Five problems in franchising that hurt franchisees

RB’s The Bottom Line looks at five issues that can cause problems for operators that invest in the business.
Burgerim closed
Photograph by Jon Springer

The Bottom Line

Franchising has proven to be an excellent business model for a lot of companies, both for the companies selling franchises, and the people who are buying those franchises. McDonald’s, as is often said, has made more millionaires than just about anybody else. Plenty of other franchises have made their fair share.

But the model can also fail miserably. When it does, the franchisees end up in the opposite situation, broke and in bankruptcy.

In recent months, we’ve written numerous stories detailing challenges with the model, and how franchisors treat their operators, from outright problems like Burgerim to disputes between franchisors and their operators like Tim Hortons and Jack in the Box.

These stories expose several problems in franchising as it is applied in the U.S., both in the sale and the operation of the franchise. Here are five big problems with the franchise business.

The sale process is terrible

This is by far the most obvious. Franchises in their early stages are eager to sell units. Some of these franchises will sell to almost anyone. They frequently use emotions to sell these units to people prone to the idea of buying into a business. “Be your own boss,” or “control your own destiny” have become common phrases in the sector.

Selling unproven businesses to inexperienced operators is a recipe for disaster. The franchise itself frequently finds itself ill-equipped to train and assist that many inexperienced operators, who then struggle and shut down.

This has been a common theme in many of the worst franchise problems in history, notably Burgerim and Quiznos, the sandwich chain that went from nearly 5,000 locations to under 300 in just over a decade.

Franchises need to be sold like the investment they are, not as some get-rich-quick scheme many salespeople push onto unsuspecting operators.

Franchise rules have no teeth

The federal government requires that all franchises compile a massive prospectus on their business, called a franchise disclosure document. A handful of states have their own rules for these FDDs and will take steps to enforce them, such as Washington and Maryland.

But most states have no specific franchise regulation. And the federal government doesn’t bother to enforce its own rules.

Burgerim walked all over these regulations, as we revealed, telling people that their restaurants would cost less to build than they ultimately did, or providing financial representations that are not published in the FDD—all in a bid to convince more people to hand over their hard-earned cash. Hundreds of people lost at least tens of thousands of dollars.

Yet few franchisors or their executives get punished, even for obvious violations. What’s the point of having a regulation if nobody is enforcing the rule?

Rules end up favoring franchisors

With few rules, the franchisor gets a lot of leeway here through the franchise agreement, a binding contract between the two companies.

Over the years, franchisors have learned to make their franchise agreements more onerous, tilting the scales vastly in their favor. To wit: I Heart Mac & Cheese, like many other franchisors, does not make its franchise fee refundable. And prospective franchisees have six months to find a location or they lose the franchise.

The company then sells its business to inexperienced operators who frequently can’t get funding, or they can’t get approved for a lease on a location. The six months pass, and those franchisees lose that fee, and get no store.

Or perhaps companies write in their agreements that franchisees must file any claims in a specific state. Or they have to first file for arbitration in a certain state. Yet if the franchisee lost everything because the restaurant they opened didn’t work, many can’t afford to pay for a lawyer across the country. (Many, many people in the Burgerim case in particular couldn’t afford to even talk to an attorney because they gave everything to the company.)

Franchisors take a lot of money from franchisees

One of the most hotly contested issues is the rebate. Many vendors will give rebates to franchisors in a bid to earn their business. Franchisors often take them, to subsidize the cost associated with running the business, and the activity is actively encouraged.

Not surprisingly, this gets abused, too. Vendors make up for the rebates by increasing their charges to franchisees.

When a franchisor takes too much in rebates, the cost of goods can soar—more than eliminating any group purchasing benefit that allegedly comes in a franchise. It can become a real problem in franchises where sales are weak.

Quiznos was notorious for this. Its charges were so high that franchisees went out of business in droves when sales stumbled during the great recession. Rebates are a central theme in a dispute between Tim Hortons and its U.S. franchisees. Burgerim started pushing rebates on numerous vendors.

Too many franchisors use their franchisees as cash cows, not thinking of the long-term stability of their system.

Private equity encourages short-term moves

Want a tip on buying a franchise? Avoid private equity-owned companies.

Private equity can be good for the restaurant industry when done correctly, and there are numerous high-quality investment firms, such as Roark Capital, that are in the business for the long term. But too many of these investment firms are pushing short-term gains coupled with excessive leverage.

That can be a problem, because it encourages companies to push unit growth, either to generate a quick sale or to pay off debt or both.

Papa Murphy’s was a private equity-owned business that pushed aggressive unit growth on small-scale operators across the country. Those operators sued the company for not properly reporting how difficult it was to break into a new market with the company’s unique business model. Those operators began struggling, the brand itself stumbled with it.

Quiznos grew aggressively, taking on an investors through a 2006 leveraged buyout that ultimately eliminated its ability to help struggling franchisees, because it relied too much on those vendor rebates.

There are certainly other issues with franchising. But these are among the biggest. With more people expected to look into franchises in the coming months and years, it would be better to fix these problems more quickly.

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