The Economist recently published a leader article entitled “Why the world needs more franchises“.
Its central argument was correct in pointing out the benefits of the franchising business model. It is true that franchising has been one of the most successful mechanisms ever developed for expanding business ownership. It has enabled countless people to acquire and build businesses of their own while benefiting from established brands, proven systems and ongoing support.
At its best, franchising aligns the interests of franchisor and franchisee and creates opportunities that would otherwise not exist. But there is an important aspect of the American franchise story, which is the basis of the Economist article, that deserves greater attention.
America did not build the world’s largest and most successful franchise sector simply by encouraging entrepreneurs to sell franchises. In 1979 it introduced franchise disclosure requirements designed to ensure that prospective franchisees received specific and truthful information before investing. The purpose was not to guarantee success. No regulatory framework can do that. The purpose was to reduce misrepresentation and confirm the bona fides of the franchisor. The purpose was to ensure that a prospective franchisee should not know materially less about a franchise opportunity than the person selling it.
Britain adopted the franchise model but not the disclosure framework. The consequences are becoming increasingly apparent. And the problem is rapidly getting worse.
The UK has no franchise-specific legislation. There is no mandatory disclosure regime. There is no dedicated franchise regulator. There is no requirement for a business to demonstrate that it is genuinely suitable or for franchises to be offered for sale. Instead, franchisees are expected to rely on their own due diligence and, if necessary, general legal remedies after problems emerge.
The British Franchise Association performs an important role in promoting ethical franchising and professional standards. However, it is a voluntary trade association rather than a regulator. Membership is optional and its powers are limited. It does have some franchisee members, but it is basically a club for franchisors.
As a result, the UK franchise market contains businesses operating to very different standards. The strongest systems are built on proven business models, sustainable economics and long-term franchisee success. Others are not. Without meaningful disclosure requirements, prospective franchisees often struggle to distinguish between them. Franchises are sold on trust to many who assume that there has been some oversight, as might be the case with buying an insurance policy.
Historically, businesses only transitioned into franchises after they had first proved to be successful. A concept would be developed, tested and refined. Systems would be documented. Financial performance would be established. Only then would the business be replicated through franchising. Increasingly, that sequence has been reversed.
A growing industry now exists to help aspiring franchisors launch franchise networks quickly and inexpensively. Generic franchise agreements, operations manuals and recruitment systems can be purchased off the shelf. Franchise consultancy services are readily available. No specialist qualification is required. No independent assessment is undertaken. No regulator examines whether the underlying business has demonstrated that it can be replicated successfully.
The barriers to becoming a franchisor are remarkably low. In some cases, individuals with little or no franchising experience, or even business experience, can establish franchise systems within weeks. The result is predictable. Businesses that have never demonstrated genuine scalability are presented as franchise opportunities. Some succeed; many do not.
How the Incentives Changed
The traditional franchise model contained natural commercial disciplines. Most franchises operated within exclusive territories, generally defined by post codes. Apart from re-sales, a territory could generally only be sold once. Franchisors therefore had a strong incentive to recruit carefully because a poor appointment could restrict future development opportunities for years.
Royalty payments were typically calculated as a percentage of franchisee turnover. If franchisees prospered, franchisors prospered. If franchisees struggled, franchisors shared at least some of the financial consequences. As a result, the interests of both parties were broadly aligned. Today, in parts of the market, those incentives have changed.
Many franchise systems are ‘virtual’ and no longer operate with meaningful territorial exclusivity. Franchisees may be recruited in large numbers and permitted to compete within overlapping markets. While often presented as flexibility, the practical effect is to remove a natural constraint on franchise recruitment.
At the same time, most agreements now contain minimum monthly management fees. The franchisee pays either a percentage of turnover or a fixed minimum amount, whichever is greater. These changes may appear technical but in reality, they fundamentally alter the economics of franchising.
Historically, a franchisor’s success depended primarily upon the success of its franchisees. Increasingly, many franchisors now generate substantial income from franchise recruitment and minimum monthly fees regardless of franchisee profitability.
The Perfect Storm
Individually, each of these developments creates risks. Together, they create a perfect storm. A business with little or no proven track record can quickly be converted into a franchise system. The franchisor can recruit large numbers of franchisees because meaningful territorial restrictions no longer exist. Competition between franchisees increases because more franchises can be sold into the same market.
Minimum monthly fees ensure that income continues to flow to the franchisor even where franchisees struggle. The commercial incentive shifts away from building a limited number of successful franchisees and towards recruiting a larger number of franchisees, regardless of their ability to succeed. The consequences are entirely predictable.
Some franchisees discover that the economics of the business simply don’t work. Others find that increased competition within the network makes profitability increasingly difficult to achieve. Many entered the relationship believing they were buying a proven business model. In reality, they were often buying a business concept that had never been adequately tested under franchise conditions.
The franchisor has no real incentive to train and support the franchisees because they are required to pay the monthly fees. The franchisor can instead concentrate on recruiting more franchisees, and as there are no territories the number can be limitless.
The Exit Trap
The final stage is often the most damaging.
Under the traditional franchise model, successful franchise businesses usually possessed resale value. A protected territory, an established customer base and a profitable trading history created an asset that could be sold.
An unprofitable business is different. Few buyers are interested in acquiring a business that has failed to generate acceptable returns for its existing owner. The situation is even worse if it is loss-making and there is a requirement to keep paying monthly fees.
The franchisee is therefore presented with an unenviable choice. Being contractually required by the franchise agreement to keep operating the business, they can inject cash each month in the hope that things will improve. Although there is little chance of finding a buyer, they can try to sell the business.
The only other option is to ask the franchisor to release them from the franchise agreement. This is where they discover the frightening reality of their situation. As the expiry date of the franchise is some time in the future, the franchisor requires all those payments to be made.
In the worst cases, investors lose their initial investment, lose years of effort and then incur massive additional costs simply to bring the relationship to an end. This is precisely the type of problem that American disclosure requirements were designed to address.
The UK should have legislation that ensures franchisees receive clear information before investing, such as: the number of franchisees who had joined the network; how many had successfully sold their businesses; what percentage were profitable; how many franchisees operated within a particular market; and whether there had been significant litigation.
This information would not eliminate commercial risk, but it would allow investors to make more informed decisions. Most importantly, it would reward the strongest franchise systems and expose the weakest.
The argument for disclosure is not an argument against franchising. It is an argument in favour of better franchising, as exists in America and many other developed economies. The strongest franchise systems have nothing to fear from transparency. They have proven business models, successful franchisees and sustainable economics. Greater disclosure would strengthen confidence in their businesses and improve the reputation of the sector as a whole.
The lesson from America is not that franchising should be heavily regulated. It is that transparency supports confidence, confidence encourages investment and investment strengthens markets.
The Economist was right. The world does need more franchises. But Britain’s experience demonstrates that successful franchising depends on more than entrepreneurial enthusiasm. It depends on trust, information and properly aligned incentives.
Britain embraced the franchise model. It has never embraced the transparency that helped make that model successful. Until it does, both franchisees and ethical franchisors will continue to pay the price.