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Understanding McDonald's: Comprehensive company primer and profitability analysis

Part 2
Understanding McDonald's: Comprehensive company primer and profitability analysis (Part 2 of 21)

What is a franchise and how do McDonald’s franchise agreements work?

Currently, McDonald’s has franchised about 80% of its restaurants, while the remainder is owned and operated by the company. Each of the company’s franchisees usually has a standard 20-year franchise license. A franchise license is an authorization granted by either a company or a government body to an individual or a group that enables them to perform specific commercial activities. For McDonald’s, the franchise model has led to years of profitability, growth, and risk mitigation.

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How much does it cost franchisees to start a McDonald’s franchise?

According to industry sources, the down payment required to start a new McDonald’s franchise is about 40% and the down payment required to purchase an existing franchise is 25%. The down payment must come from non-borrowed personal resources, which can include cash, investment securities, vested profit sharing (net of taxes), and business or real estate equity (which doesn’t include your primary residence). This generally amounts to $300,000 of capital to open a franchise. In addition to monetary capital, significant human capital is required in the form of business experience and customer service experience along with business planning and accounting skills. Also, significant time is required, including formal training in company policies and procedures.

Breaking apart the conventional franchise agreement

Under the conventional McDonald’s franchise arrangement, franchisees provide a portion of the capital required by initially investing in the equipment, signs, seating, and decor of their restaurant businesses, and by reinvesting in the business over time. The company owns the land and building or secures long-term leases for both company-operated and conventional franchised restaurant sites. In certain circumstances, the company participates in reinvestment for conventional franchised restaurants.

Conventional franchisees contribute to the company’s revenue stream through the payment of rent and royalties based on a percent of sales, with specified minimum rent payments, along with initial fees received upon the opening of a new restaurant or the granting of a new franchise term. The conventional franchise arrangement typically lasts 20 years, and franchising practices are generally consistent throughout the world. Over 70% of franchised restaurants operate under conventional franchise arrangements.

Development license arrangements

Under a developmental license arrangement, licensees provide capital for the entire business, including the real estate interest. While the company has no capital invested, it receives a royalty based on a percent of sales, as well as initial fees. The largest of these developmental license arrangements operates over 1,900 restaurants across 19 countries in Latin America and the Caribbean.

Affiliates

The company has an equity investment in a limited number of foreign affiliated markets, referred to as “affiliates.” The largest of these affiliates is Japan, where there are nearly 3,300 restaurants. The company receives a royalty based on a percent of sales in these markets and records its share of net results in equity in earnings of unconsolidated affiliates.

Collective purchasing agreements to assure price and quality

The company and its franchisees purchase food, packaging, equipment, and other goods from numerous independent suppliers. The company has established and strictly enforces high quality standards and product specifications. McDonald’s has quality centers around the world to ensure that its high standards are consistently met.

The quality assurance process involves not only ongoing product reviews, but also onsite supplier visits. A quality leadership board—composed of the company’s technical, safety, and supply chain specialists—provides strategic global leadership for all aspects of food quality and safety. Plus, the company works closely with suppliers to encourage innovation, assure best practices, and drive continuous improvement. Leveraging scale, supply chain infrastructure, and risk management strategies, the company also collaborates with suppliers toward a goal of achieving competitive, predictable food and paper costs over the long term.

Distribution

Independently owned and operated distribution centers, approved by the company, distribute products and supplies to most McDonald’s restaurants. Also, restaurant personnel are trained in the proper storage, handling, and preparation of products and in customer service.

Key risks of the franchise model

The risks associated with McDonald’s franchise business model include whether its franchisees have the experience and financial resources to be effective operators and remain aligned with the company on operating, promotional, and capital-intensive initiatives, and the potential impact on the company if they experience food safety or other operational problems or project a brand image inconsistent with the company’s values—particularly if its contractual and other rights and remedies are limited, costly to exercise, or subject to litigation.

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