McDonald’s © Bettmann/CORBIS

14 FINANCIAL HISTORY | Summer 2012 | www.MoAF.org and the New Franchising Paradigm

By Steven Mark Adelson stores, which offered lower prices through he placed on both sides a 30-foot parabolic higher turnover and a minimum of golden arch to be lit by neon at night. If you were to ask for the name of employees. As Dick McDonald explained, With the new system, customers would world’s largest real estate developer and “Our whole concept was based on speed, have to walk up to the service window and property management firm, you may be lower prices and volume. We were going place their order, and they would receive it surprised by the answer: McDonald’s. after big, big volumes by lowering prices in less than 60 seconds. Aside from being the largest purveyor of and by having the customer serve himself.” The new operation was so efficient that food in the world, the company controls The McDonald brothers examined their labor costs were slashed to 17% of gross the real estate in 33,000 restaurant loca- receipts over the prior three years and saw income, allowing the brothers to price tions in 119 countries and territories. that and cheeseburgers rep- their hamburgers at 15¢, roughly half of resented 80% of their sales. They therefore what everyone else was charging. The McDonald Brothers reduced the menu from 25 to nine items. After their regular customers got used Out went the car hops, the indoor seat- to the new self-service format The founders of McDonald’s — Richard ing, the dishwasher and the barbecue pit. boomed; during peak serving times it was and Maurice McDonald — did not start The plates, the flatware and the glasses not uncommon to see to lines 20 or more out by selling hamburgers. were replaced with paper bags, paper cups people deep. The format was so unique Natives of New Hampshire, the broth- and paper wrapping. To ensure that their that their stand made the ers moved to Los Angeles at the start of new place didn’t become a teenage hang- cover of the July 1952 issue of American the Depression in the hopes of finding out, there were no jukeboxes, vending Restaurant magazine with the headline opportunity and a better life. By 1940, they machines or pay phones. “One Million Hamburgers and 160 Tons relocated to San Bernardino, then a small The brothers redesigned the kitchen of French Fries a Year.”1 bedroom community 55 miles east of Los along the lines of a factory assembly line. Soon the brothers were making Angeles, and with a $5,000 from the They replaced their three-foot cast iron $350,000 per year and splitting $100,000 of America opened a drive-in with grill with two, custom-made stainless steel in profits (roughly $1,000,000 today). a menu consisting of 25 items, with slow- six-foot grills and added new equipment Then in 1954, they put in an order to the smoked barbecue as the featured item. designed to meet the needs of food pro- Prince Castle Sales Division in Oak Park, Located near a high school, their new duction on an industrial scale — a machine . They had no idea where that order place quickly became successful and soon to quickly form hamburger patties, a con- would eventually lead. employed 20 carhops. But by 1948, the diment pump that would squirt just the McDonald brothers were thinking of sell- right amount of ketchup or mustard with Ray Kroc ing for many reasons: dishes, glassware one squeeze and a “heat bar” under which and silverware had to be replaced due to to place the finished burgers. Ray Kroc was born on October 5, 1902 in constant breakage and theft; turnover of And like a factory assembly line, a sepa- . In his sophomore year of high both carhops and cooks were high; and rate employee was trained to do each sepa- school he dropped out. Lying about his wages consumed 35–40% of their gross rate function. This meant one employee age (he was 15), he was sent to France dur- income. But instead of selling the business only had to be taught how to perform one ing World War I to drive ambulances for outright, they experimented with some- repetitive task. Skilled and semi-skilled the Red Cross. thing new. workers were no longer necessary — an After the war he drifted about until The McDonald brothers wanted to unskilled teenager paid 1926 when he began a career as a traveling implement a trend they noticed. A new would grill the hamburger, another would salesman for the Lily Cup Company (later concept called “self-service” was becom- add condiments and wrap it, etc. Likewise, called the Lily-Tulip Company in 1929). ing popular with supermarkets and variety milk shakes and french fries were premade He sold paper cups to a variety of ice and placed into an “inventory” behind the cream parlors, dairy bars, soda fountains, counterman until the order arrived. coffee shops, mom-and-pop dinettes and Ray Kroc, founder and chairman of McDonald’s Richard came up with a new design for bars (cocktails and mixed drinks using Corporation, stands outside one of his franchises, a 1,600 square foot drive-in hamburger liqueurs and ice cream were growing in holding a hamburger and a drink. stand with a slightly cantilever roof where popularity since the repeal of Probation), © Bettmann/CORBIS

www.MoAF.org | Summer 2012 | FINANCIAL HISTORY 15 eventually establishing new accounts at In his memoir, Grinding It Out, Kroc paid to the McDonald brothers as a roy- Wrigley Field, Walgreen’s (which often describes the San Bernardino operation, alty. Kroc would keep the other 1.4% as a had a lunch counter in their drug stores) noting the building’s all-glass walls, the service fee to and run his office. and in factory commissaries at Swift, long lines, the spotless kitchen and the From the start, Kroc was determined Amour and US Steel. busy staff in their “spiffy white shirts that McDonald’s not become the sort of Then in 1939 the Lily-Tulip Company and trousers, bustling around like ants at operation he considered to be harmful to turned down an offer to be the national a picnic,” serving hamburgers and fries long-term growth. Specifically: distributor for a product that would dove- to the working-class families that drove 1. Demanding big, upfront fees for fran- tail the sales of paper cups. up. By lunchtime, 150 people had lined chises. Kroc wanted individual owner/ Earl Prince, a mechanical engineer, up. “Something was definitely happening operators — people willing to place invented a five-spindled mixer that he here, I told myself this had to be the most their life savings if need be — to invest called The Multimixer. Kroc immediately amazing merchandising operation I had in this hamburger stand, and thus be saw the sales possibilities. At the age of ever seen!” motivated to make their business a suc- 37 he acquired the marketing rights and Over the last 30 years Kroc observed the cess. He refused to consider anyone formed the Prince Castle Sales Division. food service industry up close, from man- who would be an absentee owner. He went back to his old customers and agement organization, kitchen layout and 2. Requiring the franchisee to acquire all sold them on the advantage of serving food preparation. He made a great deal of their stock, supplies and equipment their customers faster and selling more of mental notes as to what worked, what through the franchisor, who would then drinks. With his knowledge and experi- didn’t and why. Mostly Kroc noticed that charge a hefty mark-up. This spurious ence in sales and in the food service indus- many independent food service operators relationship was a common practice try, Kroc was soon selling 9,000 units had a “by-the-seat-of-your-pants” man- and accepted under the banner “Qual- a year at $150 each (over $1,000 apiece agement style. Now here was something ity Control,” but in reality this was the today) and earning a salary of $20,000 by different: a small, streamlined establish- primary means by which the franchisor the late 1940s. ment which had worked out standardized made its money, along with collecting Unfortunately, the good times did not procedures to quickly deliver a uniform monthly royalties and whatever fees it last. By the early 1950s, sales were down to product at a low price. could levy. Kroc would negotiate with just 2,000 units. Competition from Ham- purveyors to obtain the best price and ilton Beach and the flight of city dwellers 3 pass along any savings. to the suburbs was killing off the corner The Offer 3. Kickbacks from suppliers to the fran- drugstore with their lunch counters and Kroc envisioned duplicating hundreds of chisor were forbidden. Kroc believed soda fountains, representing two-thirds this little stand throughout the country on this negated the promise of delivering of his customers. The writing was on the a franchise basis. A conventional drive- a lower price through bulk purchases. wall — demand for the Multimixer was in would cost about $300,000 (in the declining by the month. Ray Kroc was 52, mid-1950s), but a unit like this would 4. Also forbidden was the awarding of an age where most men begin to think run about $40,000, plus an additional “Territorial Licenses.” In this arrange- about retirement, and now he needed $30,000 to acquire the half-acre store site. ment, an individual or corporation is another way to make a living. Although initially the McDonald brothers awarded the exclusive right to conduct Then in 1954, he received an order that said “no” (they liked going home at night business within a specific geographic would change his life. and dreaded all the traveling that running region, such as a state or a city. In a franchising organization would entail), exchange, the franchisor receives an up- front payment, which can run into the Reconnoitering Kroc was persistent and eventually got them to sign him on as their exclusive hundreds of thousands or millions of The order was for two more Multimixers franchising agent. Unfortunately, he was dollars. The Territorial Franchise holder for a small drive-in located in San Ber- so anxious to become their agent that he would then scout for sites, construct his nardino. The drive-in had already ordered found himself obligated to a horrendous own units or recruit others to establish eight recently, and now they needed financial arrangement.2 individual franchises and collect fees or two more? “What kind of an operation The arrangement he devised was as royalties from them. required a single restaurant to make 50 follows: the initial franchise fee would be 5. Often little thought was given to site milkshakes at the same time?” Kroc flew $950 and would be charged a 1.9% service selection, new product development or out to California to see for himself. fee assessed on their food sales, with 0.5% on-going management training beyond

16 FINANCIAL HISTORY | Summer 2012 | www.MoAF.org © Bettmann/CORBIS

The McDonald’s Museum, a replica of the first corporate McDonald’s restaurant, opened in Des Plaines, Illinois on April 15, 1955, after the franchise was acquired from founders Maurice and Richard McDonald.

the franchisee’s initial course of instruc- On March 2, 1955, Kroc founded McDon- Under this system, financing the sup- tion. Kroc believed these arrangements ald’s System Inc. (now known as McDon- port infrastructure Kroc aimed for was were detrimental to the success of the ald’s Corporation) and on April 15, 1955, he unobtainable. Kroc demanded military- franchisee and the system being created opened his own McDonald’s drive-in in Des like adherence to standardization and because: Plaines, Illinois so that prospective franchi- uniformity, both from individual licens- a. A conflict of interest existed between sees could see a model store in operation ees and from a myriad of suppliers. To the franchisor and the owner of the and provide CPA certified income state- enforce this Kroc would need a contingent franchise, deliberately designed to ments showing how much money these of field inspectors, along with specialists enrich franchisor. little hamburger stands could generate. responsible for developing and refining On average, a McDonald’s stand at this various “back room functions” such as: b. The franchisor made his money time generated about $200,000 in sales establishing operating procedures, quality before the franchisee did, and always yielding $40,000 in profits. Based on this standards, finance, logistics, advertising, at his expense. information: new product development, site selection Kroc envisioned McDonald’s as having $200,000 Gross Sales and building construction. The problem now became how to finance a growing a symbiotic relationship with each owner/ $3,800 Service Fee (1.9% of franchise organization without cash, col- operator — where headquarters was there Gross Sales) to support, and not exploit, the franchi- lateral or even a record of profitability. less $1,000 Royalty to McDonald see. As Kroc once explained it, “You’re Compounding this problem was the fact Brothers (0.5% of in business for yourself, but you’re not that the independents he wanted as licens- Gross Sales) by yourself.” McDonald’s would flourish ees usually didn’t have the startup money only if the individual franchisees were $2,800 Remitted to McDonald’s on hand, nor were they likely able to successful. System Inc. obtain a bank loan (then, as now,

www.MoAF.org | Summer 2012 | FINANCIAL HISTORY 17 As Kroc once explained it, were reluctant to provide for restau- “You’re in business Rent Paid By Franchise Realty rants due to their high failure rate). to Property Owner $600 What Ray Kroc desperately needed was for yourself, 40% Markup Charged by a “numbers man” who was well-versed in Franchise Realty to Licensee $240 finance and could be as enthusiastic about but you’re not Rental Fee Remitted McDonald’s as he was in running the to Franchise Realty $840 operations side. Without such a person, McDonald’s would face bankruptcy in a by yourself.” In addition to the franchisee’s base rent, few years due to undercapitalization. McDonald’s would FRC added an interest charge. Franchisees would stop paying the minimum base rent A New Kind of Sandwich flourish only if and start paying rents based on a percent- age of their sales when the store reached a TasteeFreez executive Harry J. Sonneborn sales volume equal to 5% of sales (which was looking for new opportunities in 1956. the individual rose to 8.5% in 1970). Aside from being a “numbers man,” his Sonneborn’s plan provided three main other talent lay in his ability to persuade franchisees were benefits: bankers to loan him money when he needed it. Sonneborn had the rare talent successful. 1. The McDonald’s Corporation received of understanding numbers like a banker, a steady and predictable minimum cash knowing the language of real estate bro- flow to cover its overhead costs. This kers and being able to construct a contract cash flow would increase with every like a lawyer. Sonneborn contacted Kroc unit they opened. through a mutual friend and was immedi- 2. Because the more money the franchise ately hired as Kroc’s top financial officer. made, the more McDonald’s made, this Sonneborn’s first order of business was contract was worth the paper it was writ- provided the motivation for corporate to find a way for the McDonald’s Corpo- ten on. It appeared that it could never directed site selection to be meticulous ration to make money that did not conflict stand up in a legal action.” At the time, when analyzing prospective locations. with Kroc’s concept of fairness to his fran- there wasn’t much case law dealing with This maintained Kroc’s dictum that the chisees, but would allow the company to franchise contracts. success of McDonald’s be aligned with maintain control over them so they would But there was with real estate and lease the success of the individual franchisee. comply with his operating directives. Sev- agreements. 3. By gaining control of the real estate and eral of his first licensees were already In order to satisfy Kroc’s requirements, building, McDonald’s could exercise ignoring his rules on operations manage- Sonneborn got the company into the control over the franchisee by making ment. Sonneborn realized that “funda- “landlord business” by devising a unique him a tenant. Licensees not abiding by mentally, the company couldn’t make a real estate strategy. He formed the terms of the franchise agreement profit on its franchise income because a separate and wholly owned real estate could be evicted. Among the terms, the the bulk of it [remitted to McDonald’s subsidiary in 1956 called Franchise Realty franchisees were on a “net net” basis, Systems, Inc.] was expensed as overhead.” Corporation. FRC was tasked to locate meaning they were responsible for pay- To give a sense of how undercapi- and lease sites from landowners who were ing property and taxes. talized McDonald’s was at this time, it willing to build McDonald’s units, which lost $7,000 in 1956. In 1957 the company then would be leased back to the company earned $26,000, most of which was from on a 20-year improved lease agreement Reinterpreting the Numbers one-time licensing fees charged to new with the property owner. McDonald’s FRC came into existence by leasing the land franchisees. At the start of 1958 McDon- would then take “sandwich position” by and owning the building, and then charg- ald’s had a net worth of just $24,000 with subleasing the store to the franchisee and ing rent on both from the licensee. But at 38 restaurants, and Kroc wanted to add 50 charging a 40% markup for the real estate the time McDonald’s was cash poor (Kroc’s more units. services Franchise Realty was providing. Multimixer business and his own franchise Sonneborn also expressed little faith Here is an example of the arrangement sustained him during this period), and Son- in the contract McDonald’s had with its if the landowner charged McDonald’s neborn was already making plans to buy the licensees. “I never thought the franchise $600/month: land as well. At this time, there was a flight

18 FINANCIAL HISTORY | Summer 2012 | www.MoAF.org of city dwellers to the suburbs, and many of was that it took this much time to develop Notes the sites McDonald’s sublet to franchisees a site, and real estate expenses did not 1. After the American Restaurant maga- appreciated rapidly. But, as stated earlier, generate revenues until new stores were zine article appeared, the brothers were banks are reluctant to provide loans for res- open. Boylan also convinced Sonneborn to besieged with inquiries about their opera- taurants due to their high failure rate, and capitalize interest expenses on real estate tion. Within two years the brothers sold given McDonald’s anemic balance sheet loans during the construction of a store and 15 franchises to their “Speedee System” for and income statements, banks would be amortize those costs over the 20-year life of a one-time fee of $1,000 which included equally reluctant to lend them money. a franchise. Both of these techniques were the store plans and a description of their In 1958 Sonneborn hired Richard designed to delay the reporting of expenses system. No further assistance or support Boylan, an eight-year veteran of the IRS during a time when McDonald’s was build- was given. who specialized in real estate accounting, ing units as quickly as new franchisees were 2. This was not the first place Ray Kroc tried appraisal and taxation. found to operate them. As a side benefit, the to obtain a national franchise agreement. Boylan beefed-up McDonald’s balance delaying of expenses would help generate In 1949, on West Pico Boulevard in Los sheet by using IRS valuation techniques an income statement that reported earnings Angeles, Kroc made an offer to the own- to increase the company’s reported net when ordinarily there wouldn’t be any. ers of The Apple Pan, a restaurant known worth by extending an interpretation used for their hickory flavored hamburgers, in estate appraisal. The IRS had deter- The Buy Out tuna salad sandwiches, and apple and mined that the future lease payments to pecan pies, but the owners turned him a deceased’s estate had a present value. By 1961 Kroc felt he was doing all the work down. Carl Karcher, founder of Carl’s Jr., Using this rule, Boylan concluded that of creating a hamburger chain and the said that at one point Kroc had extended McDonald’s future net rental income McDonald brothers had not contributed a similar offer to him before he went into from its franchisees had a present value anything (except for devising the original the hamburger business when he owned a as well, and that should be reported as Speedee System). Every time he needed to few hot dog stands and barbecues. an asset — assessed at roughly 10 times make a format or procedural change, he what McDonald’s collected in rents from required their written permission, and they 3. To this day, McDonald’s does not hold franchisees. This also reflected the effect were often lackadaisical in their responses. an equity position in any of the suppliers of appreciating real estate values that Finally Kroc called them and asked how it does business with. Aside from estab- McDonald’s was creating through the much it would take to buy them out? lishing the operating procedures indi- future income stream that grew every The response nearly gave him a stroke, vidual franchisees are required to follow, time McDonald’s opened a new unit and “We want $2.7 million, which would leave McDonald’s Incorporated also establishes subleased the property. By capitalizing the us one million each after taxes.” for its suppliers the recipes for every item leases in this manner, by 1960 McDonald’s Kroc swore, but he knew if he wanted of food they sell or use, and the specifica- could proudly boast a balance sheet with complete control he had to capitulate. At tions for quality. Even the recipe for the total assets of $12.4 million, impressive the time there were 228 units with sales the brine used to cure cucumbers into pickles enough for major lending institutions to year before of $37.8 million. Of that the was devised by McDonald’s. provide multi-store financing packages. brothers had received 0.5% (or $189,000) Boylan performed an encore with representing their royalty. A New York McDonald’s reported earnings which were money manager arranged a loan from equally low ($12,000 in 1958) because the several college endowment and pension Steven Mark Adelson is a graduate of the costs related to building new units showed funds, along with a $1.5 million loan from University of Maryland and the US Army up on their financial documents before State Mutual, which accepted the risk in School of Logistics. He is now a freelance new restaurant-generated revenues. exchange for 20% of McDonald’s stock. writer and lecturer on research techniques. Traditionally, a company expenses Today, with system-wide sales of over $61 He gained first-hand knowledge of restau- real estate development costs as they are billion, if both Ray Kroc and the McDonald rant operations as a teenager by working incurred, but Boylan argued that they brothers had been more flexible with their at Sam’s Grill, owned by his father, in should be reported nine months later, when franchise agreement, the royalty paid to the Washington, DC. He is also an executive the expenses could then be matched to McDonald brothers (or their heirs) would member for the Society of Southwestern the revenues they generate. His reasoning be $305 million! Authors located in Tucson, Arizona.

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