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.