Understanding Franchise Failure: "Are the Right Questions being Asked?"
In the current economic climate there are many news reports discussing franchise failure and the harsh economic realities faced by some well intentioned and hard working franchisees. These articles typically feature a struggling franchisee and then proceed with a discussion as to the economic difficulties that the franchisee is experiencing. When reading many of these articles - especially the portion where the franchisees express what he or she believes is causing the failure in the franchised business - I am concerned that many franchisees (including prospective franchisees reading the article) may be missing some critical points.
In Eilene Zimmerman's CNNMoney.com article, "Trench Warfare in the Franchise Field", Rita's franchisee Tish Reisman discusses some of the difficult circumstances that she is currently experiencing. While it certainly appears that Ms. Reisman is a hard working and well intentioned individual, I am concerned that the points she raises (as to the possible causes for her business losses) may be off the mark. In the article Ms. Reisman, raises the following points that she attributes to her losses:
(a) Encroachment: "A competing Rita's opened five miles away";
(b) Time Consuming Promotions: "A corporate marketing campaign required her to stand in front of Wal-Mart and Kmart stores handing out coupons, sucking up time and resources she couldn't spare";
(c) Product Introductions: "Rita's requires her to sell every new flavor it introduces for 24 days - even if it tanks"
While the issues raised by Ms. Reisman are certainly issues of concern, are they the actual cause of the "franchise failure" that she seems to be experiencing? Here are some of my thoughts:
- Encroachment - Encroachment is an extremely serious issue for franchisees and indeed a major contributor to franchisee failure and diminished profits / losses. However, in Ms. Reisman's case we are advised that the competing Rita's franchisee is located 5 miles away. When dealing with the "local nature" of ices and similar quick serve products is this really an encroachment issue? Five miles sounds quite reasonable and could actually serve as a benefit to Ms. Reisman in terms of economies of scale that may be created through possible joint marketing efforts and brand penetration. While encroachment is a serious issue for all franchisees, I am not certain that this is a significant factor for Ms. Reisman.
- Time Consuming Promotion - I am not sure if I buy this issue at all as a contributing factor. Having a franchisor interested in market promotion is a good thing and, quite frankly, Ms. Reisman could have paid some teenagers to hand out coupons - as opposed to doing it herself.
- Product Innovation - many times franchisees complain, and rightfully so, that the franchisor is not actively engaged in product innovation and development. So, here to, I would not criticize Rita's for its constant product introduction. However, to the extent that franchisee's are experiencing higher levels of waste (due to poor sales of new products) there should certainly be a royalty adjustment for the franchisee. This is certainly an issue for Ms. Reisman, but, again is this a substantial contributor to her unprofitability?
While Ms. Reisman may be experiencing other issues not addressed in the article, I can not help but believe that she needs to be addressing and evaluating some serious additional factors. For both Ms. Reisman and any individual considering a franchise investment, here are some other factors that I would be considering:
- Debt Service - The issue of debt service is not mentioned in the article but could be playing a substantial factor in the economics experienced by Ms. Reisman. Did Ms. Reisman borrow money to establish her Rita's franchise and, if so, how much? Too many times prospective franchisees do not consider the substantial impact that debt service will have on their bottom line. Is Ms. Reisman over levereged?
- Expectations - When purchasing her Rita's franchise what were Ms. Reisman's expectations about profitability. My only point here is that when evaluating something as a success or failure , a lot depends on your expectations. Did Ms. Reisman have the right expectation when she purchased her franchise? Did she base her expectations on solid "due diligence" involving discussions with existing franchisees, a thorough evaluation of the FDD and her legal obligations?
There are many other factors that are of extreme relevance to understanding the unfortunate circumstances that Ms. Reisman is facing. It is not enough to simply blame the franchisor and, quite frankly, Ms. Reisman needs to thoroughly assess her current circumstances and implement some immediate corrective measures. Unfortunately, if Ms. Reisman's due diligence or expectations were off, going forward, the Rita's franchise may not be the correct business for herself and her family.
UPDATE:
In a comment Paul Segreto of Franchise Essentials links to his excellent and "honest" post "Fear and Consequence of Failure: A True Story". If you are a franchisee definitely read what Paul has to say as I believe that the advice he offices speaks from experience. If you are a struggling franchisee consider what Paul has to say - especially the part of considering an exit strategy.
Great article, Charles!
I recently wrote an article about franchise failure. Actually, the fear and consequences of failure, that I strongly believe every franchise owner on the brink should read before they stick their head in the sand and think the problems will mysteriously go away.
http://franchisessentials.wordpress.com/2009/04/21/fear-and-consequences-of-failure-a-true-story/
Unfortunately, the regulation of the sale of franchises ignores the "known" problem of the failure rate of all small businesses, independent or franchised. Public policy for many years has encouraged the hiding of the failure rate -- apparently, because businesses that go in and out of business do stimulate the economy and serve the special interests etc.. all of the time, (the years and months)that their owners are trying to attain breakeven.
Statistics bear out that just as many businesses fail every year as are started up every year. SBA loans eventually fail at an alarming rate but nobody is alarmed because apparently, in franchising, only the franchisee on the bottom of the financial pyramid takes the hard fall and franchisors' systems have a better opportunity to survive the grim failure statistics.
Franchises are sold in the presale process as if there was very little risk involved and the true risk is not disclosed by the franchisor or his agents because of captured and dishonest regulation of the sale of franchises. Franchisors can disclaim that they are in any way or manner promising success or profits in the Franchise Disclosure Document and the signed adhesory franchise agreements.
These disclaimers protect franchisors in our courts from those who fail and believe they were misled in the sales process. The constructive fraud of inadequate disclosure under the FTC Rule and State FDD's enables the sale of weak and unprofitable franchises to the general public, and to unfortunates like Rita.
Raising the expectations of people like Rita and other innocents is what has made franchising so durable in our economy for franchisors.
Franchisors, of course, who are the entrepreneurs can sometimes beat the failure statistics of small businesses because they are enabled to churn and turn failed units to continue to serve the franchisor's EBITA's. There is no doubt that compounded churning and turnover of franchise units is why franchising has been so durable in our economy.
Franchisors pre-sell franchises as if there was infinite demand and little if any risk and are permitted under law to avoid providing any proof that the franchise and the business plan is successful in termns of how the franchise performs in the marketplace for all of the units of the system.
Maybe things will get better for prospective franchisees after lawsuits are filed by the investors in the franchisors who are also not provided the UNIT performance statistics of the franchise systems in which they have invested.
In the meantime --never buy a franchise without consulting a qualified and honest franchise attorney like Charles Internicola who will not permit his clients to buy franchises without understanding the risk involved for the particular franchise.
Could there be a clause in the agreement to appoint someone to do an assessment/report as the basis for discussions between the franchisor and franchisee.
Charles - could this be a new service for you?
Bob - thanks for the comment and thought. Actually when representing franchisees we do provide them with a written evaluation of the FDD and the proposed franchise agreement.