Franchising offers alternatives to IPOs. (An Advertising Supplement to the Los Angeles Business Journal: Corporate Expansion & Relocation).

Today's financial markets present unique challenges to e-commerce businesses seeking to secure the capital they need to expand. IPOs have all but dried up, and venture capitalists have shown increasing indifference to e-commerce companies. So, where can e-commerce companies turn for the capital they require? Franchising offers a potential solution, at least for certain types of e-businesses.

Franchising has long been misperceived as a device useful only to McDonalds and other fast food businesses. In fact, franchising has been used by thousands of companies in virtually all types of industries, including e-commerce, and roughly half of all retail sales in the U.S. are made through franchised businesses.

While the initial development of the Internet was characterized by pure e-commerce plays, with companies avoiding "bricks and mortar" altogether, the trend in e-tailing in recent years has been to combine e-commerce and physical retail stores, so-called "bricks and clicks" businesses. Companies have discovered that a stand-alone e-commerce business model has not attracted the number of shoppers they need to satisfy their volume requirements. Despite the ever growing number of Internet users, consumers have been slow to abandon their need to "touch and feel" products before they buy, as they can at old fashioned and bricks and mortar stores.

Consumers want to bring home color swatches before buying carpeting, flooring and home improvements, and they want to hear stereo systems, see the difference between standard TV and HDTV, and hold PDAs and cell phones and experiment with their functions.

The potential of the Internet has not been missed by franchisors, most of which now operate their own Internet web sites or authorize their franchisees to do so. GNC sells vitamins on line as well as through a large chain of retail stores; Sir Speedy and PIP printing centers allow customers to upload, preview, price and print their documents directly from their computers to one of more than 1,500 company-owned and franchised printing centers; and Papa John's Pizza recently licensed Food.com's proprietary technology so that its 2,600 company-owned and franchised restaurants could offer home delivery to its customers. Food.com's investors also include major franchisors, McDonalds and Blockbuster Video.

Even persistently successful web based companies like e-Bay have recognized the need to offer localized physical outlets for buyers to examine, ship and receive goods, leading it to partner with franchisor Mail Boxes Etc. (MBE) to offer shipping services to eBay customers. And Food.com has entered into agreements with Takeout Taxi franchisees to provide home delivery to Food.com customers. There are many other examples.

Apart from franchising directly, other options include co-branding, licensing and affiliation arrangements similar to those used by FTD.com and 1-800-flowers.com who have profited and grown by affiliating with independent flower shops who fulfill their orders, and strategic alliances with franchisors who can offer an established infrastructure, such as eBay's deal with MBE or Food.com's deal with Takeout Taxi franchisees. Well-capitalized e-tailers have also acquired existing franchised chains to provide quick vertical integration of the infrastructure.

Gateway has opened hundreds of non-franchised "Gateway Country" stores to enable its customers to view its products and talk with sales personnel before making purchases online. Gateway had the financial resources to develop its own stores, and two years ago it was almost ridiculously easy for any company to raise the necessary funds through an initial public offering. Now it's almost impossible. So how can a less capitalized e-tailer establish a chain of outlets quickly in today's financial environment?

Compare the economics of franchising and IPOs. Suppose an e-tailer wants to open 300 stores at an average cost of $250,000 per unit. The build-out costs would total $75,000,000, and then there is the cost of the staff and infrastructure needed to research potential locations in perhaps 100 major cities, acquire sites, oversee the construction of the sites, and to run the locations. This could add another $25,000,000 over the initial period of development, for a grand total of $100,000,000.

Suppose that instead of a public offering, the company identifies 30 franchise area developers who each agree to open ten units, at much more manageable $3.3 million in required capital per developer. Customarily, an area developer pays the franchisor an initial per store franchise fee of between $25,000 to $50,000, and one-half of the total anticipated initial franchise fees are often paid, in advance, in exchange for the territorial rights for their particular market. So, in this franchise model, instead of the company spending $100 million, it would collect $7.5 million from the developers upon signing the area development agreements (i.e., one-half of $50,000 for each of the 300 stores) and an additional $7.5 million upon opening the promised stores. The franchised area developers would be responsible for and bear the cost of hiring the staff and creating the infrastructure necessary to oversee the construction and to operate the stores. Area developers also pay an ongoing royalty (commonly in the range o f 5% of gross sales) and might share in the revenues generated from on-line sales.

Although the IPO approach permits the company to retain 100% of the resulting profits, it must also bear 100% of any losses sustained from failed stores. In contrast, under a franchise model, the e-tailer and developers share the profits and losses. Of course, this is a simple illustration and to develop an appropriate fee structure requires careful analysis of the specific economics of the business being franchised.

A development agreement can also be structured to grant the e-tailer an option to repurchase or "roll-up" the stores from the area developers in the future, perhaps at a time when an IPO is more viable. This offers a win-win situation for both the e-tailer and the franchised developer. The e-tailer swaps publicly tradable stock for the developers' businesses, while providing the developers with liquidity and an attractive exit strategy together with the potential to continue to profit from the e-tailer's rising stock prices after the roll up.

Franchisors have learned long ago that business owners tend to be more motivated and dedicated than salaried store managers, and franchisors have noticed a substantial increase in the caliber, sophistication and financial resources of prospective franchisees. Some are even publicly traded. Franchising is also useful for developing sister web sites in foreign countries where the cost and logistics of establishing a cohesive market presence is even more daunting. Operating internationally requires substantial adaptation to the local customs, currency, language, business practices and consumer tastes and buying habits of foreign consumers. Ironically, the pool of highly capable franchisees is partly attributable to the financial troubles experienced by e-commerce companies themselves.

Kenneth R. Costello specializes in e-commerce and franchising and is a partner in the Los Angeles office of Jenkens & Gilchrist, LLP.