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In the land of benchwarmers and black swans, consider PE’s impact

January 29, 2020

It’s a buyer’s market out there. Consider how many franchise buyers there are per year. Do new concepts attract new buyers to franchising, or pull from the existing buyer pool?

It’s also a crowded market. FRANdata reports there are 4,000-plus active U.S. franchise brands, and 200-300 new concepts enter annually (5 to 7.5 percent growth). Forty percent of brands entered since 2012. Can this influx continue?

New brand entry outstrips overall franchise unit growth. Annual net unit growth averaged 1 to 3 percent since 2012, or around 13,500 per year.

FranchiseGrade, meanwhile, estimates 80 percent of U.S. franchise unit growth resides within the top 26 percent of brands. The top quartile dramatically outperforms the field—they sign more deals, open more units and keep them open. This demand/supply disconnect will force some brands to get creative in order to grow.

I never want to be a benchwarmer

The U.S. Census counted 860,000 new business applications in Q3 2019, and estimates that 78,000 new start-ups with payroll will actually form within four quarters from those applications. That’s 300,000-plus newly formed U.S. businesses with payroll per year. Franchising is only a small portion. Why doesn’t franchising command a larger share of the market’s otherwise robust entrepreneurial appetite?

A typical franchise model has a 10-year agreement, and charges franchisees initial fees, royalties, marketing, training, technology and ongoing fees. Some also require purchases from the franchisor or approved vendors. Franchisees typically carry most of the start-up cost and risk.

The current model creates buyer uncertainty, along with a swelling inventory of unopened units (16,000 in the U.S. according to FRANdata,) and fails to attract many potential investors. Unit growth is concentrated among a few brands; the rest struggle to grow.

Due to market pressure, more brands may turn to shared-risk models. This may change buyer expectations. (Remember when you paid for shipping?) Reduced royalties or marketing consideration during start up may become more common. To speed up target market expansion, franchisors could lease locations themselves and then find operators to take over via workout plans. Guaranteed buy-out is another approach. Whatever the chosen method, changing the risk-reward equation (or reducing the perception of start-up risk,) could attract new franchise buyers who otherwise wouldn’t enter.

I see a black swan, and I’m not in Australia

One of my favorite books is “The Black Swan: The Impact of the Highly Improbable,” by Nassim Nicholas Taleb. Taleb asserts we aren’t good at predicting the future because “we underestimate outliers—or black swans.”

What must be true for your franchise to thrive long-term? What core assumptions underlie your strategic planning? What outliers could invalidate those assumptions?

One threat may be the competitor with a game-changing strategy to win and the financial backing to pull it off. What if brands are better funded earlier in their lifecycle instead of the bootstrapped, founder-led franchise entrants we’re used to seeing?

Go big or go home

Cue private equity. Instead of gradually funding infrastructure one franchisee at a time, what if your competitor suddenly received a multi-million dollar cash injection? What if that cash funded a new shared-risk paradigm, improved operating processes, added expertise, or delivered better franchisee support? Would your brand be relevant next to a competitor adding units five to 10 times faster?

Private equity is accustomed to funding high-risk start-ups (i.e. pharma and tech) that disrupt and reinvent to win. Under PE’s growing influence, franchisors may pursue more aggressive growth strategies. PE traditionally prefers large deals, and recently PE has preferred mature franchise brands. FRANdata estimates 69 percent of brands acquired by PE in 2018 had been franchising more than 10 years. That proportion was 83 percent by Q3 2019.

However, upstarts with fresh concepts and less baggage may soon look more appealing. Frothy multiples and deal competition among larger brands may also drive PE to smaller brands in search of more flexibility and larger potential exits.

The right bets made earlier in the life of a business can actually de-risk the investment, accelerate a brand’s trajectory and create higher exit valuations.
Self-funded brands will increasingly face PE-backed brands with more aggressive tactics and less patient timelines. As PE focuses on building platforms, infrastructure and support are likely pain points at standalone brands. Prospective franchisee perceptions will evolve. Candidates may come to view PE ownership as both a source of cash and brand legitimizer. Put another way, which investment has the appearance of less risk for your retirement savings, a bootstrapped or PE-backed franchise?

The disruptor could be a suddenly well-funded competitor using aggressive growth tactics. PE could bolt your competitor into a portfolio to enhance franchisee value and share operating costs, while you remain isolated. What disruption can your brand create? Withstand? The next generation of franchising is about disruption.

The right strategic investments act as accelerants. Iconic brands of tomorrow will invest today in more aggressive differentiation strategies. Top brands will both win deals away from competitors, and attract entirely new buyers who never before considered franchising.

In fact, the ability to consistently pull new buyers off the bench and over to franchise ownership may be one of the best markers of an iconic franchise brand.