Outside Insights | July 2014 | By Guest Author

Prospering Over the Long Term

How embracing and optimizing unit economics can create investment grade franchises.
Quick service restaurant franchisees prepare FDDs with unit economics in mind.
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For years, the two most important words in franchising—for both franchisors and franchisees—have been unit economics. The success or failure of a franchise concept can pivot off of how well unit economics are tracked, managed, and improved. Yet many franchisors and franchisees alike pay inadequate attention to, or ignore altogether, perhaps the most effective way to identify and exploit the chief levers for driving profitability at the franchise unit level.

There are steps franchises can take to more fully embrace and optimize the principles of unit economics and lift their concepts to what we call an “investment grade franchise.” When a franchise loses sight of the importance of unit economics, it does so at its long-term peril. While many concepts can grow and even thrive in the short term while turning a blurred or blind eye to unit economics, their disregard can often lead to a very unhealthy and dysfunctional franchise over time.

Let’s begin with an understanding of what “unit economics” means. Broadly speaking, unit economics for a franchise is a means by which franchisors and franchisees identify, measure, track, manage, and improve the performance and profitability of a franchise at the unit level. Applying the principles of unit economics is effectively an exercise in managerial or cost accounting, as well as the application of correlation analysis to identify the key drivers—often referred to as key performance indicators, or “KPIs”—that determine whether a franchise unit will be able to achieve an acceptable profitability level.

Clearly, different franchise sectors will look at different drivers and, in fact, franchises within the same sector may look at completely dissimilar metrics. Nevertheless, what differentiates the best franchises from the rest of the pack are the steps they take to fully leverage that information. These “investment grade” franchises are much more likely to thrive for the long term.

Steps toward building an “investment grade” franchise

1. Identify key performance indicators

Key performance indicators are often viewed as the Holy Grail of unit economics. Many franchisors speak about them with a hushed reverence that often masks an incomplete understanding about how to determine the most predictive and meaningful KPIs. Your business is unique, and if you select the wrong KPIs you likely may have put yourself in a worse position than if you had never done anything.

When a franchise loses sight of the importance of unit economics, it does so at its long-term peril.

For that reason, you need to avoid templates—off-the-shelf products that are not customizable for your business—and do the hard work of isolating the key measures that drive the performance and profitability of your business. 

2. Track, manage, and improve your KPIs

Of course, all of that hard work will be for naught if you cannot effectively gather the data from your franchisees. And, generally, you cannot collect all necessary data through a point-of-sale (POS) system, particularly if you’re trying to build a full P&L statement. While data from a robust, uniform, and compatible POS system is better than nothing, it’s the poor man’s substitute for a full, nimble, and customizable KPI platform/dashboard that captures the salient metrics that you need from franchisees.

Accordingly, your most important task, before you even begin your KPI project, is to get buy-in from franchisees to provide timely and accurate information. And don’t be overly concerned about getting 100 percent franchisee participation at the outset; that’s probably not a realistic goal, and you can realize many of the benefits we describe here with less than full initial involvement from franchisees.

What’s the best way to secure franchisee buy-in? Make it relatively easy on your franchisees and don’t lock the KPIs in a safe at corporate headquarters.

3. Share information about your KPIs

The best, most franchisee-centric concepts share their KPI dashboards on a regular basis—daily, weekly, monthly, quarterly and annually—with their franchisees. Among these leaders in maintaining a reciprocal, mutually beneficial, and transparent relationship with their franchisees are Popeyes Louisiana Kitchen, BrightStar Care, and Uptown Cheapskate. Their franchise management fully understands that their success is dependent on the success of their franchisees. And franchisees are far more likely to succeed if they have access to and participate in assessing the dashboard data.

The best franchisees understand that and will have meaningful incentive to participate in providing the data, so long as the process is not too burdensome and they realize tangible benefits from doing so. And they are more likely to do so with regular and reciprocal on-site, face-to-face meetings

4. Employ KPI data to disclose affirmative, robust earnings claims in your FDD 

Your long-term success is dependent upon attracting and retaining the best franchisees. More and more, prospective franchisees are expecting to see affirmative Item 19 (Financial Performance Representations) disclosures and the more robust the disclosure—basic P&L data for a broad range of company-operated and franchised units versus topline numbers for only a handpicked selection of franchises—the more likely your franchise will get the top draft picks.

Franchisors who want to be recognized as “investment grade” and attract savvy and sophisticated franchise owners need meaningful Item 19 disclosures.

This is important because prospective franchisees will do the arithmetic. And you can help them estimate ROI by having both comprehensive earnings claims as well as realistic Item 7 (Estimated Initial Investment) disclosures in your FDD. With respect to the latter, that means, at a minimum, providing an estimate beyond the mandatory three-month initial period of operations.

Further, a franchisor cannot credibly make any marketing claims about their “strong unit economics” without having affirmative Item 19 disclosures to back them up. It may be a misstep—and perhaps even a compliance issue—to recruit prospective franchisees with unsubstantiated statements about unit economics.

5. Critically reassess the basis of key franchisee variable costs that you control

Very few franchisors look beyond the market when establishing the economic terms for their franchise relationships, including royalties and ad fees. While that’s a natural and rational instinct, it avoids a critical assessment of what makes the most sense from a unit economics perspective. Benchmarking key variable costs for franchisees against competitors is an important first step in setting them, but it’s not a substitute for rigorous analysis grounded in unit economics.

For example, setting a 6 percent royalty because it seems to be the midpoint where retail food franchisors land may be expedient, but it may not be particularly helpful if your concept is larded with other non-market fees or if space requirements are below market. Similarly, national ad fees generally are set north of local ad fees—a construct that may not make sense in certain circumstances.

The market often takes time to sort out real value from short-lived trends, but it’s always right in the long run. The franchises that offer the best value are those that take a deliberate and long-term approach to building and improving their unit economics. These “investment grade” franchises are taking the right steps to ensure that their concepts endure and prosper.

Mike Sheehan is a franchise consultant and attorney. He is a principal with Franalytix LLC, which provides financial modeling services for both franchisors and franchisees, and the president of Focus Ventures LLC, a franchise broker firm. Suvendu “Du” Pal is a principal with Franalytix LLC and the principal of Modero Consulting, a financial planning and strategy consulting firm for small and mid-market enterprises. Joe Caruso is a principal at Franchise Info, which provides content marketing programs to franchisors, suppliers, attorneys, and service providers, as well as franchise sales and lead generation, development, and marketing services to franchisors.