Trouble in Franchise Nation

Even worse, new evidence suggests that the whole franchising model, far from being a consummate business paradigm for the late 20th century, as its advocates claim, is so riddled with problems and ill will that opening a franchise can often be riskier and less desirable than simply starting up your own business.

Fortune magazine
March 6, 1995

Trouble in Franchise Nation
Demand for new outlets is booming. But markets are crowded, lawsuits are flying, and the risks of getting burned have never been higher.
Andrew E. Serwer

How fares the business of franchising? Measured by ubiquity, very well, thank you. Though the outskirts of every American metropolis are already lined corner to curb with McDonald’s, 7-Elevens, and Jiffy-Lubes, new entrants continue to shove their way into these gangly, free-fire commercial zones. Nobody argues today’s Main Street a la franchise is pretty. But partisans insist that franchising remains pay dirt for some of the brightest opportunities in the new economy. The franchisee, they claim, prospers by acting as an entrepreneur in a prepackaged box, a superefficient distributor of services and goods through a decentralized web. He or she has the freedom to evolve with an ever-changing customer base and the impetus to feed crucial information to HQ, which disseminates that data and other support back out to fellow franchisees.

A few forward-looking franchisors have, in fact, created organizations resembling this ideal. For would-be entrepreneurs, these are the folks to link up with, particularly in hot-growth sectors such as business services. Example: quick printer Alpha-Graphics, which makes a habit of consulting its franchisees to hear how they think its operation should run. Innovative companies in the otherwise stale fast-food industry can also thrive. Example: Taco John’s, which has torn up its old contracts to forge a new state-of-the-art, cooperative relationship with franchisees. And franchise operations that avoid one-dimensional, saturated businesses like frozen-yogurt shoppes and instead blaze new markets based on what consultants call “extreme service” are faring well too. Example: Takeout Taxi, which delivers restaurant food directly to customers’ dining rooms (for more, see box).

In general, however, the current state of franchise nation can be summed up in two words – deeply troubled. For all their past successes, precious few systems are minting money for franchisees today. Most markets are crowded, and expenses are rising. Even worse, new evidence suggests that the whole franchising model, far from being a consummate business paradigm for the late 20th century, as its advocates claim, is so riddled with problems and ill will that opening a franchise can often be riskier and less desirable than simply starting up your own business.

Generalizing about franchising is tricky since its universe extends to at least 65 distinct businesses, generating close to $800 billion in sales every year. (And that’s excluding professional sports teams like the San Francisco 49ers or the Orlando Magic, which are also franchises.) The priestliest caste of franchises, close to untouchable, or unbuyable, are soda bottlers – ah, to own a Coke franchise! – and beer distributors. Below them are car dealers and gas stations, which can often be big moneymakers. Next come fast-food outlets, convenience marts, and auto-service shops. At the bottom are marginal operations – and, yes, these are real – such as “mini Donuts: The Sleeper of the 90s,” and “Balloon Wrap: Amaze crowds year round by what you can wrap in balloons.”

What’s incontrovertible is that most of the actions these days is at the bottom of this profitability food chain. While car dealers, gas station owners, and soft-drink bottlers account for nearly three-quarters of all franchise sales, according to Ann Dugan, director of the Small Business Development Center at the University of Pittsburgh, 87% of all new franchises today fall outside those three categories. To put it another way, nearly nine out of ten franchisors are cutting up only 36 cents of every dollar in sales. “Most people think of franchising as some kind of bonanza,” says Dugan. “The reality today is if you get a solid operation, work damn hard, and you’re making $40,000 a year after four years, that’s good.”

Even within the overcrowded end of the universe, growth lately has been trailing off. After decades of spouting upward like so many weeds, the number of U.S. franchisors and franchised outlets has, since the mid-1980s, pretty much matched or lagged behind the rise in GDP, according to new research by professor Francine Lafontaine of the University of Michigan. Reason? Saturated markets.

The quickest to pull back have been established franchisors with the keenest market intelligence. PepsiCo’s fast-food trifecta of KFC, Pizza Hut, and Taco Bell is accepted almost not new U.S. franchisees. 7-Eleven: very few. McDonald’s rookie franchisee population in the U.S. grew by 4% last year. While these companies are signing up scores of new franchisees overseas, new U.S. stores are instead being parceled out to existing franchisees or company managers.

This contraction in the supply of blue-chip outlets comes just as demand for them from disenchanted, and in many cases disenfranchised, middle managers is trending up strongly. According to the Chicago consulting firm Francorp, over 30% of all new franchisees are now ex-employees of big companies, up from 24% in 1992. Bill Cherkasky, the outgoing head of the International Franchise Association, reports that recently he’s had requests from GM, IBM, and Xerox to run seminars for prospective buyers among those being outplaced from their ranks. And an advertisement from one franchisor woos executives by pointing to former managers from Coca-Cola, Playtex, and Price Waterhouse who are franchisees in the system. In the long run, this shortage in the supply of good franchises may well be corrected as new first-tier players – perhaps Boston Chicken or an outfit like kids’ fitness center Discovery Zone- emerge to provide solid franchise opportunities for the growing crowd of corporate refugees. But for now, the top end of the business looks like a seller’s market.

One sign that market saturation is raising tensions and crimping profits: a big jump in lawsuits. Since 1990 franchisee complaints filed against parent companies with the Federal Trade Commission have been growing at a more than 50% annual rate, and they now number in the hundreds. Many involve disputes over territory. Two years ago a group of peeved KFC franchisees in Iowa pushed a bill through their state legislature that prohibits a franchisor from “encroaching” on another store – an act defined as opening up a new unit within three miles of an existing one without compensation.

One vocal litigant, McDonald’s franchisee Allen Whitehead, claims that encroachment, tingled with racism, drove him to sue the company he once loved. Whitehead, 46, a former bank loan officer and administrator at Cornell University, opened his McDonald’s in a low-income section of Hartford in 1983. “I was proud,” he says, standing in the lobby of his store. “The teamwork, the camaraderie, and the passion of the system were incredible.” Whitehead’s operation was a quick-serve hit. Annual sales rose steadily, peaking at $2.3 million – well above the national average – and he was making what he calls “a very healthy income.” Over the next several years it added four more close by. Since then his sales have dropped to $1.5 million.

What hurts most, says Whitehead, is that he was generally denied opportunities to buy those new stores on realistic terms, though McDonald’s did offer him a chance to bid on outlets in other locations. Whitehead believes McDonald’s turned him down because the stores in question were in white areas, and he’s an African American. He says McDonald’s told him that Hartford was a “company store” territory and that there was no room for him to expand. “I’m sure McDonald’s can trot out a few black franchisees in white areas, but the great majority of black owners are given stores in black areas and have few other opportunities,” he says. A McDonald’s spokesman says Whitehead’s case is without merit, and the company intends to file suit.

Whitehead acknowledges that some McDonald’s franchisees do prosper. “I think about a third are doing really well – like I was,” he says. “A third are hanging in there. And another third are barely making it. I don’t see the situation improving if the company keeps pushing in more stores.” Whitehead’s advice: “Remember the franchisor is in the business of maximizing his revenues, even if that means saturating your market with competing stores.”

One other danger that prospective franchisees should be aware of: higher-than-advertised failure rates. Franchisors like to brag that their way of doing business is safer than starting up a business on your own. The International Franchise Association maintains that “less than 5% of franchises were terminated on an annual basis.” Turns out, however, those numbers are based on old studies by the Department of Commerce that surveyed franchisors, not franchisees, and only counted a franchise as a failure if a store closed, not if the franchisee quit the business. Several new academic studies poke giant holes in the industry’s claims of a 95% success rate.

Combing through U.S. Bureau of Census data from the early 1980s through 1991 on thousands of small businesses, economist Timothy Bates of Wayne State University in Detroit has found that almost 35% of franchises had shuttered their doors by 1991, vs. 28% for other small businesses. At UCLA, work by economist Darrell Williams confirms that both groups have roughly equal, and intimidatingly high, failure rates. Why would today’s franchises be more prone to flop? “I think the golden era of franchising might be over,” says Bates. “Buying a McDonald’s 20 years ago was a great business. Buying a Subway today is nowhere near as attractive.”

No need to tell that to Greg Kane. Three and a half years ago, the 35-year-old former Navy flier with a master’s in management science bought a Subway franchise in Hanover, Massachusetts, near Plymouth. “Subway said its franchises had only a 2% failure rate,” says Kane. “That was the big hook.” To maintain his business, he borrowed $60,000 from his in-laws, who took out a second mortgage on their house. Kane lost his store last year after a new food court across the street chewed up his business. Today he works part-time in the credit department at J.C. Penny. But was Kane able or incompetent? “When I was making money, I got high marks from Subway,” he says. “When the food court opened and I started losing money, Subway marked me down for being messy.”

Now Kane is suing Subway, as are scores of other franchisees. He claims that the company “misled me with their statistics – the failure rate is much higher than 2%.” He also argues that the company “unnecessarily made my wife sign documents, and illegally increased fees.” Plenty of other Subway franchisees, of course, voice no such complaints. The company, one of the nation’s fastest-growing franchise operations, declined to comment on Kane’s case.

Beyond unfriendly market conditions, prospective franchisees should focus on a host of hazards peculiar to the way most franchises are run. “Franchise organizations have been so busy expanding, they haven’t focused on their core businesses,” says Cecilia Falbe, a professor at the State University of New York business school in Albany. “Now they’re having to pay attention to their neglected systems.” The result if often a continuous low-grade firefight between franchisor and franchisee, which detracts mightily from time that could be spent, say, serving customers. This can even put franchisees at a big disadvantage compared with company-owned stores or plain-vanilla independent businesses. Here follow some pointers culled from those who’ve paid dearly for ignoring them.

Lessons one, two, and three: It’s the contract, stupid.
Few would-be franchisees are aware just how inequitable the agreements are that franchisors typically foist upon them. “Most treat franchisees like indentured servants,” says Robert Purvin, a lawyer who heads the American Association of Franchisees and Dealers, a trade group in San Diego. “They have fewer rights than employees.” The standard contract, for example, stipulates that franchisees must arbitrate in the franchisors’ home state. Franchisees also can’t leave a system or sell a store without the franchisor’s say-so. If they do leave, they forfeit all of the store’s assets.

Franchise contracts have become onerously lengthy – McDonald’s 11-pager is a happy exception – partly because they grant ever more rights to franchisors. Garry Koenigsberg, a San Francisco lawyer, points to a contract by an international temp agency that runs more than 50 pages. Only 21/2 pages of the agreement are dedicated to “obligations of the company,” and Koenigsberg says these pages are peppered with “in its judgment” and “in its discretion.” In other words, buyer beware. “Franchisees have to dig, and they have to fight,” says Susan Kezios, the tough-talking president of the American Franchisee Association, a new lobbying group. “When a franchisor tells you he can’t negotiate his contract, that’s complete b.s.”

Simply put, you would be foolish to sign a franchise contract without having it reviewed by an attorney experienced in franchise law. Says Greg Kane of his Subway agreement: “I look at my contract now – like the part where I waived a trial by jury – and I shudder.” Greg Johns, an embattled franchisee with American Fastsigns, agrees: “Franchise contracts are inordinately one-sided. I’d never sign one again unless I could make major revisions.”

Johns, 48, fits the classic profile of the new breed of franchisee. He worked for Procter & Gamble and Ralston Purina in brand management for 15 years, and lived the good life with his family in the Town and Country suburb of St. Louis. “But I was disillusioned by corporations,” he says. “I wanted to control my own destiny.”

Johns moved home to California and joined American Fastsigns, a maker of vinyl signs out of Dallas, because the business was advertising related. He set up shop in Vista, north of San Diego, in 1989. Says he: “The contract had a lot of scary-sounding details, but my lawyer and the company said it was just boilerplate. It turns out those details mattered a great deal.” Details like a non-compete clause for him and the company having the right to John’s phone number, client list, and equipment – even though Johns paid for it – in the event of a termination. The contract also stipulated that disputes must be resolved in Texas.

Johns says American Fastsigns steered him to a location with too few customers to make a decent living. “I told the company I wanted to be able to make what I was earning as an executive, and they said I could do it. But my income was cut by more than half,” he says. “The company didn’t understand my market. I wanted to do things my own way, and so I tried to terminate the contract.” In late 1993, American Fastsigns filed for arbitration, and Johns flew to Dallas. “I thought it would be an informal half-day meeting, but it took three days, and the company called 16 witnesses. It was very intimidating.”

Last October the arbitrator ruled in the company’s favor, but instead of surrendering, Johns converted his store to an independent operation. He believes California law - which prohibits non-compete clauses – makes the Texas ruling unenforceable. Still, Johns is looking to get out of the business. He acknowledges that most American Fastsigns franchisees are successful and contented. He also admits that he’s partly responsible for his predicament: “I made a mistake by not going over the contract carefully enough.”

Be prepared for hefty upfront costs.
Sure, you’ll get some help, not to mention national-brand marketing, but you may pay dearly for these benefits. It typically costs between $5,000 and $35,000 for a franchisee to join a system. In addition, franchisees buy equipment, pay for training, and pick up a mortgage or a lease – all of which adds up to big bucks. Launching a McDonald’s today, for instance, will run you about $500,000. After a franchisee opens for business, he or she pays monthly royalties, anywhere from 2% to 8% of gross sales, plus another per-cent or two off the top for advertising.

Just because you’re a former corporate hot-shot, don’t assume you have the right stuff to succeed as a franchisee.
Executives from corporate America often make lousy franchisees,” says Dugan of the University of Pittsburgh. “They think they know everything, and they are the most devastated when they fail.” Former senior managers aren’t prepared for 70-hour weeks and the initial hit on their income. They pine for staff, perks, and three-day weekends. “All of a sudden you’re alone, and it’s tough,” adds Dugan.

Irene Lipari, 43, who has been running a Kids’ Time franchise – a drop-off center for children – for a year has learned as much. Lipari worked as a purchasing agent at Leaf, a candymaker in Chicago, but was laid off two years ago. She and a colleague, Rachel Roman, pooled their severance packages and opened their franchise Villa Park, near Chicago. It cost the women $141,000, with about $43,000 coming out of their own pockets. Like Dugan says, it’s been tough. Sales are running around $3,000 a month, about one-third the amount needed to break even. They haven’t made any 5% royalty payments. And don’t even ask about salary. “We were accustomed to working with budgets, procurement, accounting, customer service. I thought we could handle it. It’s harder than you think,” says Lipari. Lesson? “Intentions don’t cover your bills.”

**Be especially careful to investigate any new or unfamiliar franchise system. **
Few of the hassles you could encounter are as potentially costly as taking a flier or a fly-by-nighter who lures you with the five most dangerous words in franchising: “This is the next McDonald’s.” These barely aboveboard, or in some cases belowboard, “traps for the trusting” – to borrow a phrase from Boston lawyer Harold Brown – bilk investors from all walks of life. Even expert professionals like district chief Delo Breckenridge, a 24-year veteran of the New Orleans Fire Department, get taken.

In the Bywater neighborhood of the Big Easy, flames rip through dilapidated wood bungalows. Soot-black smoke billows from the blaze, as hoses blast water pressurized to 100 pounds per square inch onto the fire, occasionally, screaming bystanders. Then out from the wall of water, smoke, and flame, like one of those syrupy slo-mo scenes from the move Backdraft, comes Breckenridge. “It’s not going anywhere,” he says with a wonderful and casual certainty. “We’ll have it under control in 20 minutes.” He turns and passes on through the wall.

Back at the firehouse, though, the commanding Breckenridge suddenly seems out of his depth when talking about his franchising experience. “I was hornswoggled,” he says flatly. Breckenridge signed up with an outfit called Automated Micro Dry Cleaning Centers, which sold a system where customers would drop off dry-cleaning into a sorting machine in a small storefront in their office building. The clothes would be picked up by a cleaner and returned, and the customer could pick up and pay with the swipe of a credit card. “It was supposed to work kind of like a jukebox,” Breckenridge explains. Kind of.

“When I went to California for a demonstration, the model didn’t work,” he says. “I should have backed out. But the head guy called me a wussy. That worked.” Last year Breckenridge turned over $40,000 for one of these systems and received – absolutely nothing. Except for letters saying, in effect, we’re having problems with the machines, and by the way, we’re out of money, so could you please sent more? Nineteen other franchisees were also ,er, taken to the cleaners by this outfit. Today the group is working together trying to recoup their investment. Laments Breckenridge: “It’s kind of like getting a new car and wrecking it the first day without having any insurance. I’ll be paying $600 a month on my bank loan for the next five years.”

Breckenridge, 47, isn’t any down-home dupe. He graduated from LSU with a degree in economics. His mother wrote the society page for the Times-Picayune newspaper and his father was a lawyer. He’s partial to classical music and literary magazines. Doesn’t matter. He was taken. Why? “It really sounded like a good idea to me. I thought I investigated it, but I didn’t. I wish I could have contacted other franchisees.” That’s essential, agrees Whitehead of McDonald’s: “You must talk to franchisees before you invest. And not just those the company recommends.”

Above all, future citizens of franchise nation, learn to say no. If something, anything, doesn’t feel right to you, walk away. Remember, you’re the boss. Isn’t that why you wanted to become a franchisee in the first place?

A Few who do it right
Life isn’t all dolor and distress in franchise nation, as those who’ve joined systems attuned to the fast-growing service economy can attest. “Even in nonservice businesses, the more service-oriented the organization, the faster it will grow,” says Mark Siebert, senior vice president of Francorp, a Chicago consulting firm.

Bernard and Karen Marshall, a husband and wife who were executives at EDS and defense contractor Science Applications International, respectively, are now busily ensconced as owners of a Takeout Taxi business, delivering food to harried professionals. Their territory: Arlington County in northern Virginia and most Washington, D.C. Customers place orders with their franchise, which profits by getting a 30% discount from participating restaurants. Customers pay full price, plus a $3 to $4 delivery charge. The Marshalls have even delivered to the White House, once from the California Pizza Kitchen. Karen suspects it’s Chelsea with the yen for ‘za, not the First Fan of Fast Food.

At 7 P.M. on a Thursday night, the Marshalls’ dispatch room is humming. A half-dozen customer reps take orders, both fax machines are purring, and all four printers are whirring. Chaos: It’s a small-business owner’s dream. “This the hardest thing I’ve ever done in my entire life,” says Karen Marshall, mother of Ashley, 5. The Marshalls owe their success – they grossed some $1.8 million last year and are well in the black – to a slavish dedication to service. “We take it to extremes,” says Bernard. “Once a lady asked us to pick up some Tums. We did.”

Also thriving is a smaller group of franchise systems that have created a new partnership with franchisees. At Taco John’s, the nation No. 2 Mexican fast-food chain, corporate reps and franchisees realized at a sitdown two years ago that they could bicker and enrich their lawyers, or they could rewrite the franchise contract together. They drafted a futuristic agreement, which protects franchisees from encroachment and unjust termination. The result: franchisewide peace, harmony, and profit.

Despite an afternoon temperature of 5 degrees above zero in Missoula, Montana, Bill Miller is smiling. A year ago this former General Foods executive and father of four daughters would have been just another Joe scrambling to make a connection at O’Hare Airport. Today he owns four Taco John’s and coaches one daughter’s basketball team. “I’m the boss now,” he says, driving his Explorer through a town that spreads out about 4,000 feet below the peaks of the Bitterroot Range. “No office politics. I make my own stress.” Miller, the son of a Montana smelterman, reaped a small windfall in the buyout and sale of Famous Amos cookies, where he worked as a manager. “We lived in California but I didn’t want my kids growing up there,” he says. Then he heard several Taco John’s in his hometown were for sale. “I grew up eating the food, so I knew the product,” says Miller.

His strategy of purchasing several restaurants makes good sense, since multiple stores mitigate location risk. A recent study by professor Jeffrey Bradach of Harvard argues that multi-unit franchisees are a plus because owners can better leverage their assets and time. Of course you have to be able to afford it. Miller, who’d never worked in fast food, hired a manager and drafted family members. His wife, Sheila, niece of former U.S. Senator Mike Mansfield, does the books and puts in more hours on the businesses than he does. And his daughters? He’s taught them to call Taco Bell the ‘Evil Empire.”

This new life has its aggravations. Miller didn’t realize that much of his equipment needed replacing. His biggest challenge: learning to work with his taco-stuffing crew. “At a big company you can yell and scream,” he says, “but in a restaurant your hourlies would quit, and you’d be stuck.” What does a franchisee need to succeed? “Know your limitations. Be confident and have an intensity.” And as with everything in life, pick right: “The company you go with is critical.”


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Risks: Professor Timothy M. Bates, 1/3 franchises do well, 1/3 break even & 1/3 lose money, International Franchise Association, IFA, Boston Chicken, Discovery Zone, Encroachment (too many outlets in area), Race, Survivability (franchisee and franchisor), Academic research, Indentured servants, Non-compete restrictions, Franchisee decision, independence, Trap for the trusting, Masterpieces of deceptive wording and artful omission, Necessary illusions, Independence, American Association of Franchisees and Dealers, AAFD, American Franchisee Association, AFA, National press coverage, United States, 19950306 Trouble in

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