The Metrics of Successful Franchise Systems

June 27, 2016

Prospective franchisees should approach ownership by focusing on the investment opportunity rather than viewing it from a customer’s perspective. Proper due diligence and the identification of key risk factors can influence the success or failure of a new franchise investment.

By Jeff Lefler

This report provides an in-depth analysis of the metrics of successful franchise systems from 2010 to 2015. A breakdown of three groups of franchise systems are analyzed: 407 Start-up Franchise Systems consisting of businesses that were franchising but had zero franchise outlets in 2010; a subset of 331 Emerging Franchise Systems, those with between 25 and 50 franchise outlets in 2010; and 559 Established Franchise Systems, those with above 100 franchise outlets in 2010.

Start-up Franchise Systems

In the FranchiseGrade.com database, there are 407 franchise systems which had zero franchise outlets disclosed in their 2010 Franchise Disclosure Document’s Item 20. Although there were new franchise systems that began in 2011 and beyond, the data centers around the performance of those franchise systems from 2010. Of those franchise systems:

103 are no longer in our database,
154 have opened five or more outlets within the five-year period,
A total of 11,372 franchise outlets were opened from 2010 to 2015,
The net growth was 9,852 franchise outlets,
Franchisees invested $5.67 billion into these
franchise systems.

Interestingly, 22 percent of the emerging franchisors in our database have projected openings of more than two-times their existing locations at the end of 2014. Start-up franchisors with company-owned locations have better survival rates and a larger percentage of those systems have faster development and growth. There is a significant difference in the success rate of start-up franchise systems with 10-plus company owned locations.

Metrics of Successful Start-Up Franchisors:

Operate multiple company-owned locations to sustain slow franchised growth,
Have reasonable Projected New Outlets and Sold But Not Opened values in their Item 20,
Provide an Item 19 Financial Performance Representation,
Have higher Franchise Fees in Item 5 and do not discount fees.

Emerging Franchise Systems

In the database there are 331 franchise systems which had between 25 and 50 franchise outlets disclosed in their 2010 Franchise Disclosure Document’s Item 20. Of those franchise systems:

42 are no longer in our database,
129 have opened 25 or more outlets within the five-year period,
98 have net growth of 25 or more outlets within the five-year period,
131 have zero or negative growth since 2010,
A total of 13,234 franchise outlets were opened from 2010 to 2015,
The net growth was 7,645 franchise outlets,
Franchisees invested $20.99 billion into these franchise systems.

An interesting point regarding emerging franchisor research is the amount of Item 19s incorporated into the successful franchise systems. By 2015, 84 percent of emerging brands with a minimum net growth of 25 franchise outlets have included an Item 19 in their FDD. This compares to only 36 percent of negative growth franchise systems and 49 percent of franchise systems with growth between one and 19 franchise outlets.

Metrics of Successful Emerging Franchisors:

Provide an Item 19 Financial Performance Representation,
Provide longer initial terms than their competitors,
Disclose more accurate additional funds estimates in their Item 7,
Have a lower Franchisee Turnover Rate.

Established Franchise Systems

In the database, there are 559 franchise systems with more than 100 franchise outlets disclosed in their 2010 Franchise Disclosure Document’s Item 20. Of those franchise systems:

Five are no longer in our database,
91 have opened 100 or more franchise outlets with the five-year period,
62 have opened between 50 and 99 franchise outlets,
119 have opened between one and 49 franchise outlets,
271 have negative franchise outlet growth,
A total of 128,399 franchise outlets were opened from 2010 to 2015,
The net growth was 14,287 franchise outlets,
Franchisees invested $138.77 billion into the franchise systems.

Franchisee Turnover Rate is notably different between successful and unsuccessful established franchise systems. Successful franchise systems have an FTR of 7.8 percent compared to unsuccessful systems at 13.7 percent. Successful franchise systems have a higher number of transfers and lower franchisee terminations compared to more terminations and ceased operations for unsuccessful franchise systems.

Metrics of Successful Established Franchisors:

Have a lower Franchisee Turnover Rate,
More turnover attributed to Transfers,
Quick-Service Restaurants make up 33 percent of successful franchise systems versus 18 percent of unsuccessful franchise systems,
Lodging makes up 11 percent of successful franchise systems versus 6 percent of unsuccessful franchise systems,
Business Services make up only 3 percent of successful franchise systems versus 14 percent of unsuccessful franchise systems,
All other franchise sectors have proportional representations within successful and unsuccessful franchise systems.

Top Five Indicators of Successful Franchise Systems

Prospective franchisees may start their search for a franchise based on their consumer experience. However, what is important to a consumer is not as important to an investor. There is a significant difference between a good consumer franchise and a good investment franchise.

The expected outcome for prospective franchisees is receiving a quality return on their investment, a reasonable salary and improving the quality of life for themselves over the term of their investment. Investors would not purchase stock of a publicly traded franchise system because they like that company’s food or enjoyed a good night’s sleep at a hotel. Investing in that franchise as a franchisee should not be any different.

Here are five key risk variables to consider when searching for successful franchise investments:

Franchisee Turnover Rate: The number of franchise outlets that were terminated or ceased operations over the past five years is a measure of successful or unsuccessful franchise systems.
Franchisor Revenue Generation: A franchisor needs to ensure it is profitable. There are three primary revenue sources for franchisors: franchise fees, royalties and mark-up of goods or services sold to franchisees. An imbalance in the mix and make up
of a franchisor’s revenue can be an indication of future risk.
Franchisee Growth: A stable, long-term growth path is important to franchise health. Rapid growth could create management strain or a sporadic growth pattern could signal lack of concise development plans by the franchisor.
Item 19 Disclosure: Franchisors who provide an Item 19 give prospective franchisees the ability to create a realistic pro-forma or cash flow statement. This is a key component of a successful franchise system.
Executive Team: The culture of a franchise system is extremely important. Do executives view franchisees as a source of revenue or as a resource to drive future revenue? The best way to assess the culture and relationship is to call as many franchisees as possible and ask them directly.

Individuals who seek franchise investments need to migrate away from a customer mindset and focus on the investment opportunity. The need for proper due diligence and the identification of key risk factors can influence the success or failure of a new franchise investment.

Jeff Lefler is CEO of FranchiseGrade.com. Find him on fransocial.franchise.org