Investing in Microfranchising: What Should I Know?
This post is part of a series focused on microfranchising, a common way many social enterprises distribute their products. There has been some great discussion of microfranchising recently (such as this SSIR article). This series provides an overview of different types of microfranchising, profile many enterprises that are employing the method, and provide information for both investors and those looking for funding. The last post focused on the agents of large networks model. This post focuses on what investors looking at microfranchising models might want to know.
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To date, this series has focused on the mechanics of microfranchising from the entrepreneurs’ s point of view. (The term “entrepreneur” represents both the franchisee and the franchisor.) But to succeed, i.e. become profitable and scale, new businesses more often than not require infusions of capital to fuel growth. To that end, we at Ayllu would like to take a look at microfranchising from an investor’s point of view.
Probably the first thing to keep in mind, as we have mentioned in previous posts, is not to look at microfranchising as a business model in itself. There are a few organizations which specifically focus on microfranchising, and plan to introduce a number of businesses using this method (an example is Microfranchise Solutions), and others, like Community Enterprise Solutions, that are focused on perfecting versions of microfranchising like microconsignment. However, microfranchising is generally a distribution method used by different types of social enterprises as part of their business models (training community members to provide eye-screenings, providing clean water or renewable energy via a machine). Therefore, the first question to answer is why microfranchising is being used by the investee and whether it is the best method of distribution.
There are several general positives from the investor perspective to the use of microfranchising for distribution. First, it can potentially be less risky than individual business ownership. Why? In the franchisee’s case, s/he is implementing a tested business model, which increases the likelihood of financial success. For the franchisor, the benefit often comes from engaging experienced entrepreneurs. (Contrary to popular belief, franchising doesn’t always produce first time business owners.) Second, by using community members as salespeople, microfranchising increases the likelihood that the social enterprise will be able to understand their customers well enough to meet their needs (often a challenge for development projects). Third, for more socially oriented investors, microfranchising creates the social benefit of new jobs in the community, in addition to that of the product or service provided.
However, the risk/return relationship for microfranchises varies widely. The major factors include the franchisor organization’s size, age, and maturity, and the chosen industry, Profitability is particularly difficult to achieve for franchises that deliver public goods like health and education, as they frequently have to compete against subsidized nonprofit or government models, driving down prices and margins. In fact, research from the University of California, San Francisco indicates that the only ways for health franchises to both serve the poor and be profitable are to offer niche services or to serve higher income, high-density urban populations.
Recommendations for Investing in Microfranchised Social Enterprises
When a potential investee has adopted a microfranchising model, how can an investor know if it is likely to succeed? What are the risks? What are likely to be the crucial factors? One strong source of information is a December 2009 report by Dalberg Global Development Advisors entitled: Franchising in Frontier Markets: What’s Working, What’s Not, and Why. The report produces several insights about microfranchising, all of which is useful to tease out and discuss.
1. Traditional vs. Business Format Franchising. One challenge many franchisors face operating in BOP environments is the lack of a strong legal and regulatory framework enforcing contracts, intellectual property rights, and resolving conflicts of interest. Traditional microfranchises, i.e., variants on the business in a bag model, are less susceptible to these challenges than business format franchises, in which the franchisee licenses a business model, rather than products or services. This is because the relationship between the franchisee and the franchisor is often easier to manage. For example, there are less likely to be issues with contract enforcement; there is often less intellectual property to protect; and there are fewer conflicts of interest. Additionally, franchisees have less responsibility for managing the franchise, e.g. less input into things like marketing, and less power due to the ease with which the franchisor can dissolve the relationship.
2. Target Selection. A key focus in the due diligence process should be the size and density of the potential market for the distributed product. Density can be a key factor for franchise success, both because it makes it easier for customers demanding the product to reach the franchisee, and because word of mouth spreads more quickly among denser populations, making the product easier to promote.
3. Understand unit profitability. Not surprisingly, the margin generated by each unit has a significant impact on franchise profitability. Without unit profitability, franchise failure is more likely. As a result, it should be considered as the franchise’s purchase price and expected return are calculated.
4. Focus on outlet growth. Once the business model is set, adjusting unit profitability is difficult, partially because franchisees are reluctant to shift the product and price mix. Consequently, outlet growth can be a strong contributor to profitability.
5. Manage agency costs. Investors should identify agency costs, e.g. the costs associated with monitoring franchises, and reduce them. More specifically, areas of potential conflict between franchisees and franchisors should be minimized because conflict increases risk, which in turn impacts franchise value.
6. Focus on reducing barriers. Barriers such as access to capital (both financial and human), and durability of contracts can constrain outlet growth, and investors must understand these and work to reduce them.
7. Grant-subsidized microfranchises can be problematic. While they may be necessary, especially in the start-up phase, grants and subsidies can discourage entrepreneurs from developing their business model toward profitability. Additionally, if for-profit franchises exist in the same market, the existence of subsidized franchises can create a negative competitive effect. Dalberg’s study finds that it has thus far been difficult for most grant-subsidized franchises to successfully transition to profitability.
8. Third Party Payors. Some microfranchises provide services which are needed but seemingly impossible to make profitable at prices the customer can afford (often in the aforementioned health and education sectors). One possible way to bridge the gap between costs and customer ability to pay is the use of third party payers (government service providers, insurance companies). If a franchise can provide a service more cheaply and/or effectively than these third parties were providing it before, voucher systems can be developed where the third party pays each time the service is delivered, retaining incentives better than with grant support.