When Is a Franchise Market Too Saturated?Franchisees and franchisors have different ideas about market saturation.

Q:Many of the name brand franchises I've looked at appear to have saturated the market. Isn't there some limit to the number of outlets that these franchises can open in an area before they just cannibalize their own sales? How do you determine if a franchise has saturated the market and is no longer a good buy?

A:This is a wonderful question that deals with one of the most significant issues in franchising over the past 20 years. It all comes down to the potential conflict between the franchisor's philosophy in relation to market share goals and the franchisees' desire to maximize the profitability of their individual units.

Here's what this issue is all about: Say the total investment in a theoretical franchise is $250,000 per unit and the units average net income of 15 percent of gross sales. Now, suppose you had a choice of developing a given market with one of the following two scenarios:

1. The market could hold 10 units that would each average $1 million of gross sales and $150,000 of net income. Therefore, the total gross sales from the market would be $10 million, and the total net income to franchisees would be $1.5 million. The total amount franchisees invest to build the 10 units is $2.5 million, so their average annual rate of return on investment is 60 percent.
2. The market could hold 30 units that each average $667,000 of gross sales and $100,000 of net income. Therefore the total gross sales from the market would be $20 million, and the total net income to franchisees would be $3 million. The total invested by franchisees to build the 30 units is $7.5 million, so their average annual rate of return on investment is 40 percent.

Which is the better approach? There really is no correct answer, but you'll usually find franchisees prefer the first approach and franchisors prefer the second. The reasons are straightforward and reflect the self-interest of each party.

Franchisees usually prefer an approach that maximizes their rate of return per unit. Strategy number one features less investment, less management responsibility and a higher per-unit rate of return. If you owned one of these units, you would almost certainly like the numbers in the first example better.

Franchisors usually prefer an approach that maximizes market share. Their only caveat typically is that the overall rate of return to the franchisee needs to remain high enough so the franchisor can attract the franchisees they need to open the units. The fact is that, even though a 40 percent return is not as appealing as a 60 percent return, it's still pretty attractive.

The franchisor normally derives its ongoing income from royalty fees paid by franchisees, usually expressed as a percentage of gross sales. It's easy to see the franchisor will have twice as much income under the second scenario. If I was the franchisor, I would certainly prefer the second approach to the first.

Your question really gets to the heart of the issue: Where is the appropriate balance between the somewhat conflicting economic interests of the franchisee and the franchisor?

The real-world answer is that the franchisor gets to decide what they believe is the best balance for their system. They define the territory sizes and other factors that determine the density of units they're willing to place in a market. These decisions by the franchisor ultimately establish where the average individual unit sales, income and rate of return numbers will fall.

You then get to decide if the balance that any given franchisor has incorporated into their system is acceptable to you. If you look at the average numbers, and they don't seem reasonable from your perspective, walk away. If the average numbers are within the standards you're looking for, then saturation is not an issue for you with that franchise system. Either way, you get to make the final call...just make sure you carefully research the franchise so you know what these numbers are.