Today Horacio Ruiz takes a look at investing in franchises through the lens of an important new company called FranShares.
We’ve been following the FranShares journey closely, and they’ve come a long way since we first covered them back in early 2021.
Horacio goes into the history, benefits, and economics of franchise investing. We hope you enjoy it!
Editor’s Note: This is an independent analysis of FranShares. Kenny, the Founder and CEO, agreed to give us an unconstrained look at their company & operations. FranShares is a sponsor of Alts, but our research is neutral and unbiased. All written opinions expressed here are ours and ours alone. This should not be considered financial advice.
Let’s go! 👇
Podcast
First, Horacio did a podcast with Kenny Rose.
Horacio and Kenny go deeper into FranShares and franchise investing in general. Check it out on Spotify, iTunes, or YouTube:
The “F” Word
Kenny Rose knows what people first think of when you mention the word “franchise,” an often misunderstood industry that typically conjures up images of greasy burgers and french fries.
But Rose has made it his job – yes, literally – to educate people about the variety of franchising opportunities available and that it goes far beyond fast-food restaurants.
It’s an industry that in 2020 had more than 750k establishments in the United States, contributing $670 billion of economic output.
Few people understand franchises like Kenny does. He knows the economic opportunities and diversity of industries that franchises represent. His experience extends from founding a successful franchise brokerage to becoming Founder and CEO of FranShares, an SEC-registered investment platform fractionalizing shares of a franchise fund.
FranShares is awaiting SEC registration approval and should be open in March 2022.
Today we’ll take a deeper look at franchises’ performance during the global pandemic and analyze what makes the FranShares platform a compelling alternative investment.
The Franchise Model
The first modern franchise was established by Howard Deering Johnson, who in 1935 replicated the operations of his successful restaurant in Quincy, Massachusetts. It was a novel concept for the restaurant industry; copying a restaurant and opening up in another location.
Under the new model, Howard Johnson sold the rights to use his name and logo while also agreeing to ship the same food products to a different location. The new restaurant was a success. By 1939, there were 107 Howard Johnsons throughout the Eastern Seaboard.
The basic agreements that Johnson was able to forge in the early days of his franchise remain largely unchanged. Today, a franchising agreement occurs when a franchisor allows a small business owner, or a franchisee, to use their logo, brand, and materials to begin their own independently-owned business.
In return, the franchisee pays one-time “investments,” for set-up fees and costs, with a minimum cash requirement set by the franchisor. In addition, franchisees pay yearly fees and royalties to the franchisor for continued use of copyrighted materials and access to distribution channels.
Franchisees can also expect inspections from corporate headquarters, assuring that they meet the standard operating procedures established by franchisors.
Franchises Today
In 2020, franchises accounted for roughly 3.5% of the country’s Gross Domestic Product. Nearly 7.5 million Americans were working for a franchise.
Then COVID happened.
The effects of the pandemic on job numbers and small businesses are complicated in some parts because bad news in one area was related to good news in another. Take, for example, the number of small businesses during the pandemic.
By one estimate, the pandemic was directly responsible for the permanent closure of 200k small businesses. Nearly one-third of all small businesses were either permanently or temporarily closed at one point.
But on the other hand, fillings for employer identification numbers in the U.S. went up by 57% in 2020 compared to the average number for the previous 15 years. The 2021 numbers appeared to mirror those of 2020.
Some explanations for this include small businesses having to formalize paperwork to receive federal aid; another reason could be good old-fashioned fraud. A study in April 2021 by the Federal Reserve Board also found that permanent closures are “likely to have been lower than widespread expectations from early in the pandemic.”
To further complicate the issue, a record number of employees have taken part in the “Great Resignation,” which refers to the nearly 33 million Americans that have quit their jobs since the spring of 2021. This suggests that many in the workforce have decided to change where and how they work, reassessing their lives during a once-in-a-lifetime pandemic. Often, they have chosen to work for themselves.
When considering what kind of businesses to start, many entrepreneurs were introduced to franchises for the first time. According to the International Franchise Association (IFA), more than 26,000 franchises opened in 2021.
Franchises in the Pandemic
While small businesses were affected by the pandemic, the recovery is well underway, only one year after the worst of the outbreak. The economic output of franchises was expected to go up to $780 billion in 2021, up from $670 billion in 2020.
In 2021, according to the IFA, the growth in franchises and rise in employment would put the number of franchises and jobs on par with pre-pandemic levels.
Franchises as a whole proved to fare better than independent small businesses, in large part due to the support from franchisors who frequently provide dedicated consultants to their franchisees.
Franchisees also had a network of other business owners who could share and develop on-the-fly strategies for keeping their businesses afloat during the pandemic.
Benefits of Franchising
There are a host of benefits to owning a franchise. One of the primary benefits is the ability to “fast forward” five years, skipping some of the growing pains of finding operational efficiencies and gaining marketing insights.
Franchisees can also tap into a built-in network of fellow franchisees and the franchisor. A lot of the scaling of a business is done for the franchisee from the beginning. This was a key factor for the continued existence of many franchises.
But franchises also have one major barrier. They often require a lot of capital to get started, sometimes as high six figures and into the seven figures. Here are the startup costs for some of the most recognizable franchises:
- McDonald’s: $2.3 – $1.3 million
- Dunkin’: $465k – $1.6 million
- Jamba Juice: $270k – $500k
Of course, there are several franchises with much lower startup costs. The average startup costs for a franchise range from $50k to $100k. But it helps to go through vetting franchisors with a franchise broker.
A broker is an expert in the field, knowledgeable about costs, locations, and businesses best suited to a potential owner’s strengths and weaknesses.
This is where Kenny Rose comes back in with his expertise, the Jobs Act of 2012, and an “a-ha” moment during the pandemic.
How FranShares Started
Kenny Rose is one of the foremost experts on franchising. He started Semfia, a franchise brokerage, connecting potential franchisees to specific businesses within more than 300 industries.
As he developed his expertise, Kenny thought about the potential of bringing fractionalized shares of a franchise fund to the masses. When President Obama signed the Jumpstart Our Business Act in 2012 (JOBS Act), businesses were allowed to begin ‘crowdfunding’ to issue securities – legalizing anonymous fractional investment.
This is what led to the boom in fractional investment platforms such as Rally (fractionalizing everything), Vint (wine and whisky), Commonwealth (horse racing), Masterworks (art), Arrived (rental properties), and dozens of others that we love exploring here at Alts. Soon, we’ll have the first platform for franchises.
The tipping point came during the 2020 COVID pandemic when Kenny read an article about people gambling on the stock market because there were no sporting events to bet on. He knew he could offer a much better investment opportunity, so the wheels got rolling on FranShares, which allows you to invest in a portfolio of diversified franchises.
FranShares is on the verge of being approved by the Securities and Exchange Commission, with an expected launch in March 2022. There are nearly 9,200 potential investors on a waitlist.
What FranShares will offer is a single fund, consisting of over 50 franchises in multiple industries, personally curated by Kenny across different geographies. When asked if the pandemic had caused him to change franchises in his fund, Kenny replied with a swift, “no.”
According to Kenny, COVID had zero impact on the businesses in his fund. The companies he vetted had either one or two of the following characteristics:
- Experienced owners with prior franchising experience
- Franchises that proved to be pandemic-resilient
The Economics of FranShares
When considering a fund, it’s important to consider its economics. How is FranShares going to make money? How will investors see a return on their investment?
When a franchise is brought into the fund, 80% of the startup costs are crowdfunded by investors. The remaining 20% is funded by FranShares. The result is that FranShares is a co-investor with other fund investors.
When franchisors search for someone to open a new store, they’ll often go to a franchise broker to conduct a search. When the right franchisee is identified, franchisors pay a broker fee. FranShares also acts as the broker in this model, with franchisors paying a fee to get into the fund.
One of the most notable aspects of FranShares is that it charges investors zero fees. The reason is two-fold:
- Investors hate fees, and
- Should a competitor replicate the FranShares model, it will be unable to take a strategy of undercutting fees
Investors will get a return on their investments in two ways. Here’s a description of how that generally works:
- The company’s value increases as sales increase, which increases equity in the franchises.
- As franchises increase in value and grow to different locations, they become more attractive to private equity companies that will purchase entire franchises to the benefit of initial investors.
- FranShares will pay out proceeds from the franchises as dividends.
- However, there won’t be any dividends in the first 12 months of the fund’s existence to allow franchisees to build up capital.
The minimum investment required is $500, which Kenny believes is low enough to allow broad participation and high enough to draw in a group of serious investors. FranShares estimates that only about 2,500 investors will invest in the initial fund (remember, there are more than 9,000 investors on the waitlist). FranShares allows people to move up the waitlist through a referral program that includes a $50 bonus.
The FranShares Fund
Every franchise in the fund is subject to an Item 19 Financial Performance Representation. The Item 19 is a statement made by the franchisor about the company’s financial position.
Some franchises jump hoops around Item 19, often using the most favorable number to their advantage, be it gross profit, net profit, or how some gyms will simply provide an average number of members. FranShares vets its franchises using only net profits to gauge a business’s health and be as transparent as possible.
Kenny has also stated that many well-known franchises are reaching out to him to be included in the fund. As stated above, while he cannot give exact numbers or even names of the fund’s franchises, he is confident that he has chosen the right mix of approximately 50 companies across different regions and industries.
In addition, FranShares has partnered with franchise management companies that provide experienced teams that have worked with and bought out other franchises. The management companies will help keep track of financial documents, operations, and hiring.
FranShares Social Mission
One of Kenny’s first points when discussing FranShares is his desire to provide opportunities for upward mobility for employees from within the fund. He references the Chick-fil-A model, which chooses employees who work in the restaurants as future franchisees.
The lucky employees (and deserving) that get chosen can start their own Chick-fil-A for $10,000. This is quite a steep discount from what has otherwise been calculated to cost anywhere from $800k – $1.3 million.
His vision is to give someone who starts as a line cook in a restaurant an opportunity to become an executive at FranShares or become a franchisee of a new business in the fund.
While FranShares will initially offer one diversified fund, the goal is to localize the model, allowing people to invest in the very businesses within their community. While many people won’t view franchises in the same way as ‘mom and pop’ operations, franchise owners are small business owners and just as much a part of the community.
Conclusion
At first glance, the FranShares model is rather simple. There’s one portfolio made up of multiple franchises that you can invest into – a mutual fund of franchises, of sorts. But as we analyze this particular new asset class, it’s clear that putting together this kind of fund takes time, patience, and industry knowledge.
While FranShares awaits its final SEC approval in March, it’s important to note the rising popularity of franchises since the first Howard Johson, the strength of franchises during the pandemic, and the passive income that a fund like this will provide.
If you have $500 to invest and are lucky enough to be chosen from the waitlist, FranShares provides a great opportunity to invest in a swath of small businesses across the country.
