McDonald’s
Bettmann/CORBISMcDonald’s14FINANCIAL HISTORY Summer 2012 www.MoAF.org
and the NewFranchising ParadigmBy Steven Mark AdelsonIf you were to ask for the name ofworld’s largest real estate developer andproperty management firm, you may besurprised by the answer: McDonald’s.Aside from being the largest purveyor offood in the world, the company controlsthe real estate in 33,000 restaurant locations in 119 countries and territories.The McDonald BrothersThe founders of McDonald’s — Richardand Maurice McDonald — did not startout by selling hamburgers.Natives of New Hampshire, the brothers moved to Los Angeles at the start ofthe Depression in the hopes of findingopportunity and a better life. By 1940, theyrelocated to San Bernardino, then a smallbedroom community 55 miles east of LosAngeles, and with a 5,000 loan from theBank of America opened a drive-in witha menu consisting of 25 items, with slowsmoked barbecue as the featured item.Located near a high school, their newplace quickly became successful and soonemployed 20 carhops. But by 1948, theMcDonald brothers were thinking of selling for many reasons: dishes, glasswareand silverware had to be replaced due toconstant breakage and theft; turnover ofboth carhops and cooks were high; andwages consumed 35–40% of their grossincome. But instead of selling the businessoutright, they experimented with something new.The McDonald brothers wanted toimplement a trend they noticed. A newconcept called “self-service” was becoming popular with supermarkets and varietyRay Kroc, founder and chairman of McDonald’sCorporation, stands outside one of his franchises,holding a hamburger and a drink.stores, which offered lower prices throughhigher turnover and a minimum ofemployees. As Dick McDonald explained,“Our whole concept was based on speed,lower prices and volume. We were goingafter big, big volumes by lowering pricesand by having the customer serve himself.”The McDonald brothers examined theirreceipts over the prior three years and sawthat hamburgers and cheeseburgers represented 80% of their sales. They thereforereduced the menu from 25 to nine items.Out went the car hops, the indoor seating, the dishwasher and the barbecue pit.The plates, the flatware and the glasseswere replaced with paper bags, paper cupsand paper wrapping. To ensure that theirnew place didn’t become a teenage hangout, there were no jukeboxes, vendingmachines or pay phones.The brothers redesigned the kitchenalong the lines of a factory assembly line.They replaced their three-foot cast irongrill with two, custom-made stainless steelsix-foot grills and added new equipmentdesigned to meet the needs of food production on an industrial scale — a machineto quickly form hamburger patties, a condiment pump that would squirt just theright amount of ketchup or mustard withone squeeze and a “heat bar” under whichto place the finished burgers.And like a factory assembly line, a separate employee was trained to do each separate function. This meant one employeeonly had to be taught how to perform onerepetitive task. Skilled and semi-skilledworkers were no longer necessary — anunskilled teenager paid minimum wagewould grill the hamburger, another wouldadd condiments and wrap it, etc. Likewise,milk shakes and french fries were premadeand placed into an “inventory” behind thecounterman until the order arrived.Richard came up with a new design fora 1,600 square foot drive-in hamburgerstand with a slightly cantilever roof wherehe placed on both sides a 30-foot parabolicgolden arch to be lit by neon at night.With the new system, customers wouldhave to walk up to the service window andplace their order, and they would receive itin less than 60 seconds.The new operation was so efficient thatlabor costs were slashed to 17% of grossincome, allowing the brothers to pricetheir hamburgers at 15 , roughly half ofwhat everyone else was charging.After their regular customers got usedto the new self-service format businessboomed; during peak serving times it wasnot uncommon to see to lines 20 or morepeople deep. The format was so uniquethat their hamburger stand made thecover of the July 1952 issue of AmericanRestaurant magazine with the headline“One Million Hamburgers and 160 Tonsof French Fries a Year.”1Soon the brothers were making 350,000 per year and splitting 100,000in profits (roughly 1,000,000 today).Then in 1954, they put in an order to thePrince Castle Sales Division in Oak Park,Illinois. They had no idea where that orderwould eventually lead.Ray KrocRay Kroc was born on October 5, 1902 inChicago. In his sophomore year of highschool he dropped out. Lying about hisage (he was 15), he was sent to France during World War I to drive ambulances forthe Red Cross.After the war he drifted about until1926 when he began a career as a travelingsalesman for the Lily Cup Company (latercalled the Lily-Tulip Company in 1929).He sold paper cups to a variety of icecream parlors, dairy bars, soda fountains,coffee shops, mom-and-pop dinettes andbars (cocktails and mixed drinks usingliqueurs and ice cream were growing inpopularity since the repeal of Probation),www.MoAF.org Summer 2012 FINANCIAL HISTORY 15
eventually establishing new accounts atWrigley Field, Walgreen’s (which oftenhad a lunch counter in their drug stores)and in factory commissaries at Swift,Amour and US Steel.Then in 1939 the Lily-Tulip Companyturned down an offer to be the nationaldistributor for a product that would dovetail the sales of paper cups.Earl Prince, a mechanical engineer,invented a five-spindled mixer that hecalled The Multimixer. Kroc immediatelysaw the sales possibilities. At the age of37 he acquired the marketing rights andformed the Prince Castle Sales Division.He went back to his old customers andsold them on the advantage of servingtheir customers faster and selling moredrinks. With his knowledge and experience in sales and in the food service industry, Kroc was soon selling 9,000 unitsa year at 150 each (over 1,000 apiecetoday) and earning a salary of 20,000 bythe late 1940s.Unfortunately, the good times did notlast. By the early 1950s, sales were down tojust 2,000 units. Competition from Hamilton Beach and the flight of city dwellersto the suburbs was killing off the cornerdrugstore with their lunch counters andsoda fountains, representing two-thirdsof his customers. The writing was on thewall — demand for the Multimixer wasdeclining by the month. Ray Kroc was 52,an age where most men begin to thinkabout retirement, and now he neededanother way to make a living.Then in 1954, he received an order thatwould change his life.ReconnoiteringThe order was for two more Multimixersfor a small drive-in located in San Bernardino. The drive-in had already orderedeight recently, and now they neededtwo more? “What kind of an operationrequired a single restaurant to make 50milkshakes at the same time?” Kroc flewout to California to see for himself.16In his memoir, Grinding It Out, Krocdescribes the San Bernardino operation,noting the building’s all-glass walls, thelong lines, the spotless kitchen and thebusy staff in their “spiffy white shirtsand trousers, bustling around like ants ata picnic,” serving hamburgers and friesto the working-class families that droveup. By lunchtime, 150 people had linedup. “Something was definitely happeninghere, I told myself this had to be the mostamazing merchandising operation I hadever seen!”Over the last 30 years Kroc observed thefood service industry up close, from management organization, kitchen layout andfood preparation. He made a great dealof mental notes as to what worked, whatdidn’t and why. Mostly Kroc noticed thatmany independent food service operatorshad a “by-the-seat-of-your-pants” management style. Now here was somethingdifferent: a small, streamlined establishment which had worked out standardizedprocedures to quickly deliver a uniformproduct at a low price.The OfferKroc envisioned duplicating hundreds ofthis little stand throughout the country ona franchise basis. A conventional drivein would cost about 300,000 (in themid-1950s), but a unit like this wouldrun about 40,000, plus an additional 30,000 to acquire the half-acre store site.Although initially the McDonald brotherssaid “no” (they liked going home at nightand dreaded all the traveling that runninga franchising organization would entail),Kroc was persistent and eventually gotthem to sign him on as their exclusivefranchising agent. Unfortunately, he wasso anxious to become their agent that hefound himself obligated to a horrendousfinancial arrangement.2The arrangement he devised was asfollows: the initial franchise fee would be 950 and would be charged a 1.9% servicefee assessed on their food sales, with 0.5%FINANCIAL HISTORY Summer 2012 www.MoAF.orgpaid to the McDonald brothers as a royalty. Kroc would keep the other 1.4% as aservice fee to finance and run his office.From the start, Kroc was determinedthat McDonald’s not become the sort ofoperation he considered to be harmful tolong-term growth. Specifically:1. Demanding big, upfront fees for franchises. Kroc wanted individual owner/operators — people willing to placetheir life savings if need be — to investin this hamburger stand, and thus bemotivated to make their business a success. He refused to consider anyonewho would be an absentee owner.2. Requiring the franchisee to acquire allof their stock, supplies and equipmentthrough the franchisor, who would thencharge a hefty mark-up. This spuriousrelationship was a common practiceand accepted under the banner “Quality Control,” but in reality this was theprimary means by which the franchisormade its money, along with collectingmonthly royalties and whatever fees itcould levy. Kroc would negotiate withpurveyors to obtain the best price and3pass along any savings.3. Kickbacks from suppliers to the franchisor were forbidden. Kroc believedthis negated the promise of deliveringa lower price through bulk purchases.4. Also forbidden was the awarding of“Territorial Licenses.” In this arrangement, an individual or corporation isawarded the exclusive right to conductbusiness within a specific geographicregion, such as a state or a city. Inexchange, the franchisor receives an upfront payment, which can run into thehundreds of thousands or millions ofdollars. The Territorial Franchise holderwould then scout for sites, construct hisown units or recruit others to establishindividual franchises and collect fees orroyalties from them.5. Often little thought was given to siteselection, new product development oron-going management training beyond
Bettmann/CORBISThe McDonald’s Museum, a replica of the first corporate McDonald’s restaurant, opened in Des Plaines, Illinois onApril 15, 1955, after the franchise was acquired from founders Maurice and Richard McDonald.the franchisee’s initial course of instruction. Kroc believed these arrangementswere detrimental to the success of thefranchisee and the system being createdbecause:a. A conflict of interest existed betweenthe franchisor and the owner of thefranchise, deliberately designed toenrich franchisor.b. The franchisor made his moneybefore the franchisee did, and alwaysat his expense.Kroc envisioned McDonald’s as havinga symbiotic relationship with each owner/operator — where headquarters was thereto support, and not exploit, the franchisee. As Kroc once explained it, “You’rein business for yourself, but you’re notby yourself.” McDonald’s would flourishonly if the individual franchisees weresuccessful.On March 2, 1955, Kroc founded McDonald’s System Inc. (now known as McDonald’s Corporation) and on April 15, 1955, heopened his own McDonald’s drive-in in DesPlaines, Illinois so that prospective franchisees could see a model store in operationand provide CPA certified income statements showing how much money theselittle hamburger stands could generate.On average, a McDonald’s stand at thistime generated about 200,000 in salesyielding 40,000 in profits. Based on thisinformation: 200,000 Gross Sales 3,800 Service Fee (1.9% ofGross Sales)less 1,000 Royalty to McDonaldBrothers (0.5% ofGross Sales) 2,800 Remitted to McDonald’sSystem Inc.Under this system, financing the support infrastructure Kroc aimed for wasunobtainable. Kroc demanded militarylike adherence to standardization anduniformity, both from individual licensees and from a myriad of suppliers. Toenforce this Kroc would need a contingentof field inspectors, along with specialistsresponsible for developing and refiningvarious “back room functions” such as:establishing operating procedures, qualitystandards, finance, logistics, advertising,new product development, site selectionand building construction. The problemnow became how to finance a growingfranchise organization without cash, collateral or even a record of profitability.Compounding this problem was the factthat the independents he wanted as licensees usually didn’t have the startup moneyon hand, nor were they likely able toobtain a bank loan (then, as now, bankswww.MoAF.org Summer 2012 FINANCIAL HISTORY 17
As Kroc onceexplained it,were reluctant to provide loans for restaurants due to their high failure rate).What Ray Kroc desperately needed wasa “numbers man” who was well-versed infinance and could be as enthusiastic aboutMcDonald’s as he was in running theoperations side. Without such a person,McDonald’s would face bankruptcy in afew years due to undercapitalization.“You’re in businessA New Kind of Sandwichflourish only ifTasteeFreez executive Harry J. Sonnebornwas looking for new opportunities in 1956.Aside from being a “numbers man,” hisother talent lay in his ability to persuadebankers to loan him money when heneeded it. Sonneborn had the rare talentof understanding numbers like a banker,knowing the language of real estate brokers and being able to construct a contractlike a lawyer. Sonneborn contacted Krocthrough a mutual friend and was immediately hired as Kroc’s top financial officer.Sonneborn’s first order of business wasto find a way for the McDonald’s Corporation to make money that did not conflictwith Kroc’s concept of fairness to his franchisees, but would allow the company tomaintain control over them so they wouldcomply with his operating directives. Several of his first licensees were alreadyignoring his rules on operations management. Sonneborn realized that “fundamentally, the company couldn’t make aprofit on its franchise income becausethe bulk of it [remitted to McDonald’sSystems, Inc.] was expensed as overhead.”To give a sense of how undercapitalized McDonald’s was at this time, itlost 7,000 in 1956. In 1957 the companyearned 26,000, most of which was fromone-time licensing fees charged to newfranchisees. At the start of 1958 McDonald’s had a net worth of just 24,000 with38 restaurants, and Kroc wanted to add 50more units.Sonneborn also expressed little faithin the contract McDonald’s had with itslicensees. “I never thought the franchise18for yourself,but you’re notby yourself.”McDonald’s wouldthe individualfranchisees weresuccessful.contract was worth the paper it was written on. It appeared that it could neverstand up in a legal action.” At the time,there wasn’t much case law dealing withfranchise contracts.But there was with real estate and leaseagreements.In order to satisfy Kroc’s requirements,Sonneborn got the company into the“landlord business” by devising a uniquereal estate investment strategy. He formeda separate and wholly owned real estatesubsidiary in 1956 called Franchise RealtyCorporation. FRC was tasked to locateand lease sites from landowners who werewilling to build McDonald’s units, whichthen would be leased back to the companyon a 20-year improved lease agreementwith the property owner. McDonald’swould then take “sandwich position” bysubleasing the store to the franchisee andcharging a 40% markup for the real estateservices Franchise Realty was providing.Here is an example of the arrangementif the landowner charged McDonald’s 600/month:FINANCIAL HISTORY Summer 2012 www.MoAF.orgRent Paid By Franchise Realtyto Property Owner 40% Markup Charged byFranchise Realty to Licensee Rental Fee Remittedto Franchise Realty 600 240 840In addition to the franchisee’s base rent,FRC added an interest charge. Franchiseeswould stop paying the minimum base rentand start paying rents based on a percentage of their sales when the store reached asales volume equal to 5% of sales (whichrose to 8.5% in 1970).Sonneborn’s plan provided three mainbenefits:1. The McDonald’s Corporation receiveda steady and predictable minimum cashflow to cover its overhead costs. Thiscash flow would increase with everyunit they opened.2. Because the more money the franchisemade, the more McDonald’s made, thisprovided the motivation for corporatedirected site selection to be meticulouswhen analyzing prospective locations.This maintained Kroc’s dictum that thesuccess of McDonald’s be aligned withthe success of the individual franchisee.3. By gaining control of the real estate andbuilding, McDonald’s could exercisecontrol over the franchisee by makinghim a tenant. Licensees not abiding bythe terms of the franchise agreementcould be evicted. Among the terms, thefranchisees were on a “net net” basis,meaning they were responsible for paying property insurance and taxes.Reinterpreting the NumbersFRC came into existence by leasing the landand owning the building, and then charging rent on both from the licensee. But atthe time McDonald’s was cash poor (Kroc’sMultimixer business and his own franchisesustained him during this period), and Sonneborn was already making plans to buy theland as well. At this time, there was a flight
of city dwellers to the suburbs, and many ofthe sites McDonald’s sublet to franchiseesappreciated rapidly. But, as stated earlier,banks are reluctant to provide loans for restaurants due to their high failure rate, andgiven McDonald’s anemic balance sheetand income statements, banks would beequally reluctant to lend them money.In 1958 Sonneborn hired RichardBoylan, an eight-year veteran of the IRSwho specialized in real estate accounting,appraisal and taxation.Boylan beefed-up McDonald’s balancesheet by using IRS valuation techniquesto increase the company’s reported networth by extending an interpretation usedin estate appraisal. The IRS had determined that the future lease payments toa deceased’s estate had a present value.Using this rule, Boylan concluded thatMcDonald’s future net rental incomefrom its franchisees had a present valueas well, and that should be reported asan asset — assessed at roughly 10 timeswhat McDonald’s collected in rents fromfranchisees. This also reflected the effectof appreciating real estate values thatMcDonald’s was creating through thefuture income stream that grew everytime McDonald’s opened a new unit andsubleased the property. By capitalizing theleases in this manner, by 1960 McDonald’scould proudly boast a balance sheet withtotal assets of 12.4 million, impressiveenough for major lending institutions toprovide multi-store financing packages.Boylan performed an encore withMcDonald’s reported earnings which wereequally low ( 12,000 in 1958) because thecosts related to building new units showedup on their financial documents beforenew restaurant-generated revenues.Traditionally, a company expensesreal estate development costs as they areincurred, but Boylan argued that theyshould be reported nine months later, whenthe expenses could then be matched tothe revenues they generate. His reasoningwas that it took this much time to developa site, and real estate expenses did notgenerate revenues until new stores wereopen. Boylan also convinced Sonneborn tocapitalize interest expenses on real estateloans during the construction of a store andamortize those costs over the 20-year life ofa franchise. Both of these techniques weredesigned to delay the reporting of expensesduring a time when McDonald’s was building units as quickly as new franchisees werefound to operate them. As a side benefit, thedelaying of expenses would help generatean income statement that reported earningswhen ordinarily there wouldn’t be any.Notes1.After the American Restaurant magazine article appeared, the brothers werebesieged with inquiries about their operation. Within two years the brothers sold15 franchises to their “Speedee System” fora one-time fee of 1,000 which includedthe store plans and a description of theirsystem. No further assistance or supportwas given.2.This was not the first place Ray Kroc triedto obtain a national franchise agreement.In 1949, on West Pico Boulevard in LosAngeles, Kroc made an offer to the owners of The Apple Pan, a restaurant knownfor their hickory flavored hamburgers,tuna salad sandwiches, and apple andpecan pies, but the owners turned himdown. Carl Karcher, founder of Carl’s Jr.,said that at one point Kroc had extendeda similar offer to him before he went intothe hamburger business when he owned afew hot dog stands and barbecues.3.To this day, McDonald’s does not holdan equity position in any of the suppliersit does business with. Aside from establishing the operating procedures individual franchisees are required to follow,McDonald’s Incorporated also establishesfor its suppliers the recipes for every itemof food they sell or use, and the specifications for quality. Even the recipe for thebrine used to cure cucumbers into pickleswas devised by McDonald’s.The Buy OutBy 1961 Kroc felt he was doing all the workof creating a hamburger chain and theMcDonald brothers had not contributedanything (except for devising the originalSpeedee System). Every time he needed tomake a format or procedural change, herequired their written permission, and theywere often lackadaisical in their responses.Finally Kroc called them and asked howmuch it would take to buy them out?The response nearly gave him a stroke,“We want 2.7 million, which would leaveus one million each after taxes.”Kroc swore, but he knew if he wantedcomplete control he had to capitulate. Atthe time there were 228 units with sales theyear before of 37.8 million. Of that thebrothers had received 0.5% (or 189,000)representing their royalty. A New Yorkmoney manager arranged a loan fromseveral college endowment and pensionfunds, along with a 1.5 million loan fromState Mutual, which accepted the risk inexchange for 20% of McDonald’s stock.Today, with system-wide sales of over 61billion, if both Ray Kroc and the McDonaldbrothers had been more flexible with theirfranchise agreement, the royalty paid to theMcDonald brothers (or their heirs) wouldbe 305 million!Steven Mark Adelson is a graduate of theUniversity of Maryland and the US ArmySchool of Logistics. He is now a freelancewriter and lecturer on research techniques.He gained first-hand knowledge of restaurant operations as a teenager by workingat Sam’s Grill, owned by his father, inWashington, DC. He is also an executivemember for the Society of SouthwesternAuthors located in Tucson, Arizona.www.MoAF.org Summer 2012 FINANCIAL HISTORY 19
world’s largest real estate developer and property management firm, you may be surprised by the answer: McDonald’s. Aside from being the largest purveyor of food in the world, the company controls the real estate in 33,000 restaurant loca-tions in 119 countries and territories. The McDonald Bro
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