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“Franchising is a rocky road full of broken hearts”

Updated: May 16, 2023


Franchisees needing profit

Many years ago, your correspondent was in Washington DC attending the American National Franchise Expo. One evening a group of us went out to dinner and I found myself sitting next to a senior member of staff of the Canadian Franchise Association.


After some food and a number of drinks the discussion turned to our respective views of the franchising industry and how best to resolve franchise disputes. With inhibitions somewhat reduced this lady made a comment that has stayed with me. “Franchising is a rocky road full of broken hearts”.


Not surprisingly almost all those broken hearts belong to franchisees. One of the main reasons for this is that the UK lacks the high level of regulation that exists in the US, and slightly less so in Australia and Canada. In the UK the industry is self-regulated. And we all know what happens when people are allowed to mark their own homework.


The British Franchise Association does its best to keep up standards; but participation is voluntary and less than half the franchisors in the UK are members. The Association promotes a “Code of Ethical Conduct”, one part of which states that, to assist due diligence, franchisors should provide prospective franchisees with a full list of their franchised branches. Superficially, that sounds OK, but it does not state that the list should include any who have failed. In the case of bad franchises such a list would make grim reading because after a few years the number of failures would build up and could easily be greater than the number currently trading. That would seriously impede recruitment (but it would undoubtedly save many hearts from being broken). It is worth noting that, by contrast, the United States does have this disclosure requirement.

 
Discussing financial projections of the franchise

Another area where smoke and mirrors are sometimes used by unscrupulous franchisors is their financial projections. These are nearly always included in the recruitment process and are intended to show prospective franchisees how much they can expect to earn. The projections are usually for the first three years and show gross income, overheads, franchise service charges and the resulting profit. In small print they often carry a disclaimer to state that they are only indicative and shouldn’t be relied upon. Some also state that the figures are the average of franchisees who are following the franchise model. But who is to decide which franchisees are ‘following the franchise model’? The franchisor, of course. And by doing so exclude the results of the poorly performing ones to improve the projections.


The majority of franchisors base their charges on a percentage of sales turnover of the franchisee. Rates vary widely and relate to profitably levels from sector to sector. This is a fair and equitable way of linking effort to reward and should allow both parties to make a satisfactory return. Very importantly, the franchisor is motivated to assist the franchisee to grow and increase their sales. Some franchises don’t use this method and instead levy a fixed monthly charge. Some have a hybrid charging method involving a percentage and a minimum monthly charge. For a franchisee, the problem with a fixed or a minimum fee is that there is little or no incentive for the franchisor to help them. In the worst cases, franchisors have been known to threaten legal action to recover monthly charges from franchisors who could not work because of the pandemic lockdowns.


Another area that can be problematic is the definition of where the franchisee will operate their business. Most franchisors allocate an exclusive territory. These are usually defined by postcodes which are unambiguous and tend to work well. Some franchisors base territories on population size which are less easy to quantify. Some offer little or no exclusivity and let franchisees compete for business. They are therefore motivated to sell as many franchises as they can and have no incentive to assist the individual growth of each member of their network. Experience suggests that territory definition issues are a major factor franchise disputes.

Do you have a franchisee problem?

Another area where cheating by franchisors has been known is where the franchisor controls the supply of products or services to the franchisees. This is often by a third party and is in the form of a kickback to the franchisor. This is more likely if the franchisees are required to buy exclusively from specified suppliers. The market will ultimately dictate the price that the franchisee can charge and if the buying price is inflated by an illicit payment to the franchisor the profit margin will be reduced. This practice has also been known to involve some of the start-up costs, such as a designated vehicle, particularly if it has to be fitted out with equipment.


It is hardly surprising that bad franchises have high failure rates. Sadly, with this regular churn, they become proficient at exiting the failures. Those with sufficient assets but who cannot afford the cost of engaging the services of a franchise lawyer are threatened with legal action and forced to pay to leave. A non-disclosure agreement is always a requirement.


In spite of all these horror stories and inadequate regulation, franchised businesses still have a much higher success rate than independent ones. For prospective franchisees, the key to making the right choice and avoiding those that are doomed to fail, is to be aware of the problem areas and ask the right questions before joining. Later, if things are not working out as you were told they would, it is still possible to avoid being another broken-hearted statistic. Don’t be intimidated. There is much that can be done to hold the franchisor accountable.

 

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