Strategies to Improve the Franchise Model (April 2021)

This section of the report goes into detail about the nature between the franchisee and franchisor contract, and the business model of a typical franchise. Usually, the owner of the franchise, or franchisor, licenses trademarks, methods, and products to an outside individual. Other services that the franchisor is usually responsible for include help with finding a location, providing employee training manuals, offering marketing and website tools, and otherwise creating sources of support for the franchisee. 

Franchises are crucial to the US economy — the report discovered that they contribute millions of dollars to state and local economies, and are a major supplier of jobs in the labor market. According to the International Franchise Association (IFA), franchises employ more people than those who work in construction. More than 8 million people expect to work for nearly 800,000 franchises by February 2020.

The robustness of the franchise industry is also demonstrated in the fact that one-third of franchise businesses are fast food oriented, and on any given day, almost one-third of all American adults eat at a fast-food restaurant, many of which are franchises. On an individual level, franchises serve as mechanisms of economic empowerment for veterans and historically marginalized groups — about 1 in 7 franchises are owned by veterans, and 30 percent of franchises are owned by Black Americans, Latinos, or Asian Pacific Americans. 

Many immigrants choose to invest in franchises because of the apparent reliability of the brand and proven business model backing their store. 

Franchise Transparency

Many issues can arise when it comes to complete transparency between the franchisor and franchisee. As detailed later in the report, this can include everything from receiving inaccurate profitability projections prior to investing in a franchise, being forced to purchase overpriced goods and services, and having to comply with ambiguous and expensive stipulations. 

On the more extreme end, regional supervisors backed by the corporation can perpetuate predatory practices themselves, such as aggressively finding fault with management and operation simply for the purpose of reporting the franchisee as non compliant. Furthermore, even disclosed financial information can be manipulated to appear better than they actually are. For example, the franchise industry measures success by how many establishments remain open, but this metric does not account for profits gained from fees generated by a single store going through multiple owners in a short period of time, a sign of the business not being profitable. 

Franchise owners and regulators should be concerned about these trends in certain brands — high levels of transfers, terminations, acquisitions by the franchisor, and ceased operations can be signs of an unsustainable business model. 

The viability of a business is important because many first time franchise owners are far from the average multimillionaire investor. Therefore, they need to borrow money from lenders to cover the upfront costs of starting a franchise, and the failure of a franchise is tied to them not only losing their livelihood, but all their assets as well.

Government Oversight of Franchises

The second section of the report covers the gaps and deficiencies in government regulation of franchises. There are two main governing bodies that oversee the franchise industry: the Federal Trade Commission, or FTC, and the Small Business Administration, or SBA. 

Federal Trade Commission’s Role in Franchising

The Federal Trade Commission is responsible for regulating franchise disclosure through its Franchise Rule. This policy ensures that every entrepreneur has access to pertinent information that offers insight into the potential of a franchise investment. This information is disclosed in the FDD, or Franchise Disclosure Document. Furthermore, the FTC is responsible for investigating any deceptive or suspicious practices on the part of the franchisors. But at the same time, the report details a concerning trend — the FTC has not taken an enforcement action on a franchise matter since 2007. 

Franchise Rule – Item 19

Although the Franchise Rule brings a considerable amount of transparency and accountability to the investment process, at the same time it can be problematic by misleading investors into thinking that these franchises are somehow “government approved”. For example, the FTC does not require financial information to be disclosed in Item 19 of the FDD. This in turn allows investors to be swayed by potentially unreliable sources, such as buyer development agencies, newsletters, or other types of advertising. 

SBA Franchise Loans

The other major governing body is the Small Business Administration, which is responsible for disseminating loans to beginning entrepreneurs. As long as the franchise brand meets the SBA criteria, prospective franchise owners can receive loans under the 7(a) or 504 loan programs. Lending to franchises has increased over time — SBA-guaranteed loans to franchises have increased more than 20% in number of total loans and in amounts guaranteed since 2017. 

However, there is a generally high rate of default when it comes to SBA loans. From 2003 to 2012, more than one in four loans to franchises guaranteed by the 7(a) program defaulted, meaning that the loaner was not able to make the monthly payment. 

According to the Office of the Inspector General (OIG) in the SBA, they noted that the SBA continued to guarantee loans to high risk franchises and industries without properly monitoring the situation or taking measures to minimize risk. This included allowing lenders to get away with failing to provide necessary documentation that would have demonstrated that borrowers met requirements in regards to important factors such as eligibility, repayment ability, business valuations, debt refinance, and more. 

Franchise Case Studies

This report identified ten problematic franchisors that exploited their franchisees, usually by presenting misleading data about profitability as well as imposing unreasonable fees and expectations. Below is a list of the ten franchises included in the report, and a summary of why franchise investors should avoid them at all costs. 

Burgerim Franchise Failure

Figures can be misleading, and this was certainly true for Burgerim in 2019, when they had raised at least $57.7 million in franchise fees while many of their franchisors were facing financial ruin. In that same year, the corporation announced bankruptcy and the founding CEO fled the country. Burgerim has already been prohibited from franchise registration in the states of Maryland, Washington, and Virginia, and the state of California fined Burgerim executives for their predatory and dishonest franchise practices. This included failing to disclose in their FDD that the company was going through bankruptcy, concealing the number of cancellations and refunds, mismanaging franchisees’ initial franchise fees, bouncing refund checks, and neglecting other franchise obligations. 

Complete Nutrition Franchise Changes

This franchise company made major changes to their business model that were ultimately detrimental to their franchisors. For example, Complete Nutrition lowered prices of all their products, reducing profit margins for franchisees across the board by 30%. The company also punished franchisors for not meeting impossible sales goals, such as selling products that were not readily available. But worst of all, Complete Nutrition changed their marketing and advertising in a way that made it impossible for brick and mortar franchisors to compete with Complete Nutrition’s online business. This included making online offers so low that franchise establishments simply could not compete, as well as eliminating franchisee access to the point-of-sale system, removing franchise locations from its website, and sending a false email to customers telling them that their retail locations had been sold and that customers should order online. 

Dickey’s Barbeque Pit Franchise Trouble

This franchise corporation has always had franchise troubles, often closing more stores than opening them. In 2018, Dickey’s ended the fiscal year with 521 units, and then in 2019 and 2020 opened 60 and 30 units respectively, only to end up with 466 units by the end of the fiscal year. Franchise owners allege that these problems emerged because of a lack of transparency on the part of the franchisors, mostly by providing misleading and inaccurate revenue projections. In some cases, some franchise owners allege that Dickey’s completely lied about why franchises were available for sale. According to the 2019 Pit Owners’ Association Franchisee Satisfaction Survey, 75% of current Dickey’s franchise owners believe the franchise agreement is unfair, 85% said they would not invest in a Dickey’s again, and 61% were considering permanently closing their stores. At the end of 2019, 41 of 255 loans, or 16% of the loans issued by the SBA for Dickey’s franchise owners were charged off, meaning that the lender believed that the money originally lent out would never be collected.

Experimax Franchise Failure

One major complaint with the business practices of Experimax was the inflation of revenue projections and other financial data, all in order to receive an SBA loan. In order to receive the loan, many franchise owners had to falsify numbers. Furthermore, Experimax required unreasonably high upfront and maintenance costs on the part of the franchise owner, such as unusually high initial payments of $49,500 and an additional $130,000 to design the store and buy supplies at inflated prices. 

In 2019, 26 of the 80 loans, or almost 33% of the loans granted by the SBA to Experimax owners were charged off. Nevertheless, the franchisor denied these financial problems and continued to advertise to franchise owners a false image of profitability associated with their franchise. 

Subway Franchise Problems

Although it is a major brand name in the fast food and sandwich industry, heavily discounted products and controlling decisions made by corporate has led to the financial ruin of many Subway franchise owners. Subway franchisees have little to no say in many important business decisions, such as in the way that vendors are chosen or prices of goods are set, nor can the franchise owner use its leased premises for another purpose. Through a rigged inspection and arbitration process, Subway capitalized on minor infractions of franchisees to essentially seize the business from them. 

Subway constantly put the benefits of its corporate office ahead of their franchisors, often encouraging Subway franchises to open in close proximity to each other, a practice that Business Insider equated to “cannibalizing businesses.” Lastly, it was revealed in litigation that one Business Development Agent (BDA) was financially incentivized to report on extremely miniscule and insignificant infractions, all so Subway corporate could seize back the business. 

Curves Franchise Litigations

On two separate occasions, this franchise had legal problems with franchisees for harmful business practices.. The plaintiff argued that Curves misrepresented financial information pertinent to their decision to enter financial agreements, and that the franchise company would later violate these very same agreements. The first court case took place in Texas, which ruled in favor of the franchise owners. However, the case did settle out of court, as Curves appealed the decision.

On the second occasion, Curves’ investors received a legal complaint. Through their advisors, they discovered that the business was going to have a 15% failure rate in 2012. Likewise, the franchise owners never received this information. Instead of changing their business model to improve profitability, Curves simply increased their royalties and products sales to their franchisees. 

7-Eleven: Franchisor Has Too Much Control 

 The SBA no longer issues loans to prospective 7-Eleven owners because of the extensive and pervasive control that the company has over franchisees and their operations. 7-Eleven franchise contracts put franchisees at an enormous disadvantage, such as imposing a 59% marginal rate of all gross profits directly to the corporation despite declines in profit. Franchise owners received a new contract in 2018 that amplified these abusive practices. 

This contract included a $50,000 franchise renewal fee, required franchisees to pay 100% of liability insurance for property and equipment (even though they did not actually own the equipment), one-sided legal fees, and overpriced vendors. Besides controlling profitability, 7-Eleven controlled operational aspects, mandating the same operation hours across the board, even if staying open at night or during holidays put owners and their communities at risk. 

Other predatory practices exercised by the 7-Eleven corporation include fixing gasoline prices to the point that establishments were no longer viable amongst competitors, seizing franchise establishments if franchise owners violated immigration law, and one-sided legal provisions that make it nearly impossible for 7-Eleven to receive legal repercussions for their actions. 

Huntington Learning Center Franchise Loan Issues

Problems associated with owning a Huntington Learning Center franchise can be traced back to the bank Banco Popular, which did not appropriately assess risk and repayment ability when issuing Huntington Learning Franchise loans. They failed to realize that HLC was grossly inflating revenue projections by more than 50%. Furthermore, the percent of loans charged off for HLC entrepreneurs is 36%, or 64 out of 117 loans, an absurdly high number. Nevertheless, these alarming numbers were hidden from entrepreneurs and banks all in order to guarantee that entrepreneurs could acquire SBA loans. 

Quiznos Franchise Closures

In 2008, there were almost 5,000 Quiznos franchises, but after 10 years only a few hundred of these franchises survived. Since the start of the 21rst century, there were 5 class action lawsuits taken against Quiznos for dishonest franchise practices, including charging overly high prices for buying ingredients and other necessary restaurant items, knowingly selling franchises to entrepreneurs with little to no franchise experience, and charging higher than normal rates for royalty and advertising fees. In the end, Quiznos ended up filing for Chapter 11 bankruptcy.

Massage Envy FTCProblems

The last franchise included in the case studies of this report is Massage Envy, which received the most complaints when the FTC requested comments on its Franchise Rule. There were almost 50 comments to the FTC and even more to Senator Cortez Masto’s office — they allege that Massage Envy engaged in unfair and deceptive franchise practices, such as mismanagement of a new point-of-sale system, problems with gift cards and holiday promotions, requiring sales of inferior products, overpriced liability insurance and technology systems, and misleading revenue projections. 

These problems apparently arose after the sale of Massage Envy to a new investment company. Significant changes to the Operations Manual are the cause of these problems. Owners had to comply with them or else lose their business.

Four Factors Leading to Franchise Failures

While this report raises some serious concerns about investing in the franchise industry, it does not mean that you should not invest in a franchise. Rather, it should act as a reminder of exercising caution and due diligence when it comes to the franchise process. Even notable name brands can become problematic thanks to changes in leadership and/or ownership, which is something to also be aware of. The report details four major red flags to look out for when investing in a franchise. 

1) Unfair Franchise Agreements that Are At the Disadvantage of the Franchisee

A franchise agreement may prohibit franchise owners from forming associations, prohibit them from voice complaints, mandate arbitration clauses, change the rules, require owners to operate at inappropriate hours, force franchisees to accept unprofitable prices, etc. Promoting franchises, allowing franchisors easy access to franchised stores, and limiting sales in franchised stores.

2) Missing or Misleading Financial Documents

This rule is especially important when it comes to Item 19 of the FDD, which is the section of the Franchise Disclosure Document that includes all the necessary financial information. Despite being required by law, the federal government does not verify financial information in Item 19. Some franchises also provide misleading information in other ways. As a result, corporations and lenders may incentivize entrepreneurs to make poor financial decisions to their advantage.

3) Exorbitant Fees and Missing Services

The franchisor often charges franchisees inflated fees as a result of its overly profit-driven business model, but these fees are often skewed or unexpected for the franchisee. Notable examples include Burgerim, which charged $5,000 for “loan consultancy services” which never followed through, 7-Eleven, which continuously increased their gross profit requirement even as operating expenses increased, and Dickey’s Barbeque Pit, which collected hefty marketing fees, but instead of giving it back to franchisors used it for personal corporate expenses. 

4) Requirements to Buy from Preferred Vendors

There is this misconception that widely circulates throughout the franchise industry that one benefit to buying a franchise is group purchasing power, or the idea that a group of entities with similar purposes can negotiate better prices than a singular entity. However, this does not exist for many franchisors and vendor rebates end up becoming nothing more than indirect royalties to the franchisor. Just like the cases of 7-Eleven, Curves, and Massage Envy, buying products from these preferred vendors ended up becoming more expensive than other local vendors. 

Conclusion

Vetted Biz was founded on the premise of increasing transparency in the franchise and business for sale market. We are excited to see legislative initiatives to protect franchise buyers. Although there is always risk in buying a franchise, it is important to have clear data and information to limit your risk as much as possible from the start!