Steps to improve the franchisee's profitability

One of the age-old critiques of the financial structure of the franchisor-franchisee relationship is that the royalties payable to the franchisor are typically based on gross sales -- not net profits. Therefore, franchisees often perceive (rightly or wrongly) that the franchisor will build a culture of support and training which over- stresses building sales but not on improving profits. Naturally, in the long run, it's in neither party’s best interest if franchisees operate at a break- even or loss level on a sustained basis, as that only leads to franchisee resentment and frustration, or even to franchisee failure or litigation.

Therefore, a franchise's CFO and his team must communicate a commitment to the profitability of the franchisee. There must be financial management training and support programs which teach franchisees how to prepare and analyze a franchise P&L statement. In addition, field support personnel should have some financial analysis background and training. The field support personnel must be trained to detect “red flags” in the franchisee’s P&L statements and effectively communicate tips and traps to the franchisees and be in a position to conduct non-adversarial strategic audits which will focus on unit economic performance and profitability. The franchisor must teach the franchisee how to market, price and deliver the underlying products and services in the system in a profitable fashion. The franchisor must also take steps to negotiate volume discounts and develop cost management training for the benefit of the franchisees, recognizing that profitability is a combination of increasing sales and controlling costs. The franchise fee and royalty structure should continue to be analyzed to ensure that it is in line with current market trends and actual store performance data. And this applies to all franchise opportunities.

Agenda for Unit Performance Audit

In times of economic recession and financial market turmoil, it is critical that franchisees are armed with the tools and the support that they need to survive and thrive during financial management warfare. Although the accumulation of these skills and experience is technically their own responsibility, franchisors who develop training programs and conduct periodic mandatory store operations and financial performance audits will enjoy a much healthier franchise system. Try to instill a 'what gets measured gets managed' philosophy with each of your franchisees.

Topics to be covered in this strategic audit should include at a minimum these ten (10) items:

1. Market trends and competitive analysis
2. Store level SWOT analysis
3. Quality and integrity/durability of sales revenues and A/R analysis
4. Strategic review of all fixed and variable costs, vendor relationships and operating expenses
5. Break-even analysis
6. Benchmarking and key metrics assessment
7. Cash flow and cash management analysis
8. Candidacy for growth/additional unit assessment
9. Taxes and estate planning (including owner(s) compensation and benefits)
10. EBITDA and shareholder value drivers analysis

Some franchisors have offered to bring certain financial management and administrative services support functions, which would otherwise be performed by the franchisees or area developers and their accountants, under the franchisor’s roof for a monthly fee. Franchisors may consider bringing one or more of the following functions under the responsibility of the franchisor’s headquarters:

• per-unit calculation of revenue and expenses by accounting category based on the franchisor’s standard chart of accounts and calculation of royalty-based revenue and royalty fees (as each term is defined in the Franchise Agreement);
• administration and maintenance of payroll, and administration of the processing of payroll and calculation of applicable tax and other withholdings relating to the franchisee or area developer’s units, either through the franchisor’s designated payroll service bureau or through in-house technology;
• administration of accounts payable (including check generation and wire transfers);
• administration of recurring cash transfers between the franchisee’s or area developer’s applicable unit and corporate bank accounts;
• maintenance of lease files and compliance with reporting and disbursement obligations thereunder;
• administration and maintenance of a franchisee or area developer general ledger trial balance, balance sheet, income statement and certain other corporate and unit reports by accounting category per the franchisor’s standard chart of accounts and consistent with periodic reports the franchisor customarily prepares in the normal course of business to manage its financial affairs, and periodic distribution of such reports to franchisee or area developer using the franchisor’s standard report distribution system;
• maintenance of all accounting records supporting franchisee or area developer financial statements (consistent with the franchisor’s record retention program) in reasonable fashion separate and discrete from the accounting records of the franchisor; and
• preparation of period end reconciliations and associated period end journal entries for all franchisee and area developer balance sheet accounts.

Andrew J. Sherman is a Partner in the Washington, D.C. office of Jones Day, with over 2,500 attorneys worldwide. Mr.Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies. Mr. Sherman is an Adjunct Professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University where he has taught courses on business growth, capital formation and entrepreneurship for over twenty-three (23) years. Mr. Sherman is the author of twenty-one (21) books on the legal and strategic aspects of business growth and capital formation. His eighteenth (18th) book, Road Rules Be the Truck. Not the Squirrel. (bethetruck.com) is an inspirational book which was published in the Fall of 2008. Mr.Sherman can be reached at 202-879-3686 or e-mail ajsherman@jonesday.com.