APPENDIX II: A Quick Guide to Making Money in the Franchising Business

A franchisor has four ways of making money:

1. Sell franchises for cash up front.

2. Sell supplies to the franchisees.

3. License franchises for a percentage of sales.

4. Be a banker, financing franchisees, or building stores and leasing them.

Or, as is the case with the majority of franchisors, all of the above.

Even then, one of these ways tends to become the franchisor’s primary focus, which is a major determinant of the company’s ultimate success or failure.

1. Sell Franchises

When Harry Axene began franchising Dairy Queen his prime focus was on selling territorial franchises for $25,000 to $50,000.

His success spurred dozens of new franchisors attracted by the easy up-front money to be made from selling territories.

Minnie Pearl (here) is the extreme example of focusing on selling franchises: fast profits. But once all territories are sold, that revenue stream ends.

When the franchisor’s primary focus is up-front sales, he has little or no interest in ensuring a uniform customer experience across all stores—and may not even care whether the franchisees ever make a dime. Which was certainly the case with Minnie Pearl.

In his sales visits to restaurant kitchens across the United States, Ray Kroc had seen the almost total inconsistency between different stores of the same franchise chain. Dairy Queen was one of them. Some Dairy Queen franchisees stuck to the basic soft-serve menu, while most added an array of other products, from hamburgers and hot dogs to enchiladas and tacos.

One reason Kroc vowed to focus on maintaining control of the quality of all McDonald’s outlets.

Nevertheless, territorial sales are a recipe for faster growth—the strategy that put Burger Chef within shooting distance of overtaking McDonald’s in 1971; one that also lifted Wendy’s to the number two slot in the American market, passing Burger King, in 2013. Though Burger King regained the number two spot in 2015.1

Selling territorial franchises is a strategy used by almost all franchisors, including Burger King and McDonald’s.

But Ray Kroc added a twist: territorial franchisees had to get permission to open another store. A franchisee who failed to meet Kroc’s operating standards was denied that permission. So in Dallas for many years there was just one McDonald’s store.

Thanks to the twist, McDonald’s avoided the downside of territorial sales: large franchisees with enough clout to go their own, independent way, ignoring the standards set by the franchisor.

Internationally, all restaurant chains, from McDonald’s to Starbucks, must follow the territorial sales strategy in countries that prohibit foreigners from owning retailers.

And even in countries that invite foreign investors, it is often more efficient to team up with a local partner.

2. Supplying Franchisees

A second source of revenue is supplying franchisees with equipment and menu items.

As the subsidiary of an equipment maker, Burger Chef’s franchise agreements required franchisees to equip their restaurants exclusively with SaniServe machines.

From its beginning, Burger King centralized the sourcing of food and equipment. Initially, all its stores were company owned, but the sourcing continued when Burger King began franchising. As it grew, it, too, began manufacturing kitchen equipment.

The commissary and equipment manufacturer—two separate subsidiaries—became significant profit centers. But the impetus behind both was to better serve the franchisees, the reverse of Burger Chef.

When Burger King began expanding nationwide, supplies for new stores were delivered from a variety of manufacturers in different parts of the country. It could take three or more weeks to equip a new store once the building was completed. McLamore and Edgerton found that by centralizing all supplies in Miami, they could deliver everything a new store required—from cooking equipment to pencils and paper—in two truckloads. A new restaurant could now be up and running in just three days—at a lower cost to the franchisee.

Burger King then created a construction subsidiary in partnership with a Miami contractor. Specialization further reduced the franchisee’s cost, and the needed construction time to sixty days from breaking ground—or less.2

Burger King franchisees—unlike Burger Chef’s—were not required to buy from Burger King HQ. Most did though, since in its early years sources of specialized equipment were scarce, compared to the situation today. And franchisees appreciated Burger King HQ’s aim of making everything easier for them.

Division of Focus

When the same management team owns and runs two or more businesses, a fundamental question arises: Which one has first priority?

And related: Are you willing to sacrifice the profits of one business to boost the profits of another?

In the case of Burger Chef, the answer to that second question was no, which caused some tension between franchisees and the management. When SaniServ began producing a french fryer, franchisees had to buy it. Previously, they had been using the same one as McDonald’s, one they felt was superior to the SaniServ model.

Burger King’s primary focus in supplying franchisees was to serve them. Initially, profits from supplying franchisees were secondary to expanding the chain. Later, all three subsidiaries were sold.

This approach became a significant source of positive cash flow for both Burger Chef and Burger King. Kroc adopted it, too—but with a crucial difference.

Like Burger Chef, Kroc’s initial interest in McDonald’s was equipment sales: the vision of selling eight MultiMixers at a time to restaurants spreading from Los Angeles to New York and Miami.

But thanks to his restrictive agreement with the McDonald brothers, even if he’d wanted to (which he didn’t), Kroc had neither the cash flow nor the capital to consider going into the equipment or commissary businesses.

Aside from selling two or three MultiMixers (rather than the expected eight) to each new McDonald’s, all supplies were sourced from unrelated third parties.

But their selection was not random; nor was it left to the franchisees’ discretion. McDonald’s suppliers were chosen by Kroc, based on whether they were willing and able to produce according to Kroc’s tight specifications. But they sold direct to franchisees.

In the short run, Burger Chef and Burger King benefited from the additional profit source. But in the long run McDonald’s reaped the rewards of the intense focus on a single source of revenue.

3. Percent of Sales

Both unable and unwilling to profit from territorial sales or supplying franchisees, Kroc was left with just one source of income: percentage of sales.

Sonneborn’s real estate financing strategy enabled Kroc to get around his restrictive agreement with the McDonald brothers—and put Kroc and the franchisees firmly in the same camp.

4. The Starbucks Model

The ultimate key to franchising success is ensuring a consistent customer experience across all outlets and cultures. And despite the advantages of Kroc’s approach, his method is not the only way.

Chains such as Pret A Manger and Chipotle achieve this by owning all the outlets.

Starbucks’ approach is in between these two extremes. Worldwide, the company owns just over half of all outlets (in the United States, company stores are 61 percent of the total), the remainder being franchised.

Yet, wherever you go, you’ll see that the key ingredients of Starbucks’ products—especially coffee and tea—are supplied by the company.

Indeed, competing chains such as Coffee Bean & Tea Leaf follow the same practice. If each outlet did its own sourcing for these key ingredients, the result would be chaos, with different tea and coffee flavors at every store.

Any of these four franchising models (singly or in combination) can result in a successful business—provided the primary focus of the company, its suppliers, its partners, and its franchisees is the customer experience.