Fix debt, not taxes

When politicians talk about small business being the backbone of American prosperity, they are talking about people like me. Being an entrepreneur and creating jobs are worthy endeavors (and let's face it -- more fun than most day jobs). I'm very fortunate to have the education and temperament to do this -- and to live in a country that values taking risks and has set up a legal system that rewards success (e.g, patents and trademarks for original ideas) but doesn't punish failure (e.g., Chapter 11 reorganization, one of America's great competitive advantages).

There is a lot of debate right now about whether or not withdrawing tax cuts for 'rich' people will hurt economic growth. At the center of this argument are small businesses like my area franchise groups for Five Guys and NAKEDPizza.

My businesses, like many, have flow-through taxation, meaning that profits are taxed at personal rates; I pay taxes on my share of my company's income. Obviously, it is true that if more of our profit dollars are diverted to taxes, my partners and I will have less equity capital to re-invest in our businesses, or to spend on ourselves.

But if I really assess the numbers, there is little substantive difference to my business if the top tax rate goes from 35% to 39.6%.

Yes, more money paid to the government would pull some equity capital out of the business because we would have to allocate funds to pay for taxes.

The reality, however, is that this is much less important than the real problem: debt financing is nearly impossible to get, and it's getting harder.

Here's the math: I operate cash-flow businesses, which historically have been backed by both debt and equity (as opposed to software - nearly 100% equity). If I want to finance even 50% of a project with debt and that debt is unavailable at any price, it doesn't matter if some of my equity now goes to taxes instead. So in the simplest case where I own the whole business, if it makes $1M in profit and I am considering a $500,000 investment that will create the equivalent of 15-20 full-time jobs, the extra $30,000 in taxes (5% of the last $600k) I paid pales in comparison to the $250,000 I cannot get because the debt markets are shut.

This is why debt, not equity, is the fuel that really ignites economic growth.

This problem is only getting worse as $1 trillion worth of commercial real estate balloon payments come due in 2011 and 2012 on properties with high vacancy rates. My lender for Five Guys (BB&T) is an excellent partner, but when their overall capital ratios suffer, it doesn't matter that my business is successful. It turns out that we are only as strong as their weakest loans.

The SBA may end up with $30 billion in additional funding, but I'm not sure this is going to help much. The aggregate number of SBA loans is down, and anyway, most entrepreneurs have been required to provide personal guarantees (in the form of real estate) to backstop SBA loans. Never a good idea - see here. Also, the SBA provides a smorgasboard of programs based on one's status as a veteran, a member of a minority, or one's gender. A worthy idea but one often abused because the incentives to cheat are so high.

Like many issues we face today, this is a problem that more money alone won't solve.

As a capital-hungry SMB, what I wish is that we'd fine tune the SBA charter based on the "Race to the Top" model at the Department of Education. The SBA could create goals for small business lending and banks would apply to "win" guarantees or funding based on how successfully they fund small businesses. "Success" is defined as some combination of number of loans made, aggregate dollars lent compared to capital base, and importantly, loans made without requiring personal guarantees that rely on the same old sinking real estate.

The key is that not everyone would win dollars under such a system. Some institutions will be at the top and be eligible for SBA backstops, and some will strive but fail (which helps the SMB anyway), and some will choose not to play. But in the current system, nearly every small business loses as a falling tide sinks all boats.

From a tax perspective, the real win would be restructuring the tax code completely so that there is *zero* corporate tax, which both Robert Reich and Grover Norquist agree on. Taxes are borne by consumers eventually, and having corporate tax causes businesses to perform crazy short-term maneuvers (>$100B in lost output annually) rather than actually running their businesses for the long-term.

I'm all for having more money in my pocket rather than less -- I mean, who isn't? But let's cut government spending first (dinner) and then have a tax cut (dessert), especially when a tax cut really won't have a substantive effect on the real SMB that produces actual jobs. Now, back to work on that...

The New New Franchising

I am an entrepreneur doing startups in large area franchise developments. Since even my mother doesn't know what that means or why I am doing it, here's a brief explanation.

In a nutshell, it means that I (a) find a great concept (to date, Five Guys and NAKEDPizza) and a great territory (MA and NH have great demos and density) then buy the rights and close the deals, (b) work on the business constantly: find great sites, obsess over marketing and PR, hire/motivate/direct the best team I can assemble, and above all, (c) make sure we never run out of money. This is a different model than Franchising 1.0, in which you have a real full-time job either doing something else entirely or performing a vital daily function in your own stores.

Franchising 2.0 is about bringing operations, financial discipline, and the ability to scale to someone else's business idea and model. Working "on" the business, the right way, is a full-time job. It cannot be done any other way. This fact especially true in performing at a high level in real estate and marketing, which are key in high-margin businesses. When franchisees lose focus on these details, they can and will get killed and my friends at Apex or Nixon Peabody move in.

It is also about considering all stakeholders (employees, suppliers, partners, investors, community) more carefully and making long-term business decisions. When you develop only 1 or 2 units, you can take shortcuts that are suicide with 10, 50 or 100 units on your horizon. Ditto for franchisors.

NAKEDPizza knows this and this is one reason (of many) they are turning franchising upside down by starting with sophisticated developers. This then enables them to collaborate with franchisees in new ways to advance the concept. In turn, this requires a culture of openness, honesty and curiosity at the franchisor level - but then, to become and remain a great company, you need a culture based on those things anyway.

Area development is a business Warren Buffett would love: consumes capital (i.e., building stores), gets a high return on that capital (i.e., cash-generation from stores), and has a decent margin of safety (way better than software). For experienced developers with access to funds, it's like 1870 in railroads or the 1994 Internet: real estate's available, you can hire great contractors and managers, and my VC friends are funding the next wave of excellent and free local marketing technologies on top of Facebook, Foursquare and Twitter.

Professional investors have overlooked Franchising 2.0 as an investment class because of Franchising 1.0's brand image - but at the risk of sounding like a character in a Michael Lewis book, I say this will not last.

All that said, this is a people business. If you hire the wrong people, or hire the right ones but treat them poorly, you will fail. In NAKEDPizza, for example, Mark Cuban and the Kraft Group (owners of the NE Patriots and Revolution) are investors in the franchisor, with the Krafts part of my area franchisee group as well. Will they be a valuable strategic partner long-term? Definitely. Does their involvement get the right product delivered on time every time by a knowledgeable and personable associate? Nope. My cash registers start at zero at the start of the day like everyone else's and in a social media world, it is imperative that you serve customers an honest product in an honest way.

Summing up: Franchising 2.0 is a growing trend that enables developers and franchisors both to make money for their investors, and have a real impact on the community - financial promise with social purpose, if you will. It involves bigger territories, more capital and more collaboration, a more long-term approach, and the banking of real intellectual property that generates lasting value. This wave is only starting and I believe is the future of the $1.5 trillion U.S. franchising industry.

Denying the Denier at Pinkberry

I met the CEO of Pinkberry last night -- this kind of thing is unusual for me so while that's a pretentious-sounding thing to say, it's sort of ironic. I didn't actually realize that he was the CEO of the company until he said something like "Ted [Philip, from Highland, who I know through a mutual friend] has been a great Board member for me", and later he said "Let me bring over my Director of Operations", and he introduced himself as Ron, and then I looked him up on the web later. Yes, I'm slow on the draw.

Anyway, I was at the opening of Pinkberry's first Massachusetts store to congratulate my friend Trippe Lonian; Trippe is one of the very few people I know who also went to business school (HBS) but decided to go into franchising anyway. Standing in line, I sampled the chocolate flavor, which is not tangy like the rest of their yogurts. Ron, leaning against the wall next to me, asked me what I thought. It's not as distinctive as the rest of their flavors, but didn't want to say that, so I said "It's pretty good... seems like a classic 'deny the denier' offering."

This then led him to ask me when I became a marketer. The truth is, I got this phrase from Michael Pollan's "The Omnivore's Dilemma", but when an official-looking guy who later turns out to be the CEO of Pinkberry tells you that you sounded smart, you don't correct him.

"Deny the Denier" is one reason that McDonald's offers salads; this way, when mom tells the kids that they can't go to McDonald's because it's unhealthy, the kids can say "But mom, they have salads." Kids are huge drivers of their parents' spending, so for a company like McDonald's that relies on marketing to kids, this is crucial to build very long-term annuity streams (i.e., kids going to McDonald's for years and buying very high-margin processed food and soda).

Pinkberry has a non-tangy yogurt offering for the same reason. I have one daughter (Lily) who loves tangy pomegranate, but her twin (Sophie) won't go near it. This way, when Sophie says "I don't like Pinkberry", I can remind her of the plain chocolate version. That, and the Cinnamon Toast Crunch toppings.

Starbucks sells non-caffeinated / non-coffee drinks for a similar reason. As someone hooked on caffeine, I don't get the appeal of this personally, but I get the strategy. Starbucks' founder and CEO Howard Schultz is also on Ron's Board. I would love to get a ticket to those Board meetings.

The other Pinkberry feature I can highlight is the "one price for all the toppings you want" idea. I think this is really smart, and not just because I'm a Five Guys franchisee where all the toppings except cheese and bacon are free. The truth is that the food cost is basically the same if you get 1 ounce of 1 topping or 1/4 ounce each of 4 toppings, but as a customer, you feel like you got much better value from 4 toppings than from 1. Yes, it depends somewhat on whether you get fresh-cut kiwi or Cap'n Crunch, but since you're already paying a premium price for the base product (the yogurt in their case), it sort of doesn't matter since the aggregate profit numbers go up.

The irony is that when I brought home 3 cups of yogurt for my family, even Sophie liked the tangy stuff. The little chocolate-covered Krispies did the trick. Another denier, eliminated. Well played, Pinkberry.

Hey landlords - this is really a real business, for real

I just had the gazillionth landlord ask me for a personal guarantee for one of my franchise concepts, this time for NAKEDPizza - and yes, that's the official tally.

This baffles me. I raised almost $2.5M before launching the Third Slice business, have been doing this much longer than most area developers who knock on the door, am building out a (game-changing) concept backed by the Krafts, and am not asking for a dollar of investment from this particular landlord. Plus, by now they should know that any retail operator who offers a personal guarantee by definition either (a) doesn't know what he's doing or (b) is treating the franchise deal as a part-time or absentee job. Either way, it's a sure sign that the business itself either has insufficient capital or won't be well-managed.

It happens all the time for my Five Guys business too -- and that one's cranking out cash.

One reason I needed to raise so much money for Third Slice is that I know already that bank debt will be unattainable for at least 2 years, and probably longer. What's crazy about this is that if I invest (say) $150,000 in leasehold improvements to jumpstart the business, I can't get that financed. But if I build a $500,000 building I can probably get that financed, even if the tenant paying the rent is the same business (mine) that was deemed unworthy in the first place.

I've emailed with a few so-called franchising finance "experts" who tell me, not surprisingly, that the solution to my problem is to get an SBA loan by offering a personal guarantee. Then they helpfully offer to create a paid consulting relationship where such advice ceases to be free. Sigh.

It just goes to show that raising the visibility of franchising as a legitimate form of entrepreneurship is going to be a very long putt. Sort of like doing push-ups at age 80.

Top 8 Reasons Franchise Businesses Struggle with Social Media

In the course of developing 2 franchise concepts (Five Guys and NAKEDPizza), I'm trying to bring my online marketing/software background. Right now, I'm trying to figure out the best way to use social media at the ground level. Turns out it is hard. Really hard.

Part of this is structural; Five Guys never ever coupons or discounts (which I think is great), so unlike Red Mango, we can't simply place a $1 off coupon on my Facebook page for all to download. Part of this is where these businesses sit in their evolution; for NAKEDPizza, we don't have a lease signed yet here in MA. The experts at Hubspot would tell you to start sooner rather than later, but there is such a thing as kickoff a Facebook and Twitter presence too soon.

All that said, I have spoken with other franchisees in different concepts and it turns out we all have variations of the same problems. Here are a few of them:

1. Brand Ownership: As a franchisee, you are basically 'renting' your franchisor's brand, which they invest time and energy developing while you work the street level. Your performance in turn helps build the brand. But in the 21st century, customers build the brand, and these customers are interacting with you, not "national". On Facebook and Twitter, should they be interacting with you directly, or "national"? Put another way: whose customers are they? The brand's? Or the local business owner's?

2. Social Media is New: Very few franchisors understand how this world works - they are experts in gyms, burgers, home health care, etc. Many of them are based in places far from the social media capitals on the coasts or Boulder or Austin, so it's hard to recruit people in-house or even experienced local agencies to come up with a cohesive national/local strategy.

3. Social Media is New, Part II: If few franchisors get the social media world, that's even more true for franchisees, many of whom get into franchising because they want to operate their very own business. This is a great outcome for a lot of people, but it turns out that managing a single unit of (name your concept here) is often an 80-hour a week job that doesn't leave a lot of time to learn new things.

4. Local sensibilities: Weather-based tweets suggesting that someone eat out (very effective) don't work nationally. Ditto for sports, local events, etc.

5. Local vs. regional: On a smaller scale, what works in metro Boston doesn't work in Springfield; what works at Carolina probably doesn't work at Duke.

6. Content is King: Coming up with 'remarkable' (another steal from the Hubspot guys) content is pretty difficult even when you do have a distinct product like Five Guys or a compelling social mission like NAKEDPizza. Making this doubly challenging, the point of brand-building content is incenting your customers to collaborate on building your brand -- "brandsourcing" if you will -- so your initial tweet or post needs to inspire your customers to join the conversation. But now we're back to the tension of whose customers they really are.

7. Operations is King: If you're going to coupon or discount on Facebook and Twitter, you want to track whether your particular offer moved the needle. This means your store's point-of-sale (POS) system better handle coupon codes and your store's staff needs to know how to key things correctly. Using QR codes? Another operations challenge. And what about local v. national discount codes? What if my neighbor franchisee offers a coupon - do I have to honor it? The more I look at this, the more I admire Five Guys for never ever couponing.

8. Multi-Channel Blues: Most businesses use many channels to talk to their customers. Coordinating this is hard enough when you control all means by which messages are transmitted. But what about the franchisor that does (for example) direct mail as well -- can franchisees control their own direct mail messages but not their social media presence?

As franchisors start to consider guidelines, many have started with a perfectly logical answer, which "No local social media until further notice." Others have tried the "Let 1,000 flowers bloom" strategy as this is the agile development approach to solving a complex but important problem. That is, they've said "Hey franchisees, we trust you: you handle it, and we'll figure this out together." I'm a collaborative person, so that intuitively makes the most sense to me -- but then both social media and the franchising world are like the Wild West, so sometimes it pays to have a sheriff with a very big gun.