open the new locations allowing the franchisor to keep a relatively lean and debt-free financial structure in place while growing the brand into new markets. Second, the franchisee acts as the local owner operator who has invested in the business and takes on the owner-operator role at the local level which in turn drastically reduces operating expenses and increases unit level performance. Third, the franchisor is provided a higher valuation based on EBITDA as franchise systems with consistent revenue and unit growth will be valued at 8-12X EBITDA which creates exit strategy opportunities. Finally, the franchise model allows for rapid scalability of businesses that traditionally might not be scalable.

From the vendors and suppliers to the franchisor’s perspective, franchising offers significant returns on their investment. First, due to the nature of franchising and rapid expansion of a network, exclusive vendors benefit from the expansion of the network and additional customers to their portfolio with each new unit. Second, franchising is a business of consistency and operating controls, elements such as vendors are not allowed to be changed or altered, so in effect, the vendor has a low likelihood of being swapped out or losing the account if they provide good service and keep a positive relationship with the franchisor. Third, because the supplier is working with a group of buyers who all operate using the same business model and operating systems, there is less customization for each customer allowing for better margins and lower operating expenses.

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