The restaurant sector is seemingly still growing through franchise development, and every year more franchise companies are coming online. Unfortunately, many operators who think they are ready to franchise fall short. After all, a single-unit operation may be wildly successful, but that doesn’t mean it is ready to be franchised or expanded.
For those not properly prepared, unforeseen problems will occur. In fact, numerous franchise systems have failed in their infancy because concept testing and proper organization were not in place. The result? Franchisees who think they are getting in on a ‘ground floor’ opportunity in a start-up situation can lose their money and take their franchisors down in the litigation that follows. Those who want to franchise and stay in business need to effectively assess their operations prior to developing a franchise model and ensure they are ready for the road ahead.
While our consulting firm, Toronto’s FHG International, enjoys working with successful operators who look to business format franchising to expand their operations, we need them to meet certain minimum requirements prior to setting up a franchise system. The standards set out below will help operators determine if they are truly ready to franchise their restaurants.
Corporate units
A single-unit operation is not a sufficient model upon which to build a franchise system. An operator needs to ensure the business venture has ‘legs’ in many different markets. We recommend prospective franchisors operate at least three units for a minimum of one year each. Ideally, an operator considering franchising should have several years experience in the business as well. The franchisor, not the franchisee, needs to be the one taking the risk to develop and roll out a concept. If all three units are running successfully for more than a year — and if at least two of the operations show year-over-year sales growth — that would be an indicator of success.
And, while there are some lawyers who can help franchise a single operation, the operator will likely be liable if franchisees are unsuccessful and the concept isn’t proven in the marketplace.
Financial success
Success is defined in a number of ways. When looking at developing a franchise system ensure the business can support the franchisee, the royalty and the operation stream.
First, when we look at restaurants ready to franchise, we ensure the corporate stores are earning at least 15-per-cent Operating Profit or Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA). The average industry EBITDA is only 9.8 per cent (give or take a little, depending on the year). Therefore, corporate stores need to perform very well. The 15-per-cent EBITDA ensures that after a franchise fee of five per cent is paid, the franchisee has 10 per cent to cover interest, tax, depreciation and amortization and a little to compensate for the risk associated with working in the restaurant business.
Next, we look for year-over-year sales growth that is above inflation; a good concept will generate year-over-year increases, suggesting that customer counts are up and the average check amount is growing.
We also review return on investment. Given the high risk of the restaurant business, it’s advisable that investors (franchisees) get their investment back in three to four years. Therefore, we review the actual costs of building the three or more initial units and compare that price to the 10-per-cent anticipated EBITDA to determine if the franchisee can achieve this return.
Walk-about
The walk-about is crucial in determining where the system is at in terms of execution. In the walk-about, we take a critical look at every aspect of the restaurant, including the location visibility, access and egress, design, signage, cleanliness, restroom maintenance, receiving and storage practices, upkeep, flow, menu quality and other strategic aspects of the business operators no longer see as a problem. Any areas that are determined to be weak must be improved prior to the system rollout.
Trademarks and registrations
The prospective franchisor must be sure to own the name of the restaurant and company and have both protected through trademark registrations. We have seen restaurant operators who realized after the fact that they did not own the name of the company. In some cases, other restaurant owners owned the name, and the franchisor had to pay fees to cover the damages and change their brand identification. Franchisees will not be pleased if, after they purchase a franchise, they realize the name of the company is not controlled by their franchisor.
Documentation
We speak with many operators who have little, if any, operational documentation. This operating information is shared through comprehensive operation manuals, employee handbooks, standard costed recipes, local store marketing manuals, detailed training materials and strong branding and marketing plans. It should be quality information since it provides franchisees with valuable tools they have a right to expect, it reduces training time, it ensures costing and control, and it provides the franchisor with a level of litigation bullet-proofing. An expert in operations should review these documents to ensure all aspects of operations and management are covered.
Agreements
Once the business is ready to franchise, a reputable and experienced franchise lawyer must draft the remaining legal documents, including a franchise agreement, a disclosure document (required in five provinces and under review in a sixth), a variety of guarantees as well as leases and side agreements.
Overall, franchising takes time and doesn’t guarantee a road to riches, but it’s a great way to expand a business that has a sound financial model.
Fisher can be reached at (416) 489-6996, at [email protected] or at fhgi.com.
