Franchise Failure Rate

when franchise fails

By Michael Seid, Managing Director, MSA Worldwide

Question: In the past year several of my franchisees have closed their doors. Most of our other franchisees are doing extremely well and I am finding no shortage of buyers. We had a record year in franchise sales in 2007 and this year looks just as good, even with the downturn in the economy. Should I be concerned that a few units have closed? Is there something I should be doing to prevent unit failure? What is the average rate of failure for franchisors? Maybe my rate of closure is no worse than anyone else’s?

Answer: There is little more difficult to deal with than failure. For a franchisee, failure means more than the loss of their investment and their livelihood. Failure brings with it all of the emotional stages of loss, which frequently include embarrassment and anger. Regardless of whether it is warranted, some of that anger will be directed toward the franchisor.

For a franchisor, the failure of a single franchisee is going to be felt in a less personal way than it is for the franchisee. The franchisor’s loss of investment and the risk to their livelihood is diminutive compared to that of the franchisee. The franchisor has lost a portion of their royalty stream and a point of distribution. On the other hand, the franchisor has gained a negative disclosure in Item 20, a possible negative endorsement the next time a potential franchisee calls the closed franchisee, and occasionally the franchisor will be hit by some litigation.

The truth is that in some larger franchise systems, the loss of a single location is so immaterial it will go almost unnoticed, while in smaller systems the loss could potentially be devastating. Regardless of degree, failure is never pleasant for anyone. But, failure is normal, even in franchising. Anyone who expects that by joining a franchisor they eliminate the risk of failure is being unrealistic. There is a lot to be learned from doing a forensic review of each unit’s failure.

There are no reliable statistics on franchisee failure. For the most part when studies have been performed they only included franchisors still in existence, and franchisees of defunct systems were never counted. A further problem is that no one has ever come up with a universally accepted definition of failure. For some, if the unit hasn’t closed its doors permanently, it never failed and therefore is a successful location. For others, an indication of failure is if the franchisee sells his or her business before the term is up. But a transfer is often no more than the sale of a successful operation and the retirement of the owner. Or, it can indicate a bargain basement sale of a location that continues to lose money. SBA default rates are not a good indication of success or failure either. So, how should you view the failure of a few franchisees in your system if you can’t measurement it against “franchise industry” averages? As we tell our clients, you view the loss of every single location with concern and as an opportunity to improve your system’s performance.

In a well-run franchise system, most franchises fail because of something the franchisee has done or has not done. Failure of management at the unit level is still one of the leading causes of business failure, and frequently there is little the franchisor can do to prevent it. The root cause of unit failure can also be found in decisions made before the franchise opened: site selection, inadequate financial resources, excessive debt service obligations, etc. But, since the franchisor recruited the franchisee, trained the franchisee, approved the location, designed and updated the franchise system, and provides them with ongoing support, the franchisor in some way directly or indirectly played a part.

Understanding unit failure is a chance to improve your franchise system, and it’s important for franchisors to understand why each location failed. Do some research:

  1. Go back to the franchisee’s recruitment file. Look at the application. Would they meet your current criteria for prospective franchisees? Did you sell them a franchise or did you select them as a franchisee? Were they allowed to take on too much debt given the expected cash flow?
  2. Understand the recruitment process. If you have multiple franchise salespeople or use brokers, understand if there is some correlation between franchisee failure and who brought them into the system. If there is, find out why.
  3. Review the franchisees’ performance and your library of communications with them, including field reports, letters, e-mails, etc., to see what issues were in play while the franchisee was in operation. How did your system deal with each issue? Were other alternative approaches available?
  4. Talk to your management team and get their perspective.
  5. Talk to field staff who worked with the franchisee. They likely will have the best understanding of what took place.
  6. Hold an exit interview with the franchisee. But first, speak with your lawyer. Some lawyers may have concerns about exit interviews, but remember, the role of a lawyer is principally to guide you on legal issues and give you advice to help you reduce your legal risks. Your role is to manage the business of the franchise system. Exit interviews may not be the most pleasant conversation you can hold, but they can be a treasure trove of information for franchisors who can listen without being defensive. Even if you think you know everything about the situation, a well-structured exit interview is worth the effort.

Once you have an understanding of why the franchisee failed, schedule time during your next management meeting to debrief your team on what you have learned and why you believe the franchisee failed. Discuss ways to improve system processes that may have prevented or reduced the chance of the franchisee’s failure. Learn from each instance and make the changes you think are warranted to deal with any shortcomings.

One last comment; sometimes an abundance of sales and a low failure rate are an indication of what you would expect—a great franchise system. However, with newer systems it may only indicate a great franchise sales team. Closely monitor your franchisees’ bottom-line performance to understand their return on investment. Find out if their cash flow is allowing them to service their debt and provide them with sufficient income to take care of their family. Franchisee failure rarely takes place immediately, and monitoring early unit performance and making adjustments to your system may prevent failures in the future.

Do you have further questions about strengthening your franchise system?

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