Franchisors and the 7 Powers

One way to evaluate franchise opportunities

I’m a business nerd. I’m also a sucker for simple frameworks that explain complex things. Put these two things together, and I’m a bigger fan of Hamilton Helmer’s 7 Powers than I care to admit.

His idea is that there are seven sources of competitive advantage that give businesses “persistent differential returns”. In other words, there are 7 ways companies can create a true, lasting advantage over competition.

It’s a clear, simple, and useful framework that applies in every business context I can think of.

A few weeks ago, I wrote a long post about how the franchising game is played, but I didn’t talk too much about the ways that franchisors create value for franchisees. In some cases, they adds so much value that less than 1% of applicants get to be a franchisee. In other cases, the franchisor doesn’t create any value at all.

In this post, I’m going to explain how I think about the value that franchisors provide to franchisees through the lens of 7 Powers.

Why this matters

Franchisors typically charge franchisees a royalty of 6-10% of revenue. This is a pretty significant margin hit to the franchisee, especially in lower-margin businesses. To justify the royalty, franchisors need to add a significant amount of value.

A good question to ask is: why get into a particular business as a franchisee? Or put differently, what does the franchisor do that justifies the royalties they earn? Is there really a secret sauce in terms of marketing, systems, or the offering itself that has actual value?

If the answer is "no" (which it often is), then you end up with an undifferentiated business with a cost disadvantage. The "Chuck in a truck" independent operator isn't sinking 8% of his top-line into royalties, and if nothing else, can just beat you on price.

In some cases, though, the franchisor adds value in excess of the royalty. This is where the opportunities exist for franchisees to build great businesses.

The “7 Powers” framework is all about how companies achieve “persistent differential returns”, meaning higher margins than your closest direct competitor over a sustained period of time.

As a franchisee, an important goal is to overcome the 6-10% margin deficit so that you can compete and build a durable business. In other words, you need to achieve persistent differential returns. That’s how you beat out Chuck.

And that’s why I think 7 Powers is a useful lens through which to view the value provided by franchisors.

The 7 Powers

You can google this and get a better breakdown, but I’ll spare you the effort with a simple one here.

The 7 Powers are: Scale Economies, Network Economies, Cornered Resource, Counter-positioning, Branding, Process Power, and Switching Costs.

1. Scale Economies: A business in which per unit cost declines as production volume increases. Ex. Costco

2. Network Economies: The value of a service to each user increases as new users join the network. Ex. LinkedIn

3. Cornered Resource: Preferential access at attractive terms to a coveted asset that can independently enhance value. Ex. DeBeers

4. Counter-positioning: A market newcomer adopts a new and superior business model that the incumbents cannot mimic due to anticipated damage to their existing business. Ex. Uber

5. Branding: The attribution of higher value to a non-differentiated offering that arises from historic information or attitudes about the company. Ex. Starbucks

6. Process Power: Embedded company organization and activity sets which enable lower costs and/or superior product. Ex. Toyota

7. Switching Costs: A net value loss is expected to be incurred by the customer from switching to an alternative supplier. Ex. SAP

These are the 7 ways companies can achieve persistent differential returns. I think this framework also helps us think about the ways that franchisors can add value - in excess of the royalty - to franchisees.

Franchisors and 7 Powers

I think four of the 7 powers apply to franchises.

1. Scale Economies

2. Cornered Resource

3. Branding

4. Process Power

Scale Economies

This is one of the most clear features of joining a franchise system. As a franchisee, you can tap into scale even as a small independent operator.

Some ways scale can materialize:

1. Supply: bulk discounts are negotiated at the franchisor level, and individual franchisees benefit from lower cost of goods.

2. Sales: One of my favorite ways that B2B franchisors can add value is through a central “National Accounts” sales team. Their team will sell to large, multi-region customers, and franchisees get them as accounts. Often, the franchisee billing the national account will incur additional royalties, which offsets some or all of the benefit, at least in the context of “clearing the royalty hurdle.” This also counts as “cornered resource” - more on that below.

3. Marketing: On the marketing side, the franchisor spending time and money on things like SEO and tv commercials is a value-add to franchisees. Like national accounts though, this often comes from additional funds on top of royalties, so the value has to exceed the “marketing fund” fee, which is usually around 1-3% of revenue.

Cornered Resource

In some cases, the franchisor has exclusive access to a unique and valuable asset that franchisees also get to access.

The most visible example of this happens in Quick Serve Restaurant (QSR) franchises. Chick-fil-a franchisees have the right to sell one of the most in-demand food products in America. No one else can sell Chick-fil-a chicken, which means franchisees basically have a license to print money.

Another example: with Smash My Trash, the franchisor owns the IP for the truck-mounted smashing machine. There are copycats, but no one outside of the franchise system can use the machine that (I think) is the best.

As I mentioned, franchisees can also benefit from partnerships and national accounts established by the franchisor. When these relationships are exclusive, it’s another example of a cornered resource.

Brand

Brand, in the context of 7 powers, is all about creating a reason that a customer would choose you — and even pay more — over an identical alternative. As an independent operator, building a brand requires a sustained period of time and effort. By franchising, individual franchisees benefit directly from the time and resources that the franchisor has invested into the brand.

One example of brand power in franchising is Midas. Most people know “trust the Midas touch” as the slogan. Midas’s brand has inherent value and franchisees reap the benefits. You can open up a Midas franchise without having ever turned a wrench on an engine — and people will trust your touch.

It takes a while to build brand power, so I’m always skeptical of any new/emerging franchise concept that touts “brand” as a reason to franchise through them.

Process Power

Process Power is about delivering a competitively-comparable product or service to customers at a lower cost. Many franchises will claim that their secret sauce is that they have a “better way” of doing things.

Rolling Suds is a popular new power washing franchise that claims to have process power. Through their process, a technician can power wash a 5-story building from the ground, and in a fraction of the time it would take someone else. By franchising their brand, you get to learn this process, service more buildings in less time, and achieve higher margins, which theoretically offsets the royalty you pay to them.

There are versions of this for many B2B service franchises. Claims of process power in franchising are often deserving of skepticism, and talking to franchisees is the best way to find out for sure.

Some quick notes on the powers that I don’t think apply here:

1. Network Economies Note: There’s a case to be made that some franchisors with multiple brands can offer network economies as a power to franchisees. For example, Horse Power Brands owns Mighty Dog Roofing and Stand Strong Fencing. If these are legitimate referral channels for one another, it might be a case of network economies. The more franchisees that exist in each system, the more referrals can be shared. But I’m not convinced this is real value in most cases.

2. Counter-positioning Note: A franchise concept itself can benefit from counter-positioning, but this value doesn’t flow directly from franchisor to franchisee in the way some of the other powers do. Pursuing the business independently - not as a franchisee - would get the same counter-positioning benefit. A great example is the franchise I’m in: Smash My Trash. SMT itself is a counter-positioned service against the waste industry. We are a better way to do things that incumbents can’t afford to mimic. But I don’t get that power from the franchisor (though I do get others).

3. Switching Costs Note: Similar to counter-positioning, a concept itself can benefit from switching costs, but this power doesn’t flow from franchisor to franchisee.

Again, the best way to validate the value a franchisor provides is by speaking to existing franchisees. I think evaluating this value through the lens of the 7 powers is a useful approach.