FRANCHISING AND NOODLES & COMPANY John Burr

What is Franchising? Legal--Franchising is an organizational arrangement created by contract between the owner of a trademark and a production technology (the franchisOR) and a local entrepreneur (the franchisEE). Strategic--Franchising is an organizational form chosen by entrepreneurs to secure competitive advantage.

Where franchising? Used in service industries competing through networks under a shared trademark: –restaurants; –hotels; –car repair; –tax preparation. Low human capital industries and low capital / lower risk.

Responsibilities Franchisor provides: –Access to brand / trademarks –Blueprints / operations details –Training –Other support services (varies) Franchisee provides: –Location –Local knowledge –Managerial effort –Franchise fee and royalty payment

Cui bono? Franchisor gains access to capital: –Financial –Locational –Managerial Franchisee gains: –Technology –Brand recognition

Is Franchising Entrepreneurship? Theory –Franchisors and Franchisees: Coordinate, Bear Risk, Innovate, Arbitrage. Practice –Franchising is a route into self- employment. –Franchising is a resource assembly method.

Franchising & Agency costs Franchising solves an Agency Problem –Unit managers are agents of owners (principal) and may be ineffective or act in their best interest Need to do lots of due diligence on front end to be sure manager is good. Need to monitor after you hire them. –Franchisees are owners and not agents Franchising provides superior incentives for local supervision than employment.

Franchising & Agency Costs Multiple unit franchises are an anomaly –They reintroduce agency problem Potential explanations –Franchisees may have special locational insight about demand or customer tastes –Lets franchisees better manage competition –Reduces incentive for franchisee to free-ride –Allows franchisees to take better advantage of marketing and production efficiencies

Source: Kalnins & LaFontaine, 2004

Types of Franchises Business Format Franchise –Probably the most well-known –Franchisor provides business concept, right to use trademarks, operations details, marketing advice to franchisee –Examples: restaurants, hotels, copy centers, etc. Product Distribution Franchise –Franchisor provides exclusive license to market products in a specific location –Examples: gas stations, auto dealers Business Opportunity Franchise –Franchisee buys right to sell goods or services of franchisor in addition to location assistance –Examples: vending machines, amusement games

2005 Franchising Statistics Source: IFA

2005 Franchising Statistics (2) Source: IFA

2005 Franchising Statistics Source: IFA

Less Risky? Franchise systems still fail at a high rate Not that much better than non-franchised start- ups Source: Shane (1996)

Some Key Franchisee Issues Evaluation of the business concept Required investment Franchise fee, royalty rates, other fees Territory protection Activity restrictions Renewal rights

Franchising Resources International Franchise Association ( American Association of Franchisees & Dealers ( Inc. Magazine ( Entrepreneur.com Franchise Zone ( Franchise Times Magazine ( US Small Business Administration ( ml) ml FTC Franchising FAQ (

NOODLES & COMPANY

Some Noodley Takeaways (1) Compared to growth through company-owned stores, franchisor might be able to achieve rapid growth and market penetration with a relatively low capital investment –Noodles & Co. had $10 million - enough capital for 20 stores, lower than their planned growth of 32 in Expected to grow 45 in 2004, 64 in 2005, 100 in stores requires $115 million over 4 years –2002 debt ratio = 36% –Need equity Can they find interested investors? Is this how Kennedy wants to spend all his time?

Some Noodley Takeaways (2) There is a cost to lower risk - compared to growth through company-owned stores, franchisor has lower upside potential –Franchisor only gets royalty versus full profit margin –Will affect valuation of business –Interestingly, Noodles & Co does not have a very attractive profit margin Revenue100.0% Contribution20.0% G&A Exp16.3% Depr Exp3.0% Interest Exp.3.0% Profit-2.3% Royalty? Will Franchisees be interested?

Good service and unique culture comes at a cost – 16.3% G&A Expense –Will growth affect this? –Will franchising affect this? –Which stores should be company-owned and which stores should be franchised? Some Noodley Takeaways (3)

If franchising is the desired route to growth, it must be attractive to franchisees –Concept is certainly attractive –16.3% General and Administrative expense is a killer No room for royalty Some Noodley Takeaways (4) 1 GM$45K 2 Asst GM$60K 2 Shift Mgr$55K Total$160K Avg Rev / store$1125K Is this model sustainable? How?

There may be strategic reasons to grow quickly? –Competitive reasons Location availability –Financial reasons Capital availability Some Noodley Takeaways (5)

Epilogue Kennedy decided to franchise – –Will only work if the relationship between headquarters and franchisee was a true partnership, rather than the usual fiefdom. –$35,000 franchise fee –5% royalty –Franchisees carefully screened Given psychological tests All franchisees given a Noodles Buddy – a seasoned corporate manager who serves as a mentor Company assists with real estate selection and acquisition, as well as restaurant design and construction Only considers operators who already run several restaurants and are interested in opening 10 or more Noodles & Company locations