Funding an AR Growth Strategy: Five Key Elements Are Essential To Success

In these uncertain economic times, emerging franchise companies are finding it difficult to fund their franchise expansion strategies. Traditionally, franchise companies fund their startup and expansion in one of two ways:

1. Shoestring. Startup and expansion funds come from friends, family, home equity, and credit cards (although many of these traditional funding sources are hard to obtain these days). If all the stars align correctly, this initial capitalization bridges the gap until internally generated cash flow is able to fund future growth.
2. Institutional capital. There are two sources of institutional capital: a) loans, and b) venture or angel funding. Loans generally originate with banks. Loans often require significant collateral and personal guarantees. Institutional investors traditionally do not invest in franchise companies because they do not "get" franchising--although in recent years, this trend is changing as some institutional investors are funding more established franchise companies' expansion strategies. Angel investors do make investments in franchise companies, but often require a significant amount of control, which some franchise entrepreneurs find objectionable.

A franchise company has two assets of intrinsic value: a) intellectual property, which constitutes the "franchise system"; and b) the geographical franchise territory. Many franchisors do not realize that the opportunity to fund their startup and expansion costs can be obtained without borrowing or selling equity by leveraging these assets.

Structural funding

Structural funding is a financing mechanism that creates capital through sale of a franchise company's intellectual property and geographic territory. This can be compared to a sale/leaseback of a company's real estate to generate cash. Combine the sale of these assets with the implementation of an organizational structure that shifts operational costs and support responsibilities to a strategic partner, and you have an innovative strategy that can be used to completely fund a franchise company's start-up and growth strategy.

Here is an overview of the advantages and disadvantages to funding strategies:

Mechanism      Debt         Loss          Loss of     Revenue      Cost

              Service     of Equity       Control     Sharing    Reallocation

Structured      No            No             No         Yes       Yes

Funding

Loans (Banks)   Yes         Possible      Possible       No       No

Venture/Angel   Not           Yes          Likely        No       No

Investors       usually

There is no right or wrong funding solution. Each has its own advantages and disadvantages. However, structural funding is not reviewed by loan or investor committees. It is more akin to simply finding a good partner.

How an AR structure works

There are five elements in successfully structuring an area representative franchise growth strategy:

1. Value creation. The sale of intellectual property and geographical territory is the mechanism that generates revenue in the form of initial area representative (AR) franchise fees. The initial fees can range from $50,000 to $300,000+ per territory, depending on the complexity of the franchise system and the size of the geographical territory being awarded. These fees are deployed by the franchisor to market the AR strategy, to underwrite the training and support of the AR, and to offset other operational costs in managing the franchise company and the AR program.
2. Royalty sharing. The sharing of royalties creates a business arrangement in which much of the operational and support responsibilities are transferred to the AR strategic partner. The royalty sharing percentage can range from 40 to 75 percent, depending on the scope of support the AR is responsible for providing to franchisees. Some agreements delegate all training, opening, and ongoing support to the AR; in other situations the franchisor retains training and opening responsibilities, and field support is the only responsibility of the AR.
3. The right franchise development schedule. Frequently, franchisors are too aggressive in establishing unit franchise development schedules. If a development schedule is too aggressive, an AR may award franchises to marginally qualified franchise candidates, simply to meet the development schedule.
4. Recruiting Mr./Ms. Right. In my experience, an adequately capitalized sales-oriented individual is a better AR candidate than a well-capitalized, resumé-rich senior corporate executive. Talented operational individuals can be recruited more easily than a franchisee-centric motivator and sales-oriented executive.
5. The right support infrastructure. Most franchisors that implement an AR program use the same support system and personnel that they use to support their franchisee network. This is a huge mistake. Franchisees and ARs are two distinct constituencies. They need an appropriate support system that is focused on their needs.

A properly executed AR program will lead to brand dominance, and over the long term crush competition, which leads to profitable franchisees. These profitable franchisees generally provide higher-quality customer service, which creates customers, leading to even more brand dominance and profits, which attracts more franchisees, and the virtuous cycle continues. All of this is made possible by adopting the structural funding strategy and properly executing the area representative franchise growth strategy.

Marvin L. Storm is Managing Director of Blackstone Hathaway, which specializes in using area representatives as a franchise growth strategy. He can be reached at 925-376-2900 x201 or mstorm@blackstonehathaway.com.