Exclusive Territories and Franchise System Design

Exclusive Territories and Franchise System Design

 The Dilemma

One of the most contentious issues in franchising, and a core area of focus in designing a franchise system, is the question of territorial “rights” in favor of individual franchisees and what provisions (if any) regarding territorial protections should be included in the Franchise Agreement and other documents used by the system.

On the face of it, it may appear that Franchisor’s and Franchisees’ interests are inherently opposed, with at least some commentators assuming that Franchisors will (and should) universally oppose granting such rights to Franchisees and want to retain unlimited freedom to establish competing units (whether company-owned or franchised) in proximity to franchised units.

On the other hand, some Franchisee advocates claim that:

• Franchisors are only interested in receiving initial franchise fees and are therefore motivated to open as many units as possible notwithstanding any impact on existing units;

• Since Franchisors are commonly paid a percentage of gross sales, they will be indifferent to the impact of competing units on a Franchisee’s bottom line, so long as total system sales trend upward; and that

• Franchisees should therefore demand and receive territorial protection from both additional brick-and-mortar units and competition from other channels of distribution (internet sales, mail order, etc.) affiliated with the Franchisor or using the same brand.

When viewed this way, franchising is seen as a zero-sum game, with enhanced market presence for the Franchisor inevitably reducing opportunities for Franchisees, and territorial protection for Franchisees precluding growth of the brand presence in relevant markets.  The size of the economic “pie” is limited, a win for one party is a loss for the other and compromise is either impossible or merely a disguised form of surrender.

A More Complex Reality

In fact, the realities are far more complex than either side may be willing to admit.

It is true that, in some situations, establishment of a directly competitive physical unit in close proximity to an existing unit may, in some situations, affect sales at the first unit.  And it’s even possible (although perhaps less likely) that the availability of other channels of distribution might also adversely affect sales of traditional brick-and-mortar units.

But it’s also the case that few (at least in my experience), if any, Franchisors are truly indifferent to bottom-line results at franchised units, if for no other reason than it’s difficult to sell franchises in a system where most units fail to validate positive retail results and respond to an inquiry by a prospective Franchisee with a sad tale regarding their own experiences in the system.  At the end of the day, the easiest franchise to sell is probably the one where most of the Franchisees are delighted with their results and are demanding additional units.

At the same time, it’s true that poorly designed territorial arrangements may negatively impact the growth of the system and its performance against potential or existing competitors, even if they were originally conceived as an attempt to benefit Franchisees.

Here’s how that can happen:

Assume that a new chain, Carla’s Coffee Shops, is being rolled out on a nation-wide or regional basis.  In order to facilitate franchise sales, Carla’s agrees to give Franchisee’s extensive exclusive territories, for the full term of the Franchise Agreement, as well as to protect them against sales of Carla’s ground coffee in supermarkets in their area, by mail order or through the internet.

With these rights in hand, Johnny Jones opens his franchised Carla’s Coffee Shop in Costa Mesa, California, with rights covering that city, along with the nearby communities of Newport Beach, Balboa, Huntington Beach and Fountain Valley, secure in the knowledge that he will not be subject to competition from other Carla’s Coffee Shops in those areas, or any sales of Carla’s ground coffee in local supermarkets or through other venues.

Within a few years, however, Johnny has found that his business has stagnated, due to three factors, among others:

First, while other Carla’s Coffee Shops have certainly been kept out of his territory and he has lost no business to them, Starbucks, Peets and other competitors have remained entirely free to enter the local market, have done so and have secured all of the best possible remaining sites in the area, including ones very close to Johnny’s.

Second, since Carla’s made the strategic choice to grant expensive territories, it has been able to open only a limited number of units.  In fact, after 3 years, there are only 21 Carla’s units nationwide.  This has had the effect of severely limiting funds available for national advertising and Johnny receives none of the benefits of a healthy national marketing strategy, while his competitors have the benefit of huge levels of funding available for national ad campaigns.

Third, due to the lack of any meaningful national marketing strategy, surveys show that consumer awareness of the Carla’s Coffee Shop brand is miniscule, and that relatively little goodwill attaches to the brand on a national basis as compared to its direct competitors.

In addition, the limited number of available locations (due to the granting of broad territorial rights) has limited franchise sales, reducing royalty and other income at the Franchisor level and making the providing of extensive services to Franchisees by the Franchisor problematic at best.  And that lack of services has created dissension and dissatisfaction among the Carla’s Franchisees, further impacting franchise sales.

In short, the attempt to “protect” local Franchisees by granting territorial rights has, it can be plausibly argued, actually wounded those same Franchisees in terms of their long-term investment in the brand and their chances for future expansion and success.

Potential Solutions

While the lessons of the (hypothetical) Carla’s Coffee Shops case may or may not apply to all business models or franchise systems, it does make clear that we cannot assume that a “one-size-fits-all” approach to site location will actually work to the benefit of individual Franchisees or the franchise system as a whole.  In fact, an unsophisticated approach may end up hurting the very people it was designed to protect.

A franchise system that develops a reputation for “cannibalizing” its existing Franchisees will probably have a difficult time selling franchises, while a system precluded from responding to real-life competitive challenges or opportunities will be unlikely to succeed in the long run.

Perhaps a way out of the dilemma is to recognize that both the Franchisee and the Franchisor have legitimate interests:

One the one hand, the Franchisee wants to have a reasonable chance to become established in his business.  So, a limited term of territorial protection (perhaps by means of a right-of-first-refusal) may be appropriate to give him a fair chance to get his business off the ground.

On the other hand, the Franchisor has a justifiable interest in responding to market demand and opening units, securing locations and possibly using alternative channels of distribution when it benefits the brand.  These considerations will probably drive an approach whereby long-term and broad territorial restrictions on the Franchisor will not be built into the system and that individual cases will be dealt with on an individual basis.

What seems clear is that no single, universal approach to territories will always work for every system and that a strategy which takes into consideration the legitimate long-term interests of all the parties involved will nearly always be appropriate from a business standpoint.


Strategic Concepts in Franchising – Building the Brand

Strategic Concepts in Franchising – Building the Brand


Executive Summary

The over-riding goal of essentially all well-managed franchise systems, and one that informs both day-to-day operational decisions, as well as longer-term strategic directions, is “building the brand.” 

Major points include the following:

• Brand value begins with, and in enhanced by, a reliable, repeated, consistent and positive customer experience at the retail level.

• On both the operating unit level and as a general guiding principle for development of the entire system, building the value of the brand, and the good will associated with it, serves as a reliable basis for making almost all management decisions.


The Over-Arching Importance of Building Brand Value

At the Retail Level

Marketing professionals would tell us that “branding” involves establishing in the mind of existing and potential customers a positive association between the brand and the actual retail-level experience of the customer in dealing with the brand, whether through purchases or otherwise.

That positive brand value will have the effect of enhancing future dealings, including those with branded outlets that the customer may never have visited previously. 

In other words, if the franchisor has built in the customer’s mind a positive association with the brand, he or she is much more likely to make a buying decision in favor of that brand and make a purchase from a branded outlet (whether brick-and-mortar or otherwise), even if he or she has never patronized it before.

Obviously, then, building brand value is critical in a franchised system, where multiple locations, each operated under independent management and ownership, all use the same brand and operating system in connection with servicing customers.

While that multiplicity of outlets can be a significant advantage in establishing market presence and even dominance, it necessarily comes with some related exposure. 

If a customer has an unhappy experience at one location, the value of the brand will be damaged in her opinion and she (and anyone she shares her experience with) be that much less likely to patronize any of the outlets sharing the brand.

At the same time, a reliable, repeated, consistent and positive customer experience at the retail level will operate to ensure that the retail customer has good feelings toward any retail outlet bearing the brand, and make it more likely that she will feel comfortable in dealing with other outlets and recommending them to her friends, even if she has never patronized those other outlets herself.

The importance of building brand value through reliable, repeated, consistent and positive customer experiences is what drives much of the operational steps in managing a franchised unit, as well as the franchise system as a whole. 

In fact, it’s simply a need to build and maintain brand value that results in much of franchise activity at the Franchisor level, including product/service selection, pricing decisions, supplier approvals, advertising, location selection, training and in-store inspections/audits.  These diverse functions are often best understood as basically the means by which brand value is enhanced and preserved.


At the Strategic (or Management) Level

So, the benefits of a philosophical approach to “building the brand” are clear at the retail level, and most marketing and operational personnel understand that importance well enough. 

What’s sometimes ignored, however, is that a commitment to building the brand also serves as a reliable guide to more strategic decisions at top management levels.

Suppose, for example, that a Franchisor is considering the addition of a related product or service line to its current offerings, and that the new product or service could either be offered through existing franchised (and perhaps company-owned) outlets under the existing brand and system or through a newly branded, and separate, set of outlets.

A Franchisor who is mindful of the need to build the brand will take that consideration into mind, along with others, and may decide that the potential synergies of combining two closely related product lines (say, burgers and salads) in a single retail chain under one brand builds the value of the brand significantly, and to a degree to make the additional investment in training and operational adjustments well worthwhile.

Or, take another, sometimes more contentious, example: 

A Franchisor has a Franchisee who is a top producer and regularly makes substantial royalty payments, as well as purchasing high levels of proprietary product from the Franchisor, but who also fails to follow important operational guidelines and is the subject of a disproportionate level of customers complaints. 

And suppose further that the Franchisee has requested the award of a franchise for a second location, or her renewal option is about to come up, conditioned on the payment of a substantial renewal fee, which she’s willing and able to make.

Here, a Franchisor committed to building the brand may decide to forego short-term economic advantages and require the Franchisee to cure any operational defaults before any additional franchise, or any renewal, will be awarded.

In making the decision, the Franchisor asks itself one simple question:

“Which decision will do the most to build the long-term value of the brand?”

The answer to that question will almost always serve as a reliable guide to the best course of action.


Core Elements in the Franchise Business Model – Part Two

Executive Summary

This paper (one of a series) discusses some of the elements that must be present for a business model to be appropriately adapted for growth through franchising, and focuses specifically on the financial and emotional attractiveness of the concept to potential franchisees.

Major points include the following:

•    For a franchise system to be successful, the concept must be both emotionally and financially attractive to prospective Franchisees.

•    For many prospective franchisees, the emotional part of the equation is at least as important as the financial aspect.

•    Alternative franchise models, which will appeal to distinct target markets, include conversion franchises, start-up franchises, area franchises, area development or sub-franchises, “buy-a-job” franchises and high capital requirement franchises.

•    Franchise sales (and franchise sales management) require different skillsets than the operational and retail marketing skills which a new franchisor may already have.

The Importance of Marketability of the Franchise Concept

Marketability of the concept to be franchised is of critical importance to the success of the strategic decision to franchise, a point well understood by franchising professionals but sometimes ignored by those planning on franchising a business model, which they may have been operating for years.

Typically, new franchisors begin by concentrating on such issues as operational modifications necessary for franchising an existing business model, developing site selection and build-out criteria, writing operational and marketing training manuals, designing franchisee/manager training programs, etc.  

All of those tasks (and many more) are entirely appropriate for the prospective franchisor, but they ignore a core business reality: it’s impossible for a business to be successfully franchised if franchises are not sold.  

And that requirement implies another: the franchise must be attractive to prospective franchisees, and more attractive than competing investment opportunities, whether franchised or not.  So, both the nature of the business being franchised and type of franchise model being used, as well as consideration of the prospective franchisee’s emotional and financial needs, are vital considerations in developing any franchise model.

A Prospective Franchisee’s Financial and Emotional Needs

In designing a franchise model that can be successfully marketed, both conscious/rational and unconscious/emotional needs must be considered and addressed, and can affect the design of the franchise business model.  While prospective franchisees may or may not have thought about their needs, at least in a conscious, analytical way, the prospective franchisor should.

Let’s start with the conscious/rational needs, focusing on financial needs, which may the easier ones to analyze.

In general, most prospective franchisees are interested in making money from their franchise investment and any “sweat equity” involved in building the business.  

That desire relates to two separate metrics: the expected return on their monetary investment (can they do better for the same investment level in some other opportunity, franchised or non-franchised?) and the anticipated cash flow of the business, which the purchaser will use to justify their involvement and support an appropriate lifestyle,

Therefore, prospective franchisors should be mindful that their offering will be tested, in a financial sense, against other available opportunities and the franchisor should have designed a business model (including initial franchise fee, royalty rates and required initial investment) that will meet any such tests.

[Note that significant legal constraints, and potential liabilities for violations, are involved with respect to a franchisor’s ability to make any financial performance representations to a prospective franchisee regarding the business to be franchised, and that the methods commonly used in selling other opportunities will not be legal in the franchising context.  This is an area where advice of experienced franchise legal counsel will be critical.]

Assuming that a prospective franchisee’s financial needs can be met, let’s turn to his or her emotional needs.

Part of those needs relate to the business model itself, and the operational requirements of that business.

For example, operation of a quick serve restaurant can involve long hours, as well as the practicalities of supervising young employees who may be working for minimum wage or close to it.  The financial aspects of the business may make good sense but, for a prospective franchisee who has a white collar, non-retail background, investing in an executive search franchise may more properly suit her emotional needs and her existing skills.  

Similarly, a business requiring the franchisee to personally engage in face-to-face marketing (e.g. printing) may not be appropriate for a shy person.

An often-unstated emotional need of prospective franchisees is simply one of belonging.  Operating a business as an independent may give the operator much more freedom, but one price of that freedom is lack of support, including the feeling of belonging to a large organization, with its own culture and values, and made up of other owners similarly situated.

Individuals with that set of emotional needs can be very good franchisees, but the franchisor must be aware of those needs and be sure that the system he or she designs will meet them.

Different Franchise Models Appeal to Different Markets

Another point, sometimes not appreciated by prospective franchisors, is that franchises can be offered under a variety of structures, and that each structure can appeal to distinct markets.  

We’ve set out below some of these alternative structures, many of which can be combined, and the typical target markets related to each alternative.

•    Start-up Franchises

This model is representative of probably most of the franchises offered today.  

The prospective franchisee has never operated a business of the type in question and will have to be convinced that he or she will actually enjoy operating that business.  Such purchasers may have adequate capital, but also strong emotional needs under the “belonging” heading.

•    Conversion Franchises

Here, the prospective franchisee already owns and operates a business of the type to be franchised and is offered the opportunity to retain ownership of that business but as part of a franchised system and benefit from the related brand identity, as well as possible operational and other efficiencies.

This purchaser may have demonstrated an ability to run the business (or may be purchasing the franchise in an attempt to save it from failure!) and will have to be convinced that the costs involved will be justified by operating under the new model and meeting its operational requirements.  Adequacy of available capital may be an issue with some such franchisees.

•    Single Unit Franchises

This model is also typical of many of the franchises offered today.  

The franchisee is granted the right to operate one (and only one) unit, often at a specified location and with or without express territorial rights.  Typical purchasers usually have limited capital (adequate for opening only one unit) and focus on operational requirements.  Their management skills may be limited and they may need more support than other franchisees.

•    Area Franchises

This type of franchise involves a more extensive set of commitments than some other models, both for the franchisor and the prospective franchisee.  Here, the franchisee typically obtains rights to an area, along with the right (and the obligation) of opening a specified number of units within a defined time period.

The franchisee’s needs are for greater economic rewards than in some other models and may (and probably should) be accompanied by a greater level of risk tolerance.  Also, a higher level of franchisee management skills will generally be required under this model.

•    Area Developer and Subfranchise Franchises

In these models, the franchise may or may not operate a franchised unit, but he or she will take on some or most of the franchisor’s duties within a defined territory, including marketing franchises to other prospects, assisting them in finding locations, training new franchisees, supervising regional marketing efforts, etc.

While the economic rewards can be high with this model, the risk levels and required skills can also be higher than in other structures.

“Buy-a-Job” Franchises

Sometimes inappropriately disparaged, these franchises typically involve the franchisee actively working the business, including perhaps behind the counter, and are hoped to be adequate to pay an appropriate return to justify that level of full-time involvement.  

Capital requirements may not be excessive and any potential increase in the capital value of the business may be a secondary consideration, as is any real plan to open additional units.

High Capital Requirement Franchises

These franchises, of which hotels are a common example, require investments of perhaps millions of dollars, are generally made by sophisticated high net worth individuals or groups, and usually involve a purely economic analysis, with little consideration being given to emotional needs.

Here, the projected return on the investment will be critical and actual management of the unit will be generally delegated to employees.

Franchise Sales Management is a Distinct Skillset

Finally, let’s make a very important, although sometimes ignored, point: franchise sales and franchise sales management are distinct skills, requiring sensitivity to legal requirements, ethical constraints and good salesmanship principles.

Those skills may not be present in the founder of the franchise system. who may have spent much of his or her career in operations, finance or consumer marketing.

If that’s the case, the founder will have to be aware of that lack and be prepared to identify, hire and appropriately compensate personnel who can properly fulfill that function.