Ray Kroc, Not the Founder, but a Financial Engineer
The 52-year-old paper cup and multi-mixer peddler suffering from diabetes and arthritis made it all happen once he discovered the high-volume McDonald’s hamburger stand in San Bernadino, CA in 1954.
That Ray Kroc would go on to build the largest restaurant chain in the world and employ hundreds of thousands of people and make millions of dollars for his suppliers, franchisees and himself, is a secondary theme in the recent movie, “The Founder,” starring Michael Keaton as Kroc.
According to the movie, Kroc was one hellava boozer and a rogue franchise salesman who passed himself off as the chain’s founder and cheated the McDonald brothers out of their fortune. An unappealing portrait of Kroc, no doubt, but keep in mind Hollywood’s penchant for mangling the truth. In a world of alternative facts, checking the evidence is in order:
Dick and Maurice (Mac) McDonald’s “hamburger bar” opened in 1948 complete with the golden arches, but it wasn’t until 1952 that they began to attract franchisees. That year, American Restaurant Magazine highlighted the unique McDonald’s “Speedee Service System” that spurred 10 franchisees, two in Arizona and eight in California.
In 1954 Kroc visited the McDonald brothers to see firsthand what the hubbub was all about. His intention was more multimixer sales, but the sight of huge crowds standing in line for $.15 hamburgers, $.20 shakes and $.10 french fries unleashed his entrepreneurial euphoria.
“When I saw it working that day in 1954, I felt like some latter-day Newton who’d just had an Idaho potato caromed off his skull,” wrote Kroc in his 1977 autobiography, "Grinding it Out—The Making of McDonald’s."
Kroc believed McDonald’s could be expanded throughout the country, and he wanted to do it. Impressed with his enthusiasm and sales experience, and mired in their own frustration in dealing with franchisees, Dick and Mac negotiated a 10-year deal with Kroc that gave him the right to open and franchise their restaurants throughout the U.S. Kroc would receive a $950 franchise fee and 1.9% of the each restaurant’s revenues, of which he would remit .5% to the brothers. The contract stipulated Kroc could not deviate from the McDonald’s Speedee system unless both brothers approved of the changes in writing. Kroc’s first restaurant, which he opened as a franchisee in 1955, was near his hometown in Chicago.
Kroc had no trouble selling new franchises to friends and relatives. He started with his golfing pals at the Rolling Green Country Club near Chicago and then moved on to others with, as he put it, “common sense, dedication to principles and a love of hard work.”
However, according to Kroc, the master franchise agreement he worked out with Dick and Mac was so favorable to the brothers and the franchisees, he found it tough to make money for himself. That’s because Kroc bore the cost of training and hiring field consultants to keep the franchisees in line.
Enter Harry Sonneborn, Kroc’s first CFO and a former Tastee Freeze executive. Sonneborn devised the famous McDonald’s real estate strategy whereby the company would control the restaurant real estate and collect rent from its franchisees. “You’re not in the burger business, you’re in the real estate business,” said the movie version of Harry Sonneborn to the movie version of Ray Kroc.
In 1957, Franchise Realty Corporation was born. Kroc and Sonneborn would locate a site, purchase it on a 10-year contract for deed, and get the landowner to subordinate his interest to a building loan. They’d obtain a loan from a bank to finance the building for the franchisee, then lease it to them at a 40% markup over the combined payments. Percentage rent would kick in at 5% of sales over a certain base. If a franchisee owned the land already, they’d make him lease it to them and they would sub-lease it back. This part of the story never made it to the big screen—too complicated for the superhero crowd.
“This was the beginning of real income for McDonald’s. It appealed to my salesman’s instinct, because obviously it would make the rights to operate a McDonald’s restaurant far more valuable to a potential operator than if we were franchising a name only,” wrote Kroc in his autobiography.
Real estate became the difference-maker in finding lenders for the fledgling chain. Kroc found he was frequently rejected by large Chicago banks, but had more luck finding local ones to make loans. Sonneborn would tell skeptical bankers the company was really in the real estate business, not the shaky restaurant industry.
By 1959, Kroc had opened more than 100 restaurants and the system was attracting many new franchisee candidates. And, by August 1960 there were close to 200 restaurants. Financing restaurants on a one-by-one basis was time consuming, so Sonneborn set out to tap a large financial institution for mortgage money. He completed the first institutional restaurant financing in 1960 when he obtained a $260,000, 6% mortgage from All-American Life & Casualty. The financing would build six stores.
By 1961, Kroc wanted to open company stores and that required even more capital. Sonneborn obtained a $1.5 million unsecured, 15-year, 7% loan from three insurance companies—State Mutual Life Insurance, Paul Revere Life Insurance and Massachusetts Protective Association. The kicker? Yep, they gave up 22.5% of the equity. Imagine what that slice would be worth today?
“It took a lot more financial thrust to put us into orbit, but we would never have gotten off the ground without it,” wrote Kroc.
Kroc Buys Out the McDonald Brothers
The relationship between Kroc and the McDonald brothers deteriorated over time, especially as the number of stores grew. There were many conflict points. Kroc felt the original McDonald’s stores franchised by the brothers were poorly run and selling unapproved products such as pizza and burritos. Then there were the contract terms which forced Kroc to request any deviation in operations in writing. That got the often-volatile Kroc really revved up. Often, he claimed his changes were rejected simply because both Dick and Mac were headstrong.
“I was obsessed with the idea of making McDonald’s the biggest and the best. The McDonald brothers were simply not on my wavelength at all. They didn’t want to be bothered with more risks and more demands,” wrote Kroc.
In 1961, a Chicago paper supplier that supplied them both told Kroc the brothers could be persuaded to sell. Dick and Mac had also grown tired of the constant wrangling with Kroc and disliked dealing with their own franchisees. Mac’s declining health was also an issue. And, the brothers were toying with the idea of developing a chain of budget motels.
In his autobiography, Kroc said as agitation grew between he and the brothers, he finally asked Dick to name his price—and $2.7 million was the answer. That, Dick explained to Kroc, would provide both brothers with $1 million each after taxes.
In the movie version, Dick tells Kroc he wants $2.7 million plus an additional 1% of the company’s future profits into perpetuity. “That’s outrageous!” Kroc screams. However, during a meeting with the brothers to go over the terms, Kroc’s lawyer insists the terms are acceptable, but that Kroc wants Dick’s 1% request to be kept out of the contract. A handshake deal would suffice on that point. Kroc deftly explains to the brothers his new investor group wants it left out, but he’ll honor it. Mac frowns as if he knows he’s about to be screwed, but the brothers reluctantly agree and shake hands with Kroc.
Kroc never mentions the 1% profit percentage in his autobiography, nor does it come up in other books written about McDonald’s. Yet, the movie implies Kroc cheated the brothers out of their profit percentage that today would be worth over $100 million per year.
The source for the profit percentage into perpetuity claim probably comes from Dick McDonald’s nephew, Ronald McDonald (yes, his real name). McDonald wrote in his 1995 book, "The Complete Hamburger," that based on discussions with his uncle Dick, Kroc’s role was merely that of a “franchise agent” and his exclusive contract to sell McDonald’s franchises was about to expire.
In the book, Ronald McDonald never says Kroc actually cheated his uncles, but insinuates something shady happened:
“Why have they never questioned how Kroc, from Chicago, could have induced these savvy businessmen to sell their growing chain for less than 1 times annual earnings?”
“Why was Kroc allowed to renege on paying them the agreed .05% of gross income as a royalty?” wrote Ronald.
At the time of the sale, Kroc was paying the brothers roughly $200,000 in annual royalties, plus the San Bernadino store was quite profitable. Kroc’s payment of $2.7 million was roughly 13.5x the royalties, a princely sum for a private company in 1961. And, real money in those days.
There are a number of other factors that suggest the 1% profit claim made by the movie producers is fictitious: Kroc’s sole reason for buying out the brothers was to be rid of them for good. “I wanted to be free of their hold on me,” he wrote in his autobiography. Thus, an ongoing obligation to pay the McDonald brothers into the future seems unlikely. Neither is there a mention of the profit percentage in any books written about Ray Kroc or McDonald’s Corporation, including Kroc’s autobiography.
Donn R. Wilson, an early McDonald’s employee who began working for the company in 1961, told me he met with Dick and Mac McDonald a few years after the transaction, as he was tasked with documenting the history of the concept at the time. He told me he never heard of anything owed to them.
Furthermore, Dick and Mac McDonald never publicly made a claim for the profit percentage outlined in the movie. Kroc wrote in his book the only dispute that arose at the closing had to do with the McDonald brothers reneging on their agreement to include the original San Bernadino store in the sale. “What a goddamn rotten trick! I needed the income from that store,” wrote Kroc.
Writing the forward to Ronald McDonald’s book, Dick McDonald was sanguine about selling out to Kroc. “So, were we sorry we sold when we did? No, not at all! And I don’t believe that anyone then could have imagined that the name McDonald would become the most recognized trademark in the world,” wrote Dick McDonald.
The sore spot between the McDonald brothers, their nephew and other family members, I believe, was this: Once the McDonald brothers cashed out, both Kroc and the McDonald’s Corporation began calling Kroc the founder of McDonald’s, an irritant to the McDonald family.
In the movie, the brothers clearly are peeved Kroc is referred to as the founder. But again, the movie takes creative license. In a letter Dick McDonald wrote to a retired fast food executive, Tom Dolly, he said the founder discussion never came up until after Kroc bought the brand from the brothers.
“During the years from the time we first met Ray Kroc in 1954 and hired him in 1955 to be our franchise agent, there was never any mention over the years that Ray was founder of McDonald's. However, after we sold to Ray and his associates, he was elevated to be the founder,” wrote McDonald.
The Rest Is History
Founder or not, in 1965 in a go-go stock market, McDonald’s, with over 500 stores, went public through Paine Webber at a price of $22.50. That was valued at 17x the previous year’s earnings. On the first day of trading, McDonald’s stock was $30. By the end of the month it was $50, making Kroc and Sonneborn rich. If you had bought 100 shares of McDonald’s stock on the IPO at $22.50 per share in 1965, today it would be worth roughly $9.3 million.
After the IPO, Kroc wanted to continue the chain’s rapid growth, while Sonneborn became more conservative. Kroc proposed a 10-year plan to have 5,000 McDonald’s stores by 1977, whereas Sonneborn’s cash flow plan included 2,000 less stores. Sonneborn felt the company should only open restaurants it could finance out of cash flow.
Kroc wanted McDonald’s to begin acquiring franchisee stores for more cash flow. Sonneborn thought it was too risky to buy out the franchisees and felt the company could eventually take over the stores once the franchise agreement expired because they owned the real estate. (Hey, franchising was the Wild West in those days.) He placed a moratorium on development activities in order to conserve cash and ride out the recession.
“The halt created tremendous problems within the company,” remembers Wilson.
When Kroc heard Sonneborn stopped the development pipeline, he became extremely angry. The two stopped speaking to each other except through intermediaries. Sonneborn initially had the approval of McDonald’s board of directors, but it was Kroc who finally asserted his authority and resumed the aggressive development program. Sonneborn eventually resigned.
After Kroc retired, he praised Sonneborn for the real estate strategy. When he spoke to business groups of his decision to push growth and take risks despite the economic climate and the perilous condition of McDonald’s balance sheet, he said: “If you’re not a risk taker, you should get the hell out of business.”
"The Founder" is an entertaining movie if you’re involved in the restaurant business. Go see it. Michael Keaton is quite good as Ray Kroc. Nick Offerman, who played Ron Swanson in the TV show "Parks and Recreation," plays Dick McDonald.
There are parts of the movie that are accurate: The real Ray Kroc had a volatile temper and never saw a bottle of Early Times whiskey he didn’t crave. So what. Many of us can also point to restaurant founders we’ve known or people we’ve worked for who have similar characteristics as Kroc—loud, in-your-face personalities and drank too much.
If you think of the strength of McDonald’s over all these years, the early financial engineering and real estate ownership made the company what it is today. The real estate, more than anything else, has allowed McDonald’s to withstand the ups and downs of this crazy restaurant business.
Perhaps, if the story was taking place now, Michael Keaton would play an activist shareholder who got rich refranchising stores and unloading real estate ... instead of someone who actually built a great company.
—John Hamburger (yes, that’s my real name)
Some material from this article appeared in the Monitor in 1999. It came from conversations I had with early employees of McDonald’s Corporation including Richard Boylan, the first controller of McDonald’s, and Donn R. Wilson, who was affiliated with McDonald’s from 1957 to 1979 as an employee and later as a franchisee. Wilson reported directly to Sonneborn and eventually became head of McDonald’s in Australia. I spoke with Donn again last week. He attended many of our conferences over the years and is retired now, living in Idaho. He sends his regards.