Companies & Industries

The Issue: New Franchise Is a Tough Sell


New franchise operators struggle to compete with scads of chains. Peter Taunton set his fitness franchise apart with an unusual fee structure

Less than a year after launching three small, independent gyms near Minneapolis, Peter Taunton believed he had a business concept ripe for franchising. His Snap Fitness health clubs cost relatively little in terms of overhead, maintenance, and personnel, and had proved simple for him to run on his own. What's more, he says all three locations had turned a profit less than 90 days after opening. So in 2004 Taunton, experienced in the fitness industry but new to franchising, registered his concept as a franchise and began to court potential buyers of all stripes, emphasizing the gym's profit potential.

There were few takers at first. The problem, according to Taunton? Fierce competition. Although the number of potential franchisees—unit operators who pay a monthly fee for marketing, technology, and other kinds of structure and support— has grown over recent years, so too has the number of franchises. More than 2,700 companies have started franchising since 2004, according to Arlington (Va.)-based researcher FRANdata.

Appealing to Novice Franchisees

Taunton came up with a strategy to distinguish Snap Fitness from other franchises in three main ways. Instead of going after any potential buyer, he would target first-time franchise operators (BusinessWeek.com, 8/31/07). These franchisees would have less capital to invest, so he planned to sell units that required limited physical space and few amenities. (An initial investment in a single Snap Fitness gym typically runs around $232,200; a typical McDonald's (MCD), by comparison, is around $1 million.)

Taunton also observed that many first-time franchise owners were looking to keep their day jobs and act more as investors than day-to-day managers. With this in mind, he offered technology that would allow them to manage their club remotely. It works like this: Members use a key to gain access to the 24-hour gym at any time and operators can monitor the space via in-store cameras. Membership processing, sales data collection, and other accounting can also be done on the same, proprietary, Web-based application.

These were experimental concepts in the franchise world in 2004, but they weren't entirely new. Anytime Fitness, a franchise started two years earlier, also in Minnesota, used scaled-down health clubs and remote management to appeal to novice franchisees as well. Taunton knew one of the first questions he would get from any first-time buyer would be "How do you compare to Anytime?" So he came up with a compelling answer: the flat fee.

Flat Fee Pays Off in Volume

Whereas a majority of franchises take a percentage of monthly revenues based on different formulas, Taunton decided Snap would charge a flat monthly fee regardless of market, membership numbers, or store performance. This was perhaps the most important differentiation point. The flat-fee model would mean lower individual-unit revenues for Taunton but he projected it would pay off in the long run.

Taunton says there were doubters in the industry who told him he wouldn't be able to generate enough revenue from these low fees to support his initial franchisees. But the quick rate at which he sold franchises—18 by the end of the first year, more than 100 by the end of the second—helped him realize what he calls a "tipping point," where he could comfortably provide infrastructure and support to new and existing franchisees. He now has some 1,350 franchise locations, says his company had revenues of $19 million in 2007 (nearly 100 times the $202,000 revenues of 2004), and he expects to have 2,000 locations by the end of 2008.

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Soaring store sales spurred by an unconventional fee structure won't necessarily mean sustainable growth, says a franchise veteran

Franchise consultant Michael Seid spends the bulk of his time helping new franchisers develop business models, draft contracts, and get legal clearances. One of the most common challenges for his clients is something Peter Taunton encountered when he launched Snap Fitness: how to differentiate his concept from numerous similar franchises for sale.

Seid, a 25-plus-year industry veteran, approaches this question by first figuring out who will most likely be buying the stores. That includes determining how much experience potential owners have had in franchising, how much capital they have, and how many units they are likely to invest in. After that, Seid says, "we develop the services to the franchisee, specific to their target."

Seid, who has never worked with Snap Fitness, credits Taunton for creating a brand that appeals to inexperienced franchisees looking for an easy-to-operate business. "Snap Fitness is exciting," he says. "They have decent equipment, they have small footprints, they have key cards that allow people to exercise 24 hours a day." Moreover, low overhead costs make it conceivable for franchisees to buy two or three units.

Unusual Selling Point

Seid was surprised to learn Taunton's other big selling point: the flat fee. Of the some 3,000 companies franchising in the U.S. today, Seid estimates that about 85% charge franchisees a weekly or monthly fee based on a percentage of their revenues—and of the various remaining forms of royalty, only about 2% use flat fees. In the rare cases a flat fee is used, it's usually not about making the sale. "It has little to do with marketability," he says. "The reason that some people do it is it's simple. You don't have to worry about bookkeeping and accounting and whether your franchisee is giving you the right information or the wrong information. There's no cheating."

But there are drawbacks both for the franchiser and the franchisee, particularly in a system targeted at first-timers. In a percentage model, new and fledgling franchisees pay smaller fees while the larger, more successful ones do more to sustain the marketing and support of the system. In a flat-fee system, "an established franchisee who is doing well is not providing the franchiser with enough revenue to support the new franchisees," Seid says.

A Matter of Resources

A flat fee also ignores the fact that Snap Fitness locations are opening all over the country, in different kinds of markets. Seid asks: "Why should somebody in Manhattan, where you have an opportunity for millions of customers, pay the same rate as somebody in Peoria?" (There currently are no Snap Fitness locations in either Peoria or New York City).

The last time the franchise consultant encountered a flat-fee model firsthand was in the 1970s, when he was a senior officer for haircut chain Supercuts (RGS), which was then just starting out. While Supercuts charged its franchisees a 10% royalty fee and a 5% marketing fee, its main rival, Fantastic Sam's charged its franchisees a flat fee of $147.50 a week.

"Our franchisees made a huge amount of money because we had an extraordinary amount of resources to put into the brand: new product introductions, new services introductions, advertising and marketing, a creative staff, a management staff, and a field staff," Seid says. "Supercuts outsold [Fantastic Sam's] all the time—on the retail level and the franchise level."

Hot Seller

It's debatable whether potential Snap Fitness franchisees are being pulled in by the flat fee, but it's clear that the concept is a hot seller: Taunton plans to almost double the number of stores this year alone. Still, it's not just flat fees Seid is concerned about when it comes to the chain being able to sustain its growth. The company appears to rely heavily on franchise brokers, a common part of the industry landscape, to sell stores. The problem is, they take $12,500 to $20,000 per franchise unit, according to Seid's estimate, essentially negating Taunton's $15,000 up-front franchise fee that should go toward expanding and supporting the system.

And beyond that, the fitness franchise segment on the whole—a burgeoning trend when Snap Fitness started in 2004—is now crowded and fraught with litigation and closings. "The Curves, the Contours, and the Lady of Americas [competing fitness franchises] are seeing some real problems," he says. "Unit economics are falling off dramatically. Franchisees are unhappy, and many of them are in litigation."

If Taunton becomes unhappy with the flat fee, he can change that relatively quickly, because his franchisees are required to renew every five years, not 10 as under most systems. And each time they renew, they have to sign a new contract. "His franchisees could be presented with a franchise agreement that has a royalty that's based upon gross sales," says Seid. "If they're still around."

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Douglas MacMillan is a staff writer for BusinessWeek.com in New York.

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