The Franchise Misnomer

In the wake of the largest franchise IPO ever last week (Archos), I was reminded of a topic that I've pondered for quite some time. With franchise chains being the easiest way to get a business jumpstarted, it's no wonder that there are almost 1M locations representing $1T of sales in the US alone. No MBA required, no resume massaging; just a roll-up the sleeves attitude and a propensity to work hard is all you need to sign up. But are franchisees actually entrepreneurs? Do they run their own business or are they merely buying themselves a living?

Let's look at the dynamics of the largest franchisor on the planet, Subway, as an example. Subway makes it easy for new locations: a very small upfront fee ($10k or so), soup to nuts setup and management services, and a straightforward royalty model (take ~12% off the top). This looks great, right? If atmabus wanted to leave the corporate world for business-ownership, this seems to be a low risk option right? Let's look a bit closer of who would actually "own" this business.

Subway controls more aspects of this endeveour than atmabus would. In addition to the branding, Subway mandates your procurement for everything from napkins to lettuce (at a profit for corporate). They dictate how the store should look, how much you need to spend on improvements, and mandate computer and accounting systems. Margins and pricing is controlled at some levels -- most franchises actually lose money on the $5 footlong (but have limited say in what they can do). Sure Atmabus would manage some parts of the operations; but he would not control supply chain, advertising, pricing, and product offerings under this franchise agreement. So what's left?

When you think of entrepreneurship, you think of control and unlimited upside potential. Here you get neither. Given your sales are limited to your foot traffic in a specific geography, the only way to scale is to buy more franchises. Couldn't Subway technically "own" the stores and pay a management fee to operators and accomplish the same thing? This model feels more like a distributor relationship versus a B2B one as advertised by the franchisors. Remember the Coca-Cola bottlers? Look who owns them now.

Certainly new franchisors will command less control and costs than established players like Subway. But ultimately franchise models tilt in favor of the corporations. Incentives are misaligned; the $5 footlong promotion benefits franchisors (Subway sells the ingredients) at the expense of franchisees. Most hotel chains are moving away from ownership to franchise models because their is frankly more profit and less headache for them through the arrangement. As long as their are people willing to live on site and work 7 days a week, they can continue along this path.

Don't get me wrong - there is money to be had for franchisees. Many make a decent living doing them. You just have to do it in a big way since so much of the margin is taken by franchisors. If you get in on the ground floor of a bustling one, you might be able to negotiate a sweet deal. Plus just the mere fact that its considered a "business" gives owners a path to tax benefits associated with ownership. Given the limited control, upside, and autonomy for franchise owners, its hard to consider them entrepreneurial ventures.

Are You Undervalued or Overvalued ?

There is a long standing debate about whether or not the stock market is 'efficient.' In a perfect world, forces such as the free market system, access to information, and the law of supply/demand would price stocks at their intrinsic value. But as we know, the world is not perfect; stocks tend to be either overvalued and undervalued. Can this same logic apply to jobs and compensation?

In a vacuum, the value created by an individual would guide his or her salary; but it doesn't happen like that in the real world. One's paycheck generally have very little to do with their societal worth or even the intersection of where supply meets demand. Further, similar to daytraders in the stock market, does this inefficiency create a business opportunity?

The most overvalued job that comes to mind is a real estate agent. If you strip it down to its basest level, a real estate broker gets 6% of the value of your home to open your front door. That's it - that's really all they do. Contracts are standardized by the states, risk is mitigated by escrow agents, and frankly the negotiations really lie in the hands of the buyer and seller. Real estate agents do not create demand for your house; they simply post it online to their proprietary MLS closed system. Because of this monopoly, they have been able to keep their fees artificially high. Sure sites like Zillow and FSBO have brought fees down slightly, but there is a opportunity to bring this function to its true intrinsic value. 6% of the housing market - pretty big market size for a hungry entrepreneur.

What about wall street bankers? Goldman Sachs gets gobs of money for advising companies such as AT&T on whether they should buy T-Mobile. Do bankers have more industry knowledge than the brain trust at AT&T? Has the AT&T CEO not heard about T-Mobile ? Is AT&T's legal staff and M&A teams incapable of leading a transaction of this magnitide? If the answer is no (which i think it is), how can the market allow such enormous fees? At least in this case, there is no 'closed' system, but certainly it leaves you to wonder. Don't get me wrong, I see a huge value in the investment banking/brokerage function; its just the value significantly diminishes as the sophistication of buyers and sellers increases. This is precisely why smaller investment banks (usually started from ex-bulge bracket folks) are growing at such a fast clip these days.

On the other side of the coin, what about undervalued jobs? Certainly folks such as policemen and teachers come to mind. The most underpaid job on this planet is a stay-at-home parent. They bring in a whopping $0 and have the uneviable task of shaping our children's future. America's CEO, Obama, only gets paid $400k for the most important position on the planet. Sure, budgetary constraints of government/non-profit limit salaries of high worth positions; but how sustainable is this in the long-run? There are also many instances of this in the for-profit world.

Accountants are underpaid, overworked, and are in short supply and high demand. Yet their salaries are the lowest in the business world. The Big 4 can't find enough talent to fill open positions (PwC spent millions in a desperate attempt on LinkedIn), yet they continue to underpay and experience high turnover. Another example is the primary care physician. Demand continues to soar, supply is falling, and wages are flat at best. Without accountants, we couldn't rely on financial statements; without PCP's, we wouldn't be healthy. Not exactly low value positions; These fields will either face a major restructuring, a significant drop in quality, or a healthy rise in fees.

You would think money always follows where the world is going and intersect at the point of equibrium. There seems to always be external factors that create a market imbalance between compensation and value creation. For example, the value of atmabus' business insight relative to how much he gets paid for it is grossly imbalanced. So are you undervalued or overvalued? Where else are there market inefficiencies to capitalize upon?

Cheers to the great american startup

The American beer industry has long been known for its deep roots and rich history. From the Midwest boom years to the more recent ubiqitous TV brand building, the industry has long had visibility in most households. Despite all of this, it's ironic that in this current day, the largest American beer company is only 25 years old, founded by a Harvard MBA, and runs like a startup.

Boston Beer Company's (aka Sam Adams) roots dates back to an 1860s family recipe used in its most popular Boston Lager. It was founded by Jim Koch in 1984 with the simple goal of bringing quality craft brew to the American public. At the time, microbrews were non-existent, so it was virtually impossible for him to catch the attention of distributors and bar owners; Koch literally brewed the first batches at home and drove bar to bar with samples trying to convince establishments to serve the local beer on tap. Growing first in the Boston area, it gained national prominence by winning the top spot in the Great American Beer Festival just a few years later. The rest is history - it amassed $500M of revenue in 2010.

Despite having less than 1% of the US market, Sam Adams is the largest remaining American brewer. Budweiser sold to Inbev (Brazil/Belgium), Miller to SAB (South Africa), Coors to Molston (Canada). As these players commoditize the industry by getting bigger and bigger, Sam Adams takes the exact opposite approach. It remains very localized, differentiatied, independent, and driven by passion for quality. Annual trips to Germany are made for its premium raw materials; Sam Adams kept production local and acquired the brewery locations to ensure consistency (95% of the beer is brewed in its company-owned breweries in the US). Koch owns 100% of the voting stock and has somehow built a strong foundation in the midst of significant pressure from industry consolidation.

Sam Adams revolutionized the industry by its success. When Koch started, there were no US craft breweries. Now there are roughly 1600, representing almost 10% of the market. They frankly put quality beer on the map - No longer were tastings and premium ingredients reserved for wine aficianados. Koch also supports the industry despite potential negative impacts to his company. It sold 20,000 pounds of hops to competitive craft brewers at cost during a 2008 shortage; it funds new brewers (and other new businesses) through a partnership with a microfinance organization.

Its refreshing to see a successful American startup stay true to its roots despite its rapid growth. Sam Adams has successfully created a new concept in the midst of mass commoditization, led the industry in innovative products, remained independent, and kept production here in the US. So next time you are in an airport, have a cold Boston Lager in appreciation for the great American startup; its a shame that Obama chose a foreign beer (Bud) at his reconciliation "beer summit."

Taxes and Entrepreneurship

I read an interesting article this week in Inc. magazine which suggests that there is no correlation between a country's tax environment and entrepreneurship. This theory runs counter to the common belief that profit incentives drive innovation and new enterprise. Isn't this the crux of capitalism - self-interest creates economic value?

Meet Norway - the exact opposite of the US. A country where there so many taxes that even Nancy Pelosi would say no: 50% on income, 3 times US payroll, 25% sales, and even a 1% "wealth tax" on total assets on people making more than $120k per year. Stifling for business, right? Apparantly not. Per capita, there are more entrepreneurs than there are stateside. The rate of startups exceeds the US and the gap continues to widen. Government programs seed startups in Norway because of its large coffers. And Norweigan entrepreneurs don't seem to mind paying the lion share of their profit to support the greater good.

There are many reasons why according to the article, but i'll discuss a couple relevant to this topic. For one, people don't worry about education, health care, and retirement. All bills paid by Uncle Sven. Think about the contrast in the US; most of us are tied to our corporate job specifically because of these things. We'll stay in suboptimal situations rather than launch a risky new venture where no health benefits exist for example. Also, entrepreneurs are not driven purely by money. They want to build businesses, their reputation, and make a mark on society. Sure money helps, but successful entrepreneurs have loftier goals in mind. Warren Buffett and Bill Gates didn't start businesses to make millions; it was the effect of them building great businesses.

Are we jeopardizing the long run for short-term wins? By not providing the necessities, are we incentivizing corporate drones at the expense of the next game changing industry? Is our money-centric culture preventing us from seeing the bigger picture of what business is designed to do (such as raise the standard of living for its residents)?

I'm not convinced that socialism is a business incubator at all. I think Norway has succeeded in spite of their tax code rather than because of it (due to factors such as its net exporter situation, small size, etc...). How many Googles or IBMs has Norway produced? The US simply has done it for a longer period of time and on a much greater scale than any other country in the world. And I do think free enterprise is the most efficient vehicle to change the world for the better. But it raises an interesting question, do we undermine the power of entrepreneurship by focusing only on the wallets of the entrepreneur ?

The Innovator's Dilemma

With internet valuations back to the dizzying days of 1997, Huffington Post's sale to AOL this week for $315M actually seems reasonable. In justifying the deal to its audience, Arianna Huffington pointed to the "Innovators Dilemma" theory which states that large companies, no matter how successful, generally fail to adapt to the ever-changing business landscape and market trends. The primary reason stems from the fact that incumbents tend to focus on defensive tactics as they do not want to cannibalize existing sales by investing in areas that threaten their market position. In this case, AOL and HuffPost seek to change the face of news distribution by aggressively growing a free, open network-based media model where established players like WSJ or NYT, who are aggressively charging for access, will not.

In the internet age, its easy to see the Innovators Dilemma in play. Blockbuster filed for bankruptcy given the rise of Netflix and Redbox. Newspapers and magazines faced a quick, violent death. Bookstores and CD shops are no more thanks to e-commerce. Do you think all of these big companies failed to see the rise of the internet ? Its one thing for mom and pops to fail to adapt to the new Walmart in their locale given their limited resources, but how could Blockbuster not become the first streaming movie company? Did the handsomely paid executives miss what everyone else in the world saw ? Not at all. Their myopia handcuffed them from changing their distribution model, pricing, and cost structure. With quarterly pressure to prop up earnings, they failed to react to the bigger picture at hand. Instead of embracing change, they tried and failed to put up artificial borders around their existing business models. As they ultimately tried to cope, they were too little too late.

Long before the internet, this trend existed. American car companies almost went belly up (well 2 of the 3 did) with the Japanese invasion in the 1980s. Rather than focusing on fixing their business model, American Airlines tried to prevent Southwest from entering Dallas (but the Wright Amendment failed to stop Southwest from becoming the largest market-cap airliner). Macy's and other department stores, comfortable with their fat profit margins, failed to adapt to consumer's desire for lower priced apparel. Target was happy to oblige.

Its hard to blame the large companies from doing this. The emerging trend may not pan out. They might not execute as effectively as their competition. They are making good money, so why rock the boat? Thousands of reasons to look the other way and most of them justify it to themselves. This is why most innovation and true breakthroughs come from new players who have nothing to lose. So who's next? Cable television? PC companies like Dell ? Microsoft? Oil companies ? It's definitely an interesting question - one that will be answered by disruptive ideas and successful entrepreneurs.

What's ironic about HuffPost's argument for the deal is that AOL itself failed to adapt to the death of dial-up. It's easy to "reinvent" your business when its already in a downward spiral. I would have loved it if she was just honest and said "would you say no to $315M ?"

Goldman's Heart

It's easy and perhaps popular to deride Goldman Sachs for its role in the financial crisis, excessive employee compensation, and its overall Gordon Gecko style of arrogance. Besides peddling M&A advice and Facebook stock, however, they do some pretty noble things that most don't see. Their program, 10,000 Small Businesses, is a commendable effort that just completed its first year anniversary. It's part microfinance, part philanthropy, part business consulting; all methods that I passionately believe capitalism should be deployed to make the world a better place. Sure, there's a PR element to this that Goldman stands to gain, but for $500 million, there are better ways to attain that if that was their only endgame.

I've written about Endevour's VC- style approach and the limited microfinance efforts in the US; Goldman's 10,000 Small Businesses addresses both of these areas in a much bigger way. The goal of the program is to grow small business ($150k - $4M in revenue) into sustainable concerns with the ultimate goal of growing employee bases. They look at scalability, ability to gain from the program (ie. people with limited business background), desire to hire, and difficulty in capital raising. They're committing $200M to education and supporting community colleges and other institutions and $300M in capital through loans and grants.

Through partnerhips, they've built a whole ecosystem to do this. Entrepreneurs go through a 20 week crash MBA course designed by schools such as Wharton at their local community colleges. Grants and micro loans come primarily through non-profit local institutions. They partner with local nonprofits to provide support throughout the process. Their advisory panel, led by Warren Buffett, reads like a Who's Who in business, provides unrivaled guidance to small businesses. Goldman has built an infrastructure that leverages its national reach while customizing each effort to the local community affected. They target areas where they can make the most impact as evidenced by their recently announced $20M effort in the New Orleans area. Where else can the owner of Mel's Chicken Shack get access to capital, a Wall Street education, and local support to grow their business?

So the first year has yielded modest results. According to a recent Fortune article, they've invested in 50 businesses and educated 100 business owners, and spent $60M so far. They've kept their eligibility standards high to ensure yielding the desired results (scalable companies that grow employee bases). It will be interesting to see how the program matures and how successful these small businesses ultimately become.

I love to see capitalistic-based companies deploy their know-how into the non-profit space. Let's hope 10,000 Small Businesses is a wild success and dramatically strengthens the small business community in the US. And who knows, perhaps they may see a good opportunity to invest in a small opinion-based business blog (just need $150k more revenue to qualify).

the new new walmart

Everyone knows about the impact of Walmart on our daily lives. They've built the worlds' largest retailer by cutting out middlemen, building the smartest logistics system on the planet, and giving people what they want in a one-stop shop. They're the largest private employer in the US, and have lowered the cost of living for everyone. Certainly there have been many small businesses adversely impacted along the way, and there's probably an "atma-esque" debate on whether the net impact on society has been positive. I do have an opinion, but perhaps for another day.

For the first time, I feel the Walton clan faces a strong threat to its business model. It's not from anyone obvious; rather I see true competition from the company that I love to write about, Amazon.com. They're positioned for growth at the expense of traditional retailers like Walmart; but more importantly, they've built up their operations to take advantage of moving consumer trends while leveraging retailer best practices.

For one, e-commerce is booming. While only representing 5% of total consumer spend today, its growing at 15% per year. Walmart's only growth options is to build stores and take share away from competitors; Amazon doesn't necessarily have to do that to grow. But they are. Amazon's growth rates have been around 30%, which means they are not only taking their fair share from the Walmarts of the world, but from other ecommerce companies as well.

Walmart grew their business by increasing categories and products. Their fledgling grocery business now represents more than half of their US revenue. Similarly, Amazon continues to expand their product base every day (through acquisitions and on its own) to capture more share points. In the last couple of weeks alone, I bought diapers, high-end electronics, and air filters -- all delivered within 2 days, and all priced below every online and offline competitor i could find. Low cost, numerous offerings. Definitely the walmart way. What's even more remarkable is that they are not limited by shelf space like Walmart is; they already offer thousands of more products that Sam Walton does.

Third, and probably most important, is they've build a world class distribution system that rivals (and in some cases beats) Walmart. They've devised a clever hybrid distribution model that allows them to stock the most sold products and tightly control their third party delivered products to ensure delivery times and good in-stock ratios. Their server farms are so good that they lease space to smaller tech companies. At one point, Toys R Us and other retailers used Amazon to process and deliver their ecommerce sales (i'm not sure if they still do). They're better at brick-and-mortar style operations than most people give them credit for. This will help as they continue to scale.

Amazon has built a Walmart type back end, a front-end platform worthy of the #1 e-tailer status, world-class customer service, and prices that competitors can't match. They continue to grow fast without having to invest in traditional retail infrastructure and are taking a greater share of household purchases much like Walmart did during their growth years. And in the coming years, as ecommerce growth rates slow, don't be surprised to see Amazon.com stores in a city near you. While e-tailing is still in its infancy, there is no need to. But to me, this is a long-term growth strategy. It's easy to move into bricks and mortar when you have Amazon's infrastructure. It's more difficult to become a real e-commerce player if its not in your company DNA.

It's hard to crack into mass merchandising. I applaud Jeff Bezos for looking ahead many years out when building Amazon. He didn't want to just succeed in e-commerce; he wanted to build the next world-class retailer. Even though Amazon's $25B pales in comparison to Walmart's $400B of revenue, Mr. Bezos' company is poised to make a stronger and stronger noise in retailing, one that will eventually be heard in the tiny town of Bentonville Arkansas.