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Wednesday, August 11, 2010

A Closer Look at "Conversion Franchising"

By Tayo Akinyemi

"Convertible" SAAB 900.

This series that introduces iuMAP, a web-based social enterprise directory developed by Ayllu and launched in media partnership with NextBillion. The purpose of the series is gathering feedback from the NextBillion community as the map unfolds and to share some of the information we've collected and analyzed. You can help triple iuMAP's size by submitting social enterprises and giving feedback. Read the previous entries of the series here.

This post is the fourth entry in a series focused on microfranchising, a common way many social enterprises distribute their products.  There has been some great discussion of microfranchising recently (such as this SSIR article).  This series provides an overview of different types of microfranchising, profile many enterprises that are employing the method, and provide information for both investors and those looking for funding.  The last post focused on infrastructure-based franchising.  This post focuses on another model- conversion franchising.

What is conversion franchising?

For social enterprises that have a business model that provides an improved version of a product already being provided to their target customers, conversion franchising may be a viable option. 

Conversion franchising transforms pre-existing, independently-owned businesses into members of a standardized network.  Scalability and profitability may be enhanced because potential franchisees already have a physical location, business experience, and regular customers.  Not surprisingly, several benefits accrue to a potential franchisor including:

  • Streamlined process as compared to starting a new business;
  • Lower capital requirements because infrastructure is already built;
  • Distribution of risk because shops serve different populations in different locations;
  • Shop owners' local customer knowledge, e.g. common ailments and treatment patterns

The franchisee potentially benefits from an increase in income, access to business training, a streamlined distribution network often including volume discounts on products, and a strong franchisor brand. 

Conversion franchising has been used to network pharmaceutical sellers in Ghana (Careshops Ghana), midwives in Peru (Redplan Salud), internet cafes in Brazil (CDI LAN), and rural service kiosks in India (Drishtee), among others.  

What Does It Take to Succeed?

The benefits of conversion franchising do not accrue automatically.  One of the major positives of this model is that the franchisee is not starting from scratch but already has a business in the franchise field.  However, this can also be one of the biggest challenges, because the existing practices of the franchisee do not always fit the needs of the franchisor.  If incentives are not designed correctly, franchisees may pick and choose which of the franchisor's rules to adopt, or may try to use their previous connections to compete with the franchisor on supplies or other inputs. 

The franchisor must strike a balance between implementing standard practices and customizing parts of the business model to suit the local context. This can be difficult to accomplish when the individual and aggregate needs of conversion franchisees cannot be reliably anticipated.  The demise of CareShops Ghana demonstrates this well.

CareShops Ghana: Confronting the Pitfalls of Conversion Franchising

CareShops Ghana was a conversion franchisor founded to enhance "access to non-prescription drugs with significant health impact such as malaria and diarrhea medication ...by improving the service quality and drug supply chains of Ghana's chemical sellers."  CareShops was launched by the Ghana Social Marketing Foundation under the auspices of its for-profit subsidiary, Ghana Social Marketing Foundation Enterprises Limited (GSMFEL).  Many Ghanaians, particularly in rural areas, have limited access to healthcare facilities and experience poor service and uncertain availability of medication.  Consequently, those who cannot see trained health professionals will seek the council of licensed chemical sellers (LCS).

CareShops provided its franchisees with a streamlined distribution network that included on-site delivery, extensive business training, and a strong branding scheme supported by the renovation of franchisee stores.  In turn, the financial success of Careshops' model was contingent upon several factors, such as

  • the collection of franchising fees;
  • achieving a significant volume discount on drug purchases from suppliers;
  • margin earned on sales of medication to franchisees (which assumed that GSMFEL would be an exclusive supplier); and
  • rationalization of SKUs. 

Unfortunately, all of these factors would present challenges to CareShops' sustainability.

  • First, GSMFEL could not enforce its sole distributor status. Not only did it face competition from suppliers who elected to sell directly to CareShop franchisees, but these suppliers were often better equipped to respond to market demand and undercut GSMFEL's prices. In fact, CareShops only accounted for 15% of franchisees' product purchases during its best year, while supporting all of the costs of being a full-fledged distributor.
  • Secondly, CareShops was unable to reduce the number of different products it supplied to franchisees, driving up inventory costs. Initially, it had planned to limit its inventory, but it was forced to expand in order to respond the needs of its franchisees and their customers.
  • CareShops was unable to secure the level of volume discounting (20%) on which its business model was based. In reality, the discount was closer to 12%, significantly below break-even.
  • Additionally, GSMFEL had a difficult time collecting payment for its deliveries. For example, some shop owners would arrange to be away at delivery time, leaving behind assistants who were reluctant to pay in the absence of their supervisors.
  • Finally, although LCS's are prohibited from stocking prescription drugs, many did so anyway. Because GSMFEL did not supply these drugs to its franchisees, it missed out on the revenue that the sales would have garnered.

In the end, CareShops Ghana could not change these practices and failed because the cost of capital associated with sustaining a failing business was too high.

Drishtee: A Model of Progress in Conversion Franchising

Drishtee, a social enterprise based in India, uses entrepreneur-managed kiosks to provide a wide range of fee-based products and services ranging from insurance and microcredit to seeds and phone cards.  Each kiosk has a different suite of offerings, chosen from Drishtee's thirty templates.  These products are complemented by local services and goods that Drishtee doesn't supply, like printing and stationery.  Established as a for-profit in 2000, Drishtee reached break-even in 2005 and profitability in 2006, and has been hovering around profitability since then.

Drishtee's foray into conversion franchising came with the advent of rural retail points (RRPS) in 2008, which converted village shops selling fast moving consumer goods (FMCGs), like packaged food and hygiene products into Drishtee franchises.  
As with other models, franchisees benefited from the franchisor's distribution system.

On the surface, it's tough to tease out the differences between CareShops and Drishtee.  What enabled one to survive while the other struggled?  Although several factors contributed to Drishtee's success,  a few are particularly relevant as points of comparison to CareShops.

  • Effective supply chain management. Given the variety of products that Drishtee kiosks carry, it is difficult to achieve the volume discounts that drive down procurement costs. Consequently, Drishtee has created a web-based inventory management tool that enables kiosk managers to order supplies online and helps Drishtee better manage and aggregate orders. Drishtee's focus on FMCGs also helps it reduce costs as the frequency of sales, and therefore the monthly volume, is higher. Drishtee's continued success will be partially contingent upon supplier adoption of its online tool.
  • Incentive alignment as a substitute for enforceable contracts. As we learned in the CareShop case, contract enforcement is difficult, if not impossible in many cases. Drishtee has circumvented this challenge by offering financial incentives to shape behavior. For example, it will offer higher commissions on certain goods to help entrepreneurs overcome lack of familiarity with the products.
  • Using revenue sharing as a financing mechanism. Drishtee was able to reduce upfront franchise fees, reducing risk for entrepreneurs and eliminating fee collection challenges by focusing on sales-based revenue sharing.

Lessons Learned

Despite its troubles, CareShops established a need and demand for business training among franchisees.  Additionally, it demonstrated the effectiveness of the microfranchise format as a platform for providing "behavior changing" education and support.  Drishtee's business model exhibits some of the key principles outlined by the Acumen Fund, including the following:

  • Efficient supply chains are needed, but difficult to create.
  • Contracts and legal considerations must be situationally appropriate.
  • Microfranchisees require financing.

See Acumen's working paper entitled "Microfranchising at the Base of the Pyramid" for additional details.  

Although it is difficult to make a definitive statement about the success of conversion franchising as a way to create profitable, scalable business models, the early successes of social enterprises like Drishtee, Redplan Salud, and CDI LAN are certainly encouraging.

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