Why Some Franchise Systems Succeed While Others Fail

Posted on 16. Mar, 2010 by in Case Studies, Franchising

As this blog has reported before and as the flywheel group’s Clint Lee wrote in the white paper “Franchising, Disparity in Numbers”, a closer inspection of franchise industry promotional information about the great success of franchising is in order. All that glitters isn’t gold in franchising. While franchising can be a successful means of expanding a distribution system its reliability in achieving success is certainly questionable. This is particularly true for emerging franchisors. In fact academic research has shown that as many as three-quarters of all new franchise systems cease franchising within 10 years of formation (Shane 1996).

Why is this important ? By understanding the keys to success and applying certain disciplines from this learning, emerging franchise brands can greatly improve their chances of survival.

So what are the key variables that separate winners from losers in the franchise game ? Scott Shane of M.I.T.’s Sloan School of Management prepared some interesting academic research in 1998 which identified some key variables which are shown to be the key drivers of success. His research was published in Sloan’s Strategic Management Journal, Vol. 19, 697–707. and deserves close evaluation by franchise managers and franchisee participants.

The study tested his theories through the use of survival analysis on a cohort of 157 new franchisors established in the United States between 1981 and 1983 and tracked over time. The dependent variable in the study was exit from franchising; as previously mentioned Shane (1996) found that three-quarters of all new franchise systems ceased franchising within 10 years of their formation. The high rate of failure of new franchise systems suggested that survival of a new system over time is a critical measure of success (Carney and Gedajlovic, 1991).

Shane’s research focused on mechanisms that leverage “agency costs”, a financial theory which explains how best to organize relationships in which one party (the principal or franchisor) determines the work, which another party (the agent or franchisee) undertakes. Since the agent’s self-interest are in conflict with the principal’s, alignment of outcomes via contactual relationships is a key to mutual success.

Here are his key findings which set forth the underlying characteristics of successful franchise systems:

New franchise systems which permit passive ownership of franchised outlets are more likely to fail than are other new franchise systems.

New franchise systems which require higher levels of franchisee cash involvement are less likely to fail than are other new franchise systems.

New franchise systems which require franchisees to have experience are less likely to fail than are other new franchise systems.

New franchise systems which are geographically concentrated are less likely to fail than are other new franchise systems.

New franchise systems which are more complex are more likely to fail than are other new franchise systems.

New franchise systems which employ master franchising are more likely to fail than are other new franchise systems.

New franchise systems which have higher levels of total investment are more likely to fail than are other new franchise systems.

The results of the study indicate that franchise systems founded between 1981 and 1983, which are structured to economize on agency costs, are more likely to survive than franchise systems which are not structured to economize on agency costs. This finding is important because the failure rate of franchise systems is high, with over 72 percent of the new franchise systems in the sample ceasing to franchise by 1995.

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4 Responses to “Why Some Franchise Systems Succeed While Others Fail”

  1. Paul Segreto 18 March 2010 at 1:00 am #

    Bryan, excellent post but I believe franchise failure many times occurs for a couple of simple reasons. Assuming proper capitalization and diligence in establishing the original business concept as a franchise sytstem, in my opinion, there are two simple reasons for franchisor failure.

    One, franchisors don’t treat the franchise relationship as an interdependent relationship where success at all levels in the organization is dependent on each party to the franchise agreement. Ignoring this fact causes franchisees to feel they’re treated like unappreciated employees, breaks down communications and ultimately fractions the system itself. This results in untimely royalty payments and focuses franchisor’s attention on collections and possible legal actions.

    Second, franchisors, especially startups, whether out of necessity or overzealousness, use the practice of checkbook franchising. That’s the difference between selling a franchise and awarding a franchise. Just because a franchise candidate has the funds doesn’t mean he will be successful as a franchisee. Too many of these franchisees cause problems in all areas and affect the system as a whole resulting in closed units and legal problems. Both of which must be disclosed in disclosure documents that ultimately affects franchise sales.

    In the end, franchisors experience reduced revenue streams in both royalties and franchise fees while increasing legal expenses. Once this cycle begins it’s extremely difficult to stop without drastic change.

    • borourke 18 March 2010 at 7:32 am #

      Thanks for your comment Paul. Your observations are quite relevant and I appreciate you sharing them. Checkbook franchising and mistreatment of the relationship are really both consistent with several of the specific variables Shane identified in his research. What is most pertinent is the fact that 72% of franchise systems failed in his analysis. If one reads Clint Lee’s white paper on the subject, available on the Flywheel Group web site, it is apparent that failure of systems is more common than not. This is inconsistent with most of the industry hype one reads about the great success of franchising. There is disparity in the numbers.

  2. Jonathan Bergstein 28 July 2010 at 6:38 pm #

    Bryan,

    Thank you for an informative article. As a new franchisor, I am constantly trying to improve my chances to build a successful franchise system. From my experience as a business owner, I think another reason for franchise failure, as well as any business failure, is a lack of concern for the customer. I can not tell you how many times businesses refuse to return my phone calls, provide shoddy work, and do not follow up on work completed. I feel that a lack of customer service drives customers away. Whether it is a local business, or a franchise, I do not think business owners have a real concern for their customer. It only takes a few minutes to ask a customer, “What can I do to improve service?”. It follows that if a business owner has a lack of customer service for their customer, then the franchisor has a lack of concern for the franchisee. One reason people buy a franchisee is for the support, otherwise the franchisee would start a business on their own. Lack of support means the franchisee may not feel that the parent company has its best interest at heart. The end result is poor performance by the franchisee, and ultimately, the collapse of the entire franchise system.

  3. Norfolk Fitness Club 30 September 2011 at 3:53 pm #

    I just hope that you dont lose your style because youre definitely one of the coolest bloggers out there.


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