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October 2005 |
Volume 6, Issue 10, Part 1 |
Everyone knows that a franchisee is far more likely to succeed than an independent business owner. But now we're about to reveal to you that franchise companies that go public are also more likely to thrash the competition. Public franchises enjoy many advantages over both non-public franchises and public non-franchises, but not every franchise is ready for an IPO. In this issue we speak with Prof. Steven Spinelli from Babson College and Jeff Rosenfeld from Kessev Finance to get their views on publicly traded franchises.
 Steven Spinelli, the co-founder of Jiffy Lube, sold his highly successful franchise in 1991 and launched a new career in academia. He is now Vice Provost at Babson College, the preeminent school for entrepreneurship in Wellesley, Mass. In addition to teaching classes on franchising, Spinelli has been studying public franchises and how they measure up against Standard & Poor's (S&P) companies. So far, public franchises are getting high marks. "As of 2001," says Spinelli, "publicly traded franchises have outperformed the S&P 500 by about 12%. That has been the case for 13 out of 14 years."
 In his research, Spinelli looked at a number of variables and numbers that affect growth and performance. What he uncovered were several contributing factors: number of company stores versus franchisee units, total advertising expenditure, up-front fees and royalties. Successful public franchises have a greater percentage of company owned stores, which puts them more in touch with the marketplace. They spend more on institutional advertising (and charge higher advertising rates for their franchisees). And their franchise fees are lower and royalties are higher than typical franchises. "Instead of charging a high up-front fee, public franchises often charge higher royalties. That just seems logical to me," says Spinelli," but there's some angst in the marketplace around that. The market signals are mixed. Some prospective franchisees think that if a franchise can compete successfully in the marketplace with a high upfront fee that must mean there's proven success. On the other hand, franchises that don't try to get their profit upfront are sending the message that they are willing to bet on the long-term success of their franchisees."
Identifying superior performance strategies
Spinelli dug deeper to figure out why some public franchises did better than others. "In my latest work, I looked at a subset of franchises with a superior performance profile. That's the "best practices" group that is clearly superior - at least anecdotally - to almost anyone else in the world. I found there are a couple of things going on. One is a strategic growth strategy, which is much more focused on the 20-25 most densely populated areas. They seem to get to critical mass of units in those areas more efficiently than other folks. I think the key is having a real estate strategy. Because they are publicly traded and have a significant earnings history they are able to acquire growth debt in the form of mortgages, equity, and corporate debt. It is the real estate strategy that lowers their cost of capital. With a lower cost of capital their business model, its core foundation, is more robust. They've used the weight of their success strategically in acquiring capital, therefore improving the business model. They are focused on strategic growth and using lower cost of capital to achieve that growth," asserts Spinelli.
Do public franchises breed better franchisees?
Although Spinelli has not compared the performance of public franchises versus private franchises, he has noticed possible differences in franchisees between the two types of organizations. He continues, "We are doing case studies on franchisees as we speak, looking at those who have 30 units or more in publicly traded franchises. Usually when we look at publicly traded franchises we are looking at fairly sophisticated organizations. So we are asking the question: does that breed a more complex, more sophisticated set of franchisees?" Spinelli says the answer is yes, but not necessarily as a direct result of anything the franchisor has done. "They are acquiring more significant franchisees who are thinking more in terms of growing their organizations as a part of the corporate culture. It's a very interesting phenomenon. We are not seeing embedded systems of the franchisor being substantially more sophisticated. But rather we are seeing franchisees who are growing their own organizations who are more sophisticated. So there is correlation, but not causation. And I have to say I am a little bit surprised by what we are finding early on in this study," says Spinelli.
Despite the overall rosy picture of public franchises, Spinelli says there are pitfalls. "The biggest ones are early on in the process, but there are also some followup issues. The first pitfall I clearly see is when companies are going public they are so pressed to tell a story of growth that they sometimes put a higher priority on the growth rather than the management of the system. That can result in business format glitches and after the company goes public there can be some fraying between the franchisee and the franchisor. Other issues that emerge post-IPO are normal pressures in a public company for quarterly reporting and growth. There is going to be some pressure there and that can cause some imbalance toward growth,"says Spinelli.
Contact Information: Steven Spinelli, Vice Provost, Babson College, spinelli@babson.edu, www.babson.edu
Kessev Finance is a corporate finance boutique in Minnesota that specializes in the franchise industry exclusively. As managing partner for the firm, Jeff Rosenfeld is well versed in the financial issues surrounding public franchises. Rosenfeld says that less than 1 percent of franchises are public, "but I think that's true for most industries. To qualify to take a franchise system public you need to be large enough that institutional investors will be able to both own the stock and be able to trade it. That means you need a market cap of at least $75 to $100 million. At that level, you will be attractive and have liquidity in the marketplace, but even so you are still a little on the small side and may not be attractive to the institutions," says Rosenfeld.
Rosenfeld says the most important qualifier for going public is showing that you have a use for the money. He says, "Use of proceeds is very, very important. It is possible to take a company public when all you want to do is sell your stock, but for the most part, the market wants to buy your stock because you've got enormous growth opportunity. Investors will expect their stock is going to go up in value based on those growth opportunities so they will be looking for a track record. The old rule of thumb still stands: 15% growth in sales and 20% growth in profits. And even though you may have 100 units up, is there an opportunity to put up another 500 units? That would be a good indicator of growth potential."Almost always Rosenfeld says that you will have to show 2-3 years of very good company profitability. Investors will look to see if your unit economics have been very successful." That means that you've been opening units, that the units have great returns, that the units that you opened have stayed open, and that your franchisees are happy," claims Rosenfeld.
The ups and downs of going public
 Rosenfeld says the biggest advantage to going public is being able to raise money. He goes on, "If you need to raise a significant block of capital, going public is the cheapest way to do it. A publicly held company typically has easier access to other capital as well. So once you're public you may find that it's easier to borrow and the terms you get from the lenders are better." Rosenfeld says it's also a good way for owners to liquefy holdings. "You may have been growing for the last 5 or 10 years as a private company and people who now own the stocks want to get their money out. Going public may be the best way to do that. For owners, it also provides a value flag. So even if you don't sell your stock, there's a financial value to your holdings. You can go to a bank and borrow against the value of your stock. That essentially gives you a commodity with which you can make acquisitions." Rosenfeld adds, "I might also help you sell franchises if both the company and the stock are performing well. Potential franchisees might view it like the Good Housekeeping Seal of Approval."
But for all the advantages, Rosenfeld again stresses the importance of size. "Everything comes with a price. Today, if we are talking about a smaller company in the $100 million or less range, the cost can be prohibitive and the costs of going public keeps going up. There are both hard costs and soft costs to consider. It could easily cost a company $1 million a year to be public. Then there is the time that management spends working with analysts, supporting the stock, and going to conferences and making presentations. And you become part of the quarterly earnings game. There is a lot of pressure to make a quarter look a certain way. The reporting issue is huge and for a lot of companies it's simply not worth it because it actually adds to the million dollars of going public. If I were talking to a $100 million franchise company that was looking to raise money for liquidity, I'd probably say there might be a better way that you haven't thought of. There may be some other things I can do to meet your capital requirements without having to give up ownership of the company," responds Rosenfeld.
Contact Information: Jeffrey Rosenfeld, Founder and Managing Partner with Kessev Finance, (612)924-9081.
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