Sotos LLP

The Stages of Restaurant Franchising

At its core, franchising is nothing more than a strategy for business expansion. Most franchised restaurant systems begin with a single-unit operation. The restaurant proves to be successful, and the founder believes the concept and its success can be replicated elsewhere. The founder could choose to invest in and open more restaurants, or they could choose to expand their operations through franchising. Depending on one’s circumstances, the latter option may be more attractive. To that end, franchising typically allows a restaurant concept to grow more quickly and at a reduced risk, utilizing the capital and efforts of would-be franchisees. In turn, the franchisor realizes a smaller return from each unit than if it operated it itself.

Franchising a restaurant concept goes through fairly identifiable stages, from “birth” to “emerging” to “growth” to “maturity” and, potentially, to “exit”. Each stage brings with it new challenges and new opportunities. This article explores the typical characteristics of each stage.

Stage 1 – Birth

Most restaurant concepts are not started in anticipation of future growth by franchising. Some, however, are. Irrespective of the original intention for the concept, the birth stage for a restaurant franchise system must have the following characteristics:

  • a name that holds prospects for obtaining a registered trademark;
  • a unit that not only generates profit, but sufficient profit such that, if operated as a franchised business, it would continue to be profitable in the face of the added expenses that a franchisee would be required to pay to the franchisor (and possibly others); and
  • a “system”. A “system” includes all or some of the following components—a distinctive look and feel to the restaurant design, an optimal footprint, proximity to a welcoming customer base, a recommended or fixed equipment list, a methodology for preparation and service and an intended brand image.

The birth stage is also when the would-be franchisor must first understand the legalities and regulatory environment affecting franchise sales and franchise relationships. To that end, where statutorily required, the “system” must also include a form of disclosure document, a franchise agreement and a whole range of potential ancillary agreements to provide to prospective franchisees.

Supplementary issues for consideration at the birth stage include whether the restaurant franchisor intends to supply certain core products to its prospective franchisees and the logistics of doing so, as well as whether it intends to sell units with sites in hand or before sites have been identified. These decisions may change over time.

With these attributes in hand and determinations made, the franchisor can begin to sell franchises.

Stage 2 – Emerging

An emerging system begins with the first franchisee and, from this author’s perspective, continues until the system reaches such a size that the franchisor has created independent value in itself as a franchising company. Hallmarks of value include, among other things:

  • a stream of royalties and other payments coming in the door from franchisees;
  • receipt of rebates from suppliers; and
  • recognition of the brand outside of the trading area of the individual units.

The emerging stage may last for the first ten to twenty units.

From an administrative perspective, during the emerging stage, franchisors begin to evolve from an initial group of all-purpose personnel into an organization with specialized subgroups in charge of various discrete tasks, such as site selection, franchisee sales, menu development, product input selection, compliance, marketing and training. This organizational division will continue from the emerging stage through to maturity.

In addition, with respect to the issues of site buildout and location control, restaurant franchisors often make the important decisions at this stage of their growth whether they will take direct leases for locations or whether they will require franchisees to do so, and what role they will play in the build out of units, including the possibility of doing the construction themselves.

Stage 3 – Growth

In the growth stage, a franchisor is operating a recognized franchise system. Among other things, this translates into:

  • the franchisor’s ability to access capital as desired to hire further staff, expand extra-provincially or internationally and to pursue other development strategies. In connection with this, the franchisor has also retained research and development personnel tasked with evaluating what modifications the system may need to adapt the concept to new markets, if necessary;
  • the capacity to bring in-house certain activities which may have been previously outsourced (g., marketing, sales, legal, site selection);
  • increased market knowledge (g., about the system’s customer base and the attributes of successful franchisees);
  • well-established supply chains and rebate agreements;
  • a developed philosophy around unit transfers;
  • at least one wholesale review of the franchisor’s original agreements to reflect the evolving realities and needs of the system; and
  • reliable franchisor profits.

In Canada, the growth phase may include up to forty units, give or take. This milestone may require anywhere from five to ten years to achieve depending on the success of the concept.

Given the length of operations typically required to reach this stage, franchisors at this level of growth also start to face renewals and extensions of franchise agreements, renovation requirements and possibly unit transfers and franchisee-successors. Leases are coming up for renewal and new rents must be negotiated or arbitrated. While the system’s branding may need a refresh, its social media profile, messaging and identity are well-cemented in its markets.

Finally, the franchisor is in a better position to operate locations in the event it needs to terminate a franchise. To that end, in all likelihood, the system has experienced disputes, the creation of franchisee advisory boards and potentially a franchisee association, multi-unit operators, terminations, take backs and re-sales.

Stage 4 – Maturity

At the maturity stage, the sky is the limit in terms of system growth. Units are sold and developed at the rate that the system can handle, subject to what markets are available and feasible in light of supply chain issues, competition and the interest and ability of the franchisor to be in and service those markets.

At this stage, most founders are considering one or more of the following as next steps:

  • bringing in professional management;
  • bringing in private equity;
  • acquiring other systems;
  • making an initial public offering;
  • internal succession;
  • merging with other systems; and
  • potentially selling the system in whole or in part to other investors.

Stage 5 – Exit

A thorough discussion of the options available to founders of a mature system seeking an exit is beyond the scope of this article. Suffice it to say that throughout the life cycle of a franchise system that achieves maturity, its founders will become well-acquainted with the available exit strategies and will undoubtedly be giving consideration to what they may want to do eventually.

Two brief points ought to be mentioned:

  • early identification of a founder’s long-term goals is critical, particularly when those goals are to eventually exit the system. In that case, the sooner the founder can tailor the characteristics of their system to be most conducive to their proposed exit strategy, the better; and
  • as part of the franchisor’s strategic planning session, which is customarily held at least annually (and which also ought to include risk assessments and risk management planning and implementation), the agenda should include discussion of the potential or designed exit plan.

Conclusion

The trajectory of a restaurant franchise’s development is linear, moving from the first stage to the next, and so on. While this article has explored the typical characteristics of each stage, it is important to note that:

  • the unit count in each phase may vary from system to system;
  • the length of time it takes each system to move from stage to stage will vary; and
  • some characteristics of a particular stage may be realized sooner in the lifecycle of a franchise system or later than what is described above.

Ultimately, how fast and how well a franchisor moves from stage to stage will typically turn on the franchisor’s level of sophistication, the demand for franchises and by the levels of satisfaction and growth of its franchisees.

 

Allan Dick, Sotos LLP

At Sotos LLP, we have assisted franchisors at all stages of growth. We help franchisors accelerate their development by introducing best practices to contribute to their success. Please contact the author at adjdick@sotos.ca or 416-805-8989 if you are interested in franchising or if you are looking for experienced counsel dedicated to your success to assist you with the development of your system.

 

 

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