Enterprise and Small Business Principles

Franchising and the small business

John Stanworth and David Purdy

23.1 Introduction

At its best, franchising is an avenue into self-employment offered by franchisors (owners of a ‘tried-and-tested’ business format) to franchisees (typically aspiring small business­men and women), in exchange for payment of a one-off front-end fee followed by an on-going royalty (Hoy and Stanworth, 2003). Based on the principle of ‘cloning’ suc­cess, a principal tenet of the franchise fraternity is that franchise failure rates are low.

From the viewpoint of small business researchers, franchising has been argued to be of particular importance, since most franchisors still are, or have recently been, small businesses themselves and most of their royalty-paying franchisees are also small busi­nesses. Thus, in principle, franchising offers a route to growth for the would-be franch­isor and small business opportunities with limited risk for would-be franchisees.

This chapter examines the advantages and disadvantages of franchising from the viewpoints of franchisor, franchisee and the wider society. It also examines growth rates, internationalisation, job creation, management challenges, future trends and, not least, risk levels. What emerges here is a striking similarity between the failure rates of young franchise systems and conventional small businesses at the same stage of development.

23.2 Learning objectives

This chapter has four learning objectives:

1 To gain a basic understanding of the nature of a business format franchise.

2 To gain an understanding of the symbiotic nature of the franchisor-franchisee relationship.

3 To illustrate that franchising may be viewed as a growth strategy for small busi­nesses or, alternatively, as a strategy for large businesses penetrating what have con­ventionally been recognised as small firm markets.

4 To demonstrate the potentially contentious nature of statistics issued by commercial bodies with an interest in promoting their particular business sector.

Key concepts

■ franchising ■ enterprise ■ growth ■ symbiosis ■ survival rates

■ service economy

23.3 Franchising and enterprise

A franchise can be defined as comprising a contractual relationship between a franch­isee (usually taking the form of a small business) and a franchisor (usually a larger business) in which the former agrees to produce or market a product or service in accordance with an overall ‘blueprint’ devised by the franchisor. The relationship is a continuing one with the franchisor providing general advice and support, research and development, and help with marketing and advertising. In return, the franchisee usu­ally pays an initial franchise fee and also an ongoing royalty or management service fee, normally based on the level of turnover and/or a mark-up on supplies purchased from the franchisor. The franchisee provides the capital for the outlet and is a legally separate entity to the franchisor.

Though the franchisor is usually a ‘larger’ business than the franchisee, in only a handful of cases does the franchisor truly meet the description of ‘large’. Most franch­isors remain very much small and medium-sized enterprises (SMEs) with no more than a small handful truly qualifying as large and these are almost inevitably American in origin (e. g. McDonald’s, ServiceMaster, Coca-Cola, Pepsi-Cola, Holiday Inn, Burger King, Kentucky Fried Chicken, Pizza Hut, Kwik-Kopy, Budget Rent-a-Car). Overall, in the UK, the average franchise involves around 30-40 outlets according to the British Franchise Association’s statistics and could thus still certainly be considered an SME, if not a small business per se.

23.4 The nature of franchising: entrepreneurship or dependence?

At one extreme, it has been argued that the franchised enterprise is, in reality, a man­aged outlet featuring in the larger marketing pattern of another truly independent business - that of the franchisor (Rubin, 1978: 223-33). This distribution strategy has certain advantages for the larger enterprise but, just because the manager of the outlet has a capital stake in the business dressed up in the language of entrepreneurship, that is no reason to confuse a franchise outlet with a genuinely independent business. This is not to say that the arrangement cannot be highly beneficial to both parties but illusion should not be substituted for reality in a rigorous analysis of the status of the franchised outlet.

At the other extreme, the franchised small business may be viewed as an emerging form of independent small business in advanced industrial societies whose distinguish­ing characteristic is its overt and close relationship with another, usually larger, enter­prise. This association might be seen as being little different, except in degree and the explicit form it takes, from that now found between many small businesses and other firms with whom they do business. In an increasingly interdependent economy, such a close association may simply be seen as a reflection of the fact that ‘no firm is an island entire of itself’.

The independence of the small firm can never be absolute and is often difficult to assess accurately in practice. Any small enterprise, whatever its form, is part of a wider network of economic interaction summed up in the economist’s notion of ‘the market’ and, arguably, it is from this source that the main limitations on independ­ence are derived. Whilst, economically, franchise relationships may appear to render franchisees highly dependent at a contractual level, at an operational level higher levels of independence may manifest themselves than appear likely at first sight (Stanworth, 1984).

The pioneering Bolton Committee researchers in the UK were attracted to the idea of classifying the roles of small firms according to the type of market they supply (Bolton, 1971: 31-32). Accordingly, they located small firms along a typology of reliance upon large firms:

■ Marketeers - those firms that actually compete in the same or similar markets as large firms (e. g. computer software companies, fashion merchandise manufacturers and restaurants).

■ Specialists - those firms that carry out functions that large firms do not find it eco­nomic to perform at all, though they may include large firms among their customers (e. g. repair and maintenance in the building industry, jobbing engineering and spe­cialised retail outlets such as bookshops).

■ Satellites - where the small firm is highly dependent upon a single larger business for the majority of its trade. The degree of dependence may be even greater if the large customer actually designs the product or service and merely sub-contracts its manufacture or supply, as appears to be the case with a franchise. Franchisees would appear to fall under this category.

Product franchises, embracing the fields of car and petroleum distribution, the soft drink bottlers (Coca-Cola, Pepsi-Cola, Seven-Up, etc.) and, in the UK, tenanted public houses, are often categorised as ‘first generation’ franchises and almost totally side­lined from most mainstream debates on modern franchising. The terms franchising and business format franchising are now used practically interchangeably in the franchise industry generally.

The relevance of business format franchising is perhaps best illustrated by US statistics, which apportion just $200bn of a total of over $600bn franchise industry sales turnover to business format franchising. However, something in the region of 3,000 from a total of 3,500 franchisors and 400,000 from a total of 500,000 franch­isees reside in the business format sector (Sen and Lee, 1994).

In a nutshell, business format franchises are typically SMEs. However, given that the franchisor levies a royalty-based charge on the franchisee’s level of turnover rather than profit, pressures to achieve market penetration and growth are institutionalised rather than optional. This can be achieved by expansion within a given franchise out­let or by expansion of the overall population of outlets - often involving multiple outlet ownership by more successful franchisees. For instance, this is particularly com­mon in the field of fast-food franchising where, in the US, it is not uncommon for 50% of a franchise company’s outlets to be owned by less than 20% (and sometimes less than 10%) of its franchisees. A single large franchisee may own several hundred outlets (Bradach, 1994). Multiple ownership in other sectors appears less common and, in the UK, it is estimated that 82% of franchisees operate just a single unit (The NatWest Bank/British Franchise Association Franchise Survey, 1993, published March 1994).

Previous research has shown that approximately one-in-three of franchisees has prior experience of independent self-employment and that levels of prior educational attainment and previous earnings tend to correlate with the buy-in costs of particular franchises. Thus, individuals taking relatively high-cost franchises in a field such as fast print are more likely to be graduates and have professional backgrounds than, say, individuals taking up relatively low-cost carpet-cleaning franchises.

23.5 The advantages and disadvantages of franchising

The following section is assembled from three main sources, namely the published litera­ture on franchising, previous research and discussions with key figures in the industry, and will be presented under four headings dealing with the franchisor, the franchisee, the consumer/local economy and, finally, the national economy.

23.5.1 Advantages and disadvantages to the franchisor Advantages

■ Franchising enables the franchisor to increase the number of distributive outlets for their organisation’s product or service with limited capital investment. It is the franch­isees who provide much of the capital with their stakes in the business.

■ Since the franchisee owns their own business, they are assumed to be highly motiv­ated to maximise growth and profitability. This situation may be compared with that of a manager of a retail outlet who is a direct employee of the parent company. Generally, such a manager earns a fixed salary (with possibly an element of bonus incentive incorporated) and lacks the extra incentive to succeed, which may result from a personal financial investment in the business. A successful franchisee, with increasing profits, can be expected to contribute to the success of the franchisor.

■ A franchise unit, being locally owned, is claimed to be readily accepted by the com­munity as being a local business. It is not clear how far this is true, however, since very often local people may not be aware that a franchised unit is in fact owner-managed.

■ The franchisor has limited payroll, rent and administrative overheads, because the very nature of the operation requires franchisees to be self-employed. Franchisees are themselves responsible for the staffing arrangements and operating costs of their particular outlets.

■ As well as franchisors achieving a wider distribution network for their product or service, the nature of most franchise contracts ensures that franchisees are in some measure ‘tied’ to the franchisor. They are often obliged to purchase equipment from or through the franchisor plus, as in the case of fast-food franchise restaurants, the necessary ingredients that go to make up the final product.

Disadvantages

■ It may be difficult for the franchisor to exercise tight control over the franchisee sim­ply because they are not a direct employee of the franchisee and cannot be closely supervised. In turn, the poor reputation of one outlet, in terms of product quality or service, can be damaging to the general trade name and reputation of the franchisor and, in turn, the whole franchise organisation.

■ A franchisor cannot always be certain that a franchisee is declaring their true level of business activity. Many franchisors employ a central accounting system to com­bat this though no system can be expected to be totally successful in this respect.

■ If the franchisor believes that a franchisee has become demotivated and is not run­ning their outlet efficiently, there is relatively little that can be done in the short term as long as the franchisee is operating within the terms of the contract.

■ The management of a franchising company is limited in its flexibility. Conventional companies can move more quickly to exploit market potential when a modified selling strategy is required. However, to bring about changes can be a lengthy and cumbersome operation when dealing with individually owned franchised outlets. Any changes need to be carefully handled to avoid conflicts stemming from perceived threats to the franchisee’s independence.

■ There may be problems of information feedback from the franchisee to the franch­isor. This can result from the franchisee’s desire for independence or simply from channels of communication not being as well developed as they might be in company-owned and managed outlets.

■ The franchisor is faced with a paradox. The franchise method of business tries to capitalise on the personal attention and service that characterise the owner-managed business. However, the franchisor’s need for a standardised product or service, together with a uniform presentation, needed to give customers a sense of reliabil­ity and dependability, clashes with the former.

■ The franchisor may have difficulty in recruiting suitable franchisees who: see franchising as an attractive method of doing business; are motivated towards self­employment; and have the necessary capital available for investment.

23.5.2 Advantages and disadvantages to the franchisee Advantages

■ It is possible for an individual to run their own business yet gain the advantages and economies of scale of a larger company. Here the advantages range from initial and ongoing training to centralised buying, ongoing product/service and market research.

■ If the product or service has already achieved brand awareness, this relieves the franchisee of many of the normal demands of the sales and marketing function and allows them to concentrate on other aspects of the business. Most franchisors undertake both national and local advertising campaigns to keep franchisees’ pro­ducts or services firmly in the public mind.

■ It is claimed that franchisees require less capital than would be the case to equip a business independently. The franchisor can help with raising bank loans, site-selection, head leases on properties, and getting the business open and running smoothly. However, franchise investment levels tend to be fairly high and it could be argued that one could start a business successfully for a similar investment (or less perhaps) without the obligations imposed by a franchisor.

■ Many franchisees operate within a defined territory, which involves the franchisor giving an undertaking not to set up another competing outlet within a given geo­graphical radius. However, there is nothing to stop another franchisor, or other conventional competition, moving into the same area if it appears attractive and lucrative.

■ There are other franchisees in the same network with the same challenges and prob­lems and so any individual franchisee can use them as a source of non-threatening help and advice.

Disadvantages

■ The tight control exercised by the franchisor in order to regulate the way in which the product or service is presented to the consumer may leave little opportunity for the franchisee to impose their personality on the business.

■ Should the trade name of the franchise become tarnished, perhaps through mis­management by the franchisor, or the shortcomings of other franchisees, then it is possibile that the franchisee may suffer simply because they are seen by the public as a representative of the franchise organisation in question.

■ The service provided by the franchisor may constitute a heavy expense to the franch­isee. The franchisee may be obliged to purchase equipment and ingredients from the franchisor that they could have bought more cheaply from other sources. Also, man­agement service fees and charges may be high.

■ There is the possibility that the franchise agreement may not fulfil the franchisee’s expectations, both in terms of anticipated sales and profits and also possibly in terms of the franchisor not fulfilling their obligations.

23.5.3 Advantages and disadvantages to consumers and the local economy Advantages

■ Consumers may have the convenience of an extended-hours service. Many franchises operate on the basis of long hours of service in order to maximise their markets and many independent businesses, not bound by agreements to provide such service, may choose not to do so or may lack the resources.

■ Franchisees, as owner-managers, should be able to offer a highly personal service.

■ Although all franchised outlets are independent and separate, consumers can locate them under a single trade name and apply their knowledge of one outlet to all others because of uniform presentation and consistent standards of quality. Conversely, if a consumer is dissatisfied, they need not waste time with other outlets.

■ If a conventional small business fails, dissatisfied customers may not get satisfaction. In the case of a franchise, failure rates may be lower and, in any case, customers can, in the final analysis, contact the franchisor.

■ Franchisees receive training from their franchisors, usually ranging from between 2 and 12 weeks. A portion of this will usually involve hands-on training in existing outlets run by other franchisees. Such training can be expected to add to the stock of business training and knowledge in the local economy.

Disadvantages

■ Franchising may reduce levels of diversity in local economies due to their stress on standardisation.

■ Franchising may ‘export’ money out of the local regional economy in terms of pay­ments made to franchisors and may ‘import’ goods and services from the franchisor rather than from small suppliers locally.

23.5.4 Advantages and disadvantages of franchising to national economies

For individuals seeking self-employment opportunities but lacking the necessary ex­perience and know-how, franchising can offer an avenue of opportunity. For others, already in business on a modest scale, a franchise as an addition, or alternative, to their existing business may offer the possibility of growth levels unlikely to be achieved by their existing business.

The role of the industry as a ‘shop window’ of business formats appears to have been recognised by leading franchisors who, over time, appear to have become gener­ally less informative in response to early-stage enquiries. This has occurred in response to instances of individuals searching out information, under the guise of a potential franchisee, only to subsequently emerge in competition rather than in partnership.

The high level of publicity generated by the franchise industry, plus the steady flow of books and seminars, magazines and manuals, on the topic all act to reinforce this role. Overall, the franchise industry almost certainly plays a positive role in publicis­ing and popularising the notion of self-employment.

23.6 Franchising in the US: history and more recent trends

Franchising is more developed in the US than in any other country. Also, research and data gathering are far more advanced in the US than elsewhere. Thus, much of what is known about franchising tends to be American in origin and other countries look towards the US experience as heralding the nature and scale of future developments in their own economies.

As a result of the large-scale development of franchising in the US, it is the major exporter of franchising on a global scale and American experience is invariably quoted

(or misquoted) in justification of franchising in the UK and elsewhere. Three US statis­tics are quoted above all others:

■ Franchising accounts for approaching 35% of all retail sales in the US.

■ Franchising accounts for 10% of GDP in the US.

■ Franchising expanded by around 300% between 1975 and 1990.

Allied to these claims is an assumption that franchising is both a low-risk business option and a largely recession-proof business strategy. All of the above statistics appear essen­tially true. However, as Figure 23.1 illustrates, inflation-adjusted figures for the growth of franchising in the US over recent years pull down the overall growth figure for 1975-90 dramatically from 284.6% to 58.5%, and the average annual growth rate from 9.4% to 3.1%. Moreover, in six years of this 16-year period, franchise growth in the US was either zero or negative (Trutko et al., 1993). The franchise industry in the UK appears completely unaware of the existence of the latter adjusted statistics. (The data terminate in 1990 due to the abandonment of an annual survey of US franch­isors and franchisees by the US Department of Commerce.)

Although academics, researchers and bodies such as the International Franchise Association (America’s franchise association) use the terms ‘franchising’ and ‘business format franchising’ almost interchangeably, the fact remains that, for statistical pur­poses, ‘product’ and business format franchises are usually grouped together in the US. In 1990, 48.4% of all franchising sales stemmed from the automobile and truck sec­tor and a further 18.0% from franchised gasoline service stations.

Whereas product franchising grew by only 42.4% in inflation-adjusted (constant) dollars in the US between 1975 and 1990, against an overall sector figure of 58.5%, business format franchising grew by 115.5%, or around 5.1% in real terms per annum.

The expansion and contraction of franchising in the US seems to have closely fol­lowed general economic trends (Trutko et al., 1993: 3-19). Between 1975 and 1989, GNP in the US grew by 52.7% in real terms against a comparable growth in franchise sales of 58.5%. The decline in franchise sales (in real terms) between 1979 and 1982 again closely reflected the wider economic situation. As the US economy recovered during the mid-1980s, franchise sales reflected the upturn, as they did the subsequent downturn towards the end of the 1980s.

Interestingly, however, whilst franchise sales performed relatively well between 1975 and 1990, the number of franchise establishments in the US grew by only 13.3% com­pared with a 48.4% increase in the number of establishment units in the US as a whole. It is predicted that this trend will continue with franchisors concentrating on generat­ing higher profits per establishment in the future rather than expansion via increased outlets (Trutko et al., 1993: 9-12). In this sense, franchising could be said to be limit­ing the number of small business outlets.

The largest 88 US franchisors had more than 500 franchise units in 1986 and accounted for two-thirds (65.0%) of all franchise sales and establishments. By way of contrast, one-third (33.9%) of all franchising systems had ten or fewer establishments and accounted for about 1% of sales and establishments.

Despite the overall dominance by large systems, there is some evidence that smaller systems have played an increasing role in recent years. Also, earlier thoughts that franchising might simply represent a temporary phase in a company’s growth plans appear largely unfounded since the level of franchisee-owned stores appears to have been virtually unchanged since 1975 at 81.5%.

Women and minorities appear to have increased their representation in franchising in recent years though both groups are less visible than might be expected in terms of their general participation in the labour force at large. The evidence indicates that around 10% of franchise units are owned outright by women plus another 20% owned by women in alliance with men. Around 5% of franchise units were owned by minorities in 1986 compared with an 8.8% ownership level of US firms generally. This is despite government schemes targeted specifically at increasing the level of minority representa­tion. Although there are no comparable figures collected for the UK, the position appears broadly similar, albeit with a heavy concentration of minority franchisees in the field of fast-food franchising.

It is felt by many that the help afforded by franchisors in setting up new franchisees, particularly those with no prior business experience, renders franchising user-friendly for women and minorities.

23.6.1 Franchise growth factors

A number of factors in particular are considered to have aided the general growth of franchising in the US in recent decades. First, the growth of the US economy since World War II. Second, ‘downsizing’ policies exercised by large corporations that have released corporate executives with the necessary financial resources, experience in busi­ness management and a reduced faith in corporate security, often willing to consider self-employment.

Further, the post-war ‘baby boom’ increased both consumer spending levels and the numbers of potential franchisees during the 1970s and 1980s. At the same time, the number of women in the US civilian workforce increased from 27.5 million in 1970 to 47.4 million in 1989 - a participation rate up from 42.6% to 57.2%. The growth in the numbers of working women and dual-income families led to increased needs for support services such as day care services, educational products and services, home cleaning, fast-food, home-delivery food and other services.

In addition, technological changes heralded a revolution in electronic data processing and materials handling. Technological benefits have often been made more available to small franchise outlets than small conventional small firms due to the economies of scale delivered by the franchisor. Retailing in particular appears to have benefited from technological advances.

23.6.2 Franchising in the UK: current trends

According to trade association data, the experience of franchising in the UK is of appreciable growth for several years prior to 1990, when it dipped. Thereafter, in real terms, the trend in combined sales turnover was one of modest recovery, stabilising from 2000 onwards (see Figure 23.2 and Table 23.1).

T

Ln

(ф) Unadjusted financial values (i. e. using the values in 3a., as contained in the original reports)

Source: RP02 Retail Prices Index (RPI) all items, Office for National Statistics (April 2005); Annual Franchise Surveys, NatWest/British Franchise Association (February/March 1995-2005)

23.6.3 Franchising worldwide

A survey of franchise associations undertaken in 1995 by Arthur Andersen revealed some marked differences between the number of franchise systems in the respondent countries and regarding the corresponding number of franchisees (see Figure 23.3). At the forefront is the US (population 266 million at the time), but Canada (29 million) and Australia (22 million including New Zealand) - each also a ‘land of opportun­ity’ - have relatively large numbers of franchisees compared with their total popula­tion. All three of course had strong colonial ties to the UK. Some large-population countries were not included in the survey data - such as China (1210 million), India (952 million), Indonesia (207 million) and Russia (148 million) - but data collection can be problematic in emerging markets, especially where there is no franchise asso­ciation. Each of these missing countries is known to have a small number of franchise systems.

In the UK, the franchise industry has been strongly influenced by developments from the US. In the mid-1970s, the British Franchise Association was formed by eight franch­ise companies:

■ Budget Rent-a-Car (vehicle rentals)

■ Dyno Rod (drain cleaning and hygiene services)

■ Holiday Inn (hotels and motels)

■ Kentucky Fried Chicken (fast-foods)

■ Prontaprint (fast-print services)

■ ServiceMaster (carpet and furniture upholstery cleaners)

■ Wimpy International (fast-foods)

■ Ziebart (vehicle rust-proofing services).

Only two of the above (Prontaprint and Wimpy) were distinctly British and even the latter was based upon an imported US idea, albeit developed by a British company. This dominant representation of US involvement in franchising has continued with US companies exporting to Britain largely via the medium of granting ‘master licences’ for an individual or company in Britain to develop their format nationwide.

This situation of high-profile US involvement in international franchising is one that wins favour at the highest levels in the US, as summarised in a recent analysis by Eroglu (1992: 19):

From a balance-of-payments perspective, international franchising is considered (in the US) as a safe and speedy means of obtaining foreign currency with a relatively small financial investment abroad. It is notable in that it neither replaces (American) exports nor exports (American) jobs, all these reasons making this business arrangement one of the most pre­ferred and government-supported forms of international involvement.

The attitude of the US government here appears plain and one which recommends itself to other governments - the message is that home-produced franchises, particu­larly those with export potential, can be fruitfully considered for targeted support.

Notes: The above franchise data was derived from a survey of the franchise associations in 40 countries, which achieved a 90% response rate. The population and GDP values are estimates (1996 and 1995, respectively).

Source: Swartz (1995); Central Intelligence Agency (1996)

23.7 Ease of entry into franchising

The franchise industry is not without members who are regarded by their peers as hav­ing staged an entry into franchising by other than ‘textbook’ methods. Usually, this has involved selling franchises to members of the public before the business involved had been properly tried and tested. In fact, on such occasions, it has been literally tried and tested on its early franchisees. When this happens, it is not necessarily the case that the franchisor in question has deliberately set out to defraud the public by selling franch­ises prematurely. Rather, the explanation may lie in ignorance or over-enthusiasm. In the author’s own past career as a small business trainer, there were occasions when an individual would attend a start-up course with the intention of selling franchises in the new business idea within weeks or months of starting up in business.

The conventional wisdom in the industry is that any completely new small business will need at least two years in order to establish itself in terms of testing out sales, mar­keting, product/service, pricing and staffing strategies. After all, every small business start-up plan inevitably requires considerable modification during the initial months of its implementation. High failure-rate figures, particularly during the first 30 months of operation, verify this fact.

Having established a basic business formula, the owner should then, ideally, estab­lish an identical outlet in another location. The process of finding new premises, hiring personnel, organising a launch and all the other tasks accompanying a new outlet open­ing is an essential test of the owner’s ability to replicate the success achieved in the founding unit. Again, there will be a steep learning curve here and the process could well take a further two years.

Finally, three key documents need to be drawn up prior to beginning franchising. First, an operating manual committing to paper detailed instructions for the guidance of franchisees when running an outlet for themselves; second, a franchise contract, stipulating the legal obligations of both parties - franchisor and franchisee - and, fin­ally, a franchise prospectus as a marketing tool for use in recruiting franchisees. All three documents require a great deal of time, hard work and, usually, expensive external help from consultants, solicitors and accountants. Then begins the process of recruit­ing and training new franchisees and this, again, is liable to prove time-consuming and expensive since the business involved has no previous experience or public awareness to draw upon.

Overall, adopting a ‘textbook’ approach, a business starting up from nothing may well find itself involved in five years of hard work before it recruits its first franchisee. The founder(s) will find that they are not simply involved in testing out one business idea but two - a conventional business configuration plus an allied franchise format. Obviously, the final package has to be one capable of yielding notably better financial returns than the average small business since these must satisfy the franchisee’s income needs, service banks loans and pay off loan capital, plus sustain the franchisor’s needs for management services fees, amounting to usually around 10% on sales turnover.

Once a franchise company is well established, it will find a range of specialist ser­vices and advice on offer from bodies such as the British Franchise Association and specialist units in the clearing banks. The weakest link in the chain of development is almost certainly at an earlier stage - between establishing a conventional small business with franchise potential and launching it as a fully-fledged franchise opera­tion, without short-cuts being taken that could prove disastrous later.

Obviously, the above timetable can be safely reduced in the case of an already well- established SME wishing simply to convert to a franchise format by cloning its previous success, but the risks are still high. A report commissioned by the US Small Business Administration estimates that initial franchise development costs can exceed $500,000 (Trutko et al., 1993: 7):

The development of a business from a proven concept through to the sale of its first franchise is typically a long, expensive and risky process for the franchisor. Even excluding the costs of direct management involvement, the franchisor bears sizeable ‘upfront’ costs for developing a programme before it can be marketed to franchisees.

They also similarly identify the early stage of entry into franchising as a difficult time for the franchisee since: ‘Prospective franchisees are often reluctant to use professional advisers to evaluate franchise offerings because of the cost and/or difficulty of identi­fying an attorney in the area of franchising.’ Without doubt, most specialist franchise advisers see their principal area of vested interest as that of undertaking work for franch­isors rather than franchisees.

23.7.1 Franchise contracts

The franchise relationship is governed, in the legal sense, by a written contract which commonly spans 30-40 pages in length and can be even longer. These contracts usu­ally run for a specified period of time though are usually renewable. The most typical contract length is five years followed by ten years.

The most detailed comparative work on franchise contracts is that undertaken by Professor Alan Felstead of the Centre for Labour Market Studies at the University of Leicester, England. He compared 83 different franchise contracts on six main compon­ent elements:

■ guarantees granted to franchisees of territorial exclusivity;

■ franchisor’s rights to unilaterally imposed changes to their operating manuals;

■ post-termination restrictions on competition;

■ franchisor’s stakes in franchisees’ businesses via ownership of sites, telephone lines or equipment;

■ franchisor’s rights to police the quality of the franchisees’ output; and

■ the franchisor’s imposition of output targets.

Felstead (1993: 115) constructed an Index of Contractual Control (Figure 23.4). Each element of control is allotted a score of zero if absent, 1 if present and, where appro­priate, 2 if present in a stronger form. Although this scoring mechanism does not ‘weigh’ each of the components against one another, it does enable identification of ‘hard’ franchise systems (where the degree of contractual control is high) from ‘softer’ forms systems (where the degree of contractual control is low and franchisees enjoy greater degrees of autonomy).

Figure 23.4 Index of contractual control

COMPONENT ELEMENTS Score

a) Non-exclusivity:

TOC o "1-5" h z Exclusivity guaranteed in territory.................................................................. 0 49.4%

Qualified exclusivity....................................................................................... 1 16.9%

Non-exclusive franchise.................................................................................. 2 33.7%

b) Performance targets:

None............................................................................................................... 0 62.7%

Turnover targets/expansion triggers.............................................................. 1 37.3%

c) 'Stake' in tangible business assets:

No 'stake' evident in contract......................................................................... 0 33.7%

'Stake' in telephone lines/sites/equipment.................................................... 1 66.3%

d) Operations manual:

No rights to unilateral change......................................................................... 0 12.0%

Rights to unilateral change by franchisor........................................................ 1 88.0%

e) Post-termination restrictions:

None............................................................................................................... 0 13.3%

Non-compete or non-solicitation.................................................................... 1 25.3%

Both non-compete and non-solicitation.......................................................... 2 61.4%

f) Monitoring of output quality:

No rights to police system............................................................................... 0 41.0%

Rights to inspect/communicate with clients on reasonable notice 1 10.8%

Rights to inspect/communicate without notice.............................................. 2 48.2%

INDEX OF CONTRACTUAL CONTROL

'Soft' franchising (0-3) 13.3%

'Medium' franchising (4-6) 65.1%

'Hard' franchising (7-9) 21.7%

Source: Felstead (1993)

Around two-thirds of the systems examined fell in between the two extremes, with the overall distribution ‘scores’ skewed towards the ‘hard’ end. Felstead (1993: 116) feels that franchisees occupy an ambiguous position of being neither fully in control of ‘their’ business nor fully controlled:

First, despite operating without close and direct supervision, franchisees are required to oper­ate within procedures laid down and often subject to unilateral change. Moreover, franch­isees are sometimes committed to adhere to franchisor-set performance targets, and, in any case, to give the aim of the franchisor (turnover maximisation) primacy in the running of the business. Secondly, while they appropriate the profits (and losses) of the business, they do so only after they have made turnover payments to the franchisor. Thirdly, although franchisees buy or lease much of the physical business apparatus, some parts remain in the hands of the franchisor, and some have franchisor-imposed restrictions on their use both during and after the currency of the agreement. Furthermore, franchisees have no ownership rights in the intangible business assets - they simply ‘borrow’ the business idea, trading name and/or format.

Felstead also traces a number of instances of franchisor-franchisee litigation. One par­ticularly interesting case involved a Prontaprint franchisee in the UK who declined to renew his contract but continued to trade in the identical line of business and in the same premises, albeit under a different name. He lost a legal judgement on the grounds that:

■ he was still drawing benefit from the Prontaprint name via repeat business and, for some time at least, being listed in local directories as ‘Prontaprint’; and

■ the franchisee was deemed to have had little understanding of the print business prior to being trained by Prontaprint.

The latter fact may explain the frequently expressed franchisor preference for franch­isees without prior experience in the operational line of the franchise.

23.8 Franchisee success and failure rates

Research results (Stanworth and Purdy, 1993) identify quite clearly two principal appeals that franchising holds for ‘potential franchisees’. One is ‘independence/chance to be your own boss’ and the other access to a ‘proven business system’. Whilst both were chosen frequently and almost to the exclusion of other possible appeals of franch­ising, the precise ordering varied, depending upon whether or not respondents had prior experience of self-employment (see Figure 23.5).

Some causes of SME failure are seen as being due to ‘generic’ causes and should actually be remedied or reduced by franchising (Cross and Walker, 1987). These are:

■ under-capitalisation,

■ absence of economies of scale,

■ lack of business acumen,

■ inability to survive intense competition in sectors (such as retailing) where barriers to entry are low.

Franchising should reduce the probability of failure among franchisees due to such ‘generic’ causes, on condition of course that the franchisor’s responsibilities are met and that the appropriate back-up services expand at a rate sufficient to cope with any growth of the franchise network. Thus, attempts by the franchisor to expand too quickly or, alternatively, to simply generate profits through the accumulation of once - and-for-all front-end fees, will act to the detriment of franchisees.

Failures due to ‘franchising-related’ factors, as opposed to ‘generic’ factors, are cited by Cross as falling essentially into five key categories:

■ Business fraud, such as the use of celebrities to attract franchisees to ill-founded franchise schemes in the US during the 1960s and 1970s.

■ Intrasystem competition, involving franchise outlets being located too close together and cannibalising each other’s sales while maximising the franchisor’s sales-based royalties. Also, company-owned outlets may be sited close to franchisee-owned outlets.

■ Insufficient support of franchisees, encompassing advertising support, pre-opening programmes and management assistance.

■ Poor franchisee screening (possibly fuelled by a drive to maximise front-end fees), resulting in a mismatch between franchisee’s attributes and criteria for success.

■ Persistent franchisor-franchisee conflict.

Mittlestaedt and Peterson (1980) have conducted work in this area that suggested franchise failure rates running at around 5% and turnover at around twice that level. Padmanabhan (1986) concluded that franchise operations fail generally less often than independents but that the opposite may be true of business services and automotive franchises. Ozanne and Hunt (1971) identified an annual failure rate of 6.7% among fast-food franchise systems but concluded that the actual failure rate could be two or even three times as high. The same went for franchisee failure rates that were lower on a percentage basis, suggesting that franchisee failures tended to be concentrated in smaller franchise systems.

In summary, we still lack any harmonised methodology for assessing failure rates and the differences between franchised business failures and independents is almost certainly much less than the impression given by promotional books and franchisee recruitment packages. However, the most honest and accurate statement that can be made on the issue of comparative failure rates probably remains that made by Housden (1984: 226):

It has been claimed that as well as helping in the creation of new businesses, franchising sub­stantially reduces the subsequent rate of failure in such businesses. . . No firm evidence has yet been produced to support this contention, but it seems probable to assume that franchised outlets of a reputable system are less likely to fail than independently-owned outlets, because of the franchisor’s vested interest.

Statistics published in the US appear to underline the possible effects of franchisor fees and market saturation in influencing franchisee failure rates and profit returns. Bates (1994a: 4) drew up a sample of 7,270 small businesses started between 1984 and 1987 drawn from the US Census Bureau’s Business Owners Database. Using 1987 as a base­line (year 1), he tracked these businesses through to 1991. Bates found that 34.9% of franchise businesses failed compared with 28.0% of non-franchise businesses. Pre-tax income levels were also higher for independent businesses. Bates concluded that the dif­ference in performance rates between franchised outlets and other small businesses was based in part on differences in industry distribution, with franchises over-represented in retailing and under-represented in services. Among other possible reasons for these findings, he includes:

■ the recruitment by franchise companies of candidates poorly qualified to become franchisees;

■ the saturation of key franchise markets;

■ the high level of franchisor fees and royalties.

He hypothesises that what might once have been a prudent route to small business suc­cess may now be undermined by excessive competition and/or fees relative to the value of franchisor services.

It should be remembered that, whilst a franchisee should, and hopefully will, receive the kind of professional managerial help and advice that is not normally available to SMEs, this is only delivered at a price and often a substantial one at that - typically an on-going rate of around 10% levied on sales turnover (in addition to front-end start-up fees and charges). Many SMEs would almost certainly not make total profits of this magnitude and, by any measure, this kind of royalty regime is likely to take in the region of half the total profits of even a well-run franchised outlet. In short, the royalty regime is a heavy burden for outlets to bear, particularly where conditions of recession and market saturation also take their toll.

23.9 The quality of jobs created in franchising

Very little research has been undertaken concerning the quality of jobs provided by the franchise industry in terms of pay, training and job satisfaction levels. However, most franchised businesses tend to involve a limited range of products and services and appear to lend themselves to low-skill/low-pay human resource strategies. After all, franchise company outlets are essentially non-unionised small firms operating on the basis of human resource strategies devised by the franchisee. This is a fruitful area for future research and there are already movements on the part of researchers interested in becoming involved in this as aspect.

Felstead (1993: 200) has presented some evidence that is, in all probability, fairly typical of the industry and thus generalisable. He makes the point that franchisees, in attempting to improve their profits, may be more motivated to save money on their payroll bills than by increasing turnover levels since the latter attracts a 10% (or there­abouts) levy by the franchisor whereas the former does not. Felstead conducted a comparison of franchised and non-franchised high street printers in the East Midlands (Felstead, 1988). He found that those who worked for franchisees were more likely to be young, government-sponsored (i. e. on training schemes) women workers in receipt of payment levels and non-pay benefits (such as holiday pay) substantially below those paid by the industry’s more traditional employers.

Felstead says that these findings are corroborated by a survey of American fast-food restaurants, indicating that, despite the common characteristics that employees of company-owned and franchise restaurants exhibit, wages and especially fringe benefits (paid holidays, sick leave, uniform allowance, free meals, etc.) are greater for workers employed in company-owned stores than those employed by franchisees (Krueger, 1991; Katz and Krueger, 1992).

23.10 Chapter summary

The worldwide growth of franchising appears set to continue on a long-term basis. The growth of franchising overall (in real terms) is strongly dependent on the performance of the economy as a whole. Against this, business format franchising, concentrated upon more service-oriented activities, is likely to experience growth rates notably faster than those applying for franchising as a whole.

A number of factors appear likely to promote future growth. First is the general worldwide decline of traditional manufacturing industry and its replacement by service - sector activities. Franchising is especially well suited to service and people-intensive economic activities, particularly where these require a large number of geographically dispersed outlets serving local markets.

A second factor is the growth in the overall popularity of self-employment. Most governments throughout the world are looking towards self-employment and small business as an important source of future jobs. As franchising becomes increasingly well known and understood, it is likely to appeal to a growing number of people. Alongside this trend, we may expect to see an increase in the number of franchise opportunities. This process will be assisted, not least, by large companies following the current trend towards divestment from centralised control of an increasing propor­tion of their business activities. A notable example in the UK has been the franchising of domestic milk-delivery. Increasing female workforce participation will continue the current trend towards dual-career and dual-income families, resulting in both the need and the resources to purchase services. Home service franchises (cleaning, maiding, lawn-care, house-minding, etc.) are likely to feature here, as are childcare and child development services.

The demands of an ageing population in many countries will also create opportun­ities, ranging from the need for special diets to special needs in the fields of leisure and care. In the US, the healthcare industry is turning to franchised medicine, ranging from private-duty nursing agencies to the provision of alternative medicine. Greater aware­ness of health issues generally will also throw up opportunities in sectors ranging from food to exercise and counselling services. Entertainment and leisure activities will also offer additional franchise opportunities, ranging from travel agencies to ventures such as miniature golf courses, dance studios, specialist movie theatres, etc. American experience suggests that growth levels in the number of franchised outlets are unlikely to match growth levels in sales turnover figures, since franchise outlets tend to be larger than the average conventional small business in turnover terms.

On balance, it does not appear that franchise operations substantially displace conventional small businesses. Where they do challenge them, it is often because they act as a new force in the field with the flexibility to respond rapidly to changes in tech­nology and market demand. They themselves may then subsequently be threatened by exposure to similar market forces, thus rendering their businesses and their profit margins more vulnerable than they and their franchisees would have expected or hoped. However, it is obviously untrue that those who eat at McDonald’s do so with­out any measure of substitution concerning their former eating habits, or that cus­tomers of Kall-Kwik or Prontaprint still place their customary orders with traditional print firms. Encroachment and additionality appear to have developed hand-in-hand, usually aided by developments in technology, customer tastes and consumer spending power.

If we look at the quintessential icon of the industry - fast-food franchising - it is unlikely that it has not in some measure diverted trade away from more traditional providers in the field (many of them almost certainly small independents). However, the conditions fuelling a market restructuring here were almost certainly the develop­ment of technology capable of producing food quickly on a standardised basis, and a growth generally in trends towards convenience foods and eating out. Similarly, in the field of fast print franchising, new technology reduced the training and skill levels required to produce print copy and final product from years to weeks. The result is that print products can now be produced in hours rather than days, using cheaper and less skilled labour, while relocating from manufacturing premises off the high street to ‘business service’ premises on the high street. An additional key factor assisting the growth of fast print franchising was the trend of large firms in the 1980s to divest themselves of many internal services, and ‘buy in’ instead.

When a franchise first comes into being, it ideally requires some ‘unique selling point’, giving it an advantage over its competitors. Over time, however, competition arrives to challenge its market position. This may come in the shape of new franchise operations but may, equally, take the form of conventional small business operations.

Women and minorities appear to have increased their representation in franchising in recent years in the US. Although both groups are less visible than might be expected in terms of their general participation in the labour force at large, the evidence indi­cates that around 10% of franchise units in the US are owned outright by women plus another 20% owned by women in alliance with men. Around 5% of franchise units were owned by minorities in the US in 1986 compared with an 8.8% ownership level of US firms generally. This is despite government schemes targeted specifically at increasing the level of minority representation.

The help afforded by franchisors in setting up new franchisees, particularly those with no prior business experience, renders franchising a potentially fruitful route for increasing female and ethnic participation in small business. Thus, any government assistance to franchising is best advised to be targeted at indigenous franchises - par­ticularly those with export potential and the facility for spreading jobs and enterprise among ethnic groups where opportunities might otherwise be lacking.