Unit Economics: Boosting Financing Prospects Through Increased Disclosure

We are no longer doubting whether we are in a downturn. (As an economist, I'll refrain from calling it a recession until the economy's performance meets the technical definition.) Now the issue is how long, and how deep, a downturn we are in. Let's take the conservative approach to economic forecasting and assume that it could be longer and deeper than the past few downturns. What does that mean for unit development?

Conventional wisdom says, based on past downturns, that we should see an increasing pool of prospective franchisees in the latter stages and that franchising will carry lots of growth momentum out of the downturn. Things may be different this time around, as I noted in my last Market Trends article.

What does all of this have to do with unit economics? In today's world, it seems, a lot. Experienced franchisees looking to grow have knowledge of franchising and insights into what makes a good franchise investment. This group came of age in the past decade or so and now controls half of all franchised units in the U.S. They have influenced how franchisors conduct the business of franchising and how prospective franchisees look at franchise options.

Among those influences are the types of information they seek from franchisors. At the top of that list is how much profitability there is in a unit investment. One way or the other, any investor looking at an investment option needs to make an assessment of the return expected from the incremental investment. That is why we see significant numbers of franchise brands today (more than 700) making financial performance representations.

In a perfect economic franchise world, the unit economics of all brands would be known by potential investors. Brands with better unit economics would generate lots of interest, allowing them to raise initial fees and/or royalties. Brands with weaker unit economics would have the opposite outcomes, likely leading to the disappearance of some brands.

Don't be shocked to know that this is starting to happen. With a concept's unit initial investment, sales per square foot, and cost of goods sold, an experienced retail franchisee can make a pretty good estimate of how profitable that investment option is--and therefore how attractive it is. While the data requirements may change, the same basic analysis holds true in each of franchising's more than 230 sectors.

What many of us overlook is how similar prospective franchisees and financial institutions are: they both want to evaluate unit economics before coming to a decision. Prospective franchisees assess the opportunity and risk associated with a brand and a particular unit; and financial institutions make a similar assessment when determining whether to make credit available.

Financial institutions live in the world of assessing lending risks. They price a commodity, money, and structure access to that commodity in ways that help them get a profitable return on those risks. If they have better information about a franchisee borrower and the brand they are seeking capital to expand with, they are more likely to grant access to that commodity. Further, they are more likely to structure the terms of a transaction more favorably than if they have less information.

In past downturns, credit wasn't a constraint on unit expansion coming out of the downturn. Following our conservative approach to forecasting this time around, there are many reasons we should assume that financing may indeed be a constraint on unit growth this time around. Again, we end up back on the topic of unit economics. Good unit economics is a great risk mitigation tool for lenders. That also makes it a great marketing advantage for franchisors.

What exactly does unit economics mean? From a business perspective, it is the financial return that is expected from an investment. FRANdata has done a lot of analysis of unit financial performance claims for franchisors, as well as for prospective franchisees. Here's a sample using real data (but not disclosing the 10 individual concepts or their common sector), showing just how helpful this type of analysis can be for franchisors, franchisees, and the financial institutions they need to finance unit growth.

I'll let the graphs tell their own story.

Darrell Johnson is president of FRANdata, an independent research company that has been supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or djohnson@frandata.com.