Disruption is a term that you might be familiar with if you follow the startup ecosystem closely. There hasn’t been a bigger disruptor in the recent past than perhaps, COVID-19. This isn’t really the kind of ‘disruption’ entrepreneurs would have hoped for. COVID-19 has usurped not just businesses, but industries as a whole, forcing them to reevaluate their business models. It leaves them with a rather binary choice- adapt or perish. Consumer-facing industries like travel, hospitality, retail, and food services have been facing the brunt of this impact.
Along with a sharp decline in consumers and revenue, companies have also been struggling to raise money. March onwards, each month has seen fewer VC deals and smaller amounts Year-on-Year. In these times, for a lot of these industries, franchising has been an attractive business model to turn to- it allows for expansion with virtually no contingent liability and most importantly, without the risk of debt. Franchising essentially revolves around duplicating the franchisor’s business blueprint across different locations. This means that as a franchisor, not only do you need far less capital with which to expand, but your risk is largely limited to the capital you invest in developing your franchise. This investment is often less than the cost of opening one additional company-owned location. As industries are forced to take a step back and contemplate their business models, what will the future of franchising look like? Let’s set some context first.
India’s franchise industry is estimated at $50.4BN, with about 200,000 franchise outlets. Sectors like health and wellness, retail, and food service make up 60% of the overall franchising business in the country. Owing to the largely fragmented market, it is no surprise that half of the franchisors are regional brands, with global brands only taking 16% of the share. Franchising is a business model that revolves around 2 players-
They sign a franchise agreement- a legal, binding contract between them. Once the agreement is signed, the franchisee primarily has to pay:
The quality of replication is one of the most important KPIs of franchising which is enforced by the Franchise Agreement (FA). Like in all business transactions, the agreement is pivotal in ensuring a smooth relationship between the two parties involved. Most importantly, it helps tackle the problem of quality control, one which is inherent in this business model. A well written FA hopes to mitigate and reduce this risk by introducing a robust SOP acceptable to everyone.
We truly believe that franchising is not a one-size-fits-all model, as it is sometimes advertised to be. Like all businesses, it has nuances and patterns which start to emerge once you dive beneath the surface.
While franchising may seem straightforward, like all good business models, it has its subtleties. There are 4 major types of franchising and we have observed an interlink between the industry and the model of franchising they pick, each adapting to the strengths.
Franchising agreements typically follow these arrangements:
1) COCO - Company Owned, Company Operated
2) FOFO - Franchise Owned, Franchise Operated
3) COFO- Company Owned, Franchise Operated
4) FOCO/FICO - Franchise Owned/Invested, Company Operated
Different business models of franchising
It is also important to understand franchise types from an operations standpoint:
Business Franchises- They get to use the franchisor’s trademark, but more importantly, it gets the entire system to operate the business and market the product and/or service. This is the most popular type of franchise system and the one generally referred to when talking franchising. The most popular industries are fast food, retail, restaurant, business services, and fitness.
Product Franchises- These are based on supplier-dealer relationships, where franchisee distributes the franchisor’s products. The franchisor licenses its trademark but usually does not provide franchisees an entire system for running their business. This is very popular among soft drink manufacturers like Coca-Cola and Pepsi.
Investment Franchises- These are large scale projects which require a large capital investment. The franchisees usually invest money and then let franchisors operate the business and produce a return on their investment. This model is predominant in the hospitality industry.
A company almost always begins operations with the COCO model and when the brand is well established, the company diversifies to other models. In addition, COCO stores in collaboration with franchisees are able to further develop and refine operating standards, marketing concepts, and product and pricing strategies. We have noticed a correlation between franchise types and the models they diversify into:
1. FOFO- Adopted by companies for faster expansion of business/brand presence and to penetrate completely new markets with the help of local businessmen. In this model, the training of staff is done by the Company and handed over to the franchise to oversee the operations. Business and Product franchises (like gyms and QSRs) typically go for this. It’s the most common form of franchising- nearly 70% of all franchises adhere to this.
2. COFO- Adopted by companies when they want to reduce their operational expenditure. In this, the company leases the operations of the business to an interested franchise. This model is adopted by the Company only in well-established markets where the company has operated and got a high return on investment.
3. FOCO/FICO- This model is highly preferred by the hospitality industry. Since the industry revolves around providing service, the company needs to be responsible for running operations and maintaining quality. The company finds an interested franchise to provide capital for the development of the project and once the hotel is built, the company takes over. Very interestingly, this follows a reverse royalty system where the Franchisor pays the Franchisee.
This brings us to our first point- Franchising works the best when your business has a product to sell, rather than a service. Simply because product-focused businesses are easier to replicate than service-based. Services provided by people require skill and consistency, together which contribute to quality. Like we mentioned, quality control is the biggest hurdle in franchising and product businesses gracefully jump over it.
To understand this better, let’s explore the food services industry. There are 2 major players who are involved: QSRs and Restaurants.
1) QSRs are essentially assembly lines. They have a strong local supply chain, the cooking requires putting the readily available ingredients together, and the menus are limited. The QSRs themselves need to have a consistent, simple look, feel, and even music in each location. Menus are also the same from location to location, and consumers enjoy a recognizable, familiar experience no matter where they are, with a dependable level of quality. This need for consistency and upholding quality makes QSRs the perfect industry to franchise in. In fact, out of the top 10 biggest franchises in the world, 7 are QSRs.
2) Dine-in restaurants have a lot more depth to them than QSRs. Not only are their menu offerings more vast and elaborate, but there’s also a significant amount of service expected from them. It becomes incredibly hard to replicate these services and the skill required to cook. This lack of standardization doesn’t fit well with a franchise’s structure and it becomes difficult to keep up with the high standards. Moreover, dine-in restaurants require a lot more Capex to set up and it’s more expensive to train the employees.
Thus, we believe that wherever service is a crucial part of the experience, franchising is not a good choice.
% franchised of the total stores
A similar trend can be observed in the retail industry as well where companies are not as extensively franchised. Retail can be further broken down into Single Brand Outlets and Multi Brand Outlets. We have observed that franchising scales tend to tip towards Single Brand Outlets, although they’re never as extensively franchised as in the food industry. This is because service is an intricate part of the experience, especially in the fashion industry.
Multi Brand Outlets like Aditya Birla Fashion Group (ABFG) have franchised but their motivations are unique- with ABFG opening up in Tier 2/Tier 3 cities, they become an aspirational brand in that region. They recognized the huge linguistic and cultural differences across the country and leveraged franchises to gain local knowledge and navigate the local realities.
This brings us to our second point- Franchises are a brilliant way to enter a foreign market at a much cheaper cost and also equipped with all the local know-how. Franchising not only provides the franchisor financial leverage but also allows it to leverage human resources- by signing up with local entrepreneurs. Franchising is paramount to delivering locally relevant customer experiences and driving profitability.
By now, it has become quite clear how and why the QSR industry is a favorite for Franchising. To understand how this works out in real life, let’s take a closer look at 2 franchising legends: McDonalds and Dominos.
93% of all their stores are franchised. How has McDonald’s been able to franchise so rapidly and so well? Simple- Under a McDonald's franchise, McDonald's owns or leases the site and the restaurant building. Franchise agreements generally have a 20-year term. According to their financial reports, they have $40BN in real estate- forget the burgers and fries, McDonald’s is a multi-billion-dollar real estate company! They are essentially landlords to their franchises. This also helps them diversify their revenues. Instead of just being dependent on the royalties, they also earn through the rent paid by the franchise.
The transition to a more heavily franchised business model is a brilliant long-term strategy. The rent and royalty income received from franchisees provides a more predictable and stable revenue stream over time with significantly lower operating costs and risks. Although company-operated restaurants have higher revenues compared to franchised restaurants, they contribute less to the company’s gross margins and net income. In a way, it is almost like McDonald’s has a subscription business model, where franchisees pay a fixed amount each month leading to a recurring revenue.
Revenue growth and margins for McDonalds’ Franchises
Source: McDonalds Financial records
Let’s shift our focus to pizzas: Domino’s too has also adopted the Franchising model incredibly well. If you thought 93% was an intimidating number, Dominos is 97% franchised. Their revenue streams majorly come from 3 business segments: U.S. stores, international franchises, and the existence of a robust supply chain. Supply chain revenue mainly comes from providing equipment and supplies to the U.S. and international stores, which is a majority contributor to their topline.
70% of all orders are deliveries and hence, they don’t need to have a lot of real estate holdings. Sustainability of this franchising model depends on collecting royalties and maintaining a strong supply chain. Domino’s franchise agreements typically have a 10-year term and they charge a 5.5% royalty fee for its franchise. When they entered India, they teamed up with Jubilant Foodworks in a Master-Franchise agreement to navigate the country well. This approach of teaming up with a local player in a foreign market has been proven to be massively useful. Despite being an asset-light model, Dominos has still managed to leverage franchising in its favor- this can be attributed to its robust supply chain.
Supply chain’s contribution to overall Domino’s’ revenue
Source: Domino’s financial records
Now that we’ve extensively spoken about franchises and established some context, this brings us back to the question we had- what impact will COVID-19 have on franchising? We think this can go 2 ways.
1. Physical Stores will become less popular- Only Open Kitchens and Warehouses will exist as people get very wary of visiting crowded spaces. Even highly able QSRs like KFC are scaling up their Dark Kitchens. This decreases the Capex required and thus, the company might just own and operate all the stores themselves. Consumers are also getting hyper-aware about hygiene and this demands a tighter rein on Quality Control. It’s hard to maintain quality across franchises and thus, franchising as a concept would decrease drastically.
2. Access to Capital is getting tougher as people are financially constrained- they don’t have enough cash to start their own stores. Franchising, as an alternative form of capital acquisition, makes it a more attractive option. Since the franchisee provides all the capital required to open and operate a unit, it allows companies to grow using the resources of others. By using other people’s money, the franchisor can grow largely unfettered by debt.
Franchising definitely has its perks and we’ve extensively spoken about its merits. But, franchising in India can also be especially risky because India has no legal framework for franchises. It is simply covered under the broad definition of ‘Transfer of Technology’. This accentuates the Quality Control problem as the Franchise Agreement can be exploited and the legal recourse will take ages.
What we find really interesting about franchising is that although it’s not a one-stop solution to all the business’s problems and it may certainly not be fit for all businesses, the moment you realize it’s the right business model for you- it works like wonders. If used well, it can give you easy access to capital, help you penetrate foreign markets at a lower cost, and improve your valuations. So, pick your tools wisely.
Gaurav Marya, Chairman of FranchiseIndia, puts it very well- “Franchising is like a painting – it must be picture perfect to attract someone to buy it, install it and admire it forever.” Comparing Franchising to Art, he suggests a theory- the Picasso Theory. It lays down a structure for everyone, from local brands to conglomerates entering a foreign market, for franchising.
Source: Franchise India
A special thanks to Mr. Arunabh Sinha for taking out the time and sharing his knowledge and insights about this space with us.