Subs by design: the case of a family business in transition.(Instructor's Note)

Fuller, Barbara K.

CASE DESCRIPTION

This case focuses on the growth of a family-owned franchise from its inception in 1987 to 12 stores in 2008. The patriarch is now 70 years old and the succession planning for the business is just beginning. The background of the family and history of the company create a portrait of the current situation and provide the environment for making future decisions. The case first concentrates on the issue of growth by providing students with an opportunity to develop a profit and loss statement for a new store offered to the franchisee. All of the key figures available to the entrepreneur are provided allowing students to put themselves into the role of the decision-maker. Secondly the patriarch of the family, Ryan, is thinking about retirement. The case develops Ryan's personality as well as the characteristics and behaviors of his two children over the 20 years of the business. As the founder, Ryan must now decide what is best for the business as well as the family as he becomes less active and the business moves to the next generation. The case provides students with a unique perspective by extensively quoting Ryan and Greg Smith, the founder and his son, thus giving them insight into the thoughts of the individuals involved in the decision making. All of the events in the case are based on a true entrepreneurial experience, but the names have been disguised to provide privacy to the owner. The profit and loss statement uses actual figures and depicts the situation as it existed at the time the offer was made. The case has a difficulty level appropriate for junior to senior level undergraduate students. It is suitable for use near the end of an introductory course in entrepreneurship which is where small business growth is usually covered in entrepreneurial textbooks or in a separate entrepreneurship course that has more of an emphasis on growing the business and succession planning. Although not developed for a finance class, it could be use by emphasizing the purchase decision associated with the Rock Crest location. Depending on the emphasis at least some basic accounting background would be helpful. The case is designed to be taught in two class hours and is expected to required four hours of outside preparation by students. However, there is a lot of latitude provided to the instructor as to what direction to take the case.

CASE SYNOPSES

Ryan Smith, laid off from his position as plant manager for a textiles firm, begins a new career as the franchise owner of a group of sandwich shops doing business as Smith Enterprises. The case covers Ryan's startup of Subs by Design with the help of his family and the trials and tribulations of growing a family business. Startup financing came from some unique sources including from a fellow franchisee in a nearby territory. Early family support came from his daughter Bree who gave Ryan the confidence he needed to open the first two franchises. Bree and her husband, Brad, helped Ryan grow the business during it early days. Greg, Bree's younger brother, was not interested in the business, until an injury kept him from pursuing his first love, professional baseball. After the injury his father urged him to join the company. The case looks at the interaction among Ryan, Greg, and Brad as they continue to grow Smith Enterprises. The triangular relationship eventually results in Brad leaving to pursue a career in real estate.

After Brad and Bree's departure, the company continued to grow. Smith Enterprises is now looking forward to operating 12 stores which include two stores currently under construction. However, recently Ryan was presented with an interesting offer from the franchisor for a prospective store in a potential hot growth area. Ryan must make a decision on the offer within the next three weeks. If he doesn't accept the offer, the franchisor will offer the location to someone else. The case ends with Ryan who is now 70 looking at his retirement and planning for the succession of the business. He has to decide how to divide his estate and what to do with the business as it moves to a second generation of ownership.

INSTRUCTORS' NOTES

The specific teaching objectives

1. To explore the issues associated with family businesses that significantly alter the way businesses are organized and function in the marketplace. See references by Ang (1991) and McMahon & Davies (1994) for more information on how large and small firms operate differently because of special issues.

2. To identify the different stages of organizational growth and explain the nature of the transition to different stages as they relate to the Subs by Design.

3. To develop a profit and loss statement for the purpose of evaluating the feasibility of opening a franchise in a new location.

4. To evaluate various financial and legal strategies for passing a business on to the next generation.

Recommendations for Teaching Approaches

Teaching the case revolves around the growth of a family-based franchise business. Decisions about how large and how fast to grow a business are dependent on the capabilities and skill of the owner. Paramount to the overall success of the firm is the matching of company's capabilities with the opportunities presented over time. Subs by Design owner, Ryan Smith, in the past was concerned with only his capabilities, but now must consider the fact that he will soon be retiring and the next generations will be taking over the business. The opportunity presented by Subs by Design for a new store in Rock Crest Village is a focal point of the case. A typical question to open with is, "If you were Ryan Smith, what would your recommendation be in terms of growth for Smith Enterprises, should Ryan accept the proposal by Subs by Design for a new location in Rock Crest Village or turn down the offer allowing another franchisee to accept the offer?" Proponents of accepting the franchisor's proposal will cite the profit potential especially at the $10,000 net sales level, the ability to keep competition at bay, and accommodating the franchisors request to open an additional store in the territory. Those opposed will refer to the lack of profits at $7,000 net sales, the high level of competitions and lack of organizational structure. This will allow you to take the discussion to an analysis of the Weekly Profit and Loss Statement in appendix A of the case and in questions 1 and 2 in the instructor's note.

The case discussion can end by looking into the future of the business with students proposing and supporting different options for Ryan to retire from the business. Ryan has options to sell the business, to do an initial public offering, to bring in outside management, to offer an employee buyout, or to utilize a number of family succession planning options. The discussion should eventually get around to the fact that he has a son and daughter who have worked in the business and are interested in continued ownership in Smith Enterprises. However, there are issues associated with the division of stock in the company and management succession. Suggested questions to start the discussion include: How much ownership do Ryan's children expect in the business? When does Ryan plan to retire, and how much value does he need from the business to maintain him and Vicki during their retirement years? How involved should Ryan be in the business from now until his death? What financial and legal strategies should Ryan use for passing on his business to his children?

SUGGESTED ASSIGNMENT QUESTIONS

NOTE: An entrepreneur is a jack of all trades. Much like the entrepreneur, this case covers many decision areas that a business owner may face as the firm grows and is turned over to the next generation. The case had been constructed to give instructors multiple options. Students can be given the entire case to develop or the instructor can develop specific course or topic objectives and use only specific applications. The questions have been organized by content area to help instructors see the variety of directions available for class discussion.

Feasibility Analysis for a New Store Location: A Financial Focus

1. Develop a weekly profit and loss statement for the Rock Crest Village location based on the normal projection of $10,000 per week in sales? Based on your financial analysis would you recommend that Ryan open a Sub by Design store in Rock Crest Village or allow another franchisee to open a store in that location? Justify your answer.

2. If, because of the stiff competition in Rock Crest Village, the franchisee was only able to produce $7,000 in sales, how would this affect the profitability of this location? How would this affect your analysis and recommendation for opening a Subs by Design store at the Rock Crest Village location?

Based on his analysis of the weekly profit and loss statement outlined above, Ryan decided the costs were too high at the Rock Crest Village location. His gut told him that sales would be closer to $7,000 than $10,000. He tried to negotiate with the landlord for better terms, but could not strike a deal that he felt was reasonable. The profit and loss statement at $7,000 in net sales was not profitable. According to Ryan, the most important part of the profit and loss statement is the bottom line. Net profits need to be in the 10 to 20% range. To reach these numbers the rent cost should be around 6 to 7 % of net sales. Other issues that concerned Ryan were the stiff competition and the ability of the current organizational structure to handle additional stores.

The store was offered to another franchisee with the territory just north of Ryan's geographic area. The franchisee did open a store in the Rock Crest Village location. The store has now been open for over a year with sales of around $7,000 per week. Rock Crest Village has grown and become a very successful development. However, the competition for customers is quite aggressive and few retailers are making their perceived profit margins.

Business Management Issues

3. How has the leadership style of Subs-By-Design changes over the 20 years it has been in business? Relate the change in leadership style to the business growth cycle and be sure to discuss the differing management styles of father and son.

The type of leadership seen in an organization most often matches a firm's stage of growth. Research indicates that the most directive and autocratic styles are seen with firms that are in Stages 1 or Stage 2 of their development whereas a more nondirective leadership style such as consultative or participative are used in Stage 3. During the first two stages the business requires more nurturing environment and therefore a more directive style of leadership, such as the benevolent-autocratic style described in the case by Ryan. Ryan was responsible for all of the major decisions in the organization both strategic and operational. As the firm grows into a Stage 3 organization is becoming more professionalized and Greg's leadership style shows a more interactive and participative leadership style. He is beginning to give up some control, has delegated some tasks and is convinced that more middle management is need if the organization is to grow beyond its current size. There is additional information in the following question along with some references for additional reading if needed on the relationship of business growth cycles to leadership style.

Growth Challenges

4. What are the growth challenges Smith Enterprises faces as it moves from its current 10 store franchise base to what could be as many as 20 franchises in the next few years? Put together a time line that outlines your recommendations for growth and what that means to the management structure at Smith Enterprises.

A good source for looking at growth within companies is Eric Flamholtz and Yvonne Randle's book, Growing Pains: Transitioning from and Entrepreneurship to a Professionally Managed Company. Class discussion should focus on management systems needed for each stage of growth. First have students identify where Smith Enterprises fits into the stages of growth and then evaluate how effective the business has been at each stage and how it is poised to move into the next stage. Flamholtz and Randle (2007) identify four stages of growth from inception to maturity: Stage 1--New Venture, Stage 2-- Expansion, Stage 3--Professionalism, and Stage 4--Consolidation. Smith Enterprises is in the second stage of growth. Many of the issues of Stage 1 and startup were identified and resolved by the franchisor. The market niche and core products and services were already established. However, Smith Enterprises established it own operational systems. In the beginning, these systems were rather informal and totally run by Ryan. The company culture was established through Ryan's daily interactions with family and employees. He wanted things done quickly and liked to see things done his way. For Ryan the business was a source of personal pleasure which he expressed as "I love to get up in the morning and go to work." Ryan brought much to the business in terms of his past management experience and his keen eye for accounting and financial systems. Although he had worked for corporations all of his life, in the back of his mind he had always thought about owning his own business. He overcame his fear when faced with a career obstacle at the age of 50. The rights Ryan purchased from the franchisor made the transition into business ownership much easier than a normal startup. However, as Ryan moves into Stage 2 of the growth process, he will increasingly need to rely on his own capabilities and experiences, as well as Greg's leadership strengths. The business has grown slowly, but deliberately.

As Smith Enterprises moves into Stage 2 the management systems are still relatively informal. Store level management is in place and consists of people inside and outside of the family, but no regional or middle management structure had been developed to allow the company to grow much beyond its current level. Greg does mention that a couple of store managers may be at the Stage where they are ready to take on more responsibility at the regional level. However, no operational systems have been established at the corporate level to accommodate this growth.

Issues that may complicate the picture are the role Bree and Brad may play in the business upon the death of Ryan. Also decisions made by Ryan and Greg as to how large they want the business to become in the future may greatly influence which systems should be put into place. Ryan indicated that Greg can handle 10 stores as easily as he handled four, but what about 20 stores. Ryan contends that now that they have the format in place they can manage 100 stores just as easily as 10. But is this really true? Do they really have the structure in place to move to Stage 3? What management systems would need to be developed to move to the next Stage? How would Greg's rather laid back management style fit with the growth of the more formalized systems and controls required as the business grows? When there is change in one dimension or element of a business, it affects the alignment of other elements of the organization. As a company grows, the management structure demands that new task be accomplished and often with new and different people. The entrepreneur is pressured to manage in a different way, usually outside his comfort zone. In fact, many entrepreneurs choose to operate lifestyle businesses that provide just enough salary and size without adding the risk and complexity required by larger companies. Flexibility and control are often traded off for size and maximization of wealth. Which direction will Smith Enterprise take? Growth decisions will depend on Greg's ability to transition to a more structured hierarchical managerial style and his comfort level. Greg talks about his 40 birthday in 6 years, and tends to see this as a major juncture in his life. Where will Smith Enterprises be in 6 years?

Ryan's Retirement and Succession Management

5. How would you access the triangular relationship between Greg, Bree and Brad that eventually results in Brad leaving to pursue a career in real estate? What is the significant of Ryan's gift to Bree and Brad when they leave the business? Was he too generous or not generous enough? Should this gift affect Ryan's will in any way? If so, how? Discuss the reasoning behind your answer.

First hires in a family-owned business usually include members of the extended family which we see in this case. Early on Ryan relies heavy on the support of his family, especially Bree. She provides him with encouragement and works diligently during startup and for the first ten years of the business. In addition she brings her husband into the business to work with her father. Since he comes in from outside the family, this would be a good place to talk about how outsiders fit into the family structure. How are they treated and what types of issues arise when outsiders are included in the operations of a family business.

Most of the literature indicates that much of the culture of the family crosses over into the operation of the business, and therefore, the behavior of individuals across these two boundaries is often very similar. If fathers are strict with their children at home they will continue that strict behavior in the work environment. If that strictness is felt by the children it is multiplied by those outside the family such as son-in-laws.

The gift to Bree and Brad was to thank Bree and Brad for the more than ten years they had worked for the company. At the time they received the two stores, Smith Enterprise had opened 10 stores, and these two stores were worth $1.2 million. Ryan gave them the stores so Brad would have time to get his real estate business started. Ryan admitted that he had allowed Brad and Greg to compete for the presidency of Smith Enterprises. Ryan's comments on the competition he encouraged between Brad and Greg.

Ryan: "On the one hand it was hard, I let Brad and Greg compete, but on the other side when Brad decided to leave I gave him and Bree the two stores so they would have income while establishing their new venture. Bree and Brad helped me build the business when the Subs by Design franchise was new and unknown. In the past two years, Brad has become very successful in the real estate business and is moving on with his new career."

Ryan is aware that although his tactics allowed the strongest leader to take over Smith Enterprises, it also created some tension among family members. Bree and Greg get along as most sisters and brothers, but there are still tense moments when discussing certain subjects. Greg feels like the person in the middle and although he has proved himself as a talented leader with a good business sense, he would prefer to have a better relationship with his sister and Brad. At this point in time Ryan's "Will" is still in process however; most likely the assets of Smith Enterprise will go to Greg with the rest of the family assets going to Bree. Other family assets are well over a million dollars.

This is a good place to talk with students about the fair versus equal distribution of assets. Pushing family members back together in a business after the tension caused in earlier times does not see appropriate. However, giving the business to Greg does create some inequity in the distribution of family assets. Students can debate various options available to Ryan as to the division of his estate. Most students will favor equal distribution of assets. They need to list the pro and cons of such a decision as it relates to the future of the business.

6. How should Ryan plan for his retirement? What are the options available to Ryan in harvesting or managing the succession of his business? Which option would be the best based on the information you have from the case? Justify your answer. Should Ryan get a business valuation? Why or why not? What other professional help does he need in planning his retirement from the business?

Ryan can choose among many options available to founders who are ready to retire. He has options to sell the business, to do an initial public offering, to bring in outside management, to offer an employee buyout, or to utilize a number of family succession planning options. Since his children have been involved in the operation of the business his best option would be to develop a family succession plan. However, with family issues that have evolved through the growth process, Ryan has some serious decision to make to assure that his children are treated fairly and the business is given the best chance of survival.

Succession planning is quite complicated. Many legal and tax issues are associated the process. First Ryan will need to look at what type of help or expertise he will need in developing his succession plan. This may include several professional advisors. The IRS for tax purposes will want a valuation for the business. An estate-planning lawyer will be needed to help with deciding which method is best for Ryan to use for the stock transfer and how management succession will occur in the business. He can make recommendations and create the formal documents. Together with his financial advisor and accountant Ryan can make decision that will most closely match his values and comfort level. There are many succession options available and each have financial, tax, and control issues associated with them. First the IRS allows individuals to pass $1 million in tax free gifts, plus $12,000 a year. A second option, a family limited partnership allows owners to transfer up to 99 percent of a business while retaining control. Other options self-canceling installment notes and private annuities allows the younger generation to pay the older one a series of payments plus interest for a set period of time or until the owner's death in the case of the self-canceling note or for the seller's lifetime in the case of the private annuity. With a grantor-retained annuity trust ownership is transferred to an irrevocable trust which the owner can access for a specified period of time after which the equity is transferred to the heirs. An intentionally defective grantor trust allows one to sell the business to a trust in your family's name in return for a long-term installment note. Ryan has started the gifting process and is looking at a family limited partnership.

EPILOGUE

Rock Crest Village Site:

Ryans gut feeling was right. The new location in Rock Crest produced less than $7000 in sales volume after it opened. The current owner is currently looking for a buyer. Ryan may be interested if he is able to negotiate a lower cost structure with the landlord.

Succession Issues:

Ryan is in the process of working with his CPA, estate attorney, and business appraiser to develop his will. At the time of this writing, most of the decisions about the division of his estate have been decided. The business in its entirety will be passes on to Greg who has gradually been taking over the leadership role in the company. Most of the rest of his property, which is a sizable estate, will go to Bree.

REFERENCES

Ang, J.S. (1991). Small business uniqueness and the theory of financial management. The Journal of Small Business Finance, 1(1), 1-13.

Bowman-Upton, N. (1991). Transferring management in the family-owned business. U.S. Small Business Administration Emerging Business Series. Retrieved June 10, 2008 from http://www.sba.gov/idc/groups/public/documents/ sba_homepage/serv_sbp_exit.pdf

Clifford, S. (August 2007). Splitting Heirs, Inc. Magazine, 29, (8), 102-110.

Family Business Institute (2008). Succession Planning. Retrieved June 10, 2008 from www.familybusinessinstitute.com.

Family Firm Institute (2007). Resources for Family Business Advisors and Educators. Retrieved June 10, 2008 from www.ffi.org.

Flamholtz, E. C. & Y. Randle (2007). Growing pains transitioning from an entrepreneurship to a professionally managed firm. San Francisco: Jossey Bass by John Willey & Sons.

Karatko, D. & H. Welch (2004). Strategic entrepreneurial growth, (2nd Edition). Mason, Ohio: Thomson South Western.

McMahon, R., & L. G. Davies (1994). Financial reporting and analysis practices in small enterprise association with growth rate and financial performance. Journal of Small Business Management, 32(1), 9-17.

Barbara K. Fuller, Winthrop University Appendix 1 Rock Crest Village Weekly Proforma Profit & Loss Statement Comparison of Sales Volume at $10,000 and $7,000 $ % $ Net Sales $10,000 -Cost of Goods $3,100.00 31.00% $2,170.00 = Gross Margin $6,900.00 69.00% $4,830.000 Expenses Fixed expenses do not change based on volume of business -Gas $5.00 (1) 0.05% $5.00 -Electric $175.00 (1) 1.75% $175.00 -Telephone $15.00 (1) 0.15% $15.00 -Garbage $25.00 (1) 0.25% $25.00 -Insurance Coverage $40.00 (1) 0.40% $40.00 -Labor-Taxes $2,200.00 (1) 22.00% $2,200.00 -Repair/Maintenance $80.00 (1) 0.80% $80.00 -Miscellaneous $80.00 (1) 0.80% $80.00 -Rent and other contractual $902.00 (2) 9.02% $902.00 costs associated with lease -Royalty $800.00 8.00% $560.00 -Advertising $450.00 4.50% $315.00 =Total Operating Expenses $4772.00 47.72% $4397.00 -Loans/Administration $500.00 5% $500.00 Net Profit/Loss $1628.00 16.28% -$67.00 Comments Net Sales $7,000.00 -Cost of Goods $7,000*31% = Gross Margin Net Sales--CoGS Expenses Fixed expenses do not change based on volume of business -Gas fixed expense -Electric fixed expense -Telephone fixed expense -Garbage fixed expense -Insurance Coverage fixed expense -Labor-Taxes fixed expense -Repair/Maintenance fixed expense -Miscellaneous fixed expense -Rent and other contractual fixed expense costs associated with lease -Royalty $7,000*8% -Advertising $7,000*4.5% =Total Operating Expenses Gross Margin-Expenses -Loans/Administration Net Profit/Loss GM-Total Exp.-Loan Notes: Based on recommendations in the case from Ryan's past experience. (1) Cost of goods sold and expenses are each taken as a percentage of net sales (2) Rent includes other contractual costs as outlined at the bottom of the lease agreement: Initial Minimum Guaranteed Rental ($3700/month) + Initial Common Area Maintenance Charge ($125/month) + Initial Insurance Escrow Payment ($18.75/month) + Initial Tax Escrow Payment ($62.50/month) = Monthly Payment Total ($3906.25/month). $3906.25 (rent and other contractual costs associated with the lease/month)* 12 months = $46,875.00/year. $46,875.00/year divided by 52 weeks = $901.44/week rounded to $902.00