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« Good Deal, Bad Deal
Good Deal: Ray Kroc's agreement to franchise McDonald's (1955)
The real financial genius behind McDonald's displayed itself after McDonald's got its franchise system off the ground.
What Went Right: In 1954, in a story that is now part of business legend, 52-year-old salesman Ray Kroc went to San Bernardino, California, to pay a sales call. Kroc, a lifelong salesman and entrepreneur who had achieved, at most, modest success, was selling Prince Castle Multimixer machines at the time, which had the capacity to make five milk shakes at once. When a restaurant in San Bernadino ordered eight, Kroc traveled from Illinois to find out what kind of business would need to mix 40 milk shakes at once. There, he met the McDonald brother and saw their hamburger stand in action. At their small, spotlessly clean shop, with a limited menu, low prices, and lines around the block, Kroc saw his future. The brothers were reluctant to expand. They had sold franchises and received little in return. 
Kroc, desperate, made them an offer too good to refuse: The McDonalds would have to put up no money for the expansion; all expenses would come from Kroc's end. Kroc would sell franchises for only $950 per store, and would receive less than 2 percent of total sales. of this amount, the McDonald brothers would receive 30 percent. They reluctantly agreed, and a very wary agreement ensued.
According to legend, that's practically the end of the story. Popular accounts focus on Kroc's single-minded drive, his control of all aspects of the operation, and his near-religious fanaticism, all of which contributed to McDonald's becoming one of the world's most well-known brand names, with 25,000 locations worldwide, $30 billion in annual sales, and a market value of more than $40 billion. How Kroc built the business, from the initial agreement with the McDonald brothers, to its level of success when he stepped down as CEO in 1968, when he died in 1984, to the present day, is the story of superb deal making and managerial skill. All Kroc had really succeeded in doing, by that time was to create the foundation for a high-profile business failure. Because of the franchise agreement with the McDonald brothers, the company earned only $159,000 in 1960. Further, the master franchise agreement he struck with the brothers in 1955 was a legal nightmare, which Kroc would remedy only by repeatedly violating it, jeopardizing the future financing and his position with the company. (As much as Kroc sought to create uniform operations, he had developed modifications from the San Bernardino store, which he was prohibited from doing under the agreement. He was also prohibited from becoming a franchisee, which he needed to do to build a prototype store in Des Plaines, Illinois in 1955.) Two brilliant moves put his company on firm footing. First, at the suggestion of Kroc's first financial officer, Harry Sonneborn, McDonald's entered the real estate business, first leasing and later buying the properties on which the franchisees would operate. This was consistent with Kroc's goals of control (allowing franchisees a sweet deal in the franchise agreement but imposing operating conditions in the rental agreement and entrepreneurship (the types of people Kroc sought as franchisees did not have the wherewithal to purchase the land themselves). It produced huge profits because McDonald's set the base rent by marking up its carrying costs on the properties by up to 40 percent, and included a computation of rent based on a percentage of sales, when sales reached a certain level. McDonald's also required that franchisees post a security deposit, which the company used as capital to buy real estate. Later Sonneborn would tell stock analysts that "McDonald's is a real estate company, not a fast-food company." Shortly before Kroc's death, he credited Sonneborn with saving the company, saying, "Harry alone put in the policy that salvaged this company and made it a big-leaguer. His idea is what really made McDonald's rich." Second, Kroc stretched his resources and bought out the McDonald's brothers. He never got along with them, eventually concluding that they were not meeting the standards he was imposting on the other franchisees, and learning that there were selling franchises in Kroc's home territory. Most important, he had to get out from under the legal cloud of the master franchise agreement with the brothers. The McDonald brothers insisted on $2.7 million, in cash, nonnegotiable. For a company that earned less than $200,00, that was a lot of money. Kroc realized, however, that the business was expanding and he was getting a bargain by saving the future royalties. In 1961, Sonneborn arranged a loan of $2.7 million from several college endowments and pension funds. The money manager, John Bristol, had not head of McDonald's but was impressed by McDonald's plans to profit from its real estate investments. Although Sonneborn was able to prevent Bristol from getting equity in McDonald's as part of ht deal - McDonald's was far to risky an investment to get a straight loan - Sonneborn and Bristol engineered a repayment term and bonus payments based on McDonald's profitability. These moves provided the foundation for McDonald's rapid and profitable expansion during the 1960s. Kroc also developed a unique relationship with franchisees, insisting on uniformity in service and basic menu, but at the same time, encouraging innovation. Ronald McDonald, the Big Mac, and the Egg McMuffin are all ideas originally developed by individual franchisees. (The original Ronald McDonald was then-25-year-old Willard Scott.) When Ray Kroc died in 1984, he was one of the wealthiest men in the united States, and the international expansion of McDonald's was well underway. He also unleashed his pent-up frustrations on the McDonald brothers. Immediately after closing the deal to buy them out in 1961, he built a McDonald's one block from their San Bernardino store, which they renamed Big M. Big M's business faltered, their store was finally sold in 1968, and the next owner went out of business in 1970. Michael Craig 5/1/07
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