Scaling a servicebased business

From: alexhormozi

This article explores the only four ways to package a service, labor, and knowledge into a profitable business, focusing on how to grow and increase enterprise value. It’s especially relevant for businesses with a profitable single-location model looking for the best path to maximize earnings [00:00:00]. These methods offer different advantages regarding cash flow, profit margins, operational drag, and enterprise value [00:00:55].

The Four Vehicles for Scaling

There are four primary models for scaling a service-based business:

1. Privately Held Chain [00:01:15]
2. Franchise [00:02:05]
3. Licensing Model [00:02:56]
4. Software / Tech-Enabled Service [00:04:07]

1. Privately Held Chain

A privately held chain involves opening multiple locations (e.g., a second, third, etc.) while retaining all ownership rights, taking all the risk, fronting all the capital, hiring all the labor, and controlling the brand [00:01:22].

Pros and Cons

• Cons: Highest costs for opening each new location due to build-out, lease negotiation, and staffing [00:05:05]. Risk is borne by the owner [00:01:44]. Inconsistency of service can be a problem if the service requires highly specialized skills, making it difficult to scale [00:06:41].
• Pros: You own everything end-to-end [00:01:49]. Provides very good enterprise value (EV) [00:08:50].
• When to Consider:
  • Low Build-Out Costs: If a new location costs less than $40,000-$50,000, or less than six months’ worth of profit generated in the first year [00:05:31].
  • High Profit Margins: For example, businesses like Insomnia Cookies have tiny locations and high profit margins from selling simple products, making it worthwhile to own everything [00:05:57].
  • Low Service Requirements: The more a service can be “productized” to minimize variability and decrease the skill requirements of the labor, the more scalable a private chain becomes [00:07:14].

Speaker's Experience

One of the speaker’s businesses, which was initially a licensing model, was transitioned to a private chain because the licensees were making substantial money with the system and new locations cost very little to open. This transition led to growth from $500,000/yearto$12 million/year in 14 months [00:07:27].

2. Franchise

A franchise involves licensing out a proven single business model to investors who buy into it, such as Subway or McDonald’s [00:02:05]. Investors are attracted by the theory of lower risk compared to starting a new business [00:02:23].

Pros and Cons

• Cons: Very litigious and expensive to start (around $750,000 for setup fees, legal, and filings) [00:08:02]. It’s a slow model; most franchises don’t see profits for one to two years, as upfront fees often only cover acquisition costs [00:08:21]. Profits are made from royalties on top-line revenue once locations are open [00:08:44]. A franchise usually needs 100+ locations to make significant money, but 90-95% of franchises never reach this threshold [00:09:51].
• Pros: Offers extremely high enterprise value (EV) [00:08:50]. It allows you to shift significant capital risk to other people by “crowdsourcing” the ownership of new locations [00:09:32].
• When to Consider: When new locations have very high build-out costs, like McDonald’s (which can cost around $1 million to open) [00:09:20].

Franchise Definition

A franchise has three components: name, business systems, and fee [00:03:09]. If all three are present, and people are using your brand, systems, and paying a fee, you are operating a franchise [00:03:14]. Operating as a license while having all three components is illegal [00:03:20].

3. Licensing Model

A licensing model typically involves two out of the three franchise components (name, business systems, fee). For example, CrossFit licenses its name and has a fee but doesn’t mandate business systems [00:03:36]. Another example is a white-labeled model where you license business systems and charge a fee, but without a specific brand name [00:03:47]. This is a way to package existing knowledge or intellectual property (IP) for rapid scaling to multiple locations [00:04:00].

Pros and Cons

• Cons: Not very defensible and offers very little enterprise value (low multiples on sale) unless there’s an extremely sticky licensing agreement, ideally with 80%+ yearly retention for licensees [00:10:41].
• Pros: Lowest cost to start (almost no cost) [00:10:27]. Super high margins and can generate cash flow from day one [00:11:11]. Allows for immense speed to outpace competitors in the market [00:13:25].
• When to Consider: When capital is limited and generating cash flow sooner is a priority [00:11:26]. Also suitable if the intellectual property (IP) is not highly protectable, such as an offer-based business that is easy to copy [00:13:12].

Speaker's Experience

The speaker’s first business, Gym Launch, was a licensing business because they didn’t have substantial initial capital and wanted to generate cash flow quickly [00:11:20].

4. Software / Tech-Enabled Service

This model applies if the service can be partially or entirely replaced by software [00:04:17]. For most service-based businesses, this will not be the primary scaling strategy [00:04:30].

Pros and Cons

• Cons: Requires a significant upfront cost to build and a lot of time [00:11:50]. Initially has very low cash flow [00:11:53]. Requires a co-founder with software development, user experience, and engineering team building expertise; outsourcing development usually fails [00:04:34]. If yearly customer retention is below 80%, it will not be considered true software and will lose its high valuation [00:12:10].
• Pros: Generally has the highest enterprise value on exit, but only if the strict retention requirements (80% or higher yearly retention) are met [00:11:55].

Choosing the Right Vehicle

When considering how to scale a service-based business, it’s crucial to evaluate which of these four approaches best fits your specific situation [00:12:21]. Factors to consider include:

• The nature of your intellectual property (IP) and the value you provide [00:12:41].
• Your required cash flow [00:12:46].
• The amount of upfront investment you’re willing or able to make [00:12:47].
• The time frame for growth [00:12:49].
• Your appetite for risk [00:12:51].
• The structural soundness and reliability of the model’s return [00:12:54].

For instance, if you are certain of success in a new market and the cost to open is low, a privately held chain makes sense [00:12:57]. If you know you’ll be successful but the cost per location is high, franchising might be better [00:13:05]. For non-protectable IP, licensing offers speed and high cash flow throughout the process, though it sacrifices a large lump sum at exit [00:13:11]. Conversely, software development involves significant upfront investment and low initial cash flow but promises a high exit valuation if it achieves high customer retention [00:13:41].