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Franchising’s new headaches

A game-changing decision is just one of the challenges poking at the franchisee-franchisor relationship.

Like nearly every franchisor and franchisee in the country—restaurants or otherwise—Michael Mabry has had a phrase haunting his thoughts lately: joint employer.

At blame, the National Labor Relations Board’s recent decision that franchisors should be held responsible for a franchisee’s employees. “It’s scary,” says Mabry, chief operating officer of Plano, Texas-based Mooyah Burgers, Fries & Shakes. “The whole idea of franchising is that your franchisees want to be entrepreneurs, and franchisors want to offer that opportunity. We give them best practices, we give them a brand, but then they run their own business in their own market. To say that franchisors are responsible for the franchisees’ employees—when we didn’t go through the interview process with them, when we don’t know anything about them—seems like a real disconnect.”

It’s a disconnect that’s creating a historic challenge for the industry. But it’s not the only one franchises face in 2015—including red-hot fast casuals, which enjoyed nearly 11 percent sales growth in 2013 compared to an industry rate of 3 percent. Also standing in the way of continued growth: a tight real estate landscape and a still-sluggish lending environment.

But the same innovation that has gotten the segment where it is in the market is leading to solutions.

The Challenge: Joint employer status

Last year, the NLRB’s general counsel Richard Griffin Jr. issued an opinion concerning cases against McDonald’s, concluding that the corporation is a joint employer, along with its franchisees, of all its franchisees’ employees. That makes the home office responsible for any transgression a franchisee might conduct against, say, a line cook. The implications of this opinion—which don’t yet amount to a formal ruling—are evident to the industry.

“This is one of the biggest issues I’ve ever seen in my 25-plus years of practicing law,” says Brian Schnell, a partner at Faegre Baker Daniels in Minneapolis, which consults and litigates on behalf of franchisors. “It would be a huge game changer targeted at the whole franchise business model.”

Schnell says his firm has taken the opportunity to reinforce best practices with its clients. “Make absolutely certain you are not involved in any of your franchisee employment issues,” he says. But he acknowledges the huge gray area that exists around system standards: “What’s the right balance of a franchisor saying, ‘Here’s the system standard you need to meet, here’s how you get there.’ And saying, ‘Here’s the standard, here’s how you must get there.’”

But while a lot of restaurateurs are taking a wait-and-see approach to the ruling, Mooyah is doing something to get ahead of the new challenge. It came up with an approach that is meeting both corporate’s need to have franchisees versed in best practices and the need to maintain distance: it hired an HR consultant who works with everyone. The first order of business was for the consultant to review everything.

“The company has gone through and redrafted all our employment manuals, operations manuals, reworded them,” says Mabry. “They also had us pull the hourly handbook we gave to franchisees. It connected the dots from that hourly employee back to us. We tell them now you’ve got to create your own.”

But Mooyah’s franchisees are not alone in creating that manual or in maneuvering the tangle of HR issues any business faces; the franchisees also are able to work with the consultant Mooyah corporate hired. Every new franchisee Mooyah brings on gets four to six hours of HR education directly from the consultant, separate and apart from the franchisor. From there, the consulting firm works with the franchisee on an as-needed basis, paid for by the franchisee, but with a knowledge of the franchisor’s systems and priorities.

The Challenge: Credit for small franchisees

“We see access to capital improving. And we expect that trend to continue into 2015,” says John Reynolds, president of the International Franchise Association educational foundation.

“There is a lot of money on the sidelines coming back into franchising. The money is attracted to great concepts with mature, experienced operators,” he says. “If you flip that around and look at it the other way, the brands looking to single-unit operators who may not have restaurant experience, they are fighting a rising tide. The money is going to go to the mature brands, the well-established brands with the great operators, and there are so many of them that it crowds out everyone else.”

Corner Bakery Cafe represents one end of the fast-casual lending spectrum. “For us, capital was a nonissue in 2014,” says Gregg Koffler, VP of franchise development for the Dallas-based 182-unit chain. “Every [franchise] deal we sign is multiunit. These larger developers have no capital issues.

Other fast-casual franchises that rely more on single-unit deals and often work with franchisees new to the industry aren’t seeing those salad days however. “One of the biggest challenges we face is the financing,” says Mike Rotondo, CEO of 412-unit Tropical Smoothie Café. “We have plenty of people who want to grow the brand, but the opportunity is limited due to funding.”

In response, Atlanta-based Tropical Smoothie worked out a lending program of its own, allowing existing franchisees to borrow from the venture capital firm that owns the chain, Buckhead Investment Partners, with the loan guaranteed by Tropical Smoothie Café.

“Maybe they don’t have enough to put down to get a traditional loan,” he explains. “The [Small Business Administration] wants 30 percent down; ours is 20 percent down. Maybe their credit score is too low. Maybe their time in business isn’t long enough.

“But we only lend to existing franchisees. So we’ve looked at what they’re doing in sales. We look at their compliance with our system. We see their P&L. We rely more on that kind of relationship than you see with traditional funding.”

The process also moves a lot faster: deals are approved in five weeks as opposed to three to four months with a typical loan, says Rotondo.

In the year the lending program has been in place, he says, Tropical Smoothie Café has made 16 loans amounting to roughly $3 million. That allowed for 16 new units he says would not have opened otherwise.

The Challenge: A tight real estate market

Last fall, the real estate broker for Trufoods, which franchises several fast-casual brands, took the company’s president to show him the site for its latest store in Houston. “He took me to this field on the western end of Houston,” says Gary Occhiogrosso, the brand’s president and chief development officer. “There was a road and a bunch of grass. He says, ‘This is the site.’ I’m looking for rooftops and people, and I’m seeing longhorn and grass.”

Welcome to the real estate realities of 2015: “If you wait until it’s already built, there are 10, 15, 20 competitors already in line ahead of you,” Occhiogrosso says.

According to CoStar Group, a data-tracking firm focused on the commercial real estate industry, strip center vacancy rates—with the endcaps everybody wants—are at 9.9 percent. But the situation for fast-casual chains, which demand A locations consistent with their better-chain brand image—is worse, says Suzanne Mulvee, director of research, retail at CoStar.

“We believe the national vacancy rates are being inflated by noncompetitive space—dead centers, often in far-flung locations. If you remove these noncompetitive centers, we find a much tighter picture emerges. For example, the strip center vacancy rate is running at 9.9 percent, but when you back out noncompetitive centers, the vacancy rate is far tighter at just 6 percent.”

Meanwhile, prices have risen back to the peak levels of 2006, according to CoStar. And the outlook? Not good. Forty-eight million square feet of commercial space was built in 2014, compared to an annual average of 160 million from 2000 to 2006.

Savvy franchisors are practicing an uncomfortable strategy: patience. Not flashy, by any means, but effective, they say.

When Salsarita’s Fresh Mexican Cantina was ready to expand with a new prototype into Mississippi, outside its North Carolina home base, it found a local developer willing to take them on in an upcoming shopping center. A year and half later, the location opened.

“That’s a long time,” says Salsarita’s president Phil Friedman. “But now we’re a preferred tenant with that developer. The next unit only took eight months.”

Likewise, patience has paid off for Robert Maynard, CEO of Charlotte-based Toast Café. The small chain—five units—has signed on seven new franchisees to expand by 15 new stores this year.

When the chain wanted to expand to Davidson, a college town next to Charlotte, Maynard knew the spot they wanted across from the school.

“Somebody else got it,” he says. “We kept in touch with the guy. We were vigilant and kept on top of it. The guy dumped a lot of money into the place, and it didn’t do as well as he expected. Eventually we got it from him. It’s our best store now.”

It’s the same for large franchisors as well. “It’s a matter of having to be patient,” says  Don Fox, CEO of Jacksonville, Fla.-based  Firehouse Subs. “It’s more difficult to find a great site. You’re going to wait longer to develop a restaurant. If the sites had been available, we could have opened 50 more units in 2014.”

Firehouse franchisees are responsible for finding real estate that the corporate office signs off on. They’re given six months to open their first unit. With the current real estate market, that’s often not happening.

“If we see they’ve been making an effort to find a site, we’ll extend the contract,” says Fox. “They’ve made the financial and emotional commitment. It’s rare that a franchisee would reverse course. It just takes longer.”


More on the NLRB

As a regulatory body formed to shield employees interested in unionizing, the National Labor Relations Board is “never going to be your friend,” an attendee begging anonymity remarked at a recent industry conference. But why does the 80-year-old watchdog suddenly have its knives out for restaurant franchisors?

Experts say the perceived hostility is less of a swing at franchising than a roundabout way of opening up big-name employers in the service sector to possible unionization. If McDonald’s is held responsible for labor conditions throughout the mostly franchised chain, as the NLRB’s reclassification of franchisors as joint employers would warrant, the home office becomes the villain behind any perceived slight to employees. And the McDonald’s system has about 1.7 million of them. (As the first major court test, 10 former employees sued McD’s USA last month, alleging discrimination at franchised stores in Virginia.)

Why now? Pundits cite the recent appointment of unabashedly pro-labor directors to its board. At the same time, they say, labor is stepping up its effort to organize the service sector.

The NLRB did not respond to a request for an interview. Meanwhile, the body continues to be cursed not only for the joint-employer decision—an about-face from a legal principle courts have upheld for decades—but also by several other rulings with profound implications for restaurants.

A coalition of business groups has filed a federal lawsuit to challenge one of them, a law that would shorten the time employers have to prepare for elections. The action has yet to move forward. —Peter Romeo

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