ServiceBased Business Ep 344

In this insightful discussion, the host breaks down four business models for service-based enterprises seeking to maximize profitability and enterprise value: privately held chains, franchises, licensing, and software or tech-enabled services. He highlights the pros and cons of each model, including cost implications, scalability, control, and potential legal challenges, while sharing his personal experiences with three of these categories. By comparing factors like upfront investment, cash flow, and exit multiples, the host provides a strategic framework for business owners to evaluate which model aligns best with their goals, resources, and the unique aspects of their service offerings.

• Speaker A discusses strategies for service-based businesses to expand and increase profitability.
• The conversation is aimed at businesses that provide labor or services to others for a profit.
• The goal is to help such businesses understand how to package their services for maximum enterprise value and cash flow.
• Speaker A outlines four ways to package services into a profitable business model.
• The approaches vary in terms of cash flow, margin, operational drag, and enterprise value.
• Speaker A owns businesses in three of the four categories discussed and shares insights from experience.

So if you have a service based business or something where you have labor of some sort that you rent out at a profit to other people to provide value, then this video is for you.

This quote introduces the target audience of the video: service-based businesses looking to expand and increase profitability through strategic packaging of their services.

• A privately held chain involves opening multiple locations of a service-based business.
• The owner retains full ownership rights, assumes all risks, and provides all capital.
• The owner controls the brand and hires all labor, maintaining end-to-end ownership.
• Speaker A uses a salon business as an example of a private chain.
• This model is the first of the four vehicles for building wealth through service-based businesses.

So this is a privately held chain.

Speaker A defines a privately held chain as a business expansion model where the owner opens additional locations and retains full control and ownership.

• A franchise model allows investors to buy into a proven business model.
• Franchises typically have lower failure rates than independent startups.
• Speaker A mentions well-known franchises like Subway, McDonald's, and Jiffy Lube.
• However, there is a reality that many franchises do not make significant money.
• A large number of franchises never exceed 100 locations, which is often necessary for substantial profitability.
• The franchise model is the second vehicle for generating wealth in service-based sectors.

Now, I could talk about the actuality behind that, which is very different. I could also tell about the tons and tons and tons of franchises don't actually make money. I think it's like 90% or 95% of franchises never get past 100 locations, which, candidly, if you're doing a franchise model, you need to get past 100 to make any real money.

Speaker A points out the misconception about the profitability of franchises and emphasizes that a large number of franchises do not achieve the scale required for significant earnings.

• The third model is a licensing model, which is less familiar than franchising.
• Licensing involves allowing others to use certain aspects of the business, such as the brand name or systems, but differs from franchising in structure.
• A franchise has three components: name, business systems, and a fee.
• If a licensed business uses all three components, it is essentially operating as a franchise.
• Speaker A will discuss the pros of the licensing model and how it differentiates from franchising.

A licensing model. You might not be as familiar with the businesses that use licensing because depending on how they structure the license, you have to differentiate from what a franchise is.

Speaker A introduces the licensing model as an alternative to franchising and notes that the distinction between the two depends on the structure of the license agreement.

• Licensing is a method to scale intellectual property (IP) to multiple locations.
• It involves giving a name and charging a fee, but not necessarily providing business systems.
• CrossFit is an example of a licensing model where they provide their name and have a fee but do not offer business systems.
• A white-labeled licensing model includes a fee and business systems but not a specific brand name.
• Licensing can create a valuable enterprise by scaling existing knowledge or IP.

"So in a licensing vehicle, you're typically going to have two of those three things. So you could have, for example, CrossFit is a licensing, right? They give you the name and they have a fee, but they don't have business systems."

This quote explains the structure of a licensing model using CrossFit as an example, highlighting the components that make up this type of business vehicle.

"A different version would be, let's say you had a model that worked really well. You license all the stuff, but it's white-labeled."

This quote describes an alternative form of licensing where the business model is provided without a specific brand attached, allowing for more flexibility in branding.

• Software can be a method to scale services, particularly when the service can be automated.
• Software tech-enabled services are applicable to certain industries but not suitable for all, such as hair cutting.
• It is advised against outsourcing software development to third-party teams without the proper expertise in-house.
• The speaker warns from personal experience that attempting to develop software through outsourcing without the right skills can lead to significant financial loss.

"Now, if you're cutting hair, you probably can't replace it with software, right? But if you are providing some sort of service that software can do, then this would be software tech-enabled service."

The quote distinguishes between services that can and cannot be replaced or enhanced by software, suggesting that software solutions are not universally applicable.

"I promise you it won't work. All right, just please, just 2 million, $3 million of development later. I've made the mistakes. Let me give you a $3 million gift. Don't do it."

This quote serves as a strong cautionary advice against outsourcing software development, based on the speaker's costly personal experience, emphasizing the importance of having the right technical expertise in-house.

• A private chain involves high costs for opening each location, including build-out, lease negotiations, and staffing.
• It is considered worthwhile if the build-out costs are low compared to the profit generated.
• Insomnia Cookies is cited as an example where the low cost of build-out and high profit margin made the private chain model advantageous.
• The private chain model is also suitable for businesses with low service requirements and specialized skills that are difficult to scale.
• Major brands like Chanel and Louis Vuitton started as private chains due to the high profit relative to the build-out costs.

"So a private chain is going to have the highest costs of opening each location. So there's incremental costs. Every new location."

This quote outlines the financial implications of expanding a business through a private chain model, emphasizing the high costs associated with opening new locations.

"If it costs you less than six months worth of profit in the first year to open a new location, then it would make sense to open a private chain."

The speaker provides a benchmark for when a private chain model makes financial sense, suggesting that if the initial investment is recouped within six months of profit, it is a viable option.

"And so here it's very low to build, very high profit. And so it's worth owning the entire thing."

This quote summarizes the financial rationale behind choosing a private chain model when the cost of building a new location is low and the potential profit is high, justifying full ownership of the locations.

• Scalability can be an issue if the service provided is not standardized.
• A successful location does not guarantee a scalable model if high value is required for each consumer.
• The goal is to productize the service to minimize variability and skill requirements.

"So if you're very good at your thing and you have your location and it works well, if you are required to make that level of value provided to the end consumer, then it's not going to be a scalable model."

This quote emphasizes the challenge of scaling a service-based business that requires high-value, individualized attention for each consumer, which is not conducive to a scalable model.

• Acquisition.com is interested in helping large businesses scale up.
• Business owners aiming for substantial growth can apply for assistance.
• The website offers a point of contact for owners to discuss potential growth strategies.

"If you are a business owner that has a big old business and wants to get to a much bigger business, going to 5100 million dollars plus, we would love to talk to you."

This quote is an open invitation to business owners who are looking to significantly scale their businesses and suggests that Acquisition.com has the resources to assist in achieving that growth.

• Subway's success is attributed to its ability to standardize product quality.
• Productizing services and reducing skill requirements can lead to a scalable business model.
• Consistency and process are key to scalability.

"The reason that subway, for example, works is because anybody can make a sandwich that tastes the same way, if you use the same recipes and use the same process right now."

This quote points to the importance of standardization in scalability, using Subway as an example of how a consistent product can be replicated across various locations.

• Transitioning from a licensing model to ownership can significantly increase revenue.
• Acquisition.com shifted a business from licensing to ownership, resulting in substantial growth.
• Owning revenue and trade secrets can be more profitable than licensing.

"And when they came in as acquisition.com portfolio company, I actually moved them over here because, candidly, their licensees were making so much money using their system, and it costs so little to open new locations that I was like, we should just be owning all this revenue."

This quote explains a strategic business decision made by Acquisition.com to transition from a licensing model to ownership to retain more revenue and control over the business, which led to significant growth.

• Franchises are litigious and expensive to start.
• Initial profits can be slow due to high acquisition costs.
• The enterprise value of a franchise can be high, but it requires many locations to be profitable.
• Franchises are suitable for businesses with high setup costs for new locations.

"Most times it takes one to two years to really start seeing profits because you'll sell locations, but the cost of selling franchisees, that franchise upfront fee will typically only cover the cost of acquisition."

This quote highlights the financial challenge in starting a franchise, where initial fees often only cover the costs of acquiring new franchisees, delaying profitability.

• Franchise revenue comes primarily from royalties.
• The owner of a franchise makes money from top-line royalties, not from the profit of individual locations.
• A franchise is a method of outsourcing capital risk to franchisees while earning from the top line.
• McDonald's is an example of a franchise that also profits from real estate ownership.

"So you're only making your money off of the royalties that are coming in, and then you still have all of your cost of running your actual franchise, helping the franchisees succeed, etc."

This quote explains that the main source of income for a franchise owner is the royalties from franchisees' sales, and it also acknowledges the costs associated with supporting the franchisees.

• A franchise needs over 100 locations to make sense financially.
• The majority of franchises do not reach this threshold.
• Franchising is not an end goal but the start of a new business journey.
• Success in franchising is not solely about the number of locations but also about financial performance.

"And here's a fun fact for you. 90% to 95% of franchises don't hit over 100 locations, all right?"

This quote presents a stark reality that most franchises fail to achieve the scale necessary for significant profitability, challenging the common perception of franchising as a guaranteed path to business success.

• Licensing has the lowest cost and high margins, similar to franchising, but without the high startup costs.
• Licensing is not defensible and has low enterprise value, resulting in low multiples upon sale.
• An attractive exit multiple for a licensing business requires 80% or higher yearly retention of licensees.
• Licensing can be a suitable model for new businesses with limited capital, aiming for immediate cash flow.
• Transition from licensing to owning locations can be a strategy for growth and increased control.

The advantage here is that it's the lowest cost, so almost no cost to license out a model. Typically, you have super high margins, just like franchising does.

This quote emphasizes the financial benefits of licensing, highlighting low costs and high margins.

The problems with this is that it's not that defensible. It's very hard to defend, and there's very little enterprise value, so very low multiples when you sell, unless you have a ridiculously sticky licensing agreement.

The quote points out the drawbacks of licensing, such as its lack of defensibility and low enterprise value, affecting the sale price.

So for you, for an idea, you would want to have 80% plus yearly retention on licensees for you to get a real, really attractive exit multiple, right?

This quote specifies the importance of high licensee retention rates for achieving an attractive exit multiple in a licensing business model.

• Software development requires significant investment and time, with low initial cash flow.
• The enterprise value upon exit can be the highest among business models, provided there is high customer retention.
• A yearly retention rate of 80% or higher is crucial for a software business to be considered valuable.
• Software is seen as a long-term investment with a potentially large payoff at exit, as opposed to immediate cash flow from licensing.

So if you have a way, and this requires a ton of cost to build, lots of time, very low cash flow, you're like, why would I do software? It's because the enterprise value on the exit is usually the highest.

This quote outlines the high costs and low cash flow of software development, justified by the potential for a high enterprise value at exit.

And the higher you make that retention, it's got to be above 80% or no one's even going to consider you a software. They're just going to consider you a normal service that just has some tech element to it.

The quote stresses the necessity of high customer retention for a software business to be distinguished from a service business with a tech component.

• Entrepreneurs should consider which of the four business models (licensing, owning locations, franchising, software) best fits their service-based business.
• Decisions on scaling should take into account the intellectual property (IP) value, required cash flow, upfront investment, time to goal, and the entrepreneur's risk appetite.
• The choice of model depends on the cost-effectiveness and protectability of the business's IP.
• Licensing is suitable for quick market capture and continuous cash flow, while software requires upfront investment for a potentially larger exit value.

And so if you're thinking about scaling your service based business, I would think of which of these four buckets do you fit in and which of these strategies makes the most sense for you?

This quote suggests that service-based businesses should strategically choose among the four business models for scaling.

So if we know beyond a shadow of a doubt that when we enter a market, we're going to freaking murder it, it costs us not a lot of money to open it, then we're going to own the whole thing.

The quote illustrates the decision-making process for choosing to own locations based on market confidence and cost factors.

And if it costs no money, and we don't think that it's a really protectable ip, right? Let's say it's a more offer based business. Like Jim launch, for example, in the beginning was a very offer driven business. Offer is very easy to copy.

This quote explains why a licensing model might be chosen for a business with an easily replicable offer and low startup costs.

So for licensing, it's speed, right? You can absolutely outpace anyone else in the market on speed. And you make lots of cash flow, but you're going to sacrifice a lot of money on the exit, right?

The quote highlights the advantages of speed and cash flow in licensing and the trade-off of a lower exit value.

So if you take the time, develop the software, you put the cash up front to develop it, you figure out a way to do it and then ultimately figure out a way to make it as valuable as you have to achieve this 80% or higher yearly retention on the customers that you are selling, or it will not be valuable at all and it will be valued like the other ones, except you just wasted a bunch of money and time.

This quote emphasizes the critical nature of customer retention in software development and the risk of being undervalued without it.