Franchised Units Entry and Exit

For decades, the International Franchise Association (IFA) and the trade press have suggested that the failure rate of individual franchised units was very low compared to much higher rates of failure for independent firms.

For example, in its Fall/Winter 1990–1991 Franchise Opportunities Guide, on p. 24, the IFA states that “In 1989, for example, less than 3 percent of business-format franchisee-owned outlets were discontinued – many for reasons other than business failure. By contrast, the SBA has reported that 65 percent of business start-ups fail within five years.” Similarly, in their survey report, the IFA Educational Foundation and Arthur Andersen & Co. (1992: 16) note that

“96.9 percent of the franchised units opened within the last five years are still in operation today.”⁴⁶

There are a number of problems with these statements. First, they often compare yearly rates of franchise failures to multi-year failure rates for non-franchised businesses, per the IFA quote above. In other cases, the reported failure rates for franchised businesses are based on self-reported data from small sets of franchisors. The failure rate reported in the Arthur Andersen quote above, for example, is based on self-reported data by a set of 366 fran-chised chains. Even if franchisors in this sample truthfully reported the data, the probability that mainly successful firms with low failure rates chose to participate in this survey makes it highly unlikely that the reported failure rate is a good estimate of franchised unit failure generally.

When one examines the failure rates of blue-chip franchises, the probability of failure is in fact relatively small. Using data from disclosure documents,⁴⁷

46See Bates (1998) for references to several other such claims. The author contradicts these claims with his data. See also Bond (2001) for a pragmatic summary of existing evidence on this issue.

47Though the FTC does not require the filing of disclosure documents, nor does it re-view the information contained in these documents, the contents are rere-viewed in a

Kolton (1992) found that 4.4 percent of all franchised units were cancelled, terminated, not renewed, or reacquired each year in the 584 leading franchise systems in the U.S. Even this rate of failure, however, is much larger than those touted above. In particular, over five years, these failure rates for established franchisors still amount to one out of every five outlets failing, a rate that is lower than the five-year failure rate attributed by the IFA to independent businesses, but still not low in absolute terms.

Not surprisingly, when one considers all franchised chains, the failure rates are even larger. Bates (1995a,1995b), in particular, used the Characteristics of Business Owners (CBO) database produced in 1992 by the U.S. Census Bureau to assess the rate of failure among a representative sample of small businesses, both franchised and non-franchised. He found that failure rates of franchised small businesses were greater than those of independent businesses, though not significantly so. Specifically, he observed that 34.7 percent of franchised businesses failed as opposed to 28.0 percent for independents over a five-year period. In other words, his data show that franchised unit failure rates are underestimated in the trade press while at the same time the rates of failure quoted for independent businesses are exaggerated. This makes franchising look less risky, when in reality it is at least as risky as independent business ownership. Finally, IFA and Frandata Corp. (2000) dedicate a whole section of the Profile of Franchising to what they call turnover rates. They find that for the sample of 834 franchisors for which they have data on this, 11.33 percent of franchised units in operation at the end of 1996, on average, had their contract canceled, or were not renewed by the franchisor, or were reacquired by the franchisor, or otherwise ceased to do business during 1997. The median turnover rate in these chains was 5.5 percent. Since we do not know the age of these units at the time they stopped franchising, the figures are not directly comparable to those from Bates (1995a), but they still clearly support the high failure rates he found in the CBO data. Moreover, the difference between the mean and the median failure rates confirms the existence of a group of well-established and relatively low-failure franchised systems (those below the median rate) that coexists with a number of franchise systems with very high rates of failure. Those latter firms are responsible for raising the average failure rate of franchised businesses in the economy much above the median rate.

number of cases by state franchise examiners, and franchisors are subject to both civil and criminal penalties if they misrepresent the information in these documents. Con-sequently, the data contained therein are much more objective than data obtained from surveys.

To our knowledge, there has been no systematic study of the effect of franchisor exit, whether it be a departure from franchising or a business fail-ure, on the survival or growth of the franchised units that were tied to it.

Frazer (2001) interviewed a set of franchisors that had stopped franchising in Australia between 1996 and 1998. Though she does not indicate the number of units or chains on which the statistics are based, she reports that imme-diately following the cessation of franchising by their franchisor, 37 percent of franchise units were converted to new employment relationships and later disbanded, 19 percent continued operating as independent businesses under new names, 18 percent were sold to an external party, 9 percent closed outright, 8 percent continued to work with their ex-franchisor under a distributor or li-cense agreement, 5 percent continued operating under the original name, and 3 percent were purchased by the ex-franchisor and became company units.

Thus, her data clearly show that the fate of one’s franchisor and its decision to continue to franchise have a major impact on the future of any franchised unit.

Anecdotal accounts of individual cases confirm that success for a franchised unit is intimately tied to its franchisor’s success in franchising. In that context, the high rates of franchisor exit documented above are quite troubling. In fact, the high rate of franchisor exit surely explains the remaining difference between the rates of failures quoted in Kolton (1992) and those found in Bates (1995a,1995b). The latter examined failure rates of a random set of small businesses, so the sample would include units of chains that are not as established and where the franchisor is more likely to fail or stop franchising.

These outlets, thus, are themselves more likely to fail.

We conclude that the data contradict the notion that investing in a fran-chised business is a risk-free or very low-risk endeavor. In fact, high franchisor failure rates suggest that joining a young or new franchised system is probably more risky than starting one’s own business. Success in this case depends not only on one’s own good ideas, resourcefulness, and dedication, but also on the capacity of the franchisor and the other franchisees to pull things together.

The upside of joining a new franchise system also is potentially very high.

Those who joined McDonald’s when it was a fledgling chain have profited handsomely from this decision. When one joins an established chain, the probability of failure is lower but so is the probability that the venture will be hugely profitable.⁴⁸

Three more points deserve attention. First, Bates (1998) further pursued his analyses of franchise failures using the same database, but this time distinguished which units were sold to new franchisees and which were sold

48This is an illustration of the usual trade-off between risk and expected returns.

to existing franchisees. He found that “franchise units have better survival prospects than independents,. . . (while) young firms formed without the benefit of a franchisor parent are more likely to remain in operation than franchised start-ups” (113). He explains these seemingly contradictory re-sults by using the fact that the vast majority (84 percent) of new franchised units are opened by existing multi-unit operators. These units benefit from the multi-unit owner’s experience in the business and are, not surprisingly, very likely to survive. In fact, they are much more likely to survive than independent businesses, and as they represent the vast majority of new fran-chised businesses, their high survival prospect gives rise to the first conclusion above. New units opened by new franchisees, which Bates called “franchise start-ups,” however, were less likely to survive than independents in his data, giving rise to his second finding. He concluded that it matters greatly, when assessing survival, whether one considers firm-level or outlet-level data. In fact, he notes that “[t]he potential franchisee needs to know how start-up firms have performed, and data describing new establishment’s performance cannot provide this information” (127). We return to the issue of multi-unit franchising in Section2.4.

Second, it is important to recognize that in the majority of studies, the defi-nition of a failure is that the firm ceases to exist. But failure in franchising is not really that simple. For example, in Franchising in the Economy, the USDOC supplied data on franchised unit discontinuations but also on (1) con-tract terminations by franchisors, by franchisees, and by mutual agreement;

(2) non-renewals by franchisors, franchisees, and by mutual agreement; and (3) the number of franchised units repurchased by the company.⁴⁹ Holm-berg and Boe Morgan (1996) discuss how all of these figures relate in some way to “failure” in a franchising context. The IFA Educational Foundation and Frandata (2000) study further describes different concepts of success and failure for franchised units and note how different indicators relate to each of these. In the end, the definition of turnover they adopt is guided as much by data availability as by their desire to limit double counting and define failure properly. Though these issues of definition make it difficult to arrive at a final simple “failure” rate, it remains true that all the studies suggest a much higher incidence of failure than that claimed traditionally by the popular and the trade press.

Finally, having established that franchising is not a panacea, we now return to our earlier statement that franchising is a useful way to organize certain

49In addition, for terminations by franchisors, the USDOC data further described whether the termination resulted from a financial default, a quality control violation, or “other.”

We return to some of these data in Chapter 10.

types of businesses and to the reasons why we expect it to continue to thrive.

Franchising does not guarantee success to franchisees, but it gives them a way to develop a business locally as part of a larger system. That system, if well-established, provides access to products and suppliers, to a set of business methods, to managerial support, to a recognized brand, and so on. These are particularly valuable to individuals who do not possess the level of human capital needed to start a business from scratch. Again, early empirical evidence suggests that franchising attracts people who would not have chosen to open a business by themselves. Hunt (1972) in the U.S. and Stanworth (1977) in the UK both found that a large proportion of the franchisees in their samples – 52 percent and about one-third, respectively – would not have gone into business by themselves. Williams’ (1999) work, which also relies on the CBO database, documents differences in human capital, such as formal training, business experience, and so on, between individuals who choose to purchase a franchise and those who go in business for themselves. He finds that on average those who opt for franchising have higher education and work experience, but lower levels of business experience. His analyses further show that those who choose franchising are substantially better off as franchisees than they would have been if they had tried to start their business on their own.

The conclusion to be drawn from this body of work is that while franchising is not risk-free, it does make it possible for people who might otherwise not have this opportunity to develop a business locally and, with some luck, thrive as part of a larger business entity.