Franchising is a business unto itself, and understanding the revenue model is important. It is critical to understand how you as the franchisor make money and how you accelerate financial gain over time by making the right investments, having the right conversations, and making the difficult but necessary decisions that move the business forward.
Soon after you begin attending franchise conferences, you’ll most likely sit in on a session in which the speaker asks the group, “How does the franchisor make money?” Without fail, “franchise fees” is always the first answer given. Other common answers include “royalties,” “goods,” and “technology fees.” But the reality of the franchise industry is that most franchisor profit is generated from royalties. Though most conferences focus on franchise sales, lead generation, and closing deals, I think more should be dedicated to maximizing both franchisee unit economics and franchisor royalties.
The most successful and sustainable franchisors recognize that royalties are—or should be—where they make the majority of their profit. We know that we actually lose money on the sale of a franchise: It takes about 22 months, on average, before we achieve breakeven on the addition of a single-unit franchisee. With this level of investment in the selection, training, opening, and support of franchisees, it is critical to select great ones. Royalty dollars are not created equal. Top performers pay the most and consume the least resources—and vice versa for underperformers. Pay close attention to the best practices shared in this book about building a successful franchise system and selecting the right franchisees; otherwise you could easily go upside down, building a system with unqualified franchisees that generate little in royalties and that cost too much to support to remain sustainable.
As a franchisor the most important achievement in your life cycle is the point at which you reach royalty self-sufficiency, the point at which all overhead costs are covered by royalties and there is no longer pressure to earn franchise fees. To calculate royalty self-sufficiency, subtract from royalty revenues all of your operating expenses for all functions except franchise sales. If the number is positive (i.e., revenues exceed expenses for operations other than franchise sales), then you have reached royalty self-sufficiency. If it is negative, then you must grow royalty revenues to reach this milestone. The magnitude of the negative number will give you an idea of how long that should take.
Generally, when a franchisor has 100 units open, he should be at or near the point of royalty self-sufficiency. I like to see franchisors get there in less than five years, with a goal of three years if all plans are executed well. A dear friend, Ron Feldman, CEO of Franchise America Finance, teases me that I probably knew the precise moment we would reach royalty self-sufficiency to the minute. Well, we planned to be there in November 2008, and we were essentially there within six weeks of plan—and that was during a recession!
Sometimes, however, you consciously make the decision to move away from this milestone if critical investments are needed. We were royalty self-sufficient (what a great place to be!) in the first half of 2009; then, knowing we had achieved it once, and with full knowledge and support of our bank, we increased costs to add a new program in July 2009 to help our franchisees ramp up faster and counteract the downturn in the economy. (I talk more about our BrightStart program in chapter 9.)
BRIGHT IDEA:
You should know both the point at which you’ll attain royalty self-sufficiency and what is needed to get there. If new program costs delay that, you should know what incremental royalty the program must achieve to give you a positive ROI on the cost of the program and get you back to royalty self-sufficiency.
The key takeaway here is simple. Royalties are derived from the unit economics of franchisees, and chapters 9 through 11 are about what we do, from intake to ongoing support, to maximize franchisees’ ability to build revenue. This chapter focuses on the ways in which a franchisor maximizes royalties. Why? Because investing in franchisee success and working together to maximize franchisee revenues and bottom-line profitability is the fastest way for a franchisor to be successful.
Sometimes it feels like the road less traveled when I compare my staff-to-franchisee ratios to other franchisors, but franchisee revenue maximization clearly leads to royalty maximization for the franchisor. Also, if franchisees are making a good return they will validate favorably to prospects, they will want to consider adding franchise units, and they may want to become a franchisee of other concepts that you might start. Focusing on the franchisee is the best way for a franchisor to make money, avoid litigation, and sleep well at night. This is the beauty of franchising—the more the franchisee wins, the more the franchisor wins too.
The biggest way to ensure maximized royalties is to remain committed to awarding a franchise only to those who are most likely to succeed. We talked in the last chapter about building your ideal franchisee profile and looking for and selecting franchisees who meet the criteria. In addition to selecting strong franchisees, here are proven strategies to maximize royalties (which I’ll describe in detail in the next section):
- Invest in a strong start for your franchisees.
- Be proactive in communication; don’t postpone the tough conversations with new franchisees.
- Offer “boost” programs to support struggling franchisees, and then have a clear plan for what to do should the boost not work.
- Be prepared to make acceptable exceptions for high-performance and high-attitude franchisees: They are your proven commodities.
- Review the list of your franchisees regularly and identify the bottom performers and build plans to support them up or out.
- Right-size the franchisee’s operation and/or geography to match the skills and capitalization of the franchisee.
With some franchisees, you will need to implement more than one of these strategies simultaneously. With others, you may need one strategy now and another in 6 to 12 months. In my view, strategy 5 is the most important advice for new franchisors. If a franchisee is below goal, you must invest to support her efforts to move from average to top performer. We define the goal; franchisees and support personnel have access to real-time statistics to show the franchisee’s weekly sales performance compared to goal for the week and for inception-to-date. The franchisees must do the work and make the commitment while we provide the resources to help their effort be effective. If a franchisee’s performance is too poor and he is not putting in the effort, lacks accountability for the results, or doesn’t have a positive attitude (the single largest common trait among top performers is optimism and/or positive attitude), move him out of the system (it is best if this can be done mutually, but unilaterally may be the only option under certain circumstances).
Strategies to Maximize Royalties
It took me a while to realize that I couldn’t help everyone become successful and that not everyone will help themselves to become successful. Some franchisees believe they can handle a particular role but later realize that they can’t. When this happens, they usually hire someone else to do it. Unfortunately, with an owner-operator business model, by design, if they hire to fill every role early on, the model doesn’t work, either from execution or from proper capitalization. Owner-operator franchises like ours initially need the owner’s time and passion to succeed. Many franchise systems, including ours, allow a franchisee to develop his team over time and to transition out of working in the business to fulfill a higher-level leadership role of working on the business.
The sooner you determine whether your franchisee is in it to win it—or not—the better for both of you, especially the franchisee. So let’s look more closely at the strategies for supporting franchisees to enable them to reach their potential (and produce royalties), and when and how to suggest they follow a different path, if necessary.
Invest in a Strong Start
In chapter 9 you will see how we onboard new franchisees from the program perspective. Here I want to review the strong correlation between how a franchisee starts and her long-term potential. Unfortunately, franchisees who have a slow start often cannot recover from it. Our analysis reveals that, in general, franchisees who start strong stay strong. Because of strong franchisee performance in their second year and beyond, the critical breakthrough for us and our franchisees was in getting them started strong. In networking with other franchisors, this theory appears to hold up across brands and across industries.
Our senior leadership team has key scorecard items that we watch and strive to improve annually. Among them are three goals, with the ultimate goal of having happy, successful franchisees: Maximize franchisee unit economics, shorten the franchisee time to breakeven, and minimize the time period that a franchisee is open without billing. I challenged our team during the down economy of early 2009 to identify tools, resources, and/or programs that we could implement to impact these three goals. Two of my senior staff worked closely together and mapped out a plan for BrightStart.
The team came up with a launch program to help franchisees ramp up sales sooner through a combination of investments for (1) additional travel costs related to more on-site visits; (2) additional personnel to support preopening activities, such as territory management and reviewing the preselling process to diagnose the approach and results of sales calls; (3) personnel for the first three or four months to monitor sales activities and results and to ensure that key behaviors were formed; (4) technology to standardize the external sales process and to identify problems at any stage of the sales process; and (5) agreement by the franchisee to participate in and comply with the requirements of the program.
The travel, personnel, and technology were expenses, with an estimated 18 months to pay back the incremental costs, but we knew the program could have a significant impact for the franchisees who took advantage of the additional resources. Franchisees who do not follow the requirements of the BrightStart program are removed from the program until they have a dedicated salesperson who will follow the program. I approved the program, and we launched the first trial in July 2009. Based on the feedback we gathered from franchisees, we continued to refine the program.
The program improved franchisee results so much that payback on the incremental recurring costs (travel and personnel) occurred in less than eight months.
BRIGHT IDEA:
Tracking the realization of benefits from any new programs is critical.
Monitoring program results will encourage you to form the complementary habits of empowering employees to identify ways to help franchisees and holding the employee responsible for the results, to offset the incremental costs within a reasonable period of time. Remember, you must be financially healthy for the brand to survive and thrive. We benchmark how much we are already investing in support, so increases to that amount must demonstrate ROI by increasing franchisees’ revenues enough that the increases in royalties cover the additional support costs.
Because the BrightStart program had strong measurable goals and the team responsible was held accountable, we viewed the money we spent on travel, personnel, and technology as an investment rather than an expense. It changed our franchisees’ track records (for those who complied with the program requirements) and therefore improved our own royalty opportunity. In today’s age of more limited resources, we must be prudent in investing in these types of programs; we can no longer merely look at increasing expenses by a certain percentage per year in line with revenue growth. Ultimate success for our franchisees and for us as the franchisor requires an investment in the things that drive improved franchisee performance.
I want to return to an aspect of our program that may have been too subtle in the previous discussion. The BrightStart program works well and has been able to deliver an ROI because franchisee accountability has been built into the program. To receive these additional resources free of charge, franchisees are required to make sales calls. We remove franchisees from the program if they are not doing their part. This ensures that we are investing in those who will use the resources to drive their revenue—and ours. We will allow a franchisee who was removed to restart BrightStart once he fixes whatever had prevented him from following the program requirements.
Sometimes we’ve been guilty of spending too many resources on those who won’t do their part and then not having the right amount of resources for the franchisees who are following the model. With the BrightStart program, we got it right by being clear about what we would do for our franchisees and what we expected from them in return.
We continue to look for ways to improve the BrightStart program and look for new programs or resources to help franchisees start stronger. In a tight capital market, the longer it takes for a franchisee to reach breakeven, the harder it will be for her to manage her cash and the more difficult it will be for her to access capital until she can show positive cash flow.
As you contemplate developing your own program for a stronger start, evaluate the key aspects of the business model that have the biggest impact on franchisee profitability. For us, sales call volume and following the sales methodology (including asking for the sale rather than just dropping off brochures) was the single greatest key performance indicator for franchisee success. Knowing how important sales calls are, we created a two-pronged program to improve sales results. We built accountability into the issue of the quantity and effectiveness of sales calls, and we built a support system for salespeople. We undertook a program to coach the salesperson regarding who to call on and how to advance the call to a buying decision, and to role-play to increase the salesperson’s confidence. Your franchise system may have other key performance indicators—the important point is that they should determine how you allocate extra resources to help your franchisees get off to a strong start.
Communicate Proactively
All franchisees should want to be successful—that is, operate a profitable and sustainable business. Unfortunately, as with buying stocks, there are no guarantees in starting or buying a business. While I believe (and franchise industry research generally supports this position) that opening a franchise business is more likely to succeed than starting as an independent from scratch, not every franchisee will be able to do it.
I have had to accept, too, that a small percentage of franchisees welcome the mutual realization that the business isn’t right for them or that it isn’t the right time in their life for the business. They seem relieved when I initiate “the conversation.” There is also a statistical likelihood that franchisees will have health issues, get divorced, or encounter some other upset. When men and women meet with significant life changes, they often find it difficult to focus on the business and to determine what needs to be done.
AVOID THIS PITFALL:
As I matured as a franchisor, I realized that every day I delayed “the conversation” cost the franchisee—who I was actually trying to protect—frustration and money.
As we built our field support organization, I hired staff who said they were willing and able to have tough conversations with franchisees and hold them accountable. Giving tough love is the right medicine to get the business back on track or to help the franchisee exit quickly and/or recover as much money as possible by selling his business. As you build your field support organization and reassess it over time, the ability to have tough conversations, document solid action plans, and obtain franchisee buy-in (and a signature on the required action plan) are skills that must be demonstrated—a lack of these skills and actions is a clear indication that you need to make a change in the team. Train early and often to this expectation and inspect what you expect—your success and that of your franchisees is strengthened by it.
The sooner you can have an honest conversation with the franchisee and identify why a business is struggling, the sooner a plan can be built. Asking the right questions will help you determine whether or not the struggle is temporary. If it is, you can help the franchisee with additional resources, motivation, mentoring, or possibly a temporary realignment of financial obligations. For instance, the franchisee might simply need to hire someone to fill a skill set that he is missing. On the other hand, if the struggle is related to a lack of skills, a lack of capital, or an improper fit, then it is a permanent struggle, and the franchisee would probably prefer to exit the system—or he should exit the system. The longer an unsuccessful franchisee bleeds cash, the more the likelihood of selling the business, or selling it at a good price, declines because potential buyers will wonder if the problem is indeed the operator and not the model or the market. The sooner the plan to exit is laid out and executed, if that is the right course of action, the better for everyone.
Offer “Boost” Programs
As I’ve shown, our attitude is that if the franchisee is committed to putting in the time and doing the work with a positive attitude, we will provide additional resources to help her improve her business. This approach is true for new franchisees as well as for existing franchisees.
We didn’t implement BrightStart until mid-2009, but by then we already had some franchisees who had struggled in the beginning, or who had been successful but had stumbled a bit because of employee turnover or a health issue. In late 2009 we began to identify ways in which some franchisees could benefit from a modified BrightStart program to give them a “boost.” We identified owners who had been open longer than nine months but were not performing to the level of our expectations or theirs.
We offered them the boost program gratis, as long as they agreed to do the work and meet the requirements. This ensured that both parties were committed to an investment of time to help the business improve its results. Most franchisees took us up on the offer and benefited from the resources.
About a year later, we reviewed franchisees again and identified a new set of 10 to whom we offered the program. Evaluating the performance of franchisees is part of our DNA, and we are committed to offering additional resources to improve results. We have built in the necessary criteria to ensure that we don’t wind up with the franchisee trying to transfer the responsibility for his results to us. As long as the franchisee owns the action plan and follows it, we will guide him in what work he needs to do and how to do it.
As you contemplate initiating your own boost program, evaluate the key aspects of the business model that may be missing in the particular franchisee’s execution of the model, thus causing him to underperform. You can identify an entire group in need of a boost program by evaluating the time frame in which you expect your franchisees to reach breakeven if they follow the model. At this stage (measured in months), evaluate the revenue levels of the group of franchisees open; those below 75 percent of the expected level should be considered for incremental resources. Use the same focus to accelerate your franchisees’ results as you developed in your strong-start program. Include rules of accountability in your boost program, and if the franchisee is unable to do his part and follow your accountability guidelines, proceed to proactive communication of his need to exit the system.
Make Exceptions for High Performers
Sometimes you need to consider taking more extreme measures than offering a boost program, especially if a franchisee runs into cash-flow issues due to a decrease in business. Although we don’t have unlimited cash reserves and do have a brand to sustain and protect, on rare occasions we have offered a helping hand when a franchisee would have failed by temporarily restructuring monies they owed us or by loaning them money until other funds were secured or until their business was sold.
Attorneys will caution against helping out franchisees financially, and we have to be very careful about establishing a precedent in the way we treat similarly situated franchisees. While I am careful to not risk legal liability by trying to go above and beyond to help a franchisee, I will bet on the winning horse that has a proven jockey. During economic downturns, franchisors will be tested more frequently as to how far they will go to help a struggling franchisee who had once been a high performer with a great attitude and had maintained accountability for the results, both good and not so good. For example, one of our “Top 10” performers—who served on our franchise advisory council and consistently gives back to other franchisees by mentoring and sharing best practices—suffered a health issue. At about the same time, he had some turnover in his team. The business slid because he was unable to make sales calls for several months until his health improved, and he struggled to make payroll because sales had declined. Because he is a known performer, a great person, and a great franchisee with a positive attitude and strong accountability, BrightStar (which is me, essentially, since I own 100 percent of the business) loaned him money until his SBA loan was funded. In less than three months, he was back in the “Top 10,” got his loan funded, and repaid all that we had loaned him. The franchisee–franchisor relationship transcends the terms of the agreement.
My philosophy for BrightStar’s franchisee family is simply this: We help one another and go the extra mile in an extreme time of need when we know that the results will be different—better—within a short period of time. Top performers are a proven commodity; they have the skills and attitude to be successful again if someone merely invests and believes in them. As long as the franchisee conducts himself as a good steward of the brand and maintains accountability for the business results (rather than blaming others), we will do our best to help identify a win-win solution.
Review the Bottom Performers
Bottom performers come in different packages. Most franchisors address the franchisees who are not following the model, are noncompliant, and therefore have low revenues. I say this carefully, because some franchisors attribute all franchisee failures to the franchisees’ not following the model rather than looking at themselves. The first place to look when evaluating a franchisee’s underperformance is what, if anything, in the system contributed to the breakdown, such as recruiting, training, operations support, and so on. With this evaluation and a commitment to assist in any and all areas to bridge this deficiency, it is also appropriate to evaluate what deficiencies of the franchisee, in the commitment level, attitude, leadership capabilities, etc., could be contributing to her failure.
We identify bottom performers based on either not meeting revenue goals or having a bad attitude. Poor attitudes and/or hostile communications toward corporate staff, vendors, etc., are like a bad flu infecting every-one around. There is no easy way to get strong revenue producers with poor attitudes to leave the system if they are compliant. Sometimes offering an incentive to sell can be a great investment to get someone like this out of the system. Or sometimes peer pressure by other franchisees will improve the poor attitude or help the franchisee self-select out.
As stated in section 3, I caution against awarding a franchise to prospects with overly large egos or with unrealistic expectations. In both situations the individual often demonstrates a poor attitude. Sometimes you find out too late. I once had a franchisee who had been forced out of a company where he was making $300,000 a year. After three years as a franchisee, he measured the return on the franchise against the $900,000 he would have earned in his former career. Despite setting no expectations for this candidate as to earnings and not providing any information other than what was in the FDD, his concept of the opportunity cost turned a good performer into a difficult franchisee who would never be happy with us. So what happens when someone like this gets into your system? Every situation is unique. All I know is that I finally freed myself from trying to live up to hisunrealistic expectations so that I could use that energy to focus on the franchisees who appreciated the help and growth that our support could provide.
Remember, a customer’s or an employee’s bad experience with a poor performer damages the brand’s reputation, and that is unfair to you and the other franchisees who are following the model. Protecting the brand is the key responsibility of the franchisor, and getting noncompliant franchisees out of the system must be a key priority. The noncompliant franchisee needs to be put on notice or, depending on the circumstances, terminated in accordance with the appropriate legal requirements.
Right-Size the Franchisee’s Operation
If you choose to offer single-unit as well as multi-unit franchise opportunities, I recommend building a separate process for reviewing the performance of each type. For example, not every franchisee will have the leadership abilities or capitalization necessary to run multiple locations. The model often changes when the franchisee scales up to multiple locations; multi-unit ownership is not merely more of running one but, rather, is an entirely different model that requires separate training and infrastructure, as well as new franchisee skills, roles, responsibilities, etc.
Multi-unit operators need to be adept at developing their teams to handle key responsibilities. When a franchisee progresses to multiple locations, he will be spread too thin to be the sole individual contributor that he was as a single-unit operator. Multi-unit operators must likewise have the proper capitalization to invest in building the right team in location two and three; simply having the geography without the team to maximize its potential is not enough.
BrightStar had to build a review process to assist franchisees in evaluating what would be needed to keep the larger territory and maximize its potential if they had or could acquire the requisite skills and had the proper capitalization for multi-unit operations, as well as to create options for what to do if they could not acquire the skills and were not properly capitalized to expand. For franchisees who lacked the capital to fully staff the additional locations, we created a win-win opportunity for them to sell off the additional locations to new franchisees through the resale process. Allowing franchisees to sell their additional locations and still remain in our system as a single-unit operator created a solid financial opportunity: Franchise fees have increased each year, and additional territories cost less than first locations. When selling at current prices, the franchisee recovers cash and generally makes a return on the amount that had been invested in additional territories when fees were lower.
I like multi-unit ownership because of the scalability it offers. Multi-unit ownership allows the franchisee to leverage resources across multiple locations. For the franchisor, multi-unit franchising allows field staff to make only one visit to a franchisee who represents the revenue potential of multiple locations. While there is a tremendous opportunity for the franchisee and the franchisor, the effect can be the opposite if the franchisee isn’t focused on developing her team to assume responsibility for the results of the first location, and then a second team to assume responsibility for the results of the second location, and so on.
I also see the expansion into new franchise brands as another way to achieve scalability. My highest-performing employees will have greater opportunity for development and promotion because they will be able to move up in a different brand. Multi-concept ownership can create opportunity for the franchisee to expand and diversify into additional brands and simultaneously create an opportunity for the franchisee to attract and retain employees who see the opportunity to grow with a larger operation. This means, though, that the franchisee must allocate time to develop and empower the team to take on increasing levels of responsibility so that the franchisee has the bandwidth to take on more locations and/or more brands. Buying additional territories (or units) or into additional brands without having the right team to leverage the opportunity is a waste of energy, money, and talent.
In summary, looking at a franchisee’s capitalization and skills holistically, as well as trying to identify ways to create win-win solutions, can uncover the need for action plans for the franchisee to train and develop staff to maximize territory potential or to right-size a territory downward while creating an infusion of cash from the sale of the additional territories.
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We have looked at multiple strategies to maximize royalties, so now let’s spend a little time looking at some of the key franchisor metrics and the plans necessary to constantly improve them. For franchisors the biggest opportunity is finding the right balance between providing support to drive franchisee results and controlling infrastructure costs.
BRIGHT IDEA:
Understanding where resources will be best deployed for the highest ROI is key to maximizing franchisor profitability.
Franchisor Key Metrics
Experience shows that there are key metrics to watch to improve the sustainability and growth of the franchisor. These metrics comprise a cross section of revenue, profitability, and efficiency measures that enable you to assess performance over time and to prioritize what to focus on to achieve top quartile performance in your industry. I use a review of my competitors’ metrics (as well as a review of top performing franchisors across the service sector obtained from FRANdata), by obtaining their FDDs and building a model to calculate their revenues per dollar of payroll, EBITDA as a percentage of revenue, and so forth, to set annual budgeting goals and multiyear improvement goals for my team, and then empower my team to propose what levers to pull to reach the desired outcomes.
As discussed earlier in this chapter, the point of royalty self-sufficiency is the magical time in the life cycle of a franchisor. If you have already launched your franchise operation, be sure to ask your accountant to add a row labeled “royalty self-sufficiency” on your financial statements for the calculation of royalties less the expenses not associated with franchise sales. When the number is positive, you are no longer dependent on new franchise sales to be profitable. Until the number is positive, the business is on shaky ground, because you must sell franchises or have access to additional capital to keep the lights on.
The next metric to watch is the contribution margin per franchisee. This is measurable by taking royalty revenues less the department costs related to supporting all franchisees (not the departments focused solely on new franchisees) and dividing this number by the average number of franchisees open during the year. We are looking for an improvement in this number to measure our scalability over time by ensuring that the gap between revenue and expenses continues to widen by generating more revenues than we add expenses over time. This is a high-level measurement of the success of new programs in which we ramp up royalties and the competency and effectiveness of field support personnel.
Once a year I also like to review the cost to open a single-unit franchise and the number of months on average for BrightStar to reach breakeven with a new franchisee. To calculate my cost to open a single franchise, I look at the total amount of initial franchise fees in the year divided by the number of franchises sold in that year and subtract from it (1) the cost of goods sold (advertising and broker fees) divided by the number of franchises sold in that year; (2) the full costs of cost centers that are primarily responsible for onboarding new franchises—such as franchise sales, learning and development or training, BrightStart, and preopening—divided by the number of franchises sold in that year; and (3) the other departments such as support center, field support, etc., divided by the number of average franchises open in that year (this adjusts the number to be smaller because those resources are supporting all franchisees and not just the new ones).
This review can be applied to see how many months of royalties on average it takes to offset the cost to open a single-unit franchise. Some franchisors whose opening support is more modest or who did not use brokers to find franchisees can reach breakeven very soon or can actually make money on the sale of a franchise. For BrightStar, our time to break-even has ranged from 16 months to 22 months based on our franchisees’ results and on the cost of new programs such as BrightStart and our large infrastructure of one employee for every three franchisees.
The next metric on the monthly financial statements that I review shows the revenue per dollar of payroll; this is a calculation of all revenues divided by all payroll costs. The goal is to increase this number over time. This number reflects the scalability of the organization based upon the ability of an investment in employees (payroll dollars) to drive an even larger increase in the amount of revenues. This is a key metric that I also use to compare our organization to peers in the same industry, regardless of their size, to hold our team accountable for being the most efficient in the use of our resources. This metric is great for franchisors, regardless of the size of the organization, because it normalizes for size to really just focus on the efficiency of resource utilization.
The last two metrics relate to ratios of earnings before interest, taxes, depreciation, and amortization (EBITDA) as a function of total revenues and as a function of royalty revenues alone. The first metric will show what percentage of revenue falls out to the bottom line. In networking conversations with other financial-oriented franchisors and/or private equity groups that own franchise companies, EBITDA as a percentage of total revenues upward of 30 percent is ideal and a best practice is 60 percent. This is the metric that I use as the goal for the next year’s budgets, working the organization year-by-year incrementally toward 60 percent. We moved past 30 percent in 2010 and will move past 40 percent in 2011, nearing 50 percent in the last few months of the year. This should allow us to achieve at least 50 percent, with an opportunity to approach 60 percent, in 2012.
For organizations that are deriving a significant amount of net revenue from the sale of new franchises, the profitability can be masked by net “new-deal” revenue (measured by franchise fees less advertising costs, broker fees, and commissions). This is why I began looking at EBITDA as a percentage of royalty revenues alone to ensure that we are improving this area as well and setting an even higher bar than for EBITDA as a percentage of total revenues. While we have fairly consistent net new-deal revenue achieved or budgeted in 2009–2011 (and therefore the EBITDA as a percentage of total revenues would not be misleading), I have ensured that both of these EBITDA metrics are on the monthly financials and that we budget these metrics and also review how we are performing compared to our budget goals and compared to our peers.
You’ll remember from chapter 4 the importance of building a high-performance culture for growth, and that is the key to achieving financial results, too. We align our budgeting process to drive the improvement in the key metrics of the franchisor by providing an opportunity for stretch goals for the employees to increase their quarterly bonus payout. When the company earns greater profits, then the employees’ bonus opportunity increases. Let’s look at our budgeting process a bit more and see if there are some takeaways for you to help drive an increase in your results—regardless of your industry and regardless of whether you are a franchisee, franchisor, or business considering franchising as an expansion option.
Budgeting Process: Good, Better, Best
Budgeting can be a great way to drive results. A lot of organizations see budgeting as a necessary annual task, but they fail to see a great opportunity to drive results through a thorough budgeting process. By aligning the goals of the organization and communicating to all employees what is needed to achieve them, an organization has the potential to achieve more.
We prepare three budgets, the primary difference among them being gross margin. I have used this process for years and have found it useful in my company-owned locations (before franchising), in the training of franchisees to set goals and prepare budgets, and in evolving the franchisor organization with the employees aligned to achieve more. In the years of the company-owned model and in the training of franchisees, I used three versions of the budget: worst case, target case, and best case. I used these three labels because we were at a stage in which the worst-case scenario had tight cash flows. As I launched the franchise and progressed beyond royalty self-sufficiency, I changed the labels to good-, better-, and best-case budgets.
When budgeting in a year in which cash flows could be tight under poor conditions, I take the worst-case, target-case, and best-case approach. The worst-case budget assumes the low end of probable sales so that I know our cash flow position. I provide the bank with this conservative scenario, what I call the “keeping the lights on” budget.
The target budget includes realistic revenue goals that require some stretch but are very achievable with an identified set of underlying key performance indicators, such as sales call activity, net promoter score or customer satisfaction, recruiting activity, etc.
The best-case budget includes the optimal sales goals I want my sales team focused on. I know that setting strong goals for sales and gaining 80–90 percent achievement will assure hitting my target “mid-point” budget. We still use a three-budget approach, but now that we are cash flow positive we have evolved from worst-case/target-case/best-case budgeting to good-/better-/best-case budgeting.
Since we may look at an initial public offering at some point in the future, we want our budget process to accomplish two key things: (1) Align focus on quarterly goals, since that is what analysts will be looking for if we are publicly traded, and (2) align the employees’ earnings ability with driving additional profitability for the enterprise. The increase in bonus opportunity for the employees when moving from good budget to better budget to best budget is fully funded (plus a return for the enterprise) due to the increased profitability of the enterprise. The primary differences among the three budget scenarios are the number of new deals sold (and the associated advertising and broker fees) and royalties.
In the calculation of “good” revenue goals, the number of new deals is an industry average of deals per salesperson; the royalties are on the regression line, with the improvements in the current year over prior year calculated based upon the number of projected units generating revenues at historical performance levels, according to the number of months they will be open during the year. Thus, the good revenue goals are very realistic because we know that the goals are achievable if we keep doing what we are doing.
The “better” budget assumes increased efficiency per franchise salesperson in the number of new deals per person, and the royalty regression is increased by specific new revenue programs that will be the focus for the year. These increased efficiency goals for the franchise sales team will naturally populate the individual sales team members’ individual goals and department goals. The specific new revenue programs developed to raise the regression potential for royalties will be aligned within the employee goals that are driving the programs or their implementation.
The “best” budget assumes a higher level of increased efficiency per franchise salesperson in the number of new deals per person; it also assumes that royalties are maximized for new programs and that franchisee revenues increase above historical levels for each franchisee.
The pool of overall money increases as the EBITDA budget goals progress from good to better to best. The dollars available are double at best compared to good, and they are 50 percent higher at better than good. Our employees then work together with their manager to set two individual goals for the quarter and two shared department goals (among multiple employees within or across departments), with each of the four goals representing one-fourth of the bonus opportunity. The goals are reviewed to ensure that they increase revenues or reduce costs to drive the overall budget goals. It is great to see the collective pride when together the whole team reaches the best results, as we did in the third quarter of 2010 and first quarter of 2011.
Aligning employees’ abilities to influence the results of the organization with their own earning ability—in the short term and long term, as we discussed in chapter 4—is the key to building a sustainable organization. This is true in any industry, franchised or not. Ultimately, we have found this approach to be the key to maximizing how a franchisor makes money. We have also tried to align the goals of our corporate staff around initiatives that also improve franchisee unit economics. We want to link together the win-win for (1) the franchisees, in increased speed to breakeven and improved unit economics; (2) the franchisor, in increased royalties and earnings; and (3) the corporate staff in increased compensation, opportunities for growth, and bonus programs.
Closing Thoughts
You know from running your own business that time is precious and that optimal results are only achieved by understanding which key drivers in your business have the largest influence on financial success. We reviewed in this chapter how the franchisor makes money, underscoring that the success of the franchisees and that of the franchisor are interdependent. Therefore, it makes sense that the best way to improve the results of the franchisor is to focus on investing in the strong start of franchisees, communicating proactively and honestly, offering boost programs when needed, reviewing top performers and bottom performers, and taking the actions needed to increase the percentage of franchisees in the system that are giving their all to perform.
Furthermore, we discussed the actions needed to drive performance as well as the key metrics to watch to ensure that the actions have a measurable result on scalability and profitability. With the focus on maximizing the results of the franchisor, this chapter reviewed our budgeting process and how to align employee goals and compensation to stretch what is possible so the organization continues to achieve measurable progress.
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You now understand how important it is, given the interdependency of the franchisee’s and the franchisor’s successful results, that the franchisee start strong. We will discuss in the next chapter how to on-board your franchisees to accomplish this.
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