A Bit of Heartburn

"McDonald's does not seem to listen anymore""; "It is with great reluctance that I am signing up, but some fundamentals are badly out of balance," and "McDonald's has been dividing and conquering us for years. It is time to stand together."

The Wall Street Journal
April 17, 1996

A Bit of Heartburn
Some franchisees say moves by McDonald's hurt their operations. Rapid addition of outlets cuts profits, they gripe; new manual irks others. Firm plays down discord.
Richard Gibson

CHICAGO — Ever since the late Ray Kroc began building his fast-food empire in the 1950s, loyalty among McDonald's Corp. franchisees has been legendary. But now, the business pressures are mounting, and even though many franchisees have become millionaires, some are restless.

They range from a clandestine group that claims nearly 200 members to a California operator who sued the company for allegedly cannibalizing his sales. In New England, several dozen franchisees recently complained about what they term "a lack of respect" from company representatives. And the 7,000-member American Franchisee Association, a Chicago-based group formed several years ago to look after franchisees' rights, says McDonald's operators are joining in record numbers.

Though hardly a full-blown revolt, such defiance is threatening what McDonald's management calls a "linchpin" relationship with its 2,762 U.S. franchisees.

It is important not to overstate the breadth of the dissatisfaction: The number of complaining franchisees is still a small fraction of the total. But it is also important not to understate the significance of even a minor uprising: It raises questions about a system long regarded as the franchising industry's gold standard just as franchising in general is attracting attention from legislators. Major concerns being studied in Congress and various state legislatures are the impact of new restaurants on existing ones, the conditions under which a franchise isn't renewed and the criteria for terminating franchisees.

Indeed, dissidence is spreading throughout the fast-food industry. Franchisees of both the Subway sandwich chain and Checkers Drive-in Restaurants chain recently formed independent groups to see to their interests such wariness isn’t unexpected: As the fast-food industry matures, franchisers’ efforts to keep growing often collide with entrenched operators.

At McDonald's, the discord comes at a particularly bad time. The Oak Brook, Ill., company wants a united front as rivals' promotions and meal deals make holding onto customers a daily firefight and as competitive chains seek to keep up with the rapid proliferation of McDonald's restaurants. All the companies are playing a market-share game, figuring that whoever has the most outlets wins. But almost every restaurant that McDonald’s opens, in its unprecedented nationwide expansion, threatens to steal sales from a McDonald’s down the street. Also causing some heartburn are the company's demanding new operating procedures.

McDonald's minimizes the dissidence, saying it isn't "reflective of the current experience of the vast majority" of its franchisees. "There are bound to be some people who are unhappy among such a large and diverse group," Charles Ebeling, a spokesman, says, adding that they can vent their concerns in various ways, including through an ombudsman with access to top management. "We consider the company's relationship with franchisees a source of strength," he says.

Financial worries may be feeding the scattered unrest. McDonald's U.S. same-store sales have been dropping despite vigorous discounting and promotional efforts. Last year, they fell 2.5%, on average, to $1,538,000 from $1,577,000 per U.S. restaurant in 1994. More than half of the company's profit now comes from overseas.

Some franchisees contend that as domestic growth has become more difficult, management has turned autocratic, treating them more like employees than following the system Ray Kroc wanted — a system largely run by independent business-people but with McDonald's defining every aspect of the business, from restaurant locations to the number of pickles on hamburgers.

"In the old days, Ray's feeling was that if operators were successful, the company would be successful. Now, what the stock does seems more important than keeping the operators happy," says Hugh Schmidt, a franchisee who after 18 years in the business is seeking a buyer for his Vail, Colo., restaurant.
Keeping franchisees happy is important: Franchising is vital to McDonald's earnings, providing nearly $3 billion a year in rents and royalties on sales. Last year, 8,694, or 76%, of the company's 11,368 U.S. restaurants were run by franchisees.

In recent months, though, McDonald's has blurred the line between company- and franchisee-operated restaurants by forming joint ventures with some U.S. franchises. By taking a majority stake but letting a franchisee run these partnership restaurants, McDonald's can increase its take because franchisee stores typically are more profitable. Although the company doesn't disclose average store profits, it reported the average U.S. franchised restaurant's cash flow in February 1995 ran nearly 21% higher than that of an average company-owned store.

Some franchisees view the partnership arrangements as a threat to their independence. "The issue of control is becoming more apparent" as those ventures proliferate, says Susan Kezios, president and founder of the American Franchisee Association, which actively solicits members and pushes pro-franchisee measures in Congress and state legislatures and in the franchising agreements. It charges its members $100 per restaurant to join.

"Every week," Ms. Kezios says, "we get a check from someone in McDonald's. When we got the first one, we were so excited we photocopied it and put it on the wall." She estimates that so far 100 McDonald's restaurants are represented — still a small percentage compared with some other chains.

Many of the unhappy McDonald's franchisees, whose initial investment typically ranges from $422,000 to $651,000, would seem unlikely rebels. According to Dick Adams, a San Diego franchising consultant and one of the organizers of a recently formed clandestine group called the Consortium, the average member among the nearly 200 he currently claims to have signed up has been a McDonald's franchisee at least 10 years, operates 2.3 restaurants, owns McDonald's stock and wants to stay in the system.

"They're generally very positive toward the concept of McDonald's — the traditions, the previous corporate culture," Mr. Adams says. But, he adds, "They're not in agreement with management's current tack."
A long time McDonald's employee and former franchisee himself, Mr. Adams says the Consortium idea came from McDonald's franchisees who had retained his firm, Franchise Equity Group, on various business matters, such as how to deal with franchisers in selling a restaurant. He says more and more McDonald's franchisees complained about the company's tactics and asked him for help.

His postcard survey of franchisees about forming a group got such responses as, "Yes! Yes! Yes! We need this badly!"; "McDonald's does not seem to listen anymore"; "It is with great reluctance that I am signing up, but some fundamentals are badly out of balance," and "McDonald's has been dividing and conquering us for years. It is time to stand together."

Already, the Consortium has retained a lawyer to monitor McDonald's, to see that the current 20-year licensing agreement remains inviolate and, if needed, to challenge the company by lobbying for legislation. Recently, McDonald's has been a leader among the nation's franchisers in squelching states' moves toward legislative changes. In Iowa, it vowed not to build any more restaurants until the legislature revoked some laws the company deemed biased toward franchisees; much of that legislation has been struck down by the courts.

Says Mr. Ebeling, "We believe extremely few [franchisees] have any relationship" with Mr. Adams. If, in fact, about 200 McDonald's franchisees have joined the Consortium, they are about 7% of the company's domestic corps.

Once the Consortium is fully operational, Mr. Adams says he will be compensated by it. "My intention is to get a percentage of the fees," he says. Right now, he figures that he is earning about $15 an hour as the group's "facilitator." His primary source of income continues to be his consulting business.

It is impossible to pinpoint exactly how much dissidence there is. Franchisees fear angering their huge and powerful corporate partner. But it is clear, from interviews over a period of months, that many franchisees are concerned. Interestingly, many join the dissident movement more out of sadness than anger; they have been franchisees for a long time and remember a kinder and gentler company — in a kinder and gentler environment.

Many trace what they see as the deterioration of franchiser-franchisee relations to the 1992 death of Gerald Newman, McDonald's chief accounting officer. Mr. Newman spent much of his time dealing with franchisees. Sometimes he would give them a financial break. Sometimes he would encourage them to find other employment. But he had a reputation for a sympathetic ear. As one longtime operator wrote to Mr. Adams: "Ray Kroc and Gerry Newman must be crying in their graves." That same operator ended a lengthy, critical note to Mr. Adams this way: "It is for my love of and good of the system that I write this."
Asked in an interview why he joined the Consortium, one franchisee, who requested anonymity, says: "I honestly believe the vast majority of us are there for one reason. We love what we do. The system is truly fabulous. If you're going to be a franchisee, this is the company you want to associate with. Or at least it was. But things have changed."

McDonald's already has a franchisee organization — the National Operators Advisory Board — but some regard it as a corporate captive. Indeed, truly independent franchisee groups are rare; less than 5% of all U.S.-based franchises have independent ones. One sprang up at Burger King Corp. after that chain's acquisition by Grand Metropolitan PLC in 1988. Now numbering about 900 franchisees — 80% of the total — the Burger King association negotiates with management over such prickly matters as encroachment — where the company opens a new restaurant near an established one.

High among some McDonald's franchisees' concerns is a set of business practices, known as Franchising 2000, that McDonald's is implementing domestically. The company terms it a way to improve standards for quality, service, cleanliness and value by giving franchisees better "tools." But others see it as a bold bid for more control.

One controversial provision requires franchisees to submit annual financial goals to the company's regional managers, who sign off on them. The document also revives annual A, B, C and F grades, with only franchisees receiving As and Bs eligible for more restaurants; some franchisees doubt the system's objectivity.

In addition, McDonald's is using Franchising 2000 to try to enforce a single pricing strategy, so that a Big Mac, for example, will cost the same almost everywhere. The company says discounting — what it calls "value pricing" — is necessary to build market share. Those who ignore such guidelines and otherwise "seek personal gain and advantage to the detriment of the system," as the new handbook puts it, risk losing their franchise when it expires. Noncompliance is to be met with what an internal memo calls "in-your-face" management — a get-tough attitude that riles some franchisees.

Says McDonald's Mr. Ebeling: "The whole purpose of redefining our franchising relationship through Franchising 2000 is to run better restaurants and not to run people out of the system." Keith Melton, a Shreveport, La., franchisee who heads McDonald's operators' advisory board, says the revisions followed a year-long consultation between franchisee representatives and the company. He says that most franchisees embrace Franchising 2000.

"Once it gets going," says Andre Laprade, a Maine franchisee, "it's going to be great for the system. It'll improve overall operations and therefore the value of our restaurants."

But other franchisees wonder how their properties will withstand McDonald's expansion juggernaut, which calls for 800 to 1,000 more U.S. restaurants this year alone. Many franchisees complain that that drive to increase market share will sap their own sales and profits.

Robin Seder knows that worry. A long time McDonald's franchisee, Mr. Seder says his problems began in 1991, after he relocated from Phoenix and paid $5 million for three restaurants in the California border town of San Ysidro. He soon learned that McDonald's was building a restaurant just across the border in Tijuana, Mexico. After it opened, sales at his restaurants plunged. When he complained, he says he was told that was because he was charging too much for his food. Not so, he says, contending that an Extra Value Meal in Tijuana cost at least $1 more.

Then Mr. Seder learned that a second Tijuana restaurant was coming and would be followed by more border locations by the year 2000. He says his sales, totaling $6.8 million for his three restaurants in 1992, fell to slightly more than $6 million in 1993. To stay afloat, he refinanced his home. He also rejected a company-proposed swap — his restaurants for two that he says were in poor shape, in crime-ridden neighborhoods and vulnerable to being cut off from traffic by a planned freeway.

The 50-year-old Mr. Seder retained Robert Zarco, a Miami franchise lawyer, who sued McDonald's in federal court in San Diego. The suit accused it of "cannibalization tactics and unfair competition" and sought $24 million in damages.

McDonald's countersued, alleging breach of an agreement with the ombudsman, but, apparently anxious to avoid bad publicity, soon initiated settlement talks. It agreed to trade Mr. Seder's border restaurants for four full-size McDonald's, plus two smaller outlets in a Wal-Mart and on a naval base. Mr. Zarco says his client is "looking forward to a successful future with the company." Mr. Ebeling calls the settlement "an amicable resolution.”


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