Dahlberg Inc. wasn't exactly floundering in 1981, but it certainly wasn't flourishing, either. While sales of its hearing aids were up to $12.1 million from $9.3 million the year before, its net profit of $760,000 in 1980 had vanished.In its place was $644,000 worth of red ink. The company was headed in the wrong direction, for reasons that weren't readily apparent to Dahlberg's top managers. "It was frustrating because we knew the market had more potential," recalls K. Jeffrey Dahlberg, the 32-year-old president and son of founder Kenneth H. Dahlberg.

One possible explanation was inadequate distribution. At the time, the company's products were carried by only 2,000 of the nation's 7,000 hearing aid dealers. The logical solution was for Dahlberg's sales representatives to get the products into more stores.

But, five years later, most of the sales reps are gone, and there are fewer independent dealers carrying Dahlberg products than ever. Instead, the Golden Valley, Minn., company sells most of its hearing aids through 242 franchised Miracle-Ear Centers -- stores owned and operated by erstwhile independent dealers who have taken down their own signs to become Dahlberg franchisees. Earnings, meanwhile, have soared to $906,000 on sales of $31.1 million in 1985.

The technique is called "conversion franchising," and Dahlberg is one of a growing number of companies using it to solve their distribution and marketing problems. Others included Curtis Mathes Corp., the Dallas-based consumer-electronics firm; Four Seasons Solar Products Corp., a Farmingdale, N.Y., manufacturer of greenhouses and solariums; and Parson-Biship National Collections Inc., in Cincinnati.

It is an innovative strategy, based on a technique that's been around for years -- ever since the 1970s, when Century 21 Real Estate Corp. emerged as a national powerhouse by convincing independent real estate brokers to become its franchisees. Subsequently, the concept has been applied in many other service industries, ranging from accounting to insurance to home repair. These "traditional" conversion franchise operations are companies built, in effect, around existing channels of distribution. Only recently have companies, particularly manufacturers, turned the concept on its head -- using conversion franchising to build captive channels of distribution.

For Dahlberg and others, the technique has worked well, in part because it forces the companies to adopt a more disciplined approach to marketing, sales, and distribution. Under the old system, says Jeff Dahlberg, the company focused on adding more dealers to its network, rather than supporting the dealers it already had.It shied away from providing dealer-training programs and computer support systems for fear that they would be used to sell competitors' products as well. Furthermore, with 2,000 dealers, the cost of such programs was prohibitive. Now the company has 133 franchisees, which carry no competing products. That allows Dahlberg to concentrate on supporting its franchisees, rather than just adding new accounts.

"It comes down to marketing," says Dahlberg. "We couldn't effectively market our products before; we could only sell them. With franchising, we don't have to worry about selling, because [our franchisees] do it for us."

For the dealers (or, in some cases, the sales reps) who convert, the arrangement has obvious appeal. In exchange for giving up their status as independent businesses, they gain marketing clout never before available to them. Moreover, if the conversion suceeds, their businesses are likely to appreciate in value. "When I'm ready to sell my company," says Floyd Loupot, a Pasadena, Calif., Miracle-Ear franchisee who had operated his own hearing aid dealership for 20 years, "I believe it'll be worth more to a buyer."

Yet, for all of its potential benefits, conversion franchising can be a treacherous path for the unprepared and undercapitalized. Dahlberg's sales numbers look good, but they reveal only part of the story. The company lost $759,000 in 1984, its first full year of franchising. Selling and administrative expenses ballooned from $4.6 million in 1982, when it began developing the franchise, to $11.6 million in 1984. In addition, Jeff Dahlberg points out, there is the "mind-boggling" cost of management time devoted to the conversion. Beyond all of those costs lies a new reality that comes with the change: Dahlberg, once just a manufacturer, is now in the franchise business as well. To succeed at both, it has had to hire people with experience in franchising, real estate, training, and information systems.

If a conversion works, however, the system serves to bind valuable people to the business and gives them enormous incentive to perform. Parson-Bishop National Collections started granting franchises early this year to its 12 regional sales reps. Over the years, some had asked for equity, but company president Lou Bishop was reluctant to part with it. "Franchising was the best way to solve the problem," Bishop says. The franchise agreement guarantees the reps a protected territory. The franchises can be sold at a later date, too. "Suddenly, I have a highly motivated team of franchisees out there without giving up very much of my company," he adds.

That, indeed, is a major reason for making such a switch. In theory, at least, the franchise format encourages a higher degree of involvement and commitment than a dealership or a sales agreement, because each franchisee has a personal stake in building the franchisor's business. "Our dealers [who became franchisees] have made a real commitment to our products," says Chris Esposito, president of Four Seasons Solar Products, which launched its conversion program in 1985. "They've built showrooms. They've hired people to sell.Before, I was always trying to get that from them, with only spotty success."

Of course, to gain such commitment from franchisees, a franchisor has to make a commitment of its own, in the form of national advertising, training programs, and dealer-support services. Such programs are expensive -- beyond the means of most small manufacturers. The beauty of the franchise format is that it allows the manufacturer to share the cost with franchisees. Under most franchise agreements, franchisees pay a royalty based on gross sales. Dahlberg uses a different system, charging franchisees a flat rate of $31.50 for every product sold, as well as $15 for each lead generated in their territory by a national ad campaign. Dealers are allowed to set their own prices on products and pay no franchise fee on service revenues.

Dahlberg developed its system during a two-year period leading up to the actual conversion. The first step of that process involved the opening of a pilot retail unit in Minneapolis late in 1981. The store was patterned after an optical shop, on the theory that the hearing aid business -- with dozens of small manufacturers and thousands of independent dealers -- had reached a stage similar to that of the eyeglass industry more than 20 years before. Dahlberg hoped to outflank its competitors with a more focused marketing strategy. The risk was that, instead, it might plunge its distribution and sales into chaos.

The goal of the pilot project was to gain experience. "As manufacturers, we really had to learn the retailing business for the first time," Jeff Dahlberg says. Toward that end, the company tired out various advertising and promotion programs to see how consumers would respond. It also experimented with new management methods -- testing training programs, for example, and hiring salespeople as employees with benefits, instead of independent contractors, as is common in the industry. (Today, its franchisees do the same thing, getting group discounts on health insurance.)

By the end of 1982, the Minneapolis store was turning a profit, an encouraging sign for further expansion. The next question was, How many of Dahlberg's 2,000 dealers would have to convert to support the cost of the change? Like many manufacturers with large dealer networks, more than 80% of Dahlberg's sales came from a core group of 200 dealers. To make the conversion work, the company figured it would have to retain a large proportion of those dealers and attract some of its competitors' large dealers as well. It set a first-year conversion target of 100 franchises. Assuming it would lose some of its key dealers, it prepared for as much as a 20% drop in sales during the initial phase.

To pave the way for the conversion, Dahlberg set up a special task force, dubbed the Franchise Implementation Team, which included seven of the company's top managers as well as three outside consultants helping on various aspects of the conversion. It also invited 11 dealers to join a franchise advisory council, representing a cross section of the company's group of core dealers. These were the people to whom Dahlberg first broached the idea of converting to a franchise arrangement. The proposal met with an icy reaction from many of them. "We were asking people to change their business," says Norman Blemaster, Dahlberg's vice-president of franchising. "And, face it, people don't like change."

Among other things, the dealers objected to the company's proposal of a five-year franchise contract that strongly encouraged moves to store locations in shopping malls. "Many of us were tied into long-term leases," says Loupot, the Pasadena franchisee, "and the notion of making that kind of investment for five years really seemed unwise."

Recognizing that the conversion would be doomed if it started under a cloud of controversy, the company was determined to hammer out a mutually acceptable compromise.Throughout the year, the two sides held meetings, and Dahlberg agreed to extend the contract to 20 years. The company also waived its $12,500 franchise fee for all converting dealers, and gave them up to two years to make the necessary remodeling changes.

Once the compromise was struck, the company presented the whole franchise package to the 200 key dealers at a sales meeting in Acapulco in January 1984. Nervous about their reaction, it spent $150,000 on an 18-projector audiovisual extravaganza showing off the new concept. "Getting the first impression right is really critical," says Jeff Dahlberg. "We had facts and figures from the test, but we were still selling a lot of future." As a further inducement, the company announced a price increase of $31.50 per product, the precise amount of the franchise fee.

Dahlberg eventually signed up 103 dealers in 1984, surpassing its goal. It paid a price, however. When Dahlberg's competitors learned of the plan, they barraged dealers with sales pitches and warnings about the dangers of franchising. The tactics worked: in the first half of the year, Dahlberg lost 40% of its dealer sales, twice the amount it had anticipated. "You better believe that made us nervous," recalls Blemaster. "The whole idea suddenly started looking like more of a risk."

"I'd be kidding you if I didn't say that all of us had sweaty palms about it," says Dahlberg. "There were times when we said, 'Are we making a tragic mistake?"

Meanwhile, Dahlberg was struggling with a multitude of administrative problems associated with conversion. Franchises had to be awarded. Territories had to be allotted. Dealers had to be evaluated in terms of their management ability. In some cases, dealers were located in overlapping territories, requiring one or more to move. Other dealers were asking for multiple territories.

This is the point at which many conversions go awry. Without adequate capitalization and management skills, the new franchisees will fail, so careful screening of their finances and business ability is critical. The franchisor must also adhere steadfastly to the agreed-upon conversion plan. "The tempatation is to induce people to join the system by making special exceptions," says Jeff Dahlberg, "but you can't do it without undermining the whole program."

Then, too, the franchisor must be prepared to make conversions as soon as franchises are awarded -- both to get the program rolling and to convince dealers that they have made the right decision. Dahlberg had prepared by developing its support services ahead of time. But, to implement them, the company used its regional sales representatives, and quickly realized that the new system required service and training expertise, not a selling mentality. Over the next year, the company replaced salespeople with experienced franchise field representatives.

The first year was rocky, and Jeff Dahlberg admits that the company made mistakes. Several of the franchise agreements had to be canceled when it became apparent that the franchisees simply could not handle their new responsibilities. More important, the company neglected its nonconverting dealers, with the result that it subsequently got stuck with losses and bad debts. Meanwhile, costs were skyrocketing. Marketing expenses alone soared from $1.8 million in 1983 to $4 million in 1984. Fortunately, says Jeff Dahlberg, the company had built up sufficient cash in advance to cover the costs of conversion, which, he estimates, totaled about $5 million.

In the second half of 1984, moreover, sales started to rebound. Dahlberg finished the year with $22.7 million in revenues. In March 1985, the company "crossed the Rubicon," says Jeff Dahlberg. Earnings for the first quarter of 1985 were $148,000 on sales of $7.2 million, up from $127,000 on sales of $4.9 million in the first quarter of 1984. The trend continued through the year, and Dahlberg came out of 1985 with earnings of $906,000 on sales of $31.2 million.

These days, Dahlberg is still adjusting to its new structure. After the upheaval of 1984, the company spent 1985 digesting its growth, adding only a few more franchisees. Today, the company has 133 franchisees and 242 stores. It still distributes through independent dealers in some areas, but -- in time -- it plans to convert entirely to a franchise operation, with 800 locations by 1990.

The greatest challenge, however, is to learn to live in the brave new world of franchising. Both Dahlberg and its franchisees have to get used to a different way of doing business. The company, for example, now has to keep a close eye on franchisees, hoping to spot and correct operational problems before they become serious. The franchisees, for their part, keep a close eye on Dahlberg. "We're under the gun to give our franchisees state-of-the-art products," says Jeff Dahlberg. "They're very aware of their competition and what they need to beat them."

It is a very different relationship from the one they had as manufacturer and dealers, but neither side is regretting the change. "Franchisees serve as a never-ending pressure point," says Dahlberg's Norman Blemaster. "They'll ask much more of a company than a bunch of dealers. If you invested your money and made a commitment to one company, you'd expect a lot, too. We never had that here before. I'd say the change has made Dahlberg a much better company."