Spotting trouble in franchisees: the freedom to fail

The current government inquiry into franchising has been prompted by concerns from current and former franchisees that they have lost their businesses due to wilful or negligent acts by their franchisors.

As the inquiry progresses the Senate committee will assess these claims to consider if there are systemic issues that need to be addressed by changes to the Franchising Code of Conduct, or its enforcement.

Whether or not the Code is changed, the risk of franchisees going broke will always exist as any business – franchised or otherwise – involves risk. A franchisor can never guarantee that a franchisee won’t fail, but as much as a franchise can provide opportunity and the freedom to excel, it also comes with the freedom to fail.

When a franchisee fails, it does not benefit the franchisor. There is the human cost of a distressed franchisee to deal with, which takes its own toll on the franchisor’s support team. There is the reputational cost of a business that has closed, which may damage customer, supplier or landlord relationships.

A failure may also dissuade future potential franchisees from joining, and in turn reduce the value of successful businesses run by other franchisees. The franchisor may also be left with a hole in their network so that rather than growing the network overall, it might need to focus its efforts on just replacing what it’s lost.

Some critics of franchising argue that the franchisor can benefit by resuming what’s left of a franchisee’s business after it’s failed, and then sell it again to another buyer. This may occur occasionally, but is rarely profitable for the franchisor after all costs have been taken into account, and therefore gives the franchisor no incentive to engage in this practise.

Early warning signs

The problem with most franchisee failures is that both franchisors and franchisees overlook the early warning signs. These include:

  • Sales failing to meet expectations or business plan projections (which means both parties should be clear on the expectations via a realistic business plan);

  • Costs exceeding expectations or business plan projections (and often in regards to the cost of goods sold (COGS), rent and labour, which are usually the three biggest costs for any fixed-location business);

  • The franchisees failing to adapt to the culture of the brand and the working environment of their franchise (or in other words, just being the wrong fit for the business);

  • Franchisees starting up without first achieving full operational competency (often due to an absence of formal competency assessment while in training);

  • Franchisees disengaging with the franchisor by declining offers of assistance, or rejecting advice in regards to remedial steps to lift performance (often out of stubbornness or suspicion of the franchisor’s motivations);

  • A failure to resource or effectively implement sufficient local area marketing activities (especially where franchisees have an expectation that the franchisor’s brand will be enough to attract customers without further effort on their behalf);

  • A general failure by one or both parties to the relationship to act responsively and decisively when the business first drifts off course, and waiting too late to make course corrections.

Unfortunately if franchisors don’t have the support systems in place to intervene when these early warning signs are present, franchisees will continue to fail.

Ideally, the franchisor’s support systems should give them full visibility of the performance of all areas of the franchisee’s business. The franchisor’s fee structure will usually determine their level of visibility, which means that franchisors who charge a fee based on a franchisee’s gross sales will have a system that gives them visibility over sales, whereas franchisors that charge only a flat, periodic fee may have no visibility over the franchisee’s business at all.

Where franchisor support systems are limited only to visibility over sales, the franchisor’s capacity to apply meaningful interventions when the franchisee’s business drifts off course is limited. Sales are just one part of a successful business. The other is the appropriate management of costs which will result in profits for the operator. Without visibility over costs (including COGS, rent and labour), and the profit that flows from the surplus of sales over costs, franchisors are limited in the extent to which they can apply meaningful interventions to struggling franchisees.

Good franchise networks will have (or be developing) monitoring and support systems which will give this high level of visibility over franchisee’s businesses. Franchisees can sometimes be resistant to such “Big Brother” oversight given that it’s their business and they want to enjoy the freedoms of self-employment and entrepreneurship without undue constraint.

But unless franchisors offer support at this level, franchisees will continue to fail. And unless franchisees accept that such a high level of monitoring is necessary to ensure their long-term welfare, they will continue to have the freedom to fail.