Sour dough

"The state of franchise law in Canada is very weak," he says. "When it comes down to it, the franchise companies hold all the cards."

Canadian Business magazine
June 1, 2003

Sour dough
John Gray

Theresa Slater-Smith's Mother's Day weekend last year wasn't exactly the stuff of Hallmark cards. With her husband, six-year-old daughter and eight-year-old son in tow, Slater-Smith marched into the Great Canadian Bagel franchise she'd bought five years before and stripped it of everything not covered by her lease and other agreements. She even poured water on the Great Canadian Bagel branded napkins and sugar packets, rendering them half-dissolved mush.

It was a tiny act of revenge, compared with her original $150,000 investment in the franchise, but she knew she would never get that money back—nor the countless thousands of dollars and hours she had invested, working 60 hours a week at the 2,600-square-foot eatery in a west Toronto strip mall. That day in 2002, Slater-Smith's dream of earning great money and being her own boss was about as robust as the soggy sugar packs. The Illinois-born former model and long-distance runner had had enough. "This destroyed my finances, the financial future of my children and, nearly, my marriage," she says now.

And Slater-Smith is not alone. Over the past three years, high rents and sagging sales have forced dozens of Great Canadian Bagel franchisees to board up or abandon their stores. Even more have sold out, at a fraction of their original investments, to a new wave of franchisees - many of whom are now struggling to survive as what was once Canada's hottest franchise has grown stale. More than 60 Great Canadian Bagel outlets have closed down - so many that franchisees now have difficulty getting financing from the major banks.

Today, the Great Canadian Bagel Ltd. is at a crucial crossroads. Its old business model - large in-store bakeries pumping out fresh bagels - is all but dead. And for many franchisees, the worst is yet to come: while many of the chain's larger stores have shut down, there are still between 10 and 20 franchises with troublingly high rents. "The margins on bagels are just not strong enough to support those high rents on a full-production store," says Ed Kwiatkowski, Great Canadian's third chief executive in five years.

Now, the company is advising remaining franchisees to partner with other food outlets, such as pizza joints or even sushi restaurants, to share the rent and cut expenses. Any who can't find partners are being encouraged to open a second, smaller kiosk that will buy bagels from the larger store, helping to reduce overall costs. A number of kiosks have already opened at locations in the Bay and the Building Box, among others.

These new strategies aren't without problems. After all, who wants to open a second outlet when your first store is failing? And if you can't sell enough bagels to pay the rent now, how will moving a competitor into the store boost your sales? "There is a lot of frustration out there among franchisees," says Todd Bilquist, who operates a Great Canadian outlet in Calgary with his partner, Ed Chynoweth. They used to operate five bagel stores; now they're down to one. "The people at head office now are going in the right direction," says Bilquist. "But there's a lot of mistrust between the franchisees and the company."

So what went wrong? It's not that people are eating fewer bagels—Canadian consumption has grown almost 20% a year for the past 10 years, according to the NPD Group Inc., a market research company in Toronto. But with little or no marketing, and competitors like McDonald's and Tim Hortons flooding the market, Great Canadian franchisees have been overwhelmed. "Customers have forgotten why they should make a special trip to Great Canadian Bagel for our product," says Bilquist.

There are about 1,300 franchisors in Canada, employing more than a million people. Franchises are often touted as a low-risk opportunity, one that lets entrepreneurs run the show, but with the power of a recognized brand and the purchasing, marketing and business system of an established chain backing them up. Great Canadian franchisees were supposed to get all that for an upfront fee of about $260,000 (including the $30,000 franchise fee and start-up costs) and roughly a 10% cut of the gross. Unfortunately, as many of the company's franchisees have discovered, they've often been the ones to shoulder the risk for elusive or non-existent benefits, says Lawrence Eftoda, president of the Toronto-based Franchise Review Services Corp., a small-business advocate that (for a fee) helps potential franchisees evaluate companies, and disenfranchised franchisees negotiate settlements. (Earlier this year, he helped bring 11 disgruntled Second Cup Ltd. franchisees together to file a multimillion-dollar lawsuit, alleging, among other things, misrepresentation, breach of agreement, and lack of fair dealing and good faith. Second Cup is vigorously defending itself and has filed a $1.5-million defamation suit against Eftoda.) "The Great Canadian Bagel," says Eftoda, "is a fad franchise that has gone bad."

It wasn't always that way. For a while, Great Canadian was one of the fastest-growing franchises in the country. That was quite a feat. After all, with the exception of Montreal, Canada ain't exactly renowned for its bagel-baking - maybe beavertails and crullers, but not bagels. Yet the idea behind Great Canadian, some say, wasn't necessarily full of holes.

The company was founded in 1993 by Wayne Flatley and Neil Shopsowitz, the latter a member of the family that founded Shopsy's Deli, and Great Canadian's first president. As for Flatley, he was an experienced franchise operator who in 1987 had founded the Great American Bagel Inc., a chain of 55 shops in the US. Flatley's brothers, Aidan and Patrick, provided the financial backing. Patrick, better known as the former captain of the New York Islanders and current director of NHL alumni relations, still sits on Great Canadian's board.

For a time, the company looked like its success might rival that of another Canadian franchising juggernaut started by a hockey star: Tim Hortons. And why not? Great Canadian was a unique concept in Canada. Most locations boasted a full-service bakery that produced fresh bagels from scratch. That meant higher labor costs, since franchisees who didn't want to work 18 hours a day had to hire a professional baker. And it required more space - often between 2,500 and 3,000 square feet - and thus much higher rents than most other sandwich shops. But the company encouraged franchisees to look beyond walk-in customers and develop bulk-sales clients such as grocery stores, schools and restaurants.

The concept worked, at least in the beginning. By 1996 - dubbed the "Year of the Bagel" by one US trade magazine - Great Canadian had opened more than 100 locations across the land. Just three years after opening its first store, the company was selling a reported 1.8 million bagels a week, with annual sales of $65 million. At a gala banquet in Toronto, executives and investors celebrated as the chain was named 1996 Entrepreneur of the Year by a Canadian hospitality and restaurant magazine. All that success attracted the attention of other major franchisors. In October 1996, Great Canadian announced a deal with Second Cup, one of the largest coffee chains in Canada, that saw the coffee shop franchisor pour $6.5 million into the bagel chain in exchange for a 30% stake. The new partners opened four co-branded Second Cup/Great Canadian Bagel outlets, with promises of more to come. Over the next two years, the bagel chain expanded to every province in Canada, eventually hitting more than 150 locations—and even two in Russia. "Today," beamed an editorial in the March 1999 edition of the English-language Moscow Times newspaper, "the Great Canadian Bagel chain reigns supreme."

Franchisees profited. Theresa Slater-Smith opened her store in an upscale neighborhood in Toronto's west end in January 1997. She was even elected to the company's franchisee marketing committee. Sure, the rent was high and she worked long hours, but her store was one of the busiest and most successful bagel outlets in Toronto. Even an extended illness that often kept Slater-Smith from working full-time didn't stop her from selling more than $700,000 worth of bagels a year.

Slater-Smith had joined Great Canadian at the urging of Aidan Flatley who assured her the company was solid and growing, and would provide an excellent opportunity to get in on the ground floor. She had a personal connection to the Flatleys: they're close childhood friends of her husband, David Smith, and the couple's family photo album is jammed with pictures of Aidan reading bedtime stories to their children and of vacations her husband took with the brothers. "We knew the owners; we knew the management," she says. "It looked like a great business."

Today, Slater-Smith is not on speaking terms with the Flatleys.

The Great Canadian Bagel craze began to crumble almost as soon as it started. In 1998, Shopsowitz had been replaced by Brian Leon. Competition was rising, and monthly same-store sales - which had soared from about $7,000 in 1993 to almost $12,000 by 1996 - were starting to sag. By 1999-2000, sales were down by 5.9%. Why not? Everyone had started selling their own bagels, from Tim Hortons to McDonald's to the local grocery store. Oh, and that much-heralded investment by Second Cup was quietly liquidated and sold back to Great Canadian in 1999; the coffee chain booked a $1.5-million loss on the deal. "It was clear that the…'novelty' surrounding bagel concepts had worn off on many customers," Leon wrote in a memo to franchisees in May 2000.

Bagels - or at least the advantages of a bagels-only franchise - had become a dime a dozen. Profits at Great Canadian disappeared. While the company posted a modest gain of $400,000 in 1999, that transformed to a loss of $13,700 the following year. By the end of 2001, more than 40 franchises had been sold and at least 50 locations closed, abandoned or repossessed. Today, there are just 95 Great Canadian Bagel stores across Canada, with many having changed hands several times. And when franchises started to fail, would-be entrepreneurs quickly discovered there was little they could do.

At the beginning, the company was eager to dot the Canadian landscape with Great Canadian Bagel shops. "It was like a cult," says one former insider. "The founders felt that bagels were going to be this huge thing, and people were just going to beat a path to their door." Great Canadian's massive expansion was an attempt to stave off the kind of competition that had hurt sales at Wayne Flatley's Great American Bagel chain years earlier. As bagels became more popular, the US franchise's limited market penetration left it vulnerable to competition from bigger players. It was a mistake Flatley did not want to repeat in Canada. "We became determined," Leon said in the May 2000 memo, "to ensure that we would not be subject to the same fate."

But according to the former Great Canadian insider, it was a case of too much, too fast. The company gave new locations to underperforming franchisees, and new franchisees were only lightly screened. Expansion plans continued, even as it became more and more obvious that the new locations were cannibalizing sales from existing stores. "Same-store sales in a town would go from $15,000 to $12,000 to $6,000 to $4,000, and we would still be opening new locations," says the insider. "It was crazy." During one of Great Canadian's franchisee conventions, held in Kelowna, BC, Leon played a video purporting to show how he selected new locations. It showed him throwing darts at a map. It was meant to be funny, but few were laughing.

And small wonder. By then, many franchisees had started to question the company's marketing plan. Great Canadian had launched its first - and, ultimately, its only - major national advertising campaign in 1997. The ads featured celebrity endorsements from Olympic skater Josée Chouinard, wrestler Bret "Hitman" Hart and hockey legend Darryl Sittler - a friend of Patrick Flatley's who was rumored to be opening his own bagel outlet. Luckily for Sittler, he never did.

A scratch-and-win game launched at the same time also raised the ire of franchisees, since every card was a winner, leaving them on the hook for hundreds of dollars in promotional hats, cups and other goods, as well as deep discounts on baked goods. The only long-term effect of the campaign was a $1.8-million deficit in Great Canadian's marketing budget. So in 1998-'99, the company halted all major corporate marketing - just as sales were beginning to sag. "We begged them to keep something - anything - in the marketing budget to get the brand name out there," says Slater-Smith. "But the company said investors needed a return on their money." Desperate franchisees tried their own amateur marketing, but were shut down in a July 1999 memo from head office: "Taking a 'gorilla' [sic] approach to marketing our product and brand image…can be incredibly detrimental to the long-term growth of our business."

Today, the company says it spends about $600,000 a year - which comes from franchisees - on marketing, most of it on in-store promotions and coupons aimed at residents who live near remaining outlets. "We would like to have the multimillion-dollar marketing budget of a Tim Hortons," says Kwiatkowski, who became CEO in 2002 after Leon moved on to Booster Juice, a start-up franchise trying to cash in on the smoothie fad. "But there just isn't enough money for that."

Without a consistent marketing presence, retail customers who used to buy a dozen bagels lost interest, and there were fewer and fewer incentives for wholesale customers to pay a premium for Great Canadian's brand. As a result, bulk sales - once called a cornerstone of the company's strategy - dropped dramatically. In 1996, bulk sales of bagels and cream cheese accounted for about 50% of store sales; by February 2001, that was closer to 30%, according to internal reports. The shift squeezed not only franchisees' top-line sales, but margins as well, since bulk sales had lower production and labor costs.

In fact, the bulk sales strategy was problematic from the start. Great Canadian encouraged franchisees to sell to large national chains, such as Loblaws and Costco. But individual franchisees were left to deal with those national accounts, leading to inconsistent quality and service from one store to the next. For some customers, the business became more trouble than it was worth. When they began to pull out, it was a crushing blow to many franchisees. Slater-Smith, for instance, had worked hard to develop strong relationships with bulk customers, including the local Loblaws. When the grocery giant cut off all Great Canadian franchisees, it cost Slater-Smith more than $80,000 a year in lost sales.

As more stores closed, lawsuits from angry landlords began to pile up. The company's defence at the time was usually the same: the landlords had not maintained the property, thus driving away customers and forcing stores to close. Desperate franchisees turned to Great Canadian's roving business consultants (including the Flatleys' sister, Mary McDonnell) for suggestions on how to increase sales. "They would say, 'I don't know what your problem is—Bill at this store is doing great sales,' or 'Frank at that store is showing tremendous growth,'" recalls Slater-Smith. "Eventually, you call Bill or Frank and ask how they're doing it, and they all tell you the same thing: their sales are down, too, and they're on the verge of closing."

The situation was made worse by the company's frequent switching of suppliers - a common practice among franchisors in trouble, says Eftoda. Companies are willing to sacrifice quality for cost, but those savings are rarely passed on to franchisees. Another reason some franchisors switch is to extract upfront commissions or marketing fees from suppliers. Great Canadian's own literature says franchisees aren't entitled to any payments, commissions, benefits or other inducements from suppliers. While Great Canadian does receive upfront inducements from suppliers, says Kwiatkowski, those contracts routinely go before the company's franchisee advisory board - and all inducements go to in-store marketing and other improvements. "When we switched from Pepsi," he says, "Coca-Cola put several hundred thousand dollars into replacing the menu boards inside stores."

Yet there's no denying that when Great Canadian switched coffee in 2001, it nearly destroyed some franchisees. Coffee is a high-margin item and keeps customers coming back. But Great Canadian didn't keep on top of its new supplier, and quality slipped. Franchisees were stuck with coffee that many customers refused to drink. Within weeks of the switch, Slater-Smith saw coffee sales decline from more than 300 cups a day to just over 200 - a drop of about $53,000 a year in java sales alone. She says her complaints to head office went unheeded for weeks, and she finally resorted to buying coffee from an outside supplier - a violation of her franchise agreement. "I had no choice," she says. "People would rather eat a mediocre bagel at Tim Hortons and drink a great cup of coffee than eat a great bagel with coffee that's undrinkable."

In June 2001, Great Canadian laid out franchisees' complaints in an internal e-mail: "Complaints about quality are all over the map…that the coffee has no aroma and a mediocre taste. Many franchisees have continuously made the comment that when they clear tables, there are many half cups left." When the coffee supplier realized what was going on over at Great Canadian, it immediately took steps to see that the coffee improved. But the damage was done. Once loyal customers had moved on.

Zora McGladdery tried to use coffee to save her struggling franchise in Collingwood, Ont. McGladdery was named one of the chain's top operators in 1999, but that didn't save her when bulk sales collapsed and walk-in traffic eroded. In the fall of 2001, in a last-ditch effort to save her business, McGladdery approached Montreal-based coffee maker Van Houtte Inc. (TSX: VH) with a proposal: to remove her bakery and convert part of the store to a coffee bar. Wayne Flatley dismissed the idea outright. Instead, she says, Flatley suggested she take advantage of a new promotion the company had cooked up with another supplier - and install a soup bar. "We could barely sell two pots of soup a day in the winter, and we were a ski town," McGladdery recalls thinking. "Now you want me to sell gazpacho? I'm going to get killed."

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