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This brief illustration pertaining to franchising in frontier markets whats working, whats not, and why.
Franchising in Frontier Markets
|
What’s Working, What’s Not, and Why
|
December 2009
Franchising in Frontier Markets
|
What’s Working, What’s Not, and Why
|
A report by Dalberg Global Development Advisors with support from the John
Templeton Foundation (JTF) and the International Finance Corporation (IFC).
Dalberg contacts:
Wouter Deelder, Geneva
Robin Miller, Johannesburg
Tel. +41 (0) 22 809 9902 (Geneva) +27 (0) 11 482 7431 (Johannesburg)
Email: [email protected]; [email protected]
www.dalberg.com
John Templeton Foundation contact:
Steven R. Beck, Senior Fellow
Tel. +1 610 941 2828
Email: [email protected]; [email protected]
International Finance Corporation contact:
Daniel Runde
Head of Partnership Development
Tel. +1 202 458 4376
Email: [email protected]
Disclaimer:
The information contained herein is based on data collected by Dalberg Global De-
velopment Advisors as well as information provided by the featured organizations in
the course of the analysis. While Dalberg has taken due care in compiling, analyzing,
and using the information, it does not assume any liability, express or implied, with
respect to the statements made herein. The views expressed in this publication are
not necessarily those of the United Nations. The inclusion of company examples in
this publication is intended strictly for learning purposes and does not constitute
an endorsement of the individual companies by the United Nations. The material
in this publication may be quoted and used provided there is proper attribution.
Authors: Wouter Deelder, Robin A. Miller
Editors: Sid Seamans, Timothy Ogden
Design and Layout: Phoenix Design Aid, www.phoenixdesignaid.dk.
iii
List of Figures iv
List of Side Boxes vi
Foreword vii
Preface ix
Executive Summary xi
Chapter 1: Introduction to Franchising 1
Chapter 2: Lessons Learned from History 7
Chapter 3: Franchising in Frontier Markets: Rationale and Challenges 21
Chapter 4: Promising and Pro?table Models 37
Case Study: SPOT City Taxis 51
Chapter 5: Good as the Enemy of Great 55
Case Study: The HealthStore Foundation® 61
Case Study: VisionSpring 67
Chapter 6: Areas for Further Research 75
Annex 1: Common De?nitions 77
Annex 2: Presence of Franchise Systems in Advanced and Emerging Markets 79
Annex 3: Micro-Franchise Organizations Referred to in the Report 81
Annex 4: UCSF Annual Compendium of Clinical Social Franchises 2009 82
Annex 5: Sample Set of Micro-franchises 84
Annex 6: Financing Mechanisms for Sample Set of Micro-franchises 88
Annex 7: Growth Curves of Successful Franchise Chains 90
Annex 8: Kaldi’s and Starbuck’s – IP Challenges 97
Annex 9: Case Study: Nando’s 99
Annex 10: Interviews Conducted as of 15 October 2009 106
Annex 11: IFC Workshop Participants 109
Annex 12: Bibliography 112
Annex 13: Acronyms and Abbreviations 118
Contents
iv
List of Figures
Figure 1: Four Dimensions of Franchising 4
Figure 2: U.S. Franchising Landscape across Industries by Total Sales 5
Figure 3: The Mixed Model – Eight Examples 11
Figure 4: Growth Data for Sample Set of Large International Franchises 14
Figure 5: Growth of Leading Large-Scale Chains 15
Figure 6: Growth of Outlets Over Time: Starbucks (Company-Owned)
vs. McDonald’s (Franchised) 17
Figure 7: Working Time Required to Purchase a Big Mac vs. 1 kg of Rice 23
Figure 8: Entrepreneur.com’s 2008 Top 10 Global Franchises 25
Figure 9: Top 10 Global Franchise Chains in Sub-Saharan Africa
(Not Including South Africa) 26
Figure 10: Access and Cost of Finance for Small Businesses in
Developing Countries. 27
Figure 11: Average Start-Up Franchise Fees across
Selected Frontier Markets, 2002 28
Figure 12: Ranking of “Franchisability” by Region
(Including Developing and Emerging Markets) 30
Figure 13: Overview of Strength of Regulatory Environment
across a Sample of African Countries 31
Figure 14: Importance of Enabling Environment Conditions for Franchising 32
Figure 15: Modes of Entry into Frontier Markets 33
Figure 16: Ratio of Foreign vs. Home-Grown Franchise Chains
in Selected Emerging Markets, 2002 38
Figure 17: Selected Large-Scale African Franchise Businesses
across Sub-Saharan Africa 39
v
Figure 18: Traditional Micro-Franchising – Distribution
by Industry and Geography 41
Figure 19: Financing Requirements of Five Micro-franchises 42
Figure 20: SPOT Taxi Pro?tability (2008 Estimates) 52
Figure 21: HealthStore East Africa Pro?t/Loss, 2009, Projected (82 Units) 65
Figure 22: HealthStore East Africa Pro?t/Loss, 2018, Projected 66
Figure 23: VisionSpring Pro?tability, 2007 (Excluding Philanthropic Support) 68
Figure 24: Vision Spring Operating Subsidy Required 2007-2011 72
Figure 25: Adjustments to Franchisor Revenue, 2007 – 2012 73
Figure 26: Adjustments to Franchisor Expenses, 2007 – 2012 73
Figure 27: VisionSpring Projected Pro?tability, 2012
(without philanthropic support) 74
vi
List of Side Boxes
Side Box 1: Potential Con?icts in Franchising 21
Side Box 2: Managing the Mixed Model – Soft Drink Bottling Example 24
Side Box 3: Presence of Large-Scale, Western-Based,
Commercial Chains in Sub-Saharan Africa 34
Side Box 4: Coca-Cola Manual Distribution Centers (MDC) 50
Side Box 5: Marriott Hotel International’s Use of Management Contracts 52
Side Box 6: Excerpt from VisionSpring Prospectus 73
vii
Foreword
by Steven R. Beck, Senior Fellow, John Templeton Foundation
The John Templeton Foundation (JTF) was founded 20 years ago to serve as a
philanthropic catalyst for discovery in areas engaging life’s biggest questions. The
Foundation funds rigorous scienti?c research and related cutting-edge scholarship
on a wide spectrum of core themes, including entrepreneurship and enterprise-
based solutions to poverty.
Among poverty interventions, micro?nance has become the private enterprise
approach du jour. Yet, micro?nance – the provision of standard ?nancial services
to the poor – seems to have limited systemic impact, typically smoothing tenuous
household cash ?ows and supporting family-based, subsistence businesses operat-
ing in the informal economy. The critical challenge remains how to scale small
businesses in order to provide greater employment, wider economic vitality, and a
growing indigenous tax base.
Some researchers and practitioners have begun to promote franchising, and its
younger cousin “microfranchising,” as a higher order strategy with much greater
impact. Franchising seems to have a lot to offer frontier markets that seek to grow
private enterprise. Franchise businesses are designed for replication, require less
experienced entrepreneurial talent to run a proven business format, and provide
business-learning opportunities within a de?ned support structure. As we look at
low-income markets, there seems to be a proliferation of microfranchise businesses
– those where the franchisee is small (even a single person) or those that are serving
the base of the pyramid with public goods such as healthcare and education. But
there are relatively few large-scale international franchises operating in the frontier
markets of sub-Saharan Africa.
viii Franchising in Frontier Markets
So we are left with the question: Is franchising an underexploited business model
in frontier markets? Could franchising be the “next big thing” in development?
To address these questions and others, early in 2009 the JTF made a grant to
Dalberg Global Development Advisers to explore whether franchise business models
– large and small – have the potential to stimulate economic growth, create jobs,
and develop entrepreneurial skills in frontier economies. The study was designed to
bring greater understanding of what is actually working in the ?eld and what is not.
The objective was to separate the myths from the realities, promote investment in
effective franchise business models, and identify areas for further fruitful research.
We are grateful to Dalberg’s Wouter Deelder and Robin Miller for their research
efforts, and to the experts that granted them time to be interviewed, to compile the
?ndings presented below.
We are also grateful for the support of the International Finance Corporation
(IFC) and the World Bank Group. On September 16, 2009, the IFC hosted a one-day
workshop that brought together more than 50 practitioners, investors, researchers,
and consultants to review the team’s preliminary ?ndings. Bringing together practi-
tioners and experts in large-scale commercial franchising with those practicing and
studying franchising from a development perspective yielded a spirited debate and
enhanced understanding – both ways. The workshop helped the team sharpen and
re?ne the initial ?ndings and highlighted additional areas for research. And plans
were made during the meeting for future opportunities for dialog and learning. We
are indebted to the workshop participants and trust that the time invested in the
workshop and this report will assist future efforts.
ix
Preface
Sustainable economic growth and vitality depend on private enterprise and entrepre-
neurship. People taking innovative approaches to development in frontier economies
are increasingly using private-sector mechanisms to address development challenges,
ranging from failures along the supply chain to the provision of essential services.
As the World Bank argued in its seminal World Development Report 2005: A Better
Investment Climate for Everyone:
Private ?rms are at the heart of the development process. Driven by the quest
for pro?ts, ?rms of all types – from farmers and micro-entrepreneurs to local
manufacturing companies and multinational enterprises – invest in new ideas
and new facilities that strengthen the foundation of economic growth and
prosperity. They provide more than 90% of jobs – creating opportunities for
people to apply their talents and improve their situations. They provide the
goods and services needed to sustain life and improve living standards. They
are also the main source of tax revenues, contributing to public funding for
health, education and other services. Firms are thus central actors in the quest
for growth and poverty reduction.
In this context, our research addressed pertinent questions about franchising,
especially in frontier markets:
• Is franchising the next big thing in development?
• Is franchising an underexploited opportunity to accelerate the growth of success-
ful businesses, thereby stimulating economic growth? What is actually working
on the ground, and what is not working?
x Franchising in Frontier Markets
• What are the conditions for franchising success? What are the barriers and ena-
blers?
• What is the potential for franchise business models to effectively – and sustain-
ably – deliver “public” goods and services at scale?
• Do micro-franchises offer an effective way to reach (and employ) the base of the
pyramid in frontier markets?
• What are the synergies between micro-?nance networks and micro-franchise
businesses?
This report is based on a research effort initiated in May 2009 by Dalberg Glo-
bal Development Advisors, with support from the John Templeton Foundation
and the International Finance Corporation. Between May and October 2009 – the
team performed research, assembled case studies, conducted interviews with over
40 practitioners, investors, and researchers (the full list of organizations pro?led,
interviewees and workshop participants can be found the Annexes) and engaged
in a stakeholder workshop hosted by the International Finance Corporation (IFC),
seeking answers to the above questions. The geographic scope of the study focused
primarily on sub-Saharan Africa and South Asia but also included perspectives
from Latin America.
The report aims to provide insights for investors and donors, researchers, practi-
tioners, and policy- makers to inform and guide efforts while stimulating additional
innovation and research.
A draft version of the report informed the proceedings of a workshop hosted
by the International Finance Corporation on September 10, 2009, in Washington
D.C. The workshop was attended by investors, researchers, and practitioners who
signi?cantly contributed to the ?nal report.
Despite our best efforts, errors will almost certainly have crept into this docu-
ment, and of course we take responsibility for them.
xi
Executive Summary
There is a growing interest in franchising as a mechanism for catalyzing business
growth, economic development, job creation, and skills development in frontier
markets. Dalberg Global Development Advisors, with support from the John Tem-
pleton Foundation, conducted a 3-month study to explore franchise models in
frontier markets and the factors critical to their success. The study’s direct aim is to:
• Is franchising the next big thing in development?
• Is franchising an underexploited opportunity to accelerate the growth of success-
ful businesses, thereby stimulating economic growth? What is actually working
on the ground, and what is not working?
• What are the conditions for franchising success? What are the barriers and ena-
blers?
• What is the potential for franchise business models to effectively – and sustain-
ably – deliver “public” goods and services at scale?
• Do micro-franchises offer an effective way to reach (and employ) the base of the
pyramid in frontier markets?
• What are the synergies between micro-?nance networks and micro-franchise
businesses?
The ?ndings of the report will be of interest to the following audiences:
• Capital providers (investors and donors), with the aim to inform and guide capital
allocation to franchises.
• Policy-makers, to inform and guide efforts to stimulate franchising in frontier
markets.
• Researchers, to identify promising areas for further research.
xii Franchising in Frontier Markets
• Practitioners, to share opportunities, challenges, and recommendations for suc-
cessful franchising in frontier markets.
Despite the understandable appeal of franchising as a potential business accelera-
tor in frontier markets, our research shows that franchising per se is not the “next
big thing” in development. There are too many formidable obstacles to successful
business format franchising in the frontier markets we researched. In particular,
most frontier markets lack the purchasing power, access to capital, legal & regula-
tory framework and technical advisory services that enable most business format
franchises to grow pro?tably.
Indeed, we researched numerous socially-motivated attempts to pursue franchised
expansion in arguably the most dif?cult and problematic sector of all – healthcare.
Most of these attempted to franchise before developing a self-sustaining (that is,
pro?table) business model at the unit level. Thus, their growth has been limited
by an ever-expanding requirement to raise grant capital to grow scale and social
impact. These grant-maintained health franchise operations may still offer quality
healthcare at a lower cost than the current alternatives, but we are concerned that
their external grant subsidies have inhibited an aggressive search for more creative
and locally sustainable alternatives.
Having noted the dif?culties, we did nevertheless observe promising replicable
business models that have ?ourished in very challenging markets. In particular, we
studied a number of pro?table traditional micro-franchises – that is, very small-
scale, often single person franchisees pro?tably distributing standardized branded
products or services (think “Avon” rather than “McDonalds”) – in a variety of frontier
markets in Africa and South Asia. The simplicity of the business model meeting an
underserved market need is the key to their success.
As ever, the reality is more varied, nuanced and complex than we would like.
Further research is required, particularly into the creative possibilities around the
delivery of traditional “public goods” like healthcare and education through self-
sustaining franchise business models. Meanwhile, investors and donors need to be
highly selective, remembering the proven rules of franchise success in developed
markets. The basic lessons of the last ?ve to six decades of franchising in the West
apply in frontier markets and need to be heeded.
xiii Executive Summary
A careful study of successful franchising in developed markets
generates important lessons for franchise businesses in frontier
markets:
• Companies franchise to overcome ?nancing and monitoring challenges and to
leverage entrepreneurial skills and incentives, while individuals become franchisees
because of the perceived lower risk and greater rewards.
• Successful businesses build and manage a hybrid network of franchised and
company-owned outlets.
• Successful franchised chains grow in a predictable manner:
» Successful franchises ?rst develop a pro?table, sustainable, and scalable busi-
ness model.
» The path to franchise success is long, typically requiring 5-10 years of proving
and customizing a concept and business model before attempting to franchise it.
» Successful franchised chains are subsequently able to grow exponentially over
time.
• A number of misconceptions about franchising exist, especially those related to
the risk pro?le and the franchisee pro?le:
» Franchising is not the only way to achieve rapid scale
» Franchisors often choose a mixed-model approach, including both company-
owned and franchised units in order to maximize system wide pro?tability.
» Franchising does not automatically create ?rst-time business owners; in frontier
markets, franchisees are often established businesspeople and entrepreneurs
with access to the capital necessary to own and operate a franchise.
» Business risks for franchisees are not necessarily lower than for independent
growth; risks vary considerably in franchising. For a franchisee, franchising
risks are higher than for independent entrepreneurship when the chains are
smaller and newer, and lower when the chains are mature.
Investors and donors considering franchising in frontier markets should consider
that:
• Achieving pro?tability and sustainability from the ?rst outlet is a critical ?rst
step before any attempt to franchise is made.
• The impact of franchising on the overall pro?tability of the business is limited.
• Franchising is not the optimal choice for all expansion trajectories, with timing,
sector, and geography each playing an important role in evaluating whether
franchising is the appropriate option.
• Franchising in frontier markets does not always entail lower risk than independ-
ent growth and entrepreneurship pro?le.
xiv Franchising in Frontier Markets
Challenges for franchising are multiplied in frontier markets
Franchising is not a silver bullet for private sector development in frontier markets.
It offers selective opportunities for players considering expansion into or replication
within frontier markets, but also comes with a distinct set of barriers and challenges:
• Franchising creates the opportunity to leverage the entrepreneurial skills and
local adaptation required for frontier markets.
• Franchising requires, rather than generates, a pro?table business model. The lack
of purchasing power and market density in frontier markets are thus a limiting
factor.
• Business format franchising requires a complex ecology to ?ourish. This ecology
includes the availability of reasonably priced capital for franchisees, sophisticated
legal and regulatory frameworks, technical and legal advisory services, and the
availability of quali?ed franchisees. The lack of such ecology in frontier markets
signi?cantly increases the risk and (agency) costs of franchising, thereby imped-
ing a franchising strategy.
• The lack of relative pro?tability and scalability, as well as the perceived risks with
regards to legal and regulatory environment, has resulted in very few Western
chains expanding into frontier markets. For example, outside of South Africa,
only 4 of the 10 top international franchise chains in 2008 have expanded into
Sub-Saharan Africa (SSA), with approximately 30 outlets between them.
1
• Within frontier markets there is wide variability of “franchise friendliness,” driven
by the provision of ?nance, the ease of entrepreneurship, and the sophistication of
contractual, intellectual property (IP), and regulatory frameworks. For example,
Mauritius, Namibia, and Botswana score signi?cantly higher than other countries
in Sub-Saharan Africa on franchising friendliness.
The implications for policy-makers are to focus on the wider enabling environ-
ment for the growth of SMEs rather than on franchising per se. A ?rst focus on the
general factors of access to ?nance, ease of opening a business, and enforcement
of contracts will bene?t all scale-up, regardless of whether through franchising or
company-owned expansion. If these factors are in place, further measures can be
taken that speci?cally bene?t franchising (for example, franchising regulation and
IP protection). Policy-makers will see greater bene?ts from building the enabling
environment than from “picking winners” and supporting individual chains.
Investors should be cautious of the challenges with regard to successful franchising
in frontier market. The market potential and density, as well as hurdles with regard
1 Rankings conducted annually by Entrepreneur.com.
xv Executive Summary
to access to ?nance, ease of entrepreneurship, and the wider enabling environment
should feature prominently in the due diligence. However, investors should note as
well the stark difference that might exist in franchising friendliness between differ-
ent countries and different sectors.
A set of promising franchise models exist in frontier markets
There are a number promising franchise models that are well adapted to the con-
ditions in frontier markets and have demonstrated the ability to thrive amidst the
challenges. These models are often home-grown (incubated locally rather than
being established abroad), are based on the simpler traditional format franchising
(rather than business format), and are ?exible in customizing and mixing different
elements of franchise models.
Home-grown chains are better positioned than Western chains, due to tailored
products and pricing, lower overhead costs, and a better alignment with the ena-
bling environment. Nando’s provides an example of how a frontier market chain
has prospered in these more challenging markets.
Traditional format franchising, and especially, traditional format micro-franchising,
seems to be better suited to frontier markets than business format franchising, due
to fewer franchisor/franchisee con?icts, lower capital requirements, and less depend-
ence on favorable legal and policy environment requirements. SPOT Taxi (India),
Fan Milk (Ghana), BlueStar Ghana, Coca-Cola’s Manual Distribution Centers
(Africa), Natura (Brazil), and Kegg Farms (India) are a few examples of successful
micro-franchise chains utilizing the traditional model. These traditional franchises
also have the bene?t of increasing employment and building assets at the base-of-
the-pyramid micro-chains.
Entrepreneurs have developed solutions to overcome challenges in the enabling
ecology with regard to access to ?nance, access to human resources, and lack of
regulatory frameworks:
• Access to ?nance can be addressed, if the capital requirements are relatively low,
by joint-ventures and partnerships between franchisors and micro-?nance insti-
tutions. However, these partnerships should focus on the provision of ?nancial
services, and not push micro-?nance institutions into the separate and different
business of distributing goods and services.
• Access to human resources challenges for the franchisee can be mitigated by
approaches including management contracts, whereby the franchisor provides
skilled and trained staff members. Marriott Hotels provides an example of a
company that deploys management contracts.
xvi Franchising in Frontier Markets
• Master franchise contracts allow the (international) franchisor to interact with
only one established (local) counterparty, who is responsible for the management
of local franchisees. The master franchise relationship is more easily managed
and enforced in environments with less-developed regulatory frameworks.
• Technological solutions can strengthen the power of the franchisor in con?icts
with franchisor, and decrease the risks of a lack of contractual frameworks. Voda-
com and Spot Taxis show how technology can be applied to exclude franchisees
if needed.
Investors will want to search for indigenous franchise chains that have adapted
their business model and products and services to the local market conditions.
Franchising concepts that require lower ?nancing and a less advanced enabling
environment, such as traditional micro-franchising concepts, will tend to be more
successful. For all chains, the due diligence should focus on understanding unit level
pro?tability and outlet growth potential, potential franchisor/franchisee con?icts,
and barriers in the enabling ecology.
Good as the enemy of great: the promise and challenge of franchised
delivery of public goods and services
Franchising has been of interest to development practitioners as a potentially more
ef?cient and scalable distribution model for “public” goods and services like health-
care and education, due to its assumed potential to provide rapid scale-up, foster
local ownership and create a strong brand and quality standards. This approach has
been referred to as “social franchising.”
However, franchised chains that focus on the provision of public goods and
services have been hampered by the lack of pro?tability, and continued to be grant-
dependent, inhibiting their ability to achieve large-scale social impact. The lack of
pro?tability is driven by:
• Problematic sector economics in health and education, due to limited tradition
and/or ability to pay and competition from subsidized alternatives.
• Elevated overhead costs, and a location and product-market strategy that assigns
priority to social impact over ?nancial returns.
Evidence suggests that a reliance on grant capital reduces the incentive to discover
and design creative, pro?table business models that can scale up without requiring
an increasing subsidy. Moreover, grant-dependent models tend to cultivate a culture
and mindset that regards pro?tability as a “nice-to-have” at best rather than as a
survival imperative.
xvii Executive Summary
The franchises we studied that distributed public goods made the decision to
scale-up through franchising too early – before establishing ?nancial pro?tability
and sustainability, which causes:
• Untenable demands for fundraising and grant-?nancing, which inhibit the scale
of social impact that can be achieved.
• An increase in potential con?icts between franchisees and franchisor, especially
with regard to how to grow, improve, and expand the business model.
• Subsidized competition for other entrants who might otherwise be able to serve
the market pro?tably.
This leads to a situation where good becomes the enemy of great. In other words,
it may be good to continue with a grant-subsidized delivery model if quality services
are delivered more cost effectively than purely public or aid funded models; but the
grant subsidy may impede the innovative and urgent search for a pro?table great
business model that would otherwise be driven by unadulterated business survival
requirements.
Other franchises delivering public services, such as the HealthStore Foundation,
have recently decided to shift from a grant-based, non-pro?t model to a for-pro?t
entity, because they realized that achieving scale was not feasible in a grant-based
model that suffered from a lack of entrepreneurship and managerial ambition.
Capital providers and franchise operators will want a clear economic model, trans-
parent subsidies, and a cooperative creative search for local or national alternatives
to the external aid subsidy. Franchising models that remain unpro?table should be
evaluated within the framework of cost-effectiveness and aid-effectiveness in order
to ensure that the good does not become the enemy of the great.
Areas for further research
Through this study, we identi?ed a number of questions that would bene?t from
further research and exploration:
• What is the impact of franchising on pro?tability?
• What are the conditions for franchising friendliness across industries, across market
segments (for example urban/rural and income strata), and across geographies?
• What is the relative impact of international franchise chains on homegrown
franchise growth and development? In the case of traditional format microf-
ranchising, are concepts developed in Western countries more successful than
indigenous models?
xviii Franchising in Frontier Markets
• What are the relative merits of grant-subsidized franchise models vs. purely com-
mercial franchise business models for the delivery of public goods and services?
How can franchising be best used to deliver public goods and services at scale?
What is the role of alternative forms of ?nancing to support franchising?
This list is not meant to be exhaustive and we hope that, by disseminating this
report and sparking the discussion, we will continue to add to this list.
1
1
Chapter 1:
Introduction to Franchising
T
he history of franchising shows how signi?cant growth can be achieved despite
barriers of geographic distance and limited available capital. McDonald’s and
Subway may be symbols of franchising in the twenty-?rst century, but one of
the oldest franchise models is the expansion of the Catholic Church. Centuries before
Subway’s sandwich artists, the Catholic Church used a franchise model to expand its
geographic coverage.
2
And although it is a much more recent global phenomenon,
Coca-Cola has been franchising its bottling processes for over 100 years to extend
its geographic reach.
3
In the following section we aggregate the various models into
business format and traditional franchising, consider key aspects of the franchise
decision, and examine the impact of the franchising model.
De?ning franchising
Franchising is commonly understood as a “contractual agreement between two
legally independent ?rms in which one ?rm, the franchisee, pays the other ?rm, the
2 See www.whichfranchise.org/article.cfm?articleID=255.
3 Ibid.
2 Franchising in Frontier Markets
franchisor, for the right to sell the franchisor’s product and/or the right to use its
trademarks and business format in a given location for a speci?ed period of time.”
4
The franchise format has evolved over time to include variations ranging from
the basic rights to sell a product, to a more complex agreement that might include
branding, manufacturing, sales, distribution, and all operational processes associ-
ated with running a business. Avon, for instance, rapidly increased its business by
franchising the sale of its cosmetics using Avon Ladies who took a door-to-door
sales approach. The route McDonald’s took to franchising, in contrast, includes
most facets of operating and running the business, ranging from menu selection to
real estate to product inputs and operating procedures.
Different types of franchising
Within the ?eld of franchising, there are basically two sub-categories – traditional
(or product) format franchising, and business format franchising.
Traditional format franchising is, as the name suggests, the oldest form of
modern franchising. It involves a relationship between a company and a franchisee
in which the company owns a particular product and offers exclusive sales rights
(or distribution rights) to the franchisee. The value of traditional format franchis-
ing is the marriage between a successful product provided by the franchisor and an
outsourced distribution network owned by the franchisee.
In most traditional format franchise businesses, the franchisor is a manufacturer
who sells ?nished or semi-?nished products to its dealers/franchisees. In turn, the
franchisees resell these products to consumers or to other ?rms. The franchisor’s
pro?t is the margin placed on the sale of products and services to the franchisees,
usually with no additional royalties levied. The most common traditional franchise
models are bottling companies, car dealerships, and petroleum stations.
5
Examples
include the bottling operations of Coca-Cola, Avon cosmetics, and BP service stations.
Business format franchising is characterized by licensing a business model,
rather than products or services, to the franchisee. The franchisor charges a fee for
the use of its business model and brand to franchisees. The contractual relationship
is complex, and it encompasses the right to adopt an entire business process, with
prede?ned roles and responsibilities, for both franchisee and franchisor, for market-
ing and advertising, operational standards and procedures, monitoring and quality
control, and product distribution. The franchisor’s revenues are usually collected as
4 Francine Lafontaine and Roger D. Blair, Economics of Franchising (Cambridge, UK: Cambridge
University Press, 2005).
5 William E. Metzger is said to have been the ?rst franchisee in automotive retailing; he obtained a
franchise to sell steam automobiles from General Motors Corporation in 1898 (Justis and Judd 1998:
1-9). Coca-Cola sold its ?rst bottling franchise in 1899.
3 Chapter 1: Introduction to Franchising
a percentage of total franchisee sales. The most frequently cited examples of business
format franchises are within hospitality, restaurants, and retail, and include Subway,
Holiday Inn, and Jani-King.
For purposes of this study of franchising in frontier markets, we considered
several other dimensions (see Figure 1):
6
• The products and services offered, especially whether there is a focus on public
goods and services.
• The size of the franchisees, whether they are micro, macro, or anything in be-
tween.
• The objective of the franchise, especially whether there is a pro?t or not-for-
pro?t objective.
6 This report concentrates on understanding franchising’s various applications across frontier markets.
We rely on the World Bank’s de?nition of frontier markets, which is based on national income clas-
si?cations. Broadly speaking, frontier markets include two subsets - emerging markets and developing
markets. Speci?cally, emerging markets include both upper- and lower-middle-income economies,
and developing countries include all lower-income economies. The table in Annex 2 offers a sample of
frontier markets using this classi?cation.
4 Franchising in Frontier Markets
Figure 1: Four Dimensions of Franchising
Dimension Option Option
Type of
franchising
Business Format: Replication of
entire business models, extensive
franchisee-franchisor relation-
ships; franchisees pays royalties
Traditional format (also known as
product franchising): Focused on
distribution, less complex rela-
tionship between franchisor and
franchisee, franchisee pays no
royalties (but purchases products
under contract)
Size of the
franchised
unit
Macro: Fixed infrastructure, high
investment costs, and signi?cant
number of staff members
Micro: Limited infrastructure and
investment; owner is the only
employee
Products
and services
offered
Public goods: Goods and services
traditionally provided or subsi-
dized by the state like healthcare
and education
Commercial goods: All other prod-
ucts and services
Pro?t
objective
For-pro?t: Objective is to create
pro?ts for the owners
Non-pro?t: No direct objective to
create pro?ts; primary objective is
social impact
Source: Dalberg analysis.
This framework helps place the often-cited – and equally often-confused – con-
cepts of “micro-franchising” and “social franchising” into context:
• Micro-franchising refers primarily to the size of the franchisee – and is typically
a single person in a traditional franchise relationship.
7
• Social franchising refers to franchises whose primary objective is to deliver public
goods and services; they are most often subsidized by grant capital.
The economic contribution of franchising
In 2005, contribution of sales from business format franchising was more than
three times the economic output as traditional format franchising in the United
States. Business format franchising accounted for nearly six times as many units
7 The micro-franchising concept has been studied in detail by Jason Fairbourne and BYU’s Marriott
School, according to whom “the overall objective of microfranchising is to promote economic develop-
ment by developing sound business models that can be replicated by entrepreneurs at the base of the
pyramid; therefore, the start-up costs of microfranchises will be minimal. The key principle is replication,
replicating success to scale.”
5 Chapter 1: Introduction to Franchising
and nearly four and a half times as many jobs. Franchisees owned most (73%) of
the establishments that operated under a business format franchise. Traditional
format franchising is predominantly linked to the auto industry, with 94% of total
sales emanating from auto and truck dealers and gasoline (petrol) service stations
(see Figure 2).
Figure 2: U.S. Franchising Landscape across Industries by Total Sales
8
Source: International Franchise Association, Price Waterhouse Coopers, 2005.http://www.franchise.org/
uploadedFiles/Franchisors/Other_Content/economic_impact_documents/EconImpact_Vol2_HiLights.pdf.
Scale: The case for franchising in frontier markets
Small and medium size enterprises (SMEs) are private ?rms that can make a vital
contribution to economic development. They often struggle to grow and expand in
frontier markets, however, creating a missed opportunity to boost economic activ-
ity. This failure to achieve scale also affects SMEs that focus on resolving human
development challenges. Many innovative market-based solutions have proved suc-
cessful on a small basis in frontier markets, but most have not managed to achieve
the larger scale needed to make a real impact.
9
8 International Franchise Association, Price Waterhouse Coopers, 2005. See www.franchise.org/up-
loadedFiles/Franchisors/Other_Content/economic_impact_documents/EconImpact_Vol2_HiLights.pdf.
9 This report concentrates on understanding franchising’s various applications across frontier markets.
We rely on the World Bank’s de?nition of frontier markets, which is based on national income clas-
si?cations. Broadly speaking, frontier markets include two subsets - emerging markets and developing
6 Franchising in Frontier Markets
The franchise model – with its inherent characteristic of replication – intuitively
seems to offer the potential of helping an enterprise reach larger scale. Franchising
is seen by many as a business model uniquely positioned to facilitate development
objectives, such as imparting new skills, encouraging entrepreneurship, and creat-
ing jobs.
10
Franchise associations around the world promote the unique ability of
franchising to provide franchisors with an affordable, accelerated growth strategy,
while offering franchisees a pre-packaged, low-risk business model and training
provided through the franchise system. Franchising could in this way potentially
support SME growth in frontier markets, both for purely commercial chains as well
as for chains that deliver such public goods and services as education and healthcare.
Micro-franchising, in part because of its intuitive linkage with micro-?nancing,
has received extensive attention from the development community. Micro-franchising
is seen as a natural extension of micro-?nancing, because it builds a bridge between
the formal and informal economies, promotes enterprise growth, and increases per
capita incomes. As Katherine Terrell, Professor of Business Economics and Public
Policy at the University of Michigan, states:
Micro-franchising has enormous promise. First, [it] makes sense: it ?ts the
reality of the [base] of the pyramid, has the right incentive structure, and can
enable more [employment opportunities] than the micro?nance model (which
truly requires entrepreneurial talent). Second, the [micro-franchising] model
allows social entrepreneurs to invest in poor countries, allowing them to “do
well and do good” at the same time.
11
11
This chapter has outlined a brief history of franchising, its different forms, and
its impact. The next chapter will draw critical lessons for franchising in frontier
markets from this history.
markets. Speci?cally, emerging markets include both upper- and lower-middle-income economies,
and developing countries include all lower-income economies. The table in Annex 2 offers a sample of
frontier markets using this classi?cation.
10 First National Bank, “Franchise Think Tank White Paper: Pioneering Changes in the Franchise
Sector of South Africa,” 2009.
11 Please Copy! Franchising as a Development Tool. Allianz Knowledge Partner site.http://knowledge.
allianz.com/en/globalissues/micro?nance/alternative_?nance/microfranchising_micro?nance.html.
Accessed 22 June 2009.
7
Chapter 2:
Lessons Learned from History 2
L
essons from franchising in developed markets illustrate both the advantages
and disadvantages of franchising versus company-owned expansion and help
us understand franchising in today’s environment. Below we look at the growth
curves of successful franchised chains, and their common characteristics around
timing and business model. The ?nal lessons focus on commonly held misconcep-
tions about the franchisee pro?le and the risk pro?le of franchising.
Advantages and disadvantages of franchising
There are distinct reasons why a company would choose to franchise or choose to
pursue growth through a company-owned replication strategy. The following sec-
tion explores the key questions that a business owner must explore when deciding
whether or not to franchise.
Companies franchise to overcome ?nancing and monitoring challenges and to
leverage entrepreneurial skills and incentives. A company can expand and grow
its number of outlets in two ways: add more outlets it manages and owns (known
8 Franchising in Frontier Markets
as company-owned units), or add franchised units under the management and
ownership of the franchisee.
12
Businesses choose a franchise growth strategy over other forms of expansion to
access capital, lower the costs of performance monitoring, and make the most of
entrepreneurial incentives. The main reasons to choose the franchising path include:
• Financing for growth. Franchising overcomes limitatations for the franchisor in
accessing ?nancial resources for expansion. This argument, sometimes referred to
as the resource-based view of the ?rm,
13
is thought to be somewhat less relevant
in today’s capital markets, where franchisors have less trouble attracting capital.
14
• Incentives and monitoring costs. Franchising turns corporate managers into
pro?t-sharing owners, changing incentives and the costs of monitoring. While
the franchisor requires less expenditure on monitoring than is necessary in a
company-owned chain, he or she must nonetheless monitor the franchisee’s
adherence to the franchising contract and standards. But overall, monitoring
costs are reduced, making the argument for franchising more attractive.
15
Individuals become franchisees because of the perceived lower risk and greater
rewards. People choose to become franchisees because franchising offers them higher
rewards than being a salaried manager and lower risk than being an independent
entrepreneur. Those wanting to become franchisees believe franchising offers them the
potential for a ?nancial upside along with the entrepreneurial freedom that salaried
employment as a company manager cannot offer. They also see lower risk and more
chance to succeed compared to independent entrepreneurship – the operational
model is already de?ned and is supported by a strong brand. The franchisor usually
provides training and operational support. Several franchisees indicated to us that
they would not have started businesses on their own.
16
Successful businesses build and manage a hybrid network of franchised and
company-owned outlets. A company that grows successfully requires an ongoing
12 Hybrid forms that mix-and-match elements of company and franchised systems exist.
13 “Towards Operational Excellence in Franchising,” SAM Advanced Management Journal, 2008.
14 As discussed later, in frontier markets the franchisee’s access to ?nance might be lower than that of
the franchisor, creating a barrier for franchising
15 Monitoring costs and misalignments of incentives in a franchised setup, however, can be signi?cant.
Because the franchisor is concerned about all outlets, while the franchisee thinks primarily about his or her
own outlet, con?icts can occur, such as encroachment, intellectual property infringements, and free-riding.
16 Roger Blair and Francine Lafontaine, “The Economics of Franchising,” citing work done by Hunt
(1972) and Stanworth (1977), who state that half (Hunt) and one-third (Stanworth) of franchisees would
not have started up a business themselves.
9 Chapter 2: Lessons Learned from History
evaluation of bene?ts and costs, and must monitor costs and any misaligned incentives.
Franchising is not a ?nal, once-and-for-all decision. It is common for successful chains
to continually adjust the balance between franchised and company-owned outlets.
The expansion from one to many outlets will, regardless of the chosen model,
give rise to agency costs. The owner (the principal) will need to hire individuals
(agents) for the other outlets, creating costs incurred in monitoring and managing
them, and these are what go into agency costs.
The nature and size of the agency costs involved is an important consideration
in the decision to use franchising as opposed to adopting company-owned expan-
sion, and it will strongly in?uence whether franchising is the best business model.
In a company-owned setup, agency costs aim to avoid any lack of effort or entre-
preneurship on the part of salaried managers (so-called “shirking”). In a franchised
setup, in contrast, the objective is to reduce and monitor any misalignment between
franchisor and franchisees.
Potential con?icts between franchisor and franchisees usually concern the various
incentives, but mostly revolve around pro?t vs. revenue and one outlet vs. many
outlets. (The following side box explains these con?icts in more detail.)
10 Franchising in Frontier Markets
Side Box 1: Potential Con?icts in Franchising
Potential con?icts between franchisor and franchisee usually concern the various
incentives surrounding pro?t vs. revenue and single vs. multiple outlets.
Pro?t vs. revenue misalignment arises because the franchisor is compensated
through revenues (royalties), while the franchisee is compensated through (residual)
pro?ts. Royalties are calculated as a percentage of revenue, because revenue is easier
to monitor and track than pro?ts. The franchisor thus has an opportunistic incentive
to push products that maximize revenue rather than pro?ts. This tension is illustrated
in franchisor-mandated discounts and price wars against competitors, of which the
effects are felt much more strongly by the franchisee than by the franchisor. Amidst
the “cheeseburger war” with Burger King, for instance, McDonald’s was forced to
raise the price of its double cheeseburger from $1 to $1.19 as a “response to pressure
from franchisees, whose pro?t margins were being crimped.”
17
Single vs. multiple outlet misalignment arises when the franchisee tries to optimize
his or her outlet pro?ts, but the franchisor wants to optimize the results for the entire
system (all outlets). This shows itself in issues on free-riding, encroachment, and in-
novation/adjustment.
Free-riding refers to underinvestment in brand-building activities such as marketing,
as the franchisee will largely incur the bene?ts of the brand even if he or she does not
make investments (e.g., “the tragedy of the commons”). More seriously, franchisees
might be tempted to engage in brand-eroding activities, such as using inferior ingre-
dients, producing inferior products, or offering less service, because in such cases it
will incur the full monetary bene?ts, but only part of the costs. Chances of this con?ict
occurring are especially strong if the franchise has a large group of one-off (i.e., not
returning) consumers, such as in airports or train and bus stations.
Encroachment is the (opportunistic) incentive franchisors have to increase overall
system revenue by inviting new franchisees into a territory already occupied by exist-
ing franchisees. This behavior will increase fees and royalties for the franchisor, but
reduce revenues and pro?ts for the individual franchisees.
Adaptation and innovation refers a to franchisee incentive to maximize his or her outlet
pro?ts by adjusting services and products to the local environment. Although this is
likely to increase franchisee pro?ts and franchisor royalties, it diminishes standardiza-
tion across the chain, the economies of scale, and the value of the brand. Too much
local adjustment can in the long run endanger the franchise chain’s sustainability. Most
chains are circling around an equilibrium in which franchisees have a certain amount
of tactical freedom (e.g., opening hours, promotions), but cannot make larger innova-
tions to the product offering and business concept. Franchisors, on the other hand,
are often equally restricted in making large-scale changes and innovations, especially
if some, but not all, franchisees would bene?t.
11 Chapter 2: Lessons Learned from History
The difference in agency costs between franchising and company-owned expansion,
the opportunity to develop and incubate new product concepts, and the potential
shift in pro?tability over time cause many chains to opt for a mixed model, with both
company-owned and franchised outlets. Chains tend to shift between franchising
and company-owned expansion at different times. Mixed models are chains that
operate a mixture between franchised and non-franchised (company-owned) units.
Figure 3 illustrates this mixture for eight leading franchise chains.
17
Figure 3: The Mixed Model – Eight Examples
Source: www.entrepreneur.com; Mr. Price and Nando’s data taken from interviews. Woolworth’s 2003 data
taken from company website. All data is 2008 with the exception of Burger King, which is 2005 data. See
www.woolworths.co.za/caissa.asp?Page=ITB4_RHContext&Post=FAT_Business_Local_Disclosure.
The advantages of this approach are:
• Optimization of monitoring costs in company-owned units located where the
performace-monitoring costs are relatively low. Chains often retain ownership of
locations that are close to headquarters, and can be easily managed and monitored.
• Minimization of risks by retaining ownership of units where the risks of incentive
con?icts would be the highest. For example, chains retain ownership of locations
17 Chicago Tribune, August 28, 2009;http://www.chicagotribune.com/business/chi-biz-burger-king-
mcdonalds,0,5653780.story.
12 Franchising in Frontier Markets
with one-time visitors, such as airports, in recognition that franchisees may be oth-
erwise tempted to free-ride on the brand and provide inadequate service / quality.
• Rollout of new innovations, thereby using company-owned stores as an incubator
for new products, services or systems, allows the franchisor a greater degree of ?ex-
ibility to test changes to the business model or introduce new product innovations.
• Facilitation of benchmarking by using the management of company-owned units
as gauge for estimating future pro?tability of franchisees.
Coca-Cola and PepsiCo (see Side Box 2) provide good examples. Facing an
increase in agency costs in a changed strategic environment (buyer concentration,
marketing requirements), both companies decided to switch from franchising back
to company-owned expansion.
Side Box 2: Managing the Mixed Model – Soft Drink Bottling Example
Large soft-drink manufactures, especially Coca-Cola and PepsiCo, have historically
used traditional franchising agreements with their bottling companies. Coke and Pepsi
can exploit economies of scale in procurement (e.g., caramel, sugars) and protect
their secret recipes, while their franchisees have superior local market knowledge for
distribution and marketing.
Pepsi and Coke have taken different bottling strategies. Pepsi has aggressively converted
its traditional bottling franchisees into company-owned structures. Pepsi currently
owns a large majority of its bottler operations, concluding a buying spree with an $8
billion deal in August 2009 in which it acquired its two largest bottlers.
Pepsi’s rationale is an increased need for standardization and sophistication in its
marketing strategy. This standardization is easier to achieve in a company-owned than
a franchised setup. In the marketing war with Coke, Pepsi requires that all bottlers
support and promote the same complex advertising and marketing campaigns. The
“Pepsi Challenge” required a uniform roll-out. Some bottlers also interact with the
same consolidated retailers (e.g., Wal-Mart), and require a standardized approach.
Coke has followed suit, but has been less aggressive in buying back bottlers. Coke
has bene?ted from the stronger consolidation of its US and EU bottling operations,
and has had to coordinate its marketing strategy among far fewer franchisees, reduc-
ing the case for company ownership. Coke nevertheless maintains signi?cant equity
stakes in most of its bottlers, giving it a large say in how operations and marketing
campaigns are run.
Source: Besanko, Dranove, and Mark Shanley, Economics of Strategy (New York: John Wiley, 2000); interview
with Coca-Cola CFO, Gary Fayard:http://www.?ex-news-food.com/pages/24241/Coca/unlike-pepsico-coca-
cola-need-buy-bottling-partners-says-coke-cfo.html.
13 Chapter 2: Lessons Learned from History
Only limited information is available about the prevalence of mixed models in
frontier markets, by either commercial or franchise chains delivering public goods.
The study of prevalence and drivers will be an interesting area for further research.
The implications for investors interested in franchising in frontier markets are:
• Pro?table growth is the overall goal, and to achieve this goal, the franchising
decision must be periodically re-evaluated. Franchising should be seen as one
business concept, among others, to reach scale, and is not the be-all-and-end-all.
• Franchising is not the optimal choice for all expansion trajectories, with timing,
sector, and geography each playing an important role in evaluating whether
franchising is the appropriate option.
How franchises grow
Another lesson from history focuses on a franchise’s growth curve, from the ?rst
(pro?table) outlet to the rapid growth at the end of the curve. The growth paths of
successful franchised chains share common factors in terms of pro?table business
model and timing.
Successful franchises start with a pro?table and sustainable business model.
Successful franchised chains achieve pro?table business models on a small scale
(e.g., the ?rst outlet), before they contemplate growth. Replication takes place when
the model shows pro?tability and potential. We found no examples of chains that
started with a loss-making initial outlet but continued to franchise and managed
to grow into pro?tability.
A ?rm’s growth increases pro?tability, primarily through economies of scale and
to a much less extent due to franchising.
Economies of scale inherent in a larger size chain can have a drastic impact on
pro?tability. Bronson and Morgan
18
have shown that the difference in pro?tability
between independent entrepreneurs and franchised businesses in the travel indus-
try can be largely explained by scale economies. The impact of size on pro?tability
was also shown by Buzzel and Gale, who demonstrated that the largest ?rms in an
industry had on average a pro?t margin over 3 times larger than the fourth smallest
?rm in a given industry.
19
There is little information on the impact of franchising on overall chain pro?t-
ability. Firms will choose franchising or a certain mixed model in the belief that
18 James W. Bronson and Cyril P. Morgan, “The Role of Scale in Franchise Success: Evidence from the
Travel Industry,” Journal of Small Business Management Vol. 36 (1998).
19 David Besanko David Dranove, Mark Shanley, and Scott Shaefer, Economics of Strategy (3rd ed.;
New York: Wiley, 2003).
14 Franchising in Frontier Markets
this will positively affect their long-term pro?tability. The impact of franchising
is, however, likely to be signi?cantly less than the achievement of scale economies.
At the outlet/franchisee level, a shift toward franchising may increase pro?tability
slightly if the business is highly systematized and the franchisees are more disciplined
in managing inputs and reducing waste. A large fast-food franchisor indicated that
the cost levels of a franchisee are approximately 0.5% to 1% lower than those of a
company-owned outlet. At the franchisor level, the agency costs are reduced. How-
ever, these agency costs are only a small part of the overall franchisor cost-curve.
In summary, although precise data is not available, our research indicates that the
impact of franchising on pro?tability is very limited.
The ?ndings of this study have three important implications for investors and
donors considering franchising in frontier markets. First, it is dif?cult to establish a
pro?table business model. Thus, businesses that are unpro?table in the ?rst outlet,
with plans to achieve pro?tability through larger scale, should be viewed with a
great deal of suspicion. Second, scale, size, and market share will have a signi?cant
impact on a chain’s pro?tability. And ?nally, the impact of franchising on overall
pro?tability will be limited.
Preparation to franchise takes signi?cant time and effort. Figure 4 shows the
start-up phase for a range of franchise chains, and indicates:
Figure 4: Growth Data for Sample Set of Large International Franchises
Source: Data drawn primarily from Entrepreneur.com in 2008; most recent available data based on company
websites.
15 Chapter 2: Lessons Learned from History
• Growth from one to two outlets often takes several years. Replication toward a
small chain of units often takes between ?ve to ten years. This time is spent test-
ing the pro?tability and sustainability of the business model, and preparing the
processes, products, and procedures for replication.
• Some ?rms start with a constellation of company-owned units before moving
to franchising. A number of chains, such as Subway and 7-11, have started with
company-owned outlets, presumably to further test and adjust the business
model, before moving to franchising. Other chains, such as Dominos and KFC,
have immediately used franchising from the second outlet they opened. A direct
franchising strategy likely yields the fastest growth, but carries a higher risk pro?le,
as adjusting the business concept will be more dif?cult than in a company-owned
setup.
The implications for franchising in frontier markets are that investors and
entrepreneurs need to be patient and invest signi?cant time and effort in the ?rst
5-10 years of operations to develop and re?ne the optimal business model before
attempting to franchise. In their ambition to expand solutions to address develop-
ment issues, social entrepreneurs, social investors, and donors need to beware of
wanting to grow too fast, too soon.
Successful chains experience exponential growth, but it takes time. Once the
preparation phase is completed, subsequent expansion can be very rapid. Figure 5
compares the unit growth of four major chains between the ?rst and second decades
of operation, with growth rates in the second decade often a factor of 5 to 10 higher.
Figure 5: Growth of Leading Large-Scale Chains
First decade of operation Second decade of operation
McDonald’s 2 units 1,000 units
Subway 16 units ~600 units
20
Holiday Inn >100 units 1,000 units
Taco Bell 24 units
This brief illustration pertaining to franchising in frontier markets whats working, whats not, and why.
Franchising in Frontier Markets
|
What’s Working, What’s Not, and Why
|
December 2009
Franchising in Frontier Markets
|
What’s Working, What’s Not, and Why
|
A report by Dalberg Global Development Advisors with support from the John
Templeton Foundation (JTF) and the International Finance Corporation (IFC).
Dalberg contacts:
Wouter Deelder, Geneva
Robin Miller, Johannesburg
Tel. +41 (0) 22 809 9902 (Geneva) +27 (0) 11 482 7431 (Johannesburg)
Email: [email protected]; [email protected]
www.dalberg.com
John Templeton Foundation contact:
Steven R. Beck, Senior Fellow
Tel. +1 610 941 2828
Email: [email protected]; [email protected]
International Finance Corporation contact:
Daniel Runde
Head of Partnership Development
Tel. +1 202 458 4376
Email: [email protected]
Disclaimer:
The information contained herein is based on data collected by Dalberg Global De-
velopment Advisors as well as information provided by the featured organizations in
the course of the analysis. While Dalberg has taken due care in compiling, analyzing,
and using the information, it does not assume any liability, express or implied, with
respect to the statements made herein. The views expressed in this publication are
not necessarily those of the United Nations. The inclusion of company examples in
this publication is intended strictly for learning purposes and does not constitute
an endorsement of the individual companies by the United Nations. The material
in this publication may be quoted and used provided there is proper attribution.
Authors: Wouter Deelder, Robin A. Miller
Editors: Sid Seamans, Timothy Ogden
Design and Layout: Phoenix Design Aid, www.phoenixdesignaid.dk.
iii
List of Figures iv
List of Side Boxes vi
Foreword vii
Preface ix
Executive Summary xi
Chapter 1: Introduction to Franchising 1
Chapter 2: Lessons Learned from History 7
Chapter 3: Franchising in Frontier Markets: Rationale and Challenges 21
Chapter 4: Promising and Pro?table Models 37
Case Study: SPOT City Taxis 51
Chapter 5: Good as the Enemy of Great 55
Case Study: The HealthStore Foundation® 61
Case Study: VisionSpring 67
Chapter 6: Areas for Further Research 75
Annex 1: Common De?nitions 77
Annex 2: Presence of Franchise Systems in Advanced and Emerging Markets 79
Annex 3: Micro-Franchise Organizations Referred to in the Report 81
Annex 4: UCSF Annual Compendium of Clinical Social Franchises 2009 82
Annex 5: Sample Set of Micro-franchises 84
Annex 6: Financing Mechanisms for Sample Set of Micro-franchises 88
Annex 7: Growth Curves of Successful Franchise Chains 90
Annex 8: Kaldi’s and Starbuck’s – IP Challenges 97
Annex 9: Case Study: Nando’s 99
Annex 10: Interviews Conducted as of 15 October 2009 106
Annex 11: IFC Workshop Participants 109
Annex 12: Bibliography 112
Annex 13: Acronyms and Abbreviations 118
Contents
iv
List of Figures
Figure 1: Four Dimensions of Franchising 4
Figure 2: U.S. Franchising Landscape across Industries by Total Sales 5
Figure 3: The Mixed Model – Eight Examples 11
Figure 4: Growth Data for Sample Set of Large International Franchises 14
Figure 5: Growth of Leading Large-Scale Chains 15
Figure 6: Growth of Outlets Over Time: Starbucks (Company-Owned)
vs. McDonald’s (Franchised) 17
Figure 7: Working Time Required to Purchase a Big Mac vs. 1 kg of Rice 23
Figure 8: Entrepreneur.com’s 2008 Top 10 Global Franchises 25
Figure 9: Top 10 Global Franchise Chains in Sub-Saharan Africa
(Not Including South Africa) 26
Figure 10: Access and Cost of Finance for Small Businesses in
Developing Countries. 27
Figure 11: Average Start-Up Franchise Fees across
Selected Frontier Markets, 2002 28
Figure 12: Ranking of “Franchisability” by Region
(Including Developing and Emerging Markets) 30
Figure 13: Overview of Strength of Regulatory Environment
across a Sample of African Countries 31
Figure 14: Importance of Enabling Environment Conditions for Franchising 32
Figure 15: Modes of Entry into Frontier Markets 33
Figure 16: Ratio of Foreign vs. Home-Grown Franchise Chains
in Selected Emerging Markets, 2002 38
Figure 17: Selected Large-Scale African Franchise Businesses
across Sub-Saharan Africa 39
v
Figure 18: Traditional Micro-Franchising – Distribution
by Industry and Geography 41
Figure 19: Financing Requirements of Five Micro-franchises 42
Figure 20: SPOT Taxi Pro?tability (2008 Estimates) 52
Figure 21: HealthStore East Africa Pro?t/Loss, 2009, Projected (82 Units) 65
Figure 22: HealthStore East Africa Pro?t/Loss, 2018, Projected 66
Figure 23: VisionSpring Pro?tability, 2007 (Excluding Philanthropic Support) 68
Figure 24: Vision Spring Operating Subsidy Required 2007-2011 72
Figure 25: Adjustments to Franchisor Revenue, 2007 – 2012 73
Figure 26: Adjustments to Franchisor Expenses, 2007 – 2012 73
Figure 27: VisionSpring Projected Pro?tability, 2012
(without philanthropic support) 74
vi
List of Side Boxes
Side Box 1: Potential Con?icts in Franchising 21
Side Box 2: Managing the Mixed Model – Soft Drink Bottling Example 24
Side Box 3: Presence of Large-Scale, Western-Based,
Commercial Chains in Sub-Saharan Africa 34
Side Box 4: Coca-Cola Manual Distribution Centers (MDC) 50
Side Box 5: Marriott Hotel International’s Use of Management Contracts 52
Side Box 6: Excerpt from VisionSpring Prospectus 73
vii
Foreword
by Steven R. Beck, Senior Fellow, John Templeton Foundation
The John Templeton Foundation (JTF) was founded 20 years ago to serve as a
philanthropic catalyst for discovery in areas engaging life’s biggest questions. The
Foundation funds rigorous scienti?c research and related cutting-edge scholarship
on a wide spectrum of core themes, including entrepreneurship and enterprise-
based solutions to poverty.
Among poverty interventions, micro?nance has become the private enterprise
approach du jour. Yet, micro?nance – the provision of standard ?nancial services
to the poor – seems to have limited systemic impact, typically smoothing tenuous
household cash ?ows and supporting family-based, subsistence businesses operat-
ing in the informal economy. The critical challenge remains how to scale small
businesses in order to provide greater employment, wider economic vitality, and a
growing indigenous tax base.
Some researchers and practitioners have begun to promote franchising, and its
younger cousin “microfranchising,” as a higher order strategy with much greater
impact. Franchising seems to have a lot to offer frontier markets that seek to grow
private enterprise. Franchise businesses are designed for replication, require less
experienced entrepreneurial talent to run a proven business format, and provide
business-learning opportunities within a de?ned support structure. As we look at
low-income markets, there seems to be a proliferation of microfranchise businesses
– those where the franchisee is small (even a single person) or those that are serving
the base of the pyramid with public goods such as healthcare and education. But
there are relatively few large-scale international franchises operating in the frontier
markets of sub-Saharan Africa.
viii Franchising in Frontier Markets
So we are left with the question: Is franchising an underexploited business model
in frontier markets? Could franchising be the “next big thing” in development?
To address these questions and others, early in 2009 the JTF made a grant to
Dalberg Global Development Advisers to explore whether franchise business models
– large and small – have the potential to stimulate economic growth, create jobs,
and develop entrepreneurial skills in frontier economies. The study was designed to
bring greater understanding of what is actually working in the ?eld and what is not.
The objective was to separate the myths from the realities, promote investment in
effective franchise business models, and identify areas for further fruitful research.
We are grateful to Dalberg’s Wouter Deelder and Robin Miller for their research
efforts, and to the experts that granted them time to be interviewed, to compile the
?ndings presented below.
We are also grateful for the support of the International Finance Corporation
(IFC) and the World Bank Group. On September 16, 2009, the IFC hosted a one-day
workshop that brought together more than 50 practitioners, investors, researchers,
and consultants to review the team’s preliminary ?ndings. Bringing together practi-
tioners and experts in large-scale commercial franchising with those practicing and
studying franchising from a development perspective yielded a spirited debate and
enhanced understanding – both ways. The workshop helped the team sharpen and
re?ne the initial ?ndings and highlighted additional areas for research. And plans
were made during the meeting for future opportunities for dialog and learning. We
are indebted to the workshop participants and trust that the time invested in the
workshop and this report will assist future efforts.
ix
Preface
Sustainable economic growth and vitality depend on private enterprise and entrepre-
neurship. People taking innovative approaches to development in frontier economies
are increasingly using private-sector mechanisms to address development challenges,
ranging from failures along the supply chain to the provision of essential services.
As the World Bank argued in its seminal World Development Report 2005: A Better
Investment Climate for Everyone:
Private ?rms are at the heart of the development process. Driven by the quest
for pro?ts, ?rms of all types – from farmers and micro-entrepreneurs to local
manufacturing companies and multinational enterprises – invest in new ideas
and new facilities that strengthen the foundation of economic growth and
prosperity. They provide more than 90% of jobs – creating opportunities for
people to apply their talents and improve their situations. They provide the
goods and services needed to sustain life and improve living standards. They
are also the main source of tax revenues, contributing to public funding for
health, education and other services. Firms are thus central actors in the quest
for growth and poverty reduction.
In this context, our research addressed pertinent questions about franchising,
especially in frontier markets:
• Is franchising the next big thing in development?
• Is franchising an underexploited opportunity to accelerate the growth of success-
ful businesses, thereby stimulating economic growth? What is actually working
on the ground, and what is not working?
x Franchising in Frontier Markets
• What are the conditions for franchising success? What are the barriers and ena-
blers?
• What is the potential for franchise business models to effectively – and sustain-
ably – deliver “public” goods and services at scale?
• Do micro-franchises offer an effective way to reach (and employ) the base of the
pyramid in frontier markets?
• What are the synergies between micro-?nance networks and micro-franchise
businesses?
This report is based on a research effort initiated in May 2009 by Dalberg Glo-
bal Development Advisors, with support from the John Templeton Foundation
and the International Finance Corporation. Between May and October 2009 – the
team performed research, assembled case studies, conducted interviews with over
40 practitioners, investors, and researchers (the full list of organizations pro?led,
interviewees and workshop participants can be found the Annexes) and engaged
in a stakeholder workshop hosted by the International Finance Corporation (IFC),
seeking answers to the above questions. The geographic scope of the study focused
primarily on sub-Saharan Africa and South Asia but also included perspectives
from Latin America.
The report aims to provide insights for investors and donors, researchers, practi-
tioners, and policy- makers to inform and guide efforts while stimulating additional
innovation and research.
A draft version of the report informed the proceedings of a workshop hosted
by the International Finance Corporation on September 10, 2009, in Washington
D.C. The workshop was attended by investors, researchers, and practitioners who
signi?cantly contributed to the ?nal report.
Despite our best efforts, errors will almost certainly have crept into this docu-
ment, and of course we take responsibility for them.
xi
Executive Summary
There is a growing interest in franchising as a mechanism for catalyzing business
growth, economic development, job creation, and skills development in frontier
markets. Dalberg Global Development Advisors, with support from the John Tem-
pleton Foundation, conducted a 3-month study to explore franchise models in
frontier markets and the factors critical to their success. The study’s direct aim is to:
• Is franchising the next big thing in development?
• Is franchising an underexploited opportunity to accelerate the growth of success-
ful businesses, thereby stimulating economic growth? What is actually working
on the ground, and what is not working?
• What are the conditions for franchising success? What are the barriers and ena-
blers?
• What is the potential for franchise business models to effectively – and sustain-
ably – deliver “public” goods and services at scale?
• Do micro-franchises offer an effective way to reach (and employ) the base of the
pyramid in frontier markets?
• What are the synergies between micro-?nance networks and micro-franchise
businesses?
The ?ndings of the report will be of interest to the following audiences:
• Capital providers (investors and donors), with the aim to inform and guide capital
allocation to franchises.
• Policy-makers, to inform and guide efforts to stimulate franchising in frontier
markets.
• Researchers, to identify promising areas for further research.
xii Franchising in Frontier Markets
• Practitioners, to share opportunities, challenges, and recommendations for suc-
cessful franchising in frontier markets.
Despite the understandable appeal of franchising as a potential business accelera-
tor in frontier markets, our research shows that franchising per se is not the “next
big thing” in development. There are too many formidable obstacles to successful
business format franchising in the frontier markets we researched. In particular,
most frontier markets lack the purchasing power, access to capital, legal & regula-
tory framework and technical advisory services that enable most business format
franchises to grow pro?tably.
Indeed, we researched numerous socially-motivated attempts to pursue franchised
expansion in arguably the most dif?cult and problematic sector of all – healthcare.
Most of these attempted to franchise before developing a self-sustaining (that is,
pro?table) business model at the unit level. Thus, their growth has been limited
by an ever-expanding requirement to raise grant capital to grow scale and social
impact. These grant-maintained health franchise operations may still offer quality
healthcare at a lower cost than the current alternatives, but we are concerned that
their external grant subsidies have inhibited an aggressive search for more creative
and locally sustainable alternatives.
Having noted the dif?culties, we did nevertheless observe promising replicable
business models that have ?ourished in very challenging markets. In particular, we
studied a number of pro?table traditional micro-franchises – that is, very small-
scale, often single person franchisees pro?tably distributing standardized branded
products or services (think “Avon” rather than “McDonalds”) – in a variety of frontier
markets in Africa and South Asia. The simplicity of the business model meeting an
underserved market need is the key to their success.
As ever, the reality is more varied, nuanced and complex than we would like.
Further research is required, particularly into the creative possibilities around the
delivery of traditional “public goods” like healthcare and education through self-
sustaining franchise business models. Meanwhile, investors and donors need to be
highly selective, remembering the proven rules of franchise success in developed
markets. The basic lessons of the last ?ve to six decades of franchising in the West
apply in frontier markets and need to be heeded.
xiii Executive Summary
A careful study of successful franchising in developed markets
generates important lessons for franchise businesses in frontier
markets:
• Companies franchise to overcome ?nancing and monitoring challenges and to
leverage entrepreneurial skills and incentives, while individuals become franchisees
because of the perceived lower risk and greater rewards.
• Successful businesses build and manage a hybrid network of franchised and
company-owned outlets.
• Successful franchised chains grow in a predictable manner:
» Successful franchises ?rst develop a pro?table, sustainable, and scalable busi-
ness model.
» The path to franchise success is long, typically requiring 5-10 years of proving
and customizing a concept and business model before attempting to franchise it.
» Successful franchised chains are subsequently able to grow exponentially over
time.
• A number of misconceptions about franchising exist, especially those related to
the risk pro?le and the franchisee pro?le:
» Franchising is not the only way to achieve rapid scale
» Franchisors often choose a mixed-model approach, including both company-
owned and franchised units in order to maximize system wide pro?tability.
» Franchising does not automatically create ?rst-time business owners; in frontier
markets, franchisees are often established businesspeople and entrepreneurs
with access to the capital necessary to own and operate a franchise.
» Business risks for franchisees are not necessarily lower than for independent
growth; risks vary considerably in franchising. For a franchisee, franchising
risks are higher than for independent entrepreneurship when the chains are
smaller and newer, and lower when the chains are mature.
Investors and donors considering franchising in frontier markets should consider
that:
• Achieving pro?tability and sustainability from the ?rst outlet is a critical ?rst
step before any attempt to franchise is made.
• The impact of franchising on the overall pro?tability of the business is limited.
• Franchising is not the optimal choice for all expansion trajectories, with timing,
sector, and geography each playing an important role in evaluating whether
franchising is the appropriate option.
• Franchising in frontier markets does not always entail lower risk than independ-
ent growth and entrepreneurship pro?le.
xiv Franchising in Frontier Markets
Challenges for franchising are multiplied in frontier markets
Franchising is not a silver bullet for private sector development in frontier markets.
It offers selective opportunities for players considering expansion into or replication
within frontier markets, but also comes with a distinct set of barriers and challenges:
• Franchising creates the opportunity to leverage the entrepreneurial skills and
local adaptation required for frontier markets.
• Franchising requires, rather than generates, a pro?table business model. The lack
of purchasing power and market density in frontier markets are thus a limiting
factor.
• Business format franchising requires a complex ecology to ?ourish. This ecology
includes the availability of reasonably priced capital for franchisees, sophisticated
legal and regulatory frameworks, technical and legal advisory services, and the
availability of quali?ed franchisees. The lack of such ecology in frontier markets
signi?cantly increases the risk and (agency) costs of franchising, thereby imped-
ing a franchising strategy.
• The lack of relative pro?tability and scalability, as well as the perceived risks with
regards to legal and regulatory environment, has resulted in very few Western
chains expanding into frontier markets. For example, outside of South Africa,
only 4 of the 10 top international franchise chains in 2008 have expanded into
Sub-Saharan Africa (SSA), with approximately 30 outlets between them.
1
• Within frontier markets there is wide variability of “franchise friendliness,” driven
by the provision of ?nance, the ease of entrepreneurship, and the sophistication of
contractual, intellectual property (IP), and regulatory frameworks. For example,
Mauritius, Namibia, and Botswana score signi?cantly higher than other countries
in Sub-Saharan Africa on franchising friendliness.
The implications for policy-makers are to focus on the wider enabling environ-
ment for the growth of SMEs rather than on franchising per se. A ?rst focus on the
general factors of access to ?nance, ease of opening a business, and enforcement
of contracts will bene?t all scale-up, regardless of whether through franchising or
company-owned expansion. If these factors are in place, further measures can be
taken that speci?cally bene?t franchising (for example, franchising regulation and
IP protection). Policy-makers will see greater bene?ts from building the enabling
environment than from “picking winners” and supporting individual chains.
Investors should be cautious of the challenges with regard to successful franchising
in frontier market. The market potential and density, as well as hurdles with regard
1 Rankings conducted annually by Entrepreneur.com.
xv Executive Summary
to access to ?nance, ease of entrepreneurship, and the wider enabling environment
should feature prominently in the due diligence. However, investors should note as
well the stark difference that might exist in franchising friendliness between differ-
ent countries and different sectors.
A set of promising franchise models exist in frontier markets
There are a number promising franchise models that are well adapted to the con-
ditions in frontier markets and have demonstrated the ability to thrive amidst the
challenges. These models are often home-grown (incubated locally rather than
being established abroad), are based on the simpler traditional format franchising
(rather than business format), and are ?exible in customizing and mixing different
elements of franchise models.
Home-grown chains are better positioned than Western chains, due to tailored
products and pricing, lower overhead costs, and a better alignment with the ena-
bling environment. Nando’s provides an example of how a frontier market chain
has prospered in these more challenging markets.
Traditional format franchising, and especially, traditional format micro-franchising,
seems to be better suited to frontier markets than business format franchising, due
to fewer franchisor/franchisee con?icts, lower capital requirements, and less depend-
ence on favorable legal and policy environment requirements. SPOT Taxi (India),
Fan Milk (Ghana), BlueStar Ghana, Coca-Cola’s Manual Distribution Centers
(Africa), Natura (Brazil), and Kegg Farms (India) are a few examples of successful
micro-franchise chains utilizing the traditional model. These traditional franchises
also have the bene?t of increasing employment and building assets at the base-of-
the-pyramid micro-chains.
Entrepreneurs have developed solutions to overcome challenges in the enabling
ecology with regard to access to ?nance, access to human resources, and lack of
regulatory frameworks:
• Access to ?nance can be addressed, if the capital requirements are relatively low,
by joint-ventures and partnerships between franchisors and micro-?nance insti-
tutions. However, these partnerships should focus on the provision of ?nancial
services, and not push micro-?nance institutions into the separate and different
business of distributing goods and services.
• Access to human resources challenges for the franchisee can be mitigated by
approaches including management contracts, whereby the franchisor provides
skilled and trained staff members. Marriott Hotels provides an example of a
company that deploys management contracts.
xvi Franchising in Frontier Markets
• Master franchise contracts allow the (international) franchisor to interact with
only one established (local) counterparty, who is responsible for the management
of local franchisees. The master franchise relationship is more easily managed
and enforced in environments with less-developed regulatory frameworks.
• Technological solutions can strengthen the power of the franchisor in con?icts
with franchisor, and decrease the risks of a lack of contractual frameworks. Voda-
com and Spot Taxis show how technology can be applied to exclude franchisees
if needed.
Investors will want to search for indigenous franchise chains that have adapted
their business model and products and services to the local market conditions.
Franchising concepts that require lower ?nancing and a less advanced enabling
environment, such as traditional micro-franchising concepts, will tend to be more
successful. For all chains, the due diligence should focus on understanding unit level
pro?tability and outlet growth potential, potential franchisor/franchisee con?icts,
and barriers in the enabling ecology.
Good as the enemy of great: the promise and challenge of franchised
delivery of public goods and services
Franchising has been of interest to development practitioners as a potentially more
ef?cient and scalable distribution model for “public” goods and services like health-
care and education, due to its assumed potential to provide rapid scale-up, foster
local ownership and create a strong brand and quality standards. This approach has
been referred to as “social franchising.”
However, franchised chains that focus on the provision of public goods and
services have been hampered by the lack of pro?tability, and continued to be grant-
dependent, inhibiting their ability to achieve large-scale social impact. The lack of
pro?tability is driven by:
• Problematic sector economics in health and education, due to limited tradition
and/or ability to pay and competition from subsidized alternatives.
• Elevated overhead costs, and a location and product-market strategy that assigns
priority to social impact over ?nancial returns.
Evidence suggests that a reliance on grant capital reduces the incentive to discover
and design creative, pro?table business models that can scale up without requiring
an increasing subsidy. Moreover, grant-dependent models tend to cultivate a culture
and mindset that regards pro?tability as a “nice-to-have” at best rather than as a
survival imperative.
xvii Executive Summary
The franchises we studied that distributed public goods made the decision to
scale-up through franchising too early – before establishing ?nancial pro?tability
and sustainability, which causes:
• Untenable demands for fundraising and grant-?nancing, which inhibit the scale
of social impact that can be achieved.
• An increase in potential con?icts between franchisees and franchisor, especially
with regard to how to grow, improve, and expand the business model.
• Subsidized competition for other entrants who might otherwise be able to serve
the market pro?tably.
This leads to a situation where good becomes the enemy of great. In other words,
it may be good to continue with a grant-subsidized delivery model if quality services
are delivered more cost effectively than purely public or aid funded models; but the
grant subsidy may impede the innovative and urgent search for a pro?table great
business model that would otherwise be driven by unadulterated business survival
requirements.
Other franchises delivering public services, such as the HealthStore Foundation,
have recently decided to shift from a grant-based, non-pro?t model to a for-pro?t
entity, because they realized that achieving scale was not feasible in a grant-based
model that suffered from a lack of entrepreneurship and managerial ambition.
Capital providers and franchise operators will want a clear economic model, trans-
parent subsidies, and a cooperative creative search for local or national alternatives
to the external aid subsidy. Franchising models that remain unpro?table should be
evaluated within the framework of cost-effectiveness and aid-effectiveness in order
to ensure that the good does not become the enemy of the great.
Areas for further research
Through this study, we identi?ed a number of questions that would bene?t from
further research and exploration:
• What is the impact of franchising on pro?tability?
• What are the conditions for franchising friendliness across industries, across market
segments (for example urban/rural and income strata), and across geographies?
• What is the relative impact of international franchise chains on homegrown
franchise growth and development? In the case of traditional format microf-
ranchising, are concepts developed in Western countries more successful than
indigenous models?
xviii Franchising in Frontier Markets
• What are the relative merits of grant-subsidized franchise models vs. purely com-
mercial franchise business models for the delivery of public goods and services?
How can franchising be best used to deliver public goods and services at scale?
What is the role of alternative forms of ?nancing to support franchising?
This list is not meant to be exhaustive and we hope that, by disseminating this
report and sparking the discussion, we will continue to add to this list.
1
1
Chapter 1:
Introduction to Franchising
T
he history of franchising shows how signi?cant growth can be achieved despite
barriers of geographic distance and limited available capital. McDonald’s and
Subway may be symbols of franchising in the twenty-?rst century, but one of
the oldest franchise models is the expansion of the Catholic Church. Centuries before
Subway’s sandwich artists, the Catholic Church used a franchise model to expand its
geographic coverage.
2
And although it is a much more recent global phenomenon,
Coca-Cola has been franchising its bottling processes for over 100 years to extend
its geographic reach.
3
In the following section we aggregate the various models into
business format and traditional franchising, consider key aspects of the franchise
decision, and examine the impact of the franchising model.
De?ning franchising
Franchising is commonly understood as a “contractual agreement between two
legally independent ?rms in which one ?rm, the franchisee, pays the other ?rm, the
2 See www.whichfranchise.org/article.cfm?articleID=255.
3 Ibid.
2 Franchising in Frontier Markets
franchisor, for the right to sell the franchisor’s product and/or the right to use its
trademarks and business format in a given location for a speci?ed period of time.”
4
The franchise format has evolved over time to include variations ranging from
the basic rights to sell a product, to a more complex agreement that might include
branding, manufacturing, sales, distribution, and all operational processes associ-
ated with running a business. Avon, for instance, rapidly increased its business by
franchising the sale of its cosmetics using Avon Ladies who took a door-to-door
sales approach. The route McDonald’s took to franchising, in contrast, includes
most facets of operating and running the business, ranging from menu selection to
real estate to product inputs and operating procedures.
Different types of franchising
Within the ?eld of franchising, there are basically two sub-categories – traditional
(or product) format franchising, and business format franchising.
Traditional format franchising is, as the name suggests, the oldest form of
modern franchising. It involves a relationship between a company and a franchisee
in which the company owns a particular product and offers exclusive sales rights
(or distribution rights) to the franchisee. The value of traditional format franchis-
ing is the marriage between a successful product provided by the franchisor and an
outsourced distribution network owned by the franchisee.
In most traditional format franchise businesses, the franchisor is a manufacturer
who sells ?nished or semi-?nished products to its dealers/franchisees. In turn, the
franchisees resell these products to consumers or to other ?rms. The franchisor’s
pro?t is the margin placed on the sale of products and services to the franchisees,
usually with no additional royalties levied. The most common traditional franchise
models are bottling companies, car dealerships, and petroleum stations.
5
Examples
include the bottling operations of Coca-Cola, Avon cosmetics, and BP service stations.
Business format franchising is characterized by licensing a business model,
rather than products or services, to the franchisee. The franchisor charges a fee for
the use of its business model and brand to franchisees. The contractual relationship
is complex, and it encompasses the right to adopt an entire business process, with
prede?ned roles and responsibilities, for both franchisee and franchisor, for market-
ing and advertising, operational standards and procedures, monitoring and quality
control, and product distribution. The franchisor’s revenues are usually collected as
4 Francine Lafontaine and Roger D. Blair, Economics of Franchising (Cambridge, UK: Cambridge
University Press, 2005).
5 William E. Metzger is said to have been the ?rst franchisee in automotive retailing; he obtained a
franchise to sell steam automobiles from General Motors Corporation in 1898 (Justis and Judd 1998:
1-9). Coca-Cola sold its ?rst bottling franchise in 1899.
3 Chapter 1: Introduction to Franchising
a percentage of total franchisee sales. The most frequently cited examples of business
format franchises are within hospitality, restaurants, and retail, and include Subway,
Holiday Inn, and Jani-King.
For purposes of this study of franchising in frontier markets, we considered
several other dimensions (see Figure 1):
6
• The products and services offered, especially whether there is a focus on public
goods and services.
• The size of the franchisees, whether they are micro, macro, or anything in be-
tween.
• The objective of the franchise, especially whether there is a pro?t or not-for-
pro?t objective.
6 This report concentrates on understanding franchising’s various applications across frontier markets.
We rely on the World Bank’s de?nition of frontier markets, which is based on national income clas-
si?cations. Broadly speaking, frontier markets include two subsets - emerging markets and developing
markets. Speci?cally, emerging markets include both upper- and lower-middle-income economies,
and developing countries include all lower-income economies. The table in Annex 2 offers a sample of
frontier markets using this classi?cation.
4 Franchising in Frontier Markets
Figure 1: Four Dimensions of Franchising
Dimension Option Option
Type of
franchising
Business Format: Replication of
entire business models, extensive
franchisee-franchisor relation-
ships; franchisees pays royalties
Traditional format (also known as
product franchising): Focused on
distribution, less complex rela-
tionship between franchisor and
franchisee, franchisee pays no
royalties (but purchases products
under contract)
Size of the
franchised
unit
Macro: Fixed infrastructure, high
investment costs, and signi?cant
number of staff members
Micro: Limited infrastructure and
investment; owner is the only
employee
Products
and services
offered
Public goods: Goods and services
traditionally provided or subsi-
dized by the state like healthcare
and education
Commercial goods: All other prod-
ucts and services
Pro?t
objective
For-pro?t: Objective is to create
pro?ts for the owners
Non-pro?t: No direct objective to
create pro?ts; primary objective is
social impact
Source: Dalberg analysis.
This framework helps place the often-cited – and equally often-confused – con-
cepts of “micro-franchising” and “social franchising” into context:
• Micro-franchising refers primarily to the size of the franchisee – and is typically
a single person in a traditional franchise relationship.
7
• Social franchising refers to franchises whose primary objective is to deliver public
goods and services; they are most often subsidized by grant capital.
The economic contribution of franchising
In 2005, contribution of sales from business format franchising was more than
three times the economic output as traditional format franchising in the United
States. Business format franchising accounted for nearly six times as many units
7 The micro-franchising concept has been studied in detail by Jason Fairbourne and BYU’s Marriott
School, according to whom “the overall objective of microfranchising is to promote economic develop-
ment by developing sound business models that can be replicated by entrepreneurs at the base of the
pyramid; therefore, the start-up costs of microfranchises will be minimal. The key principle is replication,
replicating success to scale.”
5 Chapter 1: Introduction to Franchising
and nearly four and a half times as many jobs. Franchisees owned most (73%) of
the establishments that operated under a business format franchise. Traditional
format franchising is predominantly linked to the auto industry, with 94% of total
sales emanating from auto and truck dealers and gasoline (petrol) service stations
(see Figure 2).
Figure 2: U.S. Franchising Landscape across Industries by Total Sales
8
Source: International Franchise Association, Price Waterhouse Coopers, 2005.http://www.franchise.org/
uploadedFiles/Franchisors/Other_Content/economic_impact_documents/EconImpact_Vol2_HiLights.pdf.
Scale: The case for franchising in frontier markets
Small and medium size enterprises (SMEs) are private ?rms that can make a vital
contribution to economic development. They often struggle to grow and expand in
frontier markets, however, creating a missed opportunity to boost economic activ-
ity. This failure to achieve scale also affects SMEs that focus on resolving human
development challenges. Many innovative market-based solutions have proved suc-
cessful on a small basis in frontier markets, but most have not managed to achieve
the larger scale needed to make a real impact.
9
8 International Franchise Association, Price Waterhouse Coopers, 2005. See www.franchise.org/up-
loadedFiles/Franchisors/Other_Content/economic_impact_documents/EconImpact_Vol2_HiLights.pdf.
9 This report concentrates on understanding franchising’s various applications across frontier markets.
We rely on the World Bank’s de?nition of frontier markets, which is based on national income clas-
si?cations. Broadly speaking, frontier markets include two subsets - emerging markets and developing
6 Franchising in Frontier Markets
The franchise model – with its inherent characteristic of replication – intuitively
seems to offer the potential of helping an enterprise reach larger scale. Franchising
is seen by many as a business model uniquely positioned to facilitate development
objectives, such as imparting new skills, encouraging entrepreneurship, and creat-
ing jobs.
10
Franchise associations around the world promote the unique ability of
franchising to provide franchisors with an affordable, accelerated growth strategy,
while offering franchisees a pre-packaged, low-risk business model and training
provided through the franchise system. Franchising could in this way potentially
support SME growth in frontier markets, both for purely commercial chains as well
as for chains that deliver such public goods and services as education and healthcare.
Micro-franchising, in part because of its intuitive linkage with micro-?nancing,
has received extensive attention from the development community. Micro-franchising
is seen as a natural extension of micro-?nancing, because it builds a bridge between
the formal and informal economies, promotes enterprise growth, and increases per
capita incomes. As Katherine Terrell, Professor of Business Economics and Public
Policy at the University of Michigan, states:
Micro-franchising has enormous promise. First, [it] makes sense: it ?ts the
reality of the [base] of the pyramid, has the right incentive structure, and can
enable more [employment opportunities] than the micro?nance model (which
truly requires entrepreneurial talent). Second, the [micro-franchising] model
allows social entrepreneurs to invest in poor countries, allowing them to “do
well and do good” at the same time.
11
11
This chapter has outlined a brief history of franchising, its different forms, and
its impact. The next chapter will draw critical lessons for franchising in frontier
markets from this history.
markets. Speci?cally, emerging markets include both upper- and lower-middle-income economies,
and developing countries include all lower-income economies. The table in Annex 2 offers a sample of
frontier markets using this classi?cation.
10 First National Bank, “Franchise Think Tank White Paper: Pioneering Changes in the Franchise
Sector of South Africa,” 2009.
11 Please Copy! Franchising as a Development Tool. Allianz Knowledge Partner site.http://knowledge.
allianz.com/en/globalissues/micro?nance/alternative_?nance/microfranchising_micro?nance.html.
Accessed 22 June 2009.
7
Chapter 2:
Lessons Learned from History 2
L
essons from franchising in developed markets illustrate both the advantages
and disadvantages of franchising versus company-owned expansion and help
us understand franchising in today’s environment. Below we look at the growth
curves of successful franchised chains, and their common characteristics around
timing and business model. The ?nal lessons focus on commonly held misconcep-
tions about the franchisee pro?le and the risk pro?le of franchising.
Advantages and disadvantages of franchising
There are distinct reasons why a company would choose to franchise or choose to
pursue growth through a company-owned replication strategy. The following sec-
tion explores the key questions that a business owner must explore when deciding
whether or not to franchise.
Companies franchise to overcome ?nancing and monitoring challenges and to
leverage entrepreneurial skills and incentives. A company can expand and grow
its number of outlets in two ways: add more outlets it manages and owns (known
8 Franchising in Frontier Markets
as company-owned units), or add franchised units under the management and
ownership of the franchisee.
12
Businesses choose a franchise growth strategy over other forms of expansion to
access capital, lower the costs of performance monitoring, and make the most of
entrepreneurial incentives. The main reasons to choose the franchising path include:
• Financing for growth. Franchising overcomes limitatations for the franchisor in
accessing ?nancial resources for expansion. This argument, sometimes referred to
as the resource-based view of the ?rm,
13
is thought to be somewhat less relevant
in today’s capital markets, where franchisors have less trouble attracting capital.
14
• Incentives and monitoring costs. Franchising turns corporate managers into
pro?t-sharing owners, changing incentives and the costs of monitoring. While
the franchisor requires less expenditure on monitoring than is necessary in a
company-owned chain, he or she must nonetheless monitor the franchisee’s
adherence to the franchising contract and standards. But overall, monitoring
costs are reduced, making the argument for franchising more attractive.
15
Individuals become franchisees because of the perceived lower risk and greater
rewards. People choose to become franchisees because franchising offers them higher
rewards than being a salaried manager and lower risk than being an independent
entrepreneur. Those wanting to become franchisees believe franchising offers them the
potential for a ?nancial upside along with the entrepreneurial freedom that salaried
employment as a company manager cannot offer. They also see lower risk and more
chance to succeed compared to independent entrepreneurship – the operational
model is already de?ned and is supported by a strong brand. The franchisor usually
provides training and operational support. Several franchisees indicated to us that
they would not have started businesses on their own.
16
Successful businesses build and manage a hybrid network of franchised and
company-owned outlets. A company that grows successfully requires an ongoing
12 Hybrid forms that mix-and-match elements of company and franchised systems exist.
13 “Towards Operational Excellence in Franchising,” SAM Advanced Management Journal, 2008.
14 As discussed later, in frontier markets the franchisee’s access to ?nance might be lower than that of
the franchisor, creating a barrier for franchising
15 Monitoring costs and misalignments of incentives in a franchised setup, however, can be signi?cant.
Because the franchisor is concerned about all outlets, while the franchisee thinks primarily about his or her
own outlet, con?icts can occur, such as encroachment, intellectual property infringements, and free-riding.
16 Roger Blair and Francine Lafontaine, “The Economics of Franchising,” citing work done by Hunt
(1972) and Stanworth (1977), who state that half (Hunt) and one-third (Stanworth) of franchisees would
not have started up a business themselves.
9 Chapter 2: Lessons Learned from History
evaluation of bene?ts and costs, and must monitor costs and any misaligned incentives.
Franchising is not a ?nal, once-and-for-all decision. It is common for successful chains
to continually adjust the balance between franchised and company-owned outlets.
The expansion from one to many outlets will, regardless of the chosen model,
give rise to agency costs. The owner (the principal) will need to hire individuals
(agents) for the other outlets, creating costs incurred in monitoring and managing
them, and these are what go into agency costs.
The nature and size of the agency costs involved is an important consideration
in the decision to use franchising as opposed to adopting company-owned expan-
sion, and it will strongly in?uence whether franchising is the best business model.
In a company-owned setup, agency costs aim to avoid any lack of effort or entre-
preneurship on the part of salaried managers (so-called “shirking”). In a franchised
setup, in contrast, the objective is to reduce and monitor any misalignment between
franchisor and franchisees.
Potential con?icts between franchisor and franchisees usually concern the various
incentives, but mostly revolve around pro?t vs. revenue and one outlet vs. many
outlets. (The following side box explains these con?icts in more detail.)
10 Franchising in Frontier Markets
Side Box 1: Potential Con?icts in Franchising
Potential con?icts between franchisor and franchisee usually concern the various
incentives surrounding pro?t vs. revenue and single vs. multiple outlets.
Pro?t vs. revenue misalignment arises because the franchisor is compensated
through revenues (royalties), while the franchisee is compensated through (residual)
pro?ts. Royalties are calculated as a percentage of revenue, because revenue is easier
to monitor and track than pro?ts. The franchisor thus has an opportunistic incentive
to push products that maximize revenue rather than pro?ts. This tension is illustrated
in franchisor-mandated discounts and price wars against competitors, of which the
effects are felt much more strongly by the franchisee than by the franchisor. Amidst
the “cheeseburger war” with Burger King, for instance, McDonald’s was forced to
raise the price of its double cheeseburger from $1 to $1.19 as a “response to pressure
from franchisees, whose pro?t margins were being crimped.”
17
Single vs. multiple outlet misalignment arises when the franchisee tries to optimize
his or her outlet pro?ts, but the franchisor wants to optimize the results for the entire
system (all outlets). This shows itself in issues on free-riding, encroachment, and in-
novation/adjustment.
Free-riding refers to underinvestment in brand-building activities such as marketing,
as the franchisee will largely incur the bene?ts of the brand even if he or she does not
make investments (e.g., “the tragedy of the commons”). More seriously, franchisees
might be tempted to engage in brand-eroding activities, such as using inferior ingre-
dients, producing inferior products, or offering less service, because in such cases it
will incur the full monetary bene?ts, but only part of the costs. Chances of this con?ict
occurring are especially strong if the franchise has a large group of one-off (i.e., not
returning) consumers, such as in airports or train and bus stations.
Encroachment is the (opportunistic) incentive franchisors have to increase overall
system revenue by inviting new franchisees into a territory already occupied by exist-
ing franchisees. This behavior will increase fees and royalties for the franchisor, but
reduce revenues and pro?ts for the individual franchisees.
Adaptation and innovation refers a to franchisee incentive to maximize his or her outlet
pro?ts by adjusting services and products to the local environment. Although this is
likely to increase franchisee pro?ts and franchisor royalties, it diminishes standardiza-
tion across the chain, the economies of scale, and the value of the brand. Too much
local adjustment can in the long run endanger the franchise chain’s sustainability. Most
chains are circling around an equilibrium in which franchisees have a certain amount
of tactical freedom (e.g., opening hours, promotions), but cannot make larger innova-
tions to the product offering and business concept. Franchisors, on the other hand,
are often equally restricted in making large-scale changes and innovations, especially
if some, but not all, franchisees would bene?t.
11 Chapter 2: Lessons Learned from History
The difference in agency costs between franchising and company-owned expansion,
the opportunity to develop and incubate new product concepts, and the potential
shift in pro?tability over time cause many chains to opt for a mixed model, with both
company-owned and franchised outlets. Chains tend to shift between franchising
and company-owned expansion at different times. Mixed models are chains that
operate a mixture between franchised and non-franchised (company-owned) units.
Figure 3 illustrates this mixture for eight leading franchise chains.
17
Figure 3: The Mixed Model – Eight Examples
Source: www.entrepreneur.com; Mr. Price and Nando’s data taken from interviews. Woolworth’s 2003 data
taken from company website. All data is 2008 with the exception of Burger King, which is 2005 data. See
www.woolworths.co.za/caissa.asp?Page=ITB4_RHContext&Post=FAT_Business_Local_Disclosure.
The advantages of this approach are:
• Optimization of monitoring costs in company-owned units located where the
performace-monitoring costs are relatively low. Chains often retain ownership of
locations that are close to headquarters, and can be easily managed and monitored.
• Minimization of risks by retaining ownership of units where the risks of incentive
con?icts would be the highest. For example, chains retain ownership of locations
17 Chicago Tribune, August 28, 2009;http://www.chicagotribune.com/business/chi-biz-burger-king-
mcdonalds,0,5653780.story.
12 Franchising in Frontier Markets
with one-time visitors, such as airports, in recognition that franchisees may be oth-
erwise tempted to free-ride on the brand and provide inadequate service / quality.
• Rollout of new innovations, thereby using company-owned stores as an incubator
for new products, services or systems, allows the franchisor a greater degree of ?ex-
ibility to test changes to the business model or introduce new product innovations.
• Facilitation of benchmarking by using the management of company-owned units
as gauge for estimating future pro?tability of franchisees.
Coca-Cola and PepsiCo (see Side Box 2) provide good examples. Facing an
increase in agency costs in a changed strategic environment (buyer concentration,
marketing requirements), both companies decided to switch from franchising back
to company-owned expansion.
Side Box 2: Managing the Mixed Model – Soft Drink Bottling Example
Large soft-drink manufactures, especially Coca-Cola and PepsiCo, have historically
used traditional franchising agreements with their bottling companies. Coke and Pepsi
can exploit economies of scale in procurement (e.g., caramel, sugars) and protect
their secret recipes, while their franchisees have superior local market knowledge for
distribution and marketing.
Pepsi and Coke have taken different bottling strategies. Pepsi has aggressively converted
its traditional bottling franchisees into company-owned structures. Pepsi currently
owns a large majority of its bottler operations, concluding a buying spree with an $8
billion deal in August 2009 in which it acquired its two largest bottlers.
Pepsi’s rationale is an increased need for standardization and sophistication in its
marketing strategy. This standardization is easier to achieve in a company-owned than
a franchised setup. In the marketing war with Coke, Pepsi requires that all bottlers
support and promote the same complex advertising and marketing campaigns. The
“Pepsi Challenge” required a uniform roll-out. Some bottlers also interact with the
same consolidated retailers (e.g., Wal-Mart), and require a standardized approach.
Coke has followed suit, but has been less aggressive in buying back bottlers. Coke
has bene?ted from the stronger consolidation of its US and EU bottling operations,
and has had to coordinate its marketing strategy among far fewer franchisees, reduc-
ing the case for company ownership. Coke nevertheless maintains signi?cant equity
stakes in most of its bottlers, giving it a large say in how operations and marketing
campaigns are run.
Source: Besanko, Dranove, and Mark Shanley, Economics of Strategy (New York: John Wiley, 2000); interview
with Coca-Cola CFO, Gary Fayard:http://www.?ex-news-food.com/pages/24241/Coca/unlike-pepsico-coca-
cola-need-buy-bottling-partners-says-coke-cfo.html.
13 Chapter 2: Lessons Learned from History
Only limited information is available about the prevalence of mixed models in
frontier markets, by either commercial or franchise chains delivering public goods.
The study of prevalence and drivers will be an interesting area for further research.
The implications for investors interested in franchising in frontier markets are:
• Pro?table growth is the overall goal, and to achieve this goal, the franchising
decision must be periodically re-evaluated. Franchising should be seen as one
business concept, among others, to reach scale, and is not the be-all-and-end-all.
• Franchising is not the optimal choice for all expansion trajectories, with timing,
sector, and geography each playing an important role in evaluating whether
franchising is the appropriate option.
How franchises grow
Another lesson from history focuses on a franchise’s growth curve, from the ?rst
(pro?table) outlet to the rapid growth at the end of the curve. The growth paths of
successful franchised chains share common factors in terms of pro?table business
model and timing.
Successful franchises start with a pro?table and sustainable business model.
Successful franchised chains achieve pro?table business models on a small scale
(e.g., the ?rst outlet), before they contemplate growth. Replication takes place when
the model shows pro?tability and potential. We found no examples of chains that
started with a loss-making initial outlet but continued to franchise and managed
to grow into pro?tability.
A ?rm’s growth increases pro?tability, primarily through economies of scale and
to a much less extent due to franchising.
Economies of scale inherent in a larger size chain can have a drastic impact on
pro?tability. Bronson and Morgan
18
have shown that the difference in pro?tability
between independent entrepreneurs and franchised businesses in the travel indus-
try can be largely explained by scale economies. The impact of size on pro?tability
was also shown by Buzzel and Gale, who demonstrated that the largest ?rms in an
industry had on average a pro?t margin over 3 times larger than the fourth smallest
?rm in a given industry.
19
There is little information on the impact of franchising on overall chain pro?t-
ability. Firms will choose franchising or a certain mixed model in the belief that
18 James W. Bronson and Cyril P. Morgan, “The Role of Scale in Franchise Success: Evidence from the
Travel Industry,” Journal of Small Business Management Vol. 36 (1998).
19 David Besanko David Dranove, Mark Shanley, and Scott Shaefer, Economics of Strategy (3rd ed.;
New York: Wiley, 2003).
14 Franchising in Frontier Markets
this will positively affect their long-term pro?tability. The impact of franchising
is, however, likely to be signi?cantly less than the achievement of scale economies.
At the outlet/franchisee level, a shift toward franchising may increase pro?tability
slightly if the business is highly systematized and the franchisees are more disciplined
in managing inputs and reducing waste. A large fast-food franchisor indicated that
the cost levels of a franchisee are approximately 0.5% to 1% lower than those of a
company-owned outlet. At the franchisor level, the agency costs are reduced. How-
ever, these agency costs are only a small part of the overall franchisor cost-curve.
In summary, although precise data is not available, our research indicates that the
impact of franchising on pro?tability is very limited.
The ?ndings of this study have three important implications for investors and
donors considering franchising in frontier markets. First, it is dif?cult to establish a
pro?table business model. Thus, businesses that are unpro?table in the ?rst outlet,
with plans to achieve pro?tability through larger scale, should be viewed with a
great deal of suspicion. Second, scale, size, and market share will have a signi?cant
impact on a chain’s pro?tability. And ?nally, the impact of franchising on overall
pro?tability will be limited.
Preparation to franchise takes signi?cant time and effort. Figure 4 shows the
start-up phase for a range of franchise chains, and indicates:
Figure 4: Growth Data for Sample Set of Large International Franchises
Source: Data drawn primarily from Entrepreneur.com in 2008; most recent available data based on company
websites.
15 Chapter 2: Lessons Learned from History
• Growth from one to two outlets often takes several years. Replication toward a
small chain of units often takes between ?ve to ten years. This time is spent test-
ing the pro?tability and sustainability of the business model, and preparing the
processes, products, and procedures for replication.
• Some ?rms start with a constellation of company-owned units before moving
to franchising. A number of chains, such as Subway and 7-11, have started with
company-owned outlets, presumably to further test and adjust the business
model, before moving to franchising. Other chains, such as Dominos and KFC,
have immediately used franchising from the second outlet they opened. A direct
franchising strategy likely yields the fastest growth, but carries a higher risk pro?le,
as adjusting the business concept will be more dif?cult than in a company-owned
setup.
The implications for franchising in frontier markets are that investors and
entrepreneurs need to be patient and invest signi?cant time and effort in the ?rst
5-10 years of operations to develop and re?ne the optimal business model before
attempting to franchise. In their ambition to expand solutions to address develop-
ment issues, social entrepreneurs, social investors, and donors need to beware of
wanting to grow too fast, too soon.
Successful chains experience exponential growth, but it takes time. Once the
preparation phase is completed, subsequent expansion can be very rapid. Figure 5
compares the unit growth of four major chains between the ?rst and second decades
of operation, with growth rates in the second decade often a factor of 5 to 10 higher.
Figure 5: Growth of Leading Large-Scale Chains
First decade of operation Second decade of operation
McDonald’s 2 units 1,000 units
Subway 16 units ~600 units
20
Holiday Inn >100 units 1,000 units
Taco Bell 24 units