How Franchising Can Increase Profit Margins by Creating High-Margin, Recurring Revenue

For many successful business owners, growth eventually presents a difficult question.  How do you expand the company without continually increasing the amount of capital, overhead, management, and risk required to operate it?  Time, People or Money tend to be at the top of the list as obstacles for growth.

 

Traditional expansion typically means opening additional company-owned locations. The business owner funds new locations, purchases equipment, hires employees, signs leases, manages payroll, carries inventory, oversees local operations, and assumes the financial risk associated with each new unit.

 

Franchising changes that equation and can turn a traditionally non-scalable business into one that is inherently scaling through selling the business formula to third parties.

 

Instead of the parent company supplying virtually all of the capital required for expansion, qualified franchisees invest their own capital to establish and operate locations under the franchisor’s brand and operating system. In exchange, the franchisor typically receives an initial franchise fee and ongoing royalties, along with potentially other properly disclosed system revenues.

 

The result can be an attractive economic model through a growing network of independently owned businesses producing recurring revenue for the franchisor without requiring the franchisor to bear all of the operating costs associated with owning every location.

 

When structured and managed properly, this can create some of the most valuable characteristics of a franchise business: recurring revenue, scalability, reduced capital requirements, and potentially higher margins at the franchisor level.

 

The Economics of Traditional Business Expansion

Consider a successful business with one location generating $1.5 million in annual revenue.

 

The owner wants to grow to 20 locations.

 

With traditional corporate expansion, the company may need to fund each new location. Depending on the business, that could involve hundreds of thousands—or even millions—of dollars for real estate, leasehold improvements, equipment, inventory, technology, vehicles, hiring, training, marketing, and working capital.

 

The company also assumes the ongoing expenses.

 

Every new corporate location can mean additional:

• Payroll and benefits
• Rent and occupancy expenses
• Utilities
• Insurance
• Inventory and cost of goods
• Local management
• Equipment maintenance
• Marketing expenses
• Employee recruiting and turnover
• Workers’ compensation exposure
• Operational supervision
• Working-capital requirements

 

A company may grow from $1.5 million to $30 million in revenue and discover that its corporate overhead and operating expenses have grown dramatically at the same time.

 

More revenue does not automatically mean better margins.

 

Franchising creates an alternative approach.

 

Franchisees Supply the Capital for Unit-Level Expansion

One of the fundamental economic advantages of franchising is that the franchisee generally provides the capital necessary to establish the franchised business.

 

Rather than the franchisor investing its own money to open every location, the franchisee typically pays for the costs associated with opening and operating its unit.

 

The franchisee may fund the lease, construction, equipment, vehicles, inventory, employees, local marketing and working capital.

 

The franchisor provides something different, its brand, operating system, intellectual property, training, support, marketing resources, purchasing relationships, technology and accumulated business knowledge which creates leverage and the ability to grow much more rapidly and efficiently than a traditional growth model.

 

The franchisor can potentially expand into 10, 50 or 100 markets without making the same capital investment that would have been necessary to open 10, 50 or 100 company-owned locations.

 

That difference is central to the financial power of franchising.

 

Royalties Create Recurring Revenue

The royalty is typically the foundation of the franchisor’s long-term revenue model.

 

A franchise agreement might, for example, require a franchisee to pay a royalty equal to 6% of Gross Sales.

 

If a franchise location generates $1 million in annual Gross Sales, a 6% royalty would generate:

$60,000 in annual royalty revenue for the franchisor.

 

If the system grows to 10 similarly performing locations, that would represent $600,000 in annual royalty revenue.

 

At 50 locations, it would represent $3 million.

 

At 100 locations, it would represent $6 million.

 

These figures are illustrations, not predictions of what a particular franchise system will achieve. Actual franchisee sales and franchisor economics vary substantially.

 

The important point is the structure of the revenue.

 

The franchisor generally does not incur all of the expenses required to generate the franchisee’s $1 million in sales. The franchisee is operating its own business and paying its own unit-level expenses.

 

That can make royalty revenue fundamentally different from revenue generated by a company-owned location.

 

Why Royalty Revenue Can Have Attractive Margins

Suppose a company-owned restaurant generates $1 million in sales.

 

Before the owner realizes a profit, the business may have to pay food costs, hourly labor, management salaries, rent, utilities, credit-card fees, insurance, repairs, local marketing and numerous other operating expenses.

 

A franchisor receiving a royalty based on that restaurant’s sales has a very different expense structure.

 

The franchisor certainly has expenses. A responsible franchise organization needs people and infrastructure to provide training, franchisee support, compliance, operations assistance, technology, accounting, marketing administration, franchise development and system leadership.

 

But the franchisor generally isn’t paying every unit’s cooks, technicians, drivers, store managers, rent or inventory.

 

As the system expands, therefore, additional royalty revenue may be capable of growing faster than certain categories of franchisor overhead.

 

That creates the possibility of operating leverage.

 

The first few franchisees may actually be expensive to support because the franchisor must build infrastructure before significant royalty revenue exists. But as the network becomes larger, portions of that infrastructure can potentially support more franchisees without increasing proportionately with every new unit.

 

Recurring Revenue Changes the Business Model

The recurring nature of royalties is particularly important.

 

An initial franchise fee is generally received when a new franchise is sold. It can help compensate the franchisor for activities associated with establishing and supporting a new franchise relationship, but it should not be viewed as the primary economic engine of a healthy franchise organization.

 

The stronger long-term objective is usually is to build successful franchise locations that generate sustainable sales, which in turn generate sustainable royalty revenue.

 

That aligns the interests of franchisor and franchisee.

 

If franchisees succeed, remain in business, open additional locations and grow their sales, the franchisor’s recurring revenue can grow with them.

 

Instead of continually needing to make another one-time sale to generate revenue, the franchisor develops a base of recurring contractual relationships.

 

A system with 100 healthy franchisees can enter a new year with an established network already operating and generating system revenue.

 

That recurring-revenue characteristic can make a mature franchise organization economically very different from the original standalone business.

 

Franchise System Revenue Can Extend Beyond Royalties

Royalties are only one potential source of franchise-system revenue.

 

Depending upon the business model and the disclosures and agreements governing the franchise relationship, a franchisor or its affiliates may potentially generate revenue from other sources.

 

These could include technology services, training, products, equipment, distribution, proprietary products, supplier arrangements, licensing, administrative services, call centers, centralized marketing services or other system programs.

 

The exact structure varies tremendously by franchise system.

 

For example, a franchisor with proprietary software might provide its technology platform to franchisees for a monthly fee. A product-based franchise system might earn revenue from supplying proprietary products. Another system might provide optional centralized services that franchisees elect to purchase.

 

These additional revenue streams can potentially make the franchise platform more economically diverse.

 

However, franchisors should not simply invent fees for the purpose of extracting additional money from franchisees. Fees, required purchases, supplier relationships, rebates and other economic arrangements can create significant disclosure and relationship issues and should be structured with franchise counsel.

 

A strong franchise model should create value for both sides of the relationship.

 

The Power of Scale

The financial impact becomes increasingly apparent as the franchise network expands.

 

Imagine a system eventually reaches 75 franchised locations.

 

If those locations collectively generate $75 million in annual systemwide sales and the franchisor receives a hypothetical 6% royalty on those sales, the resulting royalty stream would be:

$4.5 million annually.

 

Again, this is simply an illustration.

 

Now consider what the franchisor did not necessarily have to finance to produce $75 million of franchisee sales.

 

The franchisees may have collectively invested tens of millions of dollars in locations, equipment, vehicles, inventory, employees and working capital.

 

The franchisor leveraged its brand and business system across that independently funded network.

 

That is one of franchising’s most compelling economic characteristics.

 

Franchising Can Improve Return on Invested Capital

Profit margin is only part of the story.

 

Franchising can also dramatically change the amount of capital required to generate growth.

 

Imagine two companies each develop 20 new locations.

 

Company A owns all 20.

 

Company B franchises all 20.

 

Company A may need significant capital for each opening and then continue carrying the assets and liabilities associated with those businesses.

 

Company B primarily invests in the infrastructure necessary to recruit, train, launch and support franchisees.

 

Even if Company A generates more top-line corporate revenue because it recognizes the full sales of every location, Company B may have substantially less capital tied up in unit-level operations.

 

This is why evaluating a franchise strategy solely on corporate revenue can be misleading.

 

The more important measures may include:

• Recurring royalty revenue
• Franchisor operating margin
• Free cash flow
• Capital required for expansion
• Franchisee retention
• Unit-level economics
• Systemwide sales growth
• Return on invested capital

 

A franchise system can sometimes create considerable enterprise value without owning most of the locations carrying its brand.

 

Franchisees Also Bring Entrepreneurial Energy

There is another economic advantage that doesn’t appear immediately on a financial statement.

 

Franchisees have their own capital invested in their businesses.

 

A strong franchisee is not simply another location manager collecting a salary. The franchisee has a direct financial interest in controlling expenses, developing customers, building local relationships and increasing sales.

 

That entrepreneurial motivation can be extremely powerful.

 

The franchisor combines centralized brand strategy, systems and support with local business ownership.

 

When that relationship works well, the franchisor provides the platform while franchisees provide local execution and entrepreneurship.

 

High-Margin Does Not Mean Cost-Free

There is an important qualification.

 

Franchising should never be viewed as free money.

 

A franchisor has real responsibilities and real expenses.

 

It must build the franchise infrastructure, prepare appropriate legal documents, develop training programs, establish operational systems, protect trademarks, recruit qualified franchisees, assist with openings, monitor standards and provide the support promised in its franchise agreements.

 

As the system grows, the franchisor may need additional field support personnel, trainers, technology, accounting resources, marketing personnel and management.

 

A poorly capitalized franchisor that sells franchises without investing in franchisee support can damage both the franchisees and the brand.

 

The objective therefore isn’t to maximize the margin on every royalty dollar by minimizing support.

 

The objective is to build an efficient support organization that helps franchisees build stronger businesses while allowing the franchisor’s infrastructure to scale efficiently.

 

The Real Financial Engine Is Franchisee Success

This leads to perhaps the most important principle in franchise economics.

 

A franchisor becomes more valuable by helping franchisees become successful—not simply by selling more franchises.

 

A franchisee who opens, struggles and closes may produce an initial franchise fee but little long-term royalty revenue.

 

A franchisee who operates successfully for 10 or 20 years can potentially produce years of recurring royalties while strengthening the brand, referring other franchise candidates and potentially developing additional locations.

 

Consider the difference.

 

A $40,000 initial franchise fee is received once.

 

A franchise producing $60,000 in annual royalties for 10 years would produce $600,000 in gross royalty revenue over that period before considering expenses, changes in sales or other factors.

 

This is why sophisticated franchisors focus so intensely on unit-level economics.

 

The economics of the franchisor ultimately depend upon the economics of its franchisees.

 

Turning a Business Into a Scalable Platform

The most significant financial transformation that occurs through franchising is conceptual.

 

The original entrepreneur starts with a business that sells a product or service.

 

After developing a successful franchise system, the entrepreneur may own something much broader:

a platform through which independent business owners deploy capital and operate businesses under a common brand and system.

 

That platform can generate recurring royalty revenue across numerous markets.

 

A local business may therefore evolve into a regional or national organization without the founder personally financing every new location.

 

The company transitions from asking:

 

to asking:

 

That is a fundamentally different growth constraint.

 

Building Long-Term Enterprise Value Through Franchising

The ultimate attraction of franchising isn’t simply collecting franchise fees.

 

It is the potential to create a scalable recurring-revenue organization.

 

When properly structured, franchising can allow a company to expand using franchisee capital, reduce the amount of corporate capital required for unit-level growth, establish recurring royalty streams, add appropriate system revenues and leverage centralized infrastructure across an expanding network.

 

That combination can create attractive margins and potentially significant enterprise value.

 

But the sequence matters.

 

The business must first have strong unit economics. Then the franchise model must be structured properly. Franchisees must be selected carefully. Training and support must work. The franchisor must invest in infrastructure. Franchisees must have a reasonable opportunity to build healthy businesses.

 

When those pieces come together, the financial model becomes powerful:

 

Franchisees invest in and operate individual businesses. The franchisor invests in and grows the system.

 

Each additional successful franchise adds another location to the brand, another entrepreneur to the organization, another source of systemwide sales and another potential stream of recurring royalty revenue.

 

That is why franchising can be such an effective strategy for transforming a successful business into a scalable enterprise—and why recurring, potentially high-margin franchise-system revenue can become one of the most valuable financial characteristics of a well-developed franchise organization.

 

For more information on the franchise model and how to franchise your business, contact Franchise Marketing Systems:  www.FMSFranchise.com