Converting existing employees or businesses to become franchisees can accelerate a franchise network’s growth rate, but is fraught with traps for the unwary.

A conversion franchising strategy can rapidly expand a network’s footprint, but at the same time deplete its resources to service and support the extra franchisees it creates. Additionally, conflict can more readily occur when the franchise fails to meet the expectations of the converted franchisee.

Although conversion franchising is commonly viewed as the changeover of an existing outlet or business from an independent or rival brand to another, it can also be viewed as the transformation of an existing company-owned operation to a franchise, as well as the transformation of a franchise employee to a franchise owner in their own right.

These approaches to conversion franchising can be divided into internal and external conversion. Internal conversions come from the franchising of existing company-owned operations or the transformation of employees into franchisees. External conversions come from changing over existing independent businesses or those which wish to convert from rival brands.

A summary of the relative advantages and disadvantages of the both internal and external conversion franchising from a franchisor’s point of view is shown in the table below.

This article discusses the relative merits of internal conversion of existing company-owned sites or territories.

Internal Conversion – Converting existing company-owned outlets to franchises

Converting an existing company-owned outlet or service operation can produce many advantages for a franchisor, but as a strategy also has its downsides.  Conversion of outlets internally held by the franchisor is also known as branchising, which means franchising of existing company branches. 

Internal conversion: Advantages

Operational and Cultural Alignment:

An existing company-owned outlet with its own staff will already contain a high level of organisational knowledge and operational expertise. The team will be familiar with the mission and aims of the franchise brand and will be familiar with the organizational culture. A franchisee coming in to run this business (or an existing manager who converts to a franchisee) has the capacity to bring further refinements to the working culture of the business, while at the same time boosting performance in areas where the owner/operator has a greater profit incentive and can pay more attention to detail than a corporate operator.

Boost in outlet performance

The attention to detail and profit motive brought to a converted company outlet by a franchisee will usually result in a boost to the outlet’s performance for several reasons. Firstly, the franchisee will be more concerned about waste and inefficiency than a corporate owner acting via a salaried manager. The franchisee is likely to develop more efficient rostering and inventory management processes (among other things) to reduce costs. The franchisee is also likely to introduce more effective local area marketing programs (or to implement existing ones more comprehensively) to boost sales, and build sustainable customer relationships.

For a franchisee who has put their own cash on the line, a vested interest in the profitability and long-term capital appreciation of their business is a stronger motivational force than any profitshare incentive program available to an employee. This usually leads franchisees to work harder for longer hours and with more innovation, which combines to enhance outlet performance.

Reduced risk of losses

Franchisors with under-performing outlets may find that such outlets may prosper under the care and attention of an owner/operator. This reduces the franchisor’s risk of incurring or continuing to sustain losses from an underperforming location. However, converting loss-making company-owned sites to franchises should be done with great care to ensure that potential franchisees are prepared for the challenge involved in turning around such a business. Preferably these are franchisees who have prior experience in the business, or are former employees, in preference to new franchisees from outside the system who are less capable of assessing the risks of taking on a loss-making or borderline operation.

Going concern sale / Return of capital

By selling company-owned locations, a franchisor can get a return of the capital it has invested in starting that business. It may also make a capital gain on the sale which can help fund the opening of future outlets (which may then later be franchised as well). The process of opening stores or territories, and trading them before making them available as franchises has worked well as a growth strategy for many franchisors. Existing businesses can be easier to sell because potential buyers are able to see the historical financial performance of the business, compared to a new “greenfield” franchise where the financial performance will be unknown. Also selling an existing business provides a buyer with something tangible to consider in their due diligence. They see the business in action, talk with the staff, talk with the customers, review the premises and equipment, and so on. This is not possible with greenfield franchises until after the site has opened.

Internal conversion: Disadvantages

Selling an existing outlet can often reduce the human resources available to a franchisor. Store managers and other staff are usually taken on by a franchisee in their acquisition of the outlet, potentially making these staff no longer available to the franchisor to redistribute across the rest of their company-owned operations. Franchising too many company-owned stores or territories too quickly can deplete the very expertise needed to provide support and guidance within a franchise network. Furthermore, if the franchisee themselves has come from a franchisor position such as field support, operations or similar, the talent drain from the franchisor is greater still as core head office capabilities become diluted.

Innovation mismatch

Internally converted outlets, particularly those where the store manager or a company employee becomes the franchisee, can become the source of tremendous innovation in a franchise network. With high levels of operational expertise, and an existing customer base to work with, converted outlets can more readily experiment with initiatives to accelerate business growth. If successful, these initiatives may subsequently be adopted by the franchisor, resulting in a mismatch in the rate of innovation development where the franchisee is innovating for the franchisor, and not the other way around. This may create future tension about the value proposition of royalties paid to the franchisor.

Reduced profits

Whereas a franchisor is responsible for 100% of the losses of a company-owned outlet, it will also forego profits by franchising and only receive royalty payments after the outlet is franchised. Unless the outlet has been a break-even or loss generator for the business, a franchisor’s income may well be reduced by receiving only royalties (the extent of which would be determined by the royalty method applied). The offset to this is the return of capital through the sale of the outlet (which might also include a capital gain), and the decreased management resources required to supervise the outlet on a day-to-day basis.

Financing issues

Where suitable franchise candidates are unable to raise the capital themselves to buy the company-owned outlet to be franchised, the franchisor may be inclined to consider vendor-financing part or all of the sale amount simply to be rid of the day-to-day management responsibilities of the site. Vendor financing is not unusual, but requires greater care in selecting buyers, striking an appropriate deal with adequate security, and monitoring buyer performance. This may erode many of the benefits of conversion franchising and set a potentially dangerous precedent for future franchise deals which can cause problems for a franchisor’s financial stability.

Internal conversion – Summary

The benefits and downfalls of an internal conversion strategy should be thoroughly evaluated to determine its appropriate use. For many start-up retail franchisors, internal conversion franchising may be the only way to build sufficient awareness of the brand as a viable franchise offer prior to releasing greenfield sites alone. This may be via sequential conversion, where the sale and conversion of one outlet effectively funds the opening of the next, or where multiple existing company-owned outlets are simultaneously “branchised” (ie. converted) to free-up capital and management resources for further growth or other projects.

Copyright © Jason Gehrke, 2009.