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Hospitality Leadership Through Learning
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Biting Off More Than They Can Chew: Unfulfilled Development Commitments in International Master Franchising Ventures

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Vol 5 No 12
By: Arturs Kalnins Ph.D.

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Executive Summary: In the last 25 years, many U.S. food franchisors have ventured into foreign markets, commonly with local partners as master franchisees. Many international master franchising contracts include development commitments that specify a number of outlets that the franchisees must develop in exchange for exclusive rights to an assigned market (often, their entire nation).

Based on a sample of 142 ventures of 53 U.S. food franchisors in 37 countries, the inescapable conclusion is that the development commitments in most master franchise agreements are excessively large relative to the number of units actually built by the master franchisee.

Specifically, a regression analysis found the following:

  • Ventures with larger development commitments have a lower probability of survival than those with smaller commitments.
  • With a development commitment size at the 25th percentile of those in the data ($8.2 million), the probability of a venture's survival is 49 percent. The probability goes down to 33 percent with a larger development commitment at the 75th percentile ($40 million). Surprisingly, factors other than development commitment size, such as the experience level of franchisors and franchisees, did not significantly affect survival rates.

Other key findings include:

  • Of the 142 ventures in the sample, only 55 (39%) survived until the end of the development commitment periods, typically five years.
  • The median development-commitment size is 34 units, or $19.2 million when normalized across chains by average investment per unit for each franchisor's brand.
  • Development commitments are usually not fulfilled or enforced. Master franchisees operated a median of only three units at the end of the development-commitment period in the 55 surviving ventures.

That figure is less than 10 percent of the median commitment size of 34 units. Additionally, the franchisees completely fulfilled the development commitment in only six (11%) of the surviving ventures. As a consequence, franchisors and franchisees should realize that aggressively large development commitments do not yield larger or more successful ventures. They do not help franchisors develop foreign markets. Further, excessive development commitments are not without cost. Large commitments generate unrealistic expectations and a misallocation of resources that lower venture survival rates. Rather than overcommit resources, a better approach would be for franchisors to set modest initial development commitments-not exceeding a total required investment of $10 million. This number allows the franchisees to allocate resources appropriately without overdeveloping. If they fulfill this initial commitment, they can renegotiate a larger commitment with the franchisor in exchange for a larger geographic territory.

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Comments

I read your article, and I must say I was stunned! Finally ... someone has exposed the truth behind all the hyperbole out there regarding international (and in many cases domestic) franchise development deals. Thank you for playing the role of the little boy in "The Emporer's New Clothes" with your report. Your report was brought to my attention by my boss, Ron Petty who was, as you may know, the president of Burger King International for about 12 years, and he "opened" 30 or so countries around the world for them. In my own small way, I too played in that arena as vice-president of international franchising for El Torito back from 1998 to 2001, working in a dozen or so countries from the middle east to south-east asia. My old group's performance internationally mirrored what you reported, but in my own defense I must say I did try to move toward doing direct (not master) franchising and scaling agreements down to more achievable sizes*. Here at Del Taco, Ron and I, having learned the lessons you describe, have spent the last few years signing up developers (domestically only) to very small deals by industry standards. We have often remarked internally that the big deals just never work out, so we're committed to aligning our development schedules with what we believe is actually possible. What a concept!
So again, I wanted to thank you for your article. My compliments!
Best regards,

J. Marc Mushkin
Senior Director, Franchising
Del Taco, Inc.

*PS -- I know from first hand experience how people in my old position are pressured to write the big, unrealistic deals you exposed. I would be delighted to speak with you about it. I believe that in your article the only weakness I perceived was your examination of the causes behind this phenomenon (page 12 - 13)

This has been a known fact for some time now. But the very fact that it has come in the form of a study clearly establishes the fact that something needs to be done about it. Especially when an established institution such as Cornell is forced to give a wake up call which has been long coming.

This will assist the developers to rethink their strategy and the franchisers to establish realistic targets which are attainable. Growth and opportunity must never be taken for granted or substituted with over enthusiasms or over optimism. Especially in the developing world and market such as India which is now seeing burgeoning developments in the retail, hospitality and real estate. This piece of work can well act as guide line for all markets and greatly assist in getting the mist out off the way to provide greater clarity in establishing lasting workable partnerships.

Warm Regards
Rayomand.Eranee
Senior Manager Hotel Projects
Kohinoor Planet Constructions Pvt Ltd
Kohinoor Corporate Office

With regard to the above referenced report.

I am a consultant to a casual dining restaurant franchisee in Asia. Your report is right on. My experience with this franchisee, which is very successful by the way, and my knowledge of other franchisees of the same brand internationally replicate your findings. For example:

  1. My successful franchisee believes that you build the first restaurant, build the business. Reach stability and profitability and then, and only then, build the second and third and so on.

  2. The franchisor and the franchisee tend to engage in a mutual admiration relationship in the courting stage of these development agreements with the franchisor overplaying the advantages and viability of the brand and the ongoing support they will provide and the franchisee for complex reasons of his own tends to believe all the franchisors claims and believes in his ability to operate the franchise successfully.

  3. Many local franchisees are investors and real estate developers (office buildings and shopping centers) and are using the franchise brand to anchor or fill their spaces. They are not food service people.

  4. These franchisees appear at first to "buy in" to the franchisors philosophy, culture, business/operating system, quality standards, and training program but after the initial training and honeymoon period they tend to go local by relaxing standards, minimizing or eliminating ongoing training and by hiring marginal employees.

  5. Often the downward spiral of unsuccessful franchisees starts with the initial hiring of their management team and the selection of the first restaurant location, both of which are bad.

  6. The franchisor often pushes the "reach critical mass" formula which says you must quickly build several restaurants and then market aggressively to be successful. This often means that the franchisee does not build his management team properly and picks marginal locations in his rush to get a presence in the market.

The above are but a few of the most common mistakes made by franchisors and franchisees in the overseas market. Thanks for your great article.

-International Business Consultant

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About Arturs Kalnins Ph.D.

Arturs Kalnins is an associate professor at the School of Hotel Administration. His primary research focus is on hospitality, franchising and small business strategy with an emphasis on geographical issues. Specific projects include analysis of impact, agglomeration and immigrant-entrepreneur business groups in the lodging industry, franchisee selection and intrabrand competition within fast food chains, and development commitments in master franchising ventures. His work has been published in many leading publications including the Journal of Economic Perspectives; Management Science; Marketing Science; RAND Journal of Economics; Strategic Management Journal; Academy of Management Journal; Academy of Management Review; Journal of Economics and Management Strategy; and the Journal of Law, Economics, and Organization. Among his recent works are "The U.S. Lodging Industry," Journal of Economic Perspectives," 2006; and "Social Capital, Geography, and Survival: Gujarati Immigrant Entrepreneurs in the U.S. Lodging Industry" (with Wilbur Chung), Management Science. Kalnins has consulted for United Parcel Service and AT Corp. Kalnins holds a B.A., Swarthmore College; an M.B.A., Lehigh University; and a Ph.D., University of Michigan.

For more information visit http://www.hotelschool.cornell.edu/research/facultybios/faculty.html?id=150