Tim Bates Oversight Hearing

In short, the franchise route to self-employment is associated with higher business failure rates and lower profits than independent business ownership.

USHouseofRepresentatives.png

U.S.A. House of Representatives
June 24, 1999

Oversight Hearing on the Franchising Relationship
Wayne State University
Professor Timothy Bates

United States of America
House of Representatives
Subcommittee on Commercial and Administrative Law

PROFESSOR TIMOTHY BATES

FINDINGS
Persons entering self employment by becoming franchisees commonly believe that their chances of surviving the early turbulent years of small business operation are improved by their decision to align with a franchisor parent company. The franchise is a safe bet, according to conventional wisdom. It is time to reconsider this wisdom.

My study - sponsored by the Office of Advocacy of the U.S. Small Business Adminstration - tracked survival patterns among franchise and nonfranchise small firms started in 1986 and 1987. A large, representative sample of these young firms was drawn from the U.S. Bureau of the Census small business data: all of these firms were surveyed in late 1991 to determine firm survival rates. By late 1991, 38.1 percent of the young franchise firms had gone out of business - shut down; the failure rate for the independent business startups was a lower 31.9 percent.

Although the franchise operations were larger scale, better capitalized young firms, the independent business startups were found to be more profitable and their survival prospects were better than those of franchises. In short, the franchise route to self employment is associated with higher business failure rates and lower profits than independent business ownership.

Owners making their initial entry into self-employment by purchasing an existing franchise operation from a previous owner — the most widespread route to entry in retailing — are particularly at risk. The ongoing franchise units that are available for purchase appear to be disproportionately prone to going out of business. My study tracked a large group of ongoing franchisee operations that were bought by new owners in 1986 and 1987: only 52.4 percent were still operating in 1991 with the owner of record present in 1987. The ongoing franchisees lag badly behind their independent small-business owner cohorts when it comes to keeping their firms in operation.

BACKGROUND
For four decades, the International Franchise Association (IFA) has been promoting the idea that small businesses in general have much higher rates of discontinuance than franchised small firms. A book by Atkinson (1968) presented evidence that most small retail firms close down within five years, while franchises were estimated to discontinue operations at an annual rate of 1.6 percent. A report of the U.S. Senate Select Committee on Small Business criticized the methodology used by Atkinson, concluding that "the book Franchising: Odds-On Favorite by J.F. Atkinson, published by the International Franchise
Association, makes erroneous comparisons with overall retail trade failure rates" (p. 98, 1971). The prestigious Conference Board sifted through the various studies and conflicting claims about franchisee viability and concluded that there was no solid evidence that franchisees had either a better or poorer chance for business survival than similarly qualified independent entrepreneurs (1971).

Similar claims of low franchise discontinuance rates have commonly been received with skepticism reminiscent of the Atkinson study. Figures cited by Ashman (1988) indicated that 92 percent of franchises are still in business at the end of five years, versus only 23 percent of the independent firms. Ashman's results, which cite the "U.S. Department of Commerce" as their source, typify business discontinuance rate figures that have been used in industry promotional literature. In fact, the U.S. Department of Commerce has, until recently, conducted annual surveys of franchisors and published the results in biennial reports, Franchising in the Economy. According to the staff of the U.S. House of Representatives Committee on Small Business, a comprehensive review of the Franchising in the Economy reports "fails to show any figures providing comparable failure or success rates for franchises or franchisees. On the contrary, the reports note specifically that the number of failures is unknown" (Franchising in the Economy, 1988), cited in Hearings before the Committee on Small Business (1992, p. 144).

More recent research sponsored by the IFA claims that 96.9 percent of the franchised units opened nationwide within the past five years were still in operation (Arthur Anderson and Co., 1992). Significantly, this survival rate information was compiled by surveying franchisors — the corporations that sell franchises — rather than the actual franchisee owners of the businesses whose survival is at issue. Castrogiovanni, Justis, and Julian observe that "individual franchisors may be reluctant to 'air their dirty laundry' by reporting excessive failure rates…it is in the best interests of the franchise sector as a whole to convey the appearance that franchising is a relatively safe form of business ownership" (1993, p. 106).

Knowledgeable scholars who study franchising issues routinely express concern about the reliability of failure rate statistics publicized by franchisors. Lafontaine, for example, states "one of the major selling points of franchising to franchisees over the years has been the statistics vehiculated by the trade press on the very low failure rates of franchised businesses compared to independent operations. These statistics never had real scientific basis" (p. 39, 1995).

In the course of writing his recent doctoral dissertation examining several franchises in depth, Birkeland noted that many of his subject franchisees were disappearing. For example, among King Cleaners franchisees, turnover in one 12 month period was 35.1 percent: 29.7 percent discontinued outright and 5.4 percent sold their franchises to new owners (Birkeland, 1995). Discontinuance rates of franchisor parent companies were recently scrutinized by Shane, who identified all franchisor parent companies nationwide that first began selling franchises in 1983. By 1993, only 24.6 percent of these franchisors were still
operating (Shane, 1996).

Studies of small business formations utilizing U.S. Census Bureau data on startups occurring during the 1984-1987 period have contradicted the IFA's claims of low franchise failure rates. A sample of 20,554 young firms drawn from the U.S. Bureau of the Census Characteristics of Business Owners (CBO) database was examined by Bates (1995a, 1995b), and all of these firms were surveyed in late 1991 to determine survival rates. By late 1991, 34.7 percent of the franchisees and 28.0 percent of the
nonfranchised young firms active in 1987 had discontinued operations.

Noting the "heated debate" surrounding the issue of franchise survival, IFA president Cherkasky conceded recently that "it has never been precisely clear as to how many units have changed hands or ceased operating" (International Franchise Association Educational Foundation, 1996, p.1).

ANALYSIS OF SMALL FIRMS ENTERING FRANCHISING
My study analyzed firms in the Census Bureau's Characteristics of Business Owners (CBO) data base that were formed over the 1986-1987 period and the unit of analysis is firms, not establishments. Thus, the universe of firms covered in this section is 2,621,810 young small businesses, 82,202 of which are small business franchisees (franchisees were 3.1 percent of the 1986, 1987 small business startups that were operating in 1987) (Bates, 1996).

Table one data indicate that franchisees are generally better endowed with traits linked to survival than nonfranchised young firms. In terms of mean 1987 sales revenues, the young, franchisees report $440,391, over five times larger than the corresponding figure of $86,489 reported by the independent businesses (table one). Capitalization at startup is similarly much greater (mean value = $94,886) for the proprietorship, partnership, and S-corporation franchisee firms, more than three times greater than the nonfranchised firm capitalization of $29,319. Despite the obvious strengths of the young franchisee firms summarized in table one, they are dramatically less profitable than independent firms of the same age, and they exhibit a lower survival rate — 61.9 percent (versus 68.1 percent for nonfranchised firms) — over the 1987-late 1991 time period. The differences in profitability are particularly dramatic: the average young franchisee reported negative profits in 1987, while the cohort independent small firm reported a profit of $15,511. Despite the advantages of being larger scale, better capitalized young firms, the franchises are dramatically less profitable and their survival prospects are worse than those of independent business startups.

Saturation in retailing niches (including restaurants) has been suggested as a possible cause of laggard franchise performance (Bates, 1995a). Extracting retail firms from table one, the franchises certainly lag behind the overall franchise population, as well as independent retail firms:

Young retail franchisees only Young retail independents only

1987 net income (mean) -$15,877 $10,368

% of firms still operating
in late 1991 61.3% 73.1%

The retail trait for young franchisees, however, may be highly correlated to another factor that is responsible for their laggard performance. Careful examination of the data base reveals one peculiarity of the retail franchisee group. They are much more likely to be entered by purchasing an ongoing operation from a previous owner (as opposed to starting a firm de novo): 53.5 percent of the young retail franchisee firms described in table one were ongoing when the present owner entered, versus 29.2 percent of the independent young retailers and 29.3 percent of nonretail young franchisees. Transfers of ownership among franchised units, according to a recent International Franchise Association Educational Foundation study, often arise in troubled situations. "In many cases, a franchised unit is not renewed or canceled and then subsequently is transferred" (p. 10, 1996). This transfer of ownership might place the unit directly in the hands of a new franchisee. Alternatively, ownership may revert to the franchisor, and the unit may be subsequently sold to a new franchisee owner.

There are two ways for the owner of a young franchisee firm to exit from the firm, and only one has been considered so far. The firm can either be closed down, or it can be sold to a new owner. Some of the franchisees operating in 1987 had changed ownership via such sales: 2.6 percent of the new firms and 15.2 percent of the ongoing operations that were still in operation in late 1991 had changed ownership. Among the ongoing, franchisee firms, only 52.4 percent were operating in late 1991 with the same owner (or owners) present in 1987: nearly half of the original owners were gone by 1991. Many owners of ongoing firms exit by selling the firm to a new owner, who keeps the business in operation. Since ongoing firms (i.e. those purchased from a previous owner) are most common in retailing, it follows that the larger retail franchisees are the ones most prone to ownership turnover. Table two tracks ownership turnover and firm closure patterns. On the issue of the ongoing characteristic being associated with franchisee discontinuance, table two offers insights. Among the firms active in 1987 that had been purchased from a previous owner, 32.4 percent of the franchisees and 18.2 percent of the independents had closed down their operations by late 1991. In other words, the ongoing franchisees were 78.0 percent more likely than the independents to close down (.182 x 1.78 = .324). The corresponding discontinuance rate differential for the new franchisees and independents was 20.8 percent. The ongoing franchisees have significantly higher sales, capitalization, more employees, and their owners are more likely to be college graduates, relative to the ongoing independent young firms. Despite their larger size and greater investments of owner financial and human capital, the ongoing franchisees lag badly behind their independent cohorts when it comes to keeping their firms in operation. This suggests the following hypothesis: entering self-employment by purchasing an ongoing franchise operation is riskier than alternative routes to small business ownership. Econometric analyses support this conclusion (Bates, 1998).

SUMMARY AND IMPLICATIONS
Findings of my research indicate that new and small franchisees are more likely to discontinue operations than independent startups, and this holds true when firm and owner traits are controlled for statistically. One clear-cut finding was that franchisees starting by purchasing the firm from a previous owner were riskier than franchisees starting from scratch. A person entering self-employment by purchasing an ongoing franchise risks acquiring a firm that is more likely than a de novo startup to go out of business within the next few years.

Potential entrepreneurs drawn to franchising are often attracted by industry promotional material asserting that survival rates are high among franchised firms. Yet the information needed by potential franchisees to make informed choices about risks of failure in franchise versus independent business startups is fragmentary and misleading. What is needed? First, units owned by franchisors should be netted out, and descriptive statistics should portray the record of franchisee operations only. Second, information on franchisee startups should be disaggregated from data describing the established firms in the franchisee population. Cross-sectional information describing young and old operations alike runs the risk of generating survival rate statistics that overstate firm closure rates among the older firms, while understating the incidence of closure among recent entrants. Third, establishment data is much less useful than firm data when it comes to identifying new franchisee operation performance. The multi-unit franchisee opening up another establishment may enjoy low risk of unit closure due to its substantial experience functioning in the applicable industry niche (Bates, 1998). A newcomer entering the industry cannot assume that this low risk of closure has applicability to the startup lacking such industry-specific experience. The potential franchisee needs to know how startup firms have performed, and data describing new establishment performance cannot provide this information. Fourth, studies of franchisee survival would convey more useful information if they were based upon data that were somehow representative of the franchisee universe. The recent IFA-sponsored study of discontinuance among franchise units owned by 444 franchise systems typifies this problem (International Franchise Association Educational Association, 1996). This study 1) fails to delineate franchisor-owned units from franchisee units, 2) mixes together young and old franchise units, 3) reports establishment, not firm data, and 4) does not explain how the 444 franchise systems studied fit into the broader universe of franchising in the United States. The potential franchisee who relied upon statistics such as these to judge the relative risk of firm failure in franchising, as opposed to independent business formation, is simply not relying upon useful information.

Table one: CBO Firms Operating in 1987: A Comparison of Firm Traits for Franchisee and Independent Business
Startups (Firms formed from 1986-1987 Only).

A. Firms in all industries
Franchises Nonfranchised firms
1987 sales (mean) $440,391 $86,489*
1987 net income (mean) $4,501 $15,511*
Total financial capitalization at startup (mean) $94,886 $29,319*
% of firms in retailing 38.6% 16.5%*
% of firms still operating in late 1991 61.9% 68.1%*
B. Firms in retailing only
1987 sales (mean) $911,522 $130,371*
1987 net income (mean) -$15,877 $10,368*
Total financial capitalization at startup (mean) $146,139 $45,966*
% of firms still operating in late 1991 61.3% 73.1%*

*Trait differences between the above groups are statistically significant at the .05 significance level.

Source: CBO database.

Table two: Late 1991 Status of Young Firms that were Operating in 1987 (1986 and 1987 firm startups only).

All Franchisees All Independent Firms

A. Young Firms Purchased from Previous
All Franchisees All Independent Firms
Owner (Ongoing Firms)
1. Operating, same ownership 52.4% 68.1%
2. Operating, new ownership 15.2% 13.7%
3. Discontinued by 1991 32.4% 18.2%

B. All Young Firms

1. Operating, same ownership 54.2% 62.4%
2. Operating, new ownership 7.7% 5.7%
3. Discontinued by 1991 38.1% 31.9%

C. Young Firms Started as Births

1. Operating, same ownership 56.1% 61.5%
2. Operating, new ownership 2.6% 4.3%
3. Discontinued by 1991 41.3% 34.2%

References
Arthur Anderson and Co. 1992. Franchising in the Economy: 1989-1992. Washington, D.C.: International Franchise Education Association.

Ashman, R. 1988. Ingenuity and hard work equals franchise business success. Franchising World 12: 55-67.

Atkinson, J. 1968. Franchising: The Odds-On Favorite. Chicago: International Franchise Association.

Bates, T. 1995. Analysis of survival rates among franchise and independent small business startups. Journal of Small Business Management 33: 26-36.

Bates, T. 1995. A comparison of franchise and independent small business survival rates. Small Business Economics 7: 377-388.

Bates, T. 1996. Survival patterns among franchisee and nonfranchise firms started in 1986 and 1987. Report to the U.S. Small Business Administration under contract SBA-8121-OA-94.

Bates, T. 1998. Survival Patterns among newcomers to franchising. Journal of Business Venturing 13: 113-30.

Castrogiovanni, G., Justis, R., and Julian, S. 1993. Franchise failure rates: an assessment of magnitude and influencing factors. Journal of Small Business Management 31: 105-114.

International Franchise Association Educational Association. 1996. Study of franchised unit turnover. Unpublished report.

Lafontaine, F., and Bhattacharyya S. 1995. The role of risk in franchising. Journal of Corporate Finance 2: 39-74.

Shane, S. 1996. Hybrid organizational arrangements and their implications for firm growth and survival: A study of new franchisors. Academy of Management Journal 39: 216-234.

U.S. House of Representatives, Committee on Small Business. 1992. Hearings: New Developments in Franchising. Washington, D.C.: U.S. Government Printing Office.

U.S. Senate, Select Committee on Small Business. 1971. The Economic Effects of Franchising. Washington, D.C.: U.S. Government Printing Office.

http://judiciary.house.gov/legacy/bate0624.htm


Brought to you by WikidFranchise.org

Risks: Academic research, Professor Timothy M. Bates, U.S. Oversight Hearings on the Franchise Relationship, 1999, Economics, Academic research, Books, Survivability (franchisee and franchisor), International Franchise Association, IFA, Mask of respectability, Fraud, lies, misrepresentations & half truths, Churning (serial reselling), Independent businesses survive longer than franchised ones, Independent businesses much higher profit than franchised ones, Buying an existing outlet even riskier than from scratch, Trade association propaganda, Success rates fudged, Academic scorn, Universities provide unbiased expert knowledge and pursue objective truth, United States, 19990624 Tim Bates

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License