Look Before you Leap

…young businesses started without the benefit of a parent franchisor generated higher profits and had lower failure rates…Buying a franchise from a previous owner is particularly risky for prospective business owners. And buying a large retail franchise puts new owners at greater risk yet.

Inc. magazine
July 1, 1995

Look Before you Leap
Dr. Timothy Bates

When Eli Weissman voluntarily retired from IBM, in 1992, he decided to buy a franchise. At age 51, with a child still in college, he needed to find a new line of work. Despite his advanced degree in mathematics, Weissman's skills in data processing were not up to date, and his specialized career at IBM had left him ill prepared for most lines of small-business ownership. So he used his IBM retirement money to buy a franchise in the fast food industry.

Two years later Weissman described his experience in franchising as "a nightmare." He had put more than $120,000 into the business and had not made a dime of profit. Worse still, the franchisor was demanding that he sink another $60,000 into his shop for leasehold improvements. Faced with exhausted personal resources and unable to raise any more credit, Weissman was forced to abandon the franchise.

Is Eli Weissman a rare exception among franchisees? While the industry has never claimed that franchise ownership is an absolutely sure thing, many franchisors — Mail Boxes Etc., for instance — assert that 95% of their new franchises are still in business after five years. According to research sponsored by the International Franchise Association (IFA), nearly 97% of all franchise units opened nationwide over the past five years are still in operation. The franchise, we are told, is a pretty safe bet. Aspiring owners who choose to become franchisees expect that certain advantages will improve their chances of survival during the turbulent early years of their businesses. The advantages include the franchisors' offer of managerial training, site-selection assistance, and other business advice. And franchises often come with a recognized brand name and product line, which new owners expect will give them a head start against the independents in attracting customers.

Despite industry claims to the contrary, however, Weissman's experience is not uncommon. For example, my research shows that among small businesses started nationwide in 1986 and 1987, franchises generated average pretax profits of minus $4,501 in 1987. Independent start-ups, by contrast, had average profits of plus $15,511. By late 1991, 38% of the franchises and 32% of the independents had gone out of business. In other words, young businesses started without the benefit of a parent franchisor generated higher profits and had lower failure rates.

When new owners buy ongoing businesses, the success rate for independent companies is higher than that of franchises as well. Like many new retail owners, Weissman had bought an operating franchise. (Fifty-three percent of new retail franchise owners in 1987 bought their businesses from a previous owner.) Again, he was not the exception in his experience of failure. When I looked at purchasers of ongoing franchises, I found that only 52% of the owners in 1987 were still operating the same franchise in late 1991; 32% had shut down; 15% were still operating but under different ownership. Among the new independent owners who bought ongoing businesses in the same period, 68% were still operated by the same owner in late 1991; 18% had closed down; the balance had new owners. Whether new owners started a business from scratch or purchased an operating business, then, if they took the franchise route, the risk was greater, on average, that they would shut down.

Why should you believe my numbers instead of those put forward by the franchise industry? Let me start by saying that no one survey methodology is flawless. Still, the IFA and other industry sources base their estimates on surveys of franchisors — the corporations that sell franchises. The IFA study cited earlier, which reported a franchise five-year survival rate of nearly 97%, was conducted by Arthur Andersen and Co., the Big Six accounting firm. It surveyed 2,100 franchisors; fewer than 20% responded. I relied on franchisees to report information about their businesses. The U.S. Bureau of the Census compiled the data, which were based on surveys of 12,778 small businesses — both independents and franchises — whose owners created or bought their companies in 1986 or 1987. The response rate exceeded 72%.

Assuming my figures are a closer reflection of reality, we have to wonder what's going on in the world of franchising that's hindering success. On the surface, franchises would seem to have the edge: larger-scale, better-capitalized small businesses are the ones most likely to stay in business, according to most studies of start-up survival rates, and the franchises outweighed the independents in those characteristics. Sales revenues in 1987 for the young franchises averaged $440,391, more than five times greater than the average of $86,489 reported by independent start-ups. The franchises were also better capitalized overall: the average initial capital was $94,886 for the franchises, compared with $29,329 for the independents. In addition, the franchises scored higher on the number of hours the owners worked in a week and on their previous management experience.

Part of what accounts for the poorer performance of franchises lies in the choice of industries. Franchises are more heavily concentrated in retail operations (which include eating and drinking establishments), and those most often fit the high-risk, low-return profile. Even in retail, though, there are stark differences between franchises and independents. Again, looking at the new owners — both those who started businesses and those who bought them — the mean 1987 net income for retail franchises was minus $15,877; for independents, it was plus $10,368. Seventy-three percent of the independent retailers were still in business in late 1991, compared with 61% of the franchise retailers. One likely explanation for the differences is that popular franchising niches in retailing may have become saturated, leaving dim prospects for newcomers.

Buying a franchise from a previous owner is particularly risky for prospective business owners. And buying a large retail franchise puts new owners at greater risk yet. When I looked only at franchises with start-up capital exceeding $25,000 in 1987 that were still operating in 1991, I found that 22% of the 1987 owners had sold their businesses to new owners by late 1991. Although it's easy to understand why the owners would want to sell, it's not so easy to see what attracted the buyers to those particular franchises. (In 1987 the large franchises that would change owners by 1991 were, on average, even less profitable than the franchises that would go out of business by 1991.)

The relevant message here is that some troubled franchisees resolve their affairs by going out of business, while others get out by selling their problems to a new owner. I know of no exhaustive studies that look at the motivation of the new buyers, but anecdotal evidence suggests that, most commonly, they are simply naïve. For one reason or another, they either don't get access to accurate numbers or, if they do, don't study them carefully.

While it would be wrong to conclude that franchising opportunities across the board are poor, the likelihood of success is much dimmer than the industry spokespeople would have us believe. In a recent study Scott Shane, professor of management at Georgia Institute of Technology, in Atlanta, reported that of the 138 franchisors that first offered franchises for sale in the United States in 1983, more than 75% had gone out of business by 1993.

Eli Weissman, meanwhile, is still in the same line of business, running an ice-cream shop, but he is now on his own and operating without the benefit of a franchisor parent. His monthly revenues as an independent small-business owner are exceeding those he had in similar periods last year with the franchise, and his costs are down substantially. A wiser Weissman writes from Mendham, N.J., "I do not know the eventual results of my efforts, but so far, so good."

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What Had Happened to 1987's New-Business Owners by Late 1991

Still running the business 54%
Lost the business 38%
Sold the business to new owner 8%

Still running the business 62%
Lost the business 32%
Sold the business to new owner 6%

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Timothy Bates is a professor of economics at Wayne State University, in Detroit. The research comparing franchises and independent companies was conducted at the Center for Economic Studies at the U.S. Bureau of the Census.

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