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Leveraging Intellectual Capital Through Franchising

Andrew J. Sherman, Partner, Dickstein Shapiro Morin and Oshinsky LLP

Intellectual capital consists of human capital, intellectual property, and relationship capital, the major assets for driving business growth in all economic conditions. The biggest challenge for entrepreneurial companies is how to keep growing in a slowing economy. For years, companies of all sizes and in many different industries did not understand how to harvest intangible assets and traditionally viewed the assets passively as a way to defend market share instead of proactively regarding them as a source of new opportunity.

Consider that many intellectual properties that can be protected can lead to possible revenue sources. Patents can lead to the spin off of new companies; trademarks, including brands and slogans, to joint ventures or alliances; and copyrights to technology and software licenses. Trade secrets can be shared productively in co-branding arrangements, and distribution channels can be maximized through franchising. The list goes on. However, the focus in this article will be on franchising.

A Strategic Process

The harvesting of intellectual capital is a strategic process that begins with management and outside advisors taking an inventory to get a comprehensive handle on the scope, breadth, and depth of the company's intangible assets. In these times of distrust and disappointment by shareholders in the management teams and boards of publicly held companies, leaders have an obligation to uncover hidden value and make the most of the assets which have been developed with corporate resources. The leadership of the company will never know if it has a Picasso in the basement unless it takes inventory of what's hiding in the basement and relies on advice from a qualified intellectual capital inventory team that is capable of distinguishing between a Picasso and a child's art project.

Once these assets are properly identified, management should develop an Intellectual Asset Management (IAM) system to ensure open communication and strategic management of these assets. At that point, the company is ready to engage in the strategic planning process to determine how to convert the assets into profitable revenue streams and new opportunities that enhance and protect shareholder value.

In the strategic planning process, the company's leadership should be considering the following important questions:

  • What patents, systems, and technologies have non-competing applications that could be licensed to third parties to create new revenue streams, joint ventures, partnering opportunities, distribution channels, or profit centers?
  • What brands lend themselves to extension licensing or co-branding opportunities?
  • What distribution channels or partnering opportunities can be strengthened if the company has greater control or provided additional support and services to the channel?
  • What types of different growth and expansion strategies do the company's competitors utilize and why?\
  • Where are the strategic/operational gaps in the company's current licensing and alliance relationships?

Building, Franchising, and Licensing Programs

Over the past five decades, franchising and licensing have emerged as leading intellectual property leveraging strategies for a variety of product and service companies at various stages of development. Recent statistics from the International Franchise Association (IFA) demonstrate that retail sales from franchised outlets comprise nearly 50 percent of all retail sales in the United States, estimated at more than $1 trillion and employing more than 12 million people in 2003. These impressive figures notwithstanding -- and despite the recent favorable media attention -- franchising as a method of marketing and distributing products and services is appropriate only for certain kinds of companies. It is not for everyone. A host of legal and business prerequisites must be satisfied before any company can seriously consider franchising as one option for rapid expansion.

Many companies prematurely select franchising or licensing as a growth alternative and then haphazardly assemble and launch the program. Other companies are urged to franchise by unqualified consultants or advisers who may be more interested in professional fees than in the long-term success of the franchising program. Still others move too quickly in the development of their franchising program without devoting the time and resources to the formation of an effective business and economic model. This has caused financial distress and failure at both the franchiser and franchisee level and usually results in litigation.

Responsible franchising starts with an understanding of the strategic essence of the business structure. There are three critical components of the franchise system: the brand, the operating system, and the ongoing support provided by the franchiser to the franchisee. The brand creates the demand, allowing the franchisee to initially obtain customers. The brand includes the franchiser's trademarks and service marks, its trade dress and décor, and all of the intangible factors that create customer loyalty and build brand equity. The operating system essentially "delivers the promise," thereby allowing the franchisee to maintain customer relationships and build loyalty. The ongoing support and training provide the impetus for growth, giving the franchisee the tools and tips to expand its customer base and build its market share. The responsibly built franchise system is one that provides value to its franchisees by teaching them how to get and keep as many customers as possible, who consume as many products and services as possible, as often as possible.

In fact, most litigation in franchising and licensing revolves around the gap between the actual needs of the franchisees to remain competitive in the marketplace and the reality of what support the franchiser is capable of providing. The genesis of the disappointment begins during the recruitment phase of the relationship and continues beyond the start up, as the franchisee struggles to remain competitive unless the franchiser delivers on its promises and is committed to providing excellent initial and ongoing training and support.

Reasons for Franchising 

Franchisers cite a number of reasons for the popularity of franchising as a method of growth and distribution. Through franchising, they say, they are able to accomplish the following:

  • Obtain operating efficiencies and economies of scale.
  • Increase market share and build brand equity.
  • Use the power of franchising as a system to get and keep more and more customers, which builds customer loyalty.
  • Achieve more rapid market penetration at a lower capital cost.
  • Reach the targeted consumer more effectively through cooperative advertising and promotion.
  • Sell products and services to a dedicated distributor network.
  • Replace the need for internal personnel with motivated owner/operators.
  • Shift the primary responsibility for site selection, employee training and personnel management, local advertising, and other administrative concerns to the franchisee, licensee, or joint venture partner with guidance or assistance from the franchiser.

In the typical franchising relationship, the franchisee shares the risk of expanding the franchiser's market share by committing its capital and resources to the development of satellite locations modeled after the proprietary business format of the franchiser. The risk of business failure of the franchiser is further reduced by the improvement in competitive position, reduced vulnerability to cyclical fluctuations, the existence of a captive market for the franchiser's proprietary products and services (due to the network of franchisees), and the reduced administrative and overhead costs enjoyed by a franchiser.

Making the Franchise Work

Typically, the most important strategic prerequisites for the success of any licensing or business format franchise system is the operation and management of a successful prototype and a business and financial model which makes sense for both franchiser and franchisee. This prototype location is where virtually all operating problems are to be resolved, recipes and new products tested, equipment and design decisions made, management and marketing techniques tested, a trade identity and goodwill established, and financial viability proven. The franchiser is, in theory, offering a tried and tested package to a franchisee, and the contents of that package must be clearly identified prior to sale. It is irresponsible and potentially in violation of the law to ask someone to part with their life savings to invest in a system which is not ready for replication. The financial aspects of the business model should be analyzed and tested to ensure that both parties can do well and are fairly rewarded for their efforts.

The concept of a system or prescribed business format that is operated according to a uniform and consistent trade identity and image is at the heart of a successful franchising program. Therefore, a prospective franchiser must be able to reduce all aspects of running the business to be franchised into an operations-and-training manual for use by franchisees in the day-to-day operation of their business. These systems must be adequately and clearly communicated in the initial and ongoing training program. If a company offers services that are highly personalized or a product that is difficult to reproduce, then franchising may not be the most viable alternative for growth because of the difficulty in replicating these systems or products in the operator's manual or in the training program. Similarly, if all the "kinks" in the system have not yet been worked out, it is probably premature to consider franchising.

A number of other important business and strategic factors must be considered before franchising. First, franchising should not be viewed as a solution to under-capitalization or as a "get-rich-quick" scheme. While it is true that franchising is less capital intensive than is the construction of additional company-owned sites, the initial start-up costs for legal, accounting, and consulting fees can be extensive. Second, franchisers must view franchising as the establishment of a series of long-term relationships. The ongoing success of the company as a franchiser will depend on the harmony of these relationships.

A field support staff must be built to provide ongoing services to the existing franchisees, as well as to maintain quality control and uniformity throughout the system. New products and services must be developed so that the franchisee can continue to compete with others in its local market. Innovative sales and marketing strategies must be continually developed to attract new customers and retain existing patrons of the franchised outlet. If the franchiser expects the franchisee to continue to make its royalty payment on gross sales each week, then an array of valuable support services must be provided on an ongoing basis to meet the franchisee's changing needs.

Executed well, franchising can be a solution to the never-ending entrepreneurial challenge of harvesting intellectual capital to achieve the goal of driving business growth. If it is right for your company, consider making it work.

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