Updated: Dec 18, 2020
A debate among investors raised a question. Is better to buy a franchise or to buy or create an independent small business? This post compares and contrasts the virtues and vices of each while landing on the answer: it depends. The same outcome can be achieved with both, so this is really a question of means and not a question of ends.
What is a Franchise?
In some ways, pointing out the differences between a franchise and an independent small business is like highlighting the differences between real and personal property. You start by defining one and end by saying the other one isn't that. For instance, real property is land and everything permanently attached to it. Personal property is everything else. There are significant differences between independent small businesses and franchises, so lets begin with a definition of a franchise.
A franchise is an investor-funded corporate growth strategy. Mind you, this is a practice-developed definition. From a practice perspective, a franchise is not a business at all, per se. It's a strategy. A tactic. A means to an end.
A franchise is a way for a private business owner to get someone else to pay for the growth of the business through an investment. The private business owner is called a franchisor. The new investor is called a franchisee who receives majority ownership of the part of the growth financed. The minority ownership share is determined by the percentage of revenues and profits owed to the franchisor on regular intervals, along with royalty, training, and marketing fees. By contrast, independent small businesses are very different.
Guidance vs. Control
When you buy a franchise, you are buying a company that comes along with a lot guidance (presumably) and a little bit of control (if any). When buying an independent small business, you're buying a company that comes with no guidance and total control. You have complete freedom to create your own processes while being responsible for all operational expenses.
The True Owner
One question that often comes up when these kinds of topics are discussed, is whether a franchise can be properly characterized as "your business." The answer to this question is no. First, every franchise agreement expires after a given period of time, i.e. 5, 10, 15 or 20 years. A franchisor can decide not to renew after that time or a franchisee can decide to walk away. In addition, attempts to prevent competition through non-disclosure and non-compete clauses, as well those designed to prevent the misappropriation of intellectual property clearly establish that the frachisee is being allowed to profit from financing and operating a division of someone else's business.
Whether a franchise is a better investment than an independent business depends on two metrics: (1) the means you would like to take to achieve your investment objectives; and (2) your risk tolerance. These metrics make it almost impossible to say definitively whether an independent is better than a franchise. The same outcome can be achieved with both, for the most part.
Everyone goes into business with the same investment objective: to make money. At issue is how are you going to do it? Are you going to take an original approach to organized alchemy or a non-original approach?
The original approach is for those who are building a business with an original idea, insight, product or service. As authors W. Chan Kim and Renée Mauborgne mention in their book, Blue Ocean Strategy, original ideas can lead to uncontested market space, which can lead to highly scalable opportunities. Franchising, by contrast, is a non-original approach.
The main difference between the two is the level of risk inherent in each operation. Franchises, by comparison, tend to involve less risk because investors are buying into a proven business model. Original ideas tend to involve high risk because the proof of concept has yet to be established. Venture capital is typically needed to finance proof of concept for original ideas and it can be pretty expensive. See the movie Something Ventured about the history of venture capital industry.
Risk and reward go hand-in-hand. Less risk tends to lead to less reward. Generally, franchisees don't scale their individual investments as fast as the owners of original concepts in terms of sales and operations. However, there are exceptions. Franchise operators like former NBA player Jr. Bridgeman turned $350,000 into a $600 million fortune by scaling his ownership of Wendy's and Chili's franchises. Many don't believe that it is possible to achieve such an outcome through franchising. Granted, it is not very probable, but it is possible.
Needless to say, arriving at such an outcome is just as improbable with the launch of an independent small business concept. An extraordinary sequence of occurrences must come to pass before an unproven concept can scale to an operation with a valuation of $500 million or more. The main question to be answered by the independent operator is how much of the company will you own by the time its valuation reaches $500 million?
First, you have to launch. Start with family and friends and use Kickstarter, if necessary, to establish the proof of your concept. Then you have to establish distribution. How are you going to get your product or service to people? Then you have to expand from a solo operation to managing employees and customer demands, which will be growing rapidly. Then you have to finance growth, which must be done carefully and thoughtfully. If growth is financed with debt, interest may consume needed cash flow to grow. If the growth is financed with equity, the incentive to improve the value of the business increases as long as the founder owns more than 51% of the equity. By contrast, the founder's incentive to increase the value of the business decreases when he or she owns less than 50% of the equity because they've become an employee in a company that they started. So, equity financing can be tricky. Equity financing is a quantitative means that can create significant qualitative issues.
Suffice it to say, there are more ways for things go wrong than right. If you create an operation that ultimately scales to the point where it has a nine figure valuation, or buy into a franchise that you can scale unit acquisitions to that point, you will have achieved an outcome that only occurs in very few business starts. Whether you take a well worn path or the road less traveled, you have about the same odds of achieving significant financial success. Whether a franchise can help you to achieve significant financial success faster than an independent small business depends on the level risk you can tolerate and the depth of your determination. At the end of the day, it's up to you.
Thank you for reading. Scott Capital Consulting helps investors buy or start franchises from new or existing businesses. If you are thinking about buying a franchise, or if franchising can provide a solution to help you grow, scale or expand your small business, we can help. Thanks again for reading.