PE Interview Style Question
Looking for some insight into this question. I am curious to see what other peoples thoughts are on the owner/operator vs franchise model.
"Take two companies - one is an owner and operator of 300 fast food restaurants and other is a franchisor of 300 restaurants and collects 5% of profits from each. Let's say they have the same EBITDA. Which would you pay more for?"
The franchisor is usually valued higher - there is higher cash flow because minimal capex needs. That also means it's easier to expand because the upfront investment in the next incremental restaurant is lower.
Franchises also usually take a percentage of revenue (5% of some metric of profit seems very low as well, given the margins that restaurants run at), not some metric of profit, so less tied to operating leverage performance of actual restaurants.
I might be missing some big points, but this gives you a general sense.
I forgot to mention advertising, which is usually borne by the franchiser - but in this case, we are assume EBITDA per restaurant is the same between the two companies, so you're somewhat mitigating this negative.
Thanks for the response CHItizen, That was my initial reaction as well in terms of the franchisee model providing more growth opportunity which would be captured in the value. But thinking upon it further, doesn't the franchise model also pose more of a risk? I.e. Thinking about the two companies in an isolated universe where they are the only competitors, during down times, the owner/operator model is at a much bigger advantage given that the franchisees have a much higher break-even point due to the 5% profit royalty. Therefore, they are not able to lower prices to compete against the owner/operator model. This problem is exaggerated even more when you implement a royalty model based on revenues. I.e. if you charge 5% of revenues, at a profit margin of 4.9%, the franchisee would close the store because they are losing money whereas the owner/operator model would still continue to operate. So although you get greater upside/growth in good times with the franchisee model, you experience a lot more risk on the downside. How do you weigh the risk vs growth prospects in this argument? This is a thought that came to mind for me when comparing these two models.
I think your original questions asks whether it is more valuable to be a franchisor or an owner/operator for the same restaurant (i.e., would you rather be McDonalds (the franchiser) or an owner-operator of a McDonalds franchise).
The question you're posing now is a little bit different because you're not really comparing franchisers vs. owner operators but rather owner operators of two different business models: is it better to be an owner-operator of a McDonalds franchise or an owner-operator of a theoretical McDonalds clone that doesn't franchise? Here it gets a little murkier and differs on a case by case basis more. For one thing, you're right in that a non-franchised restaurant doesn't have to pay franchise fees, but on the other hand, it does have to pay its own advertising. Non-franchised restaurants also have more control since you can choose your own menu, operations etc., but on the other hand, there's a lot of value in not having to handle menu and supply chain issues. There are a lot of other considerations for both sides too, but I think you get the point here.
Thanks for the response CHItizen, That was my initial reaction as well in terms of the franchisee model providing more growth opportunity which would be captured in the value. But thinking upon it further, doesn't the franchise model also pose more of a risk? I.e. Thinking about the two companies in an isolated universe where they are the only competitors, during down times, the owner/operator model is at a much bigger advantage given that the franchisees have a much higher break-even point due to the 5% profit royalty. Therefore, they are not able to lower prices to compete against the owner/operator model. This problem is exaggerated even more when you implement a royalty model based on revenues. I.e. if you charge 5% of revenues, at a profit margin of 4.9%, the franchisee would close the store because they are losing money whereas the owner/operator model would still continue to operate. So although you get greater upside/growth in good times with the franchisee model, you experience a lot more risk on the downside. How do you weigh the risk vs growth prospects in this argument? This is a thought that came to mind for me when comparing these two models.
Interested to know more
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