8 ways the franchise relationship hurts franchisees

A recent report by U.S. Sen. Catherine Cortez Masto highlighted several problems in franchising and how it hurts operators. RB’s The Bottom Line looks at eight of them.
Problems in the franchise business
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The Bottom Line

Franchising is booming right now and for good reason. A lot of people lost jobs last year and they grew frustrated with the corporate life and want to “control their own destiny.” This can be good for plenty of people and a lot of people get rich by owning franchises—many of whom started out as crew members sweeping floors and working long hours.

But, as we’ve reported a few times, investing in a franchise business is a far bigger risk than many people believe it is. That was highlighted in a recent report on franchising abuses by U.S. Sen. Catherine Cortez Masto, a Democrat from Nevada, who highlighted several problems in the business model that need fixing.

Let’s take a look at eight of them.

Mandatory arbitration. Many franchise agreements will require franchisees to arbitrate any disputes. They will often require it be done in a certain area, likely where the franchisor is headquartered. That gives the franchisor “a home-field advantage, which is very difficult for a franchise owner to overcome,” the report says. It’s also expensive and time consuming and many operators who invested their life savings in a business can ill afford to file an arbitration.

The franchisor gets to change the rules. Franchisors often give themselves the ability to change rules at any time, for any reason. That was a major point of concern for Subway operators who recently published a letter to Elisabeth DeLuca, widow of cofounder Fred DeLuca—a concern that was confirmed by franchisees we spoke with. Cortez Masto’s report says that franchisors use it in sometimes “far-reaching ways,” such as requiring store remodeling policies or requirements of the sale of franchises.

Demanding unprofitable promotions. Franchisees have pushed back against promotions forever, but their complaints have grown louder in recent years. Subway franchisees pushed back hard against that chain’s proposed 2-for-$10 promotion last year. In 2009, Quiznos sent out a coupon for a free sandwich. Operators of that chain—already struggling with large discounts—refused to accept the deal. That angered customers and helped speed what has been a massive collapse.

The non-disparagement clause. It’s certainly understandable that a franchisor wouldn’t want their franchisees to speak out against the chain they operate. But many franchisors aggressively use non-disparagement clauses in the franchise agreement to stamp out opposition to various rules and requirements. And sometimes they extend it to comments on profitability to prospective operators. The Cortez Masto report notes that many franchise owners will avoid telling a prospective franchisee about their actual profits for fear they will get sued or terminated by their operator. This also extends to operators who try forming associations. It’s also not uncommon for franchisors to terminate people connected with an independent franchise association.

Limits on store sales. Franchisors typically keep a right to buy any restaurant in their franchise agreement, even if they have no intent on using it. But franchisors have been aggressive in using these clauses to steer stores into the hands of certain operators, which can limit the valuation on restaurants that are put up for sale. Or they simply refuse to approve a deal. And the investment that a franchisee thought they had is not worth as much.

Misleading financial disclosures. In general, it’s good for franchises to disclose how much a franchise can expect to make in revenue and earnings. But this can be ripe for problems. Numbers can be fudged or made to look better than they really are. A 2011 SBA audit found franchisors’ revenue projections in disclosure documents was often significantly higher than they really were. Even if they don’t report the data, however, franchise sales folks will sometimes just give out random figures to make the restaurants sound good—a major problem in the Burgerim situation two years ago.  

Supply chain rebates. A franchisor’s primary revenue stream comes from royalty payments. Franchisees pay a percentage of their revenues to the franchisor. But the franchisor can also make a substantial amount of money off of their franchisees in other ways. One such strategy: Rebates on products the operators are required to purchase. A vendor will pay a franchisor a rebate—sometimes derided as “kickbacks”—for the right to sell that product to operators. The vendor then increases charges to the franchisees for those items. It can be disastrous for the operators—Quiznos charges operators so much they went out of business. In the McDonald’s system, requirements that operators use a certain ice cream machine caused the company continual problems, as is happening now thanks to a Wired article on the topic.

Marketing fund misuse. Another common area of dispute between franchisor and franchisee is over the marketing fund, which operators pay into as a percentage of revenues. Pizza Inn franchisees more than a year ago, for instance, accused parent company Rave Restaurant Group of using marketing funds to market Pie Five, which they view as a competing concept. According to the Cortez Masto report, Dickey’s would use marketing fund dollars to pay the expenses of executives’ travel, for instance. The report also noted that Dickey’s would decide where it should spend marketing dollars, so operators in some areas don’t get any marketing benefit while those in other markets might get more benefits.

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