One path to self-made wealth that I have followed for years is to purchase a franchise. For a long time, franchise ownership has been a viable and accessible path to wealth. This is especially the case for entrepreneurs with no college degree, and first- generation immigrants who may lack connections and career opportunities but are willing to work hard and take risks to build wealth in a generation. Other successful franchisees I have worked with have been mid-career professionals looking to start a business, escape the corporate world, and achieve financial independence.
The franchise model.
Albert Singer is credited with starting the first franchise model in the United States to distribute his sewing machines in the 1860’s. Rather than run a chain of stores himself, independent operators would be licensed to run a store selling their machines in their local community. In the 1960’s Ray Croc further popularized the model after purchasing and then franchising McDonalds restaurants throughout the world
Today the individual locations of many large restaurant brands (McDonalds, Subway, etc.), service businesses such as delivery drivers (FedEx, Amazon), shipping (UPS Store), and retail are owned and operated by small business owners in your local community.
In a franchise model, the entrepreneur gains access to the established brand and a detailed business plan to implement with the help of the franchisor. The financial risk of the endeavor is mostly borne by the franchisee, and some revenue is shared with the franchisor. Success rates for franchises tend to be higher than for independent businesses in the same field. This of course does not mean it is risk free and many franchises do fail for reasons outside the control of the operator.
These franchises are usually started up with a variable rate loan guaranteed by the Small Business Administration. Some of these businesses rely on lower wage labor in order to be profitable enough to pay off the SBA loan. (Think fast food.)
Significant wealth building potential of the franchise model.
A successful franchisee of one location can often take out further loans to open multiple locations. The entrepreneur can gain operating leverage by hiring professional management as they grow. If this process is repeated, the overall value of the collection can grow at a compound rate (helped along with leverage from the loan) leading to relatively rapid wealth gain compared to investing in public markets.
A successful franchisee can see significant income, growth in net worth, and an independent lifestyle. The franchise locations can ultimately be sold to a new franchisee to fund retirement.
Threats to the franchise model as a way to build wealth.
Higher interest rates. The SBA loans that franchisees use to start, purchase, and grow their franchises use variable rate loans. The average interest rate on a small business loan has grown significantly during this inflationary era. These loans typically have ten year terms. Higher rates are a direct cost to the business during the term. Unless the franchisee can grow revenue to match, their profit margins will be reduced by these higher rates. Additionally, the multiple they can expect to sell their business for may fall (reducing their net worth) because a purchaser would need to finance the purchase of their franchise with the higher interest rate loan. So the franchisee’s income is reduced at the same time the value of the business itself is reduced. Meanwhile the debt hangs over them.
Higher labor costs. The higher inflation of the past few years has increased wages in many industries (although in many cases has not kept up with inflation), especially in traditionally lower income fields such as fast-food. At the same time governments in some parts of the country have raised the minimum wage and added further mandates to franchisees such as paid sick leave. For example the state of California recently implemented a $20 per hour minimum wage for fast food workers.
These higher labor costs further squeeze even franchisees who have already paid off their SBA loans. For those newer franchisees who have both higher labor costs and higher interest rates their margins could be thin indeed.
Higher non-labor input costs. In addition to higher labor costs inflation has affected other costs as well. This includes just about everything the franchisee needs to buy, including the product itself. (Food ingredients in the case of the fast food franchise.)
Solutions to higher costs.
There are a few levers that franchisees have to maintain their profit margins, although neither are easy and both have downsides. Raise prices, increase volume, or reduce labor costs.
Raise Prices. This is the most direct solution. For example, the price a a big mac has gone from $3.99 in 2014 to $5.99 this year. Prices though can only be increased as much as the market can bear. These price increases can also have an indirect impact on the second revenue raising option for franchisees by reducing volume.
Higher prices may dissuade consumers from visiting a franchise in the first place. This does not seem to be happening yet as consumer spending has held up remarkably well during this inflationary era.
Increase Sales. Of course sales growth is an ideal goal. This may require a higher marketing spend which further pressures margins.
Reduce Labor Costs. On the cost side, franchisees can consider reducing labor costs through automation. This has been slowly happening for years. The downside of this method is that automation has high up front costs that may require further loans at the current higher interest rates.
Is franchise ownership still a viable path to wealth?
I think that franchise ownership remains a viable but less certain path to wealth than it was in the past. The new inflationary era, higher costs, and potential new government regulation have not been kind to the model. New franchisees will need to be better capitalized with more starting cash and smaller loans. Existing franchisees will need to work within the current framework to grow revenue and reduce labor costs. However I still think that it is possible to realize dreams of wealth in a generation by starting and operating a successful franchise.
