The Deification of Franchising: A Bit of A Stretch
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The Deification of Franchising: A Bit of A Stretch

At this year's very successful International Franchise Association annual convention, we were bombarded with a plethora of laudatory statements about franchising. We were told that franchising accounts for more than 40% of retail sales in the U.S. economy, generating over a trillion dollars in sales per year, and that franchising companies provide the source of employment for more than eight million American workers. We heard success stories from both franchisors and franchisees.

By the end of the program, we were inspired. Franchising, we felt, was almost the cure to all of the world's ills. We could not survive without it. As one who has made a nice living and career through his involvement with franchising, I can join in the singing of the hymn-at least to some degree.

But those of us-lawyers, consultants and other suppliers of services to the franchise industry-who are called upon to advise others on distribution matters must recognize that franchising is not right for everyone. Some distribution systems will not be best served by franchising, and some prospective franchisees/entrepreneurs are not going to function well in a franchise environment; some of them may want to be their own bosses, but they are not made out of the right cloth to be franchisees.

Let's look critically at some of the drawbacks of franchising. First, if a business system is successful, franchising may be, from a financial standpoint, a terrible decision. Look at the economics. If the margins in the business are that good, why should a company desire to share those with others? Almost every franchisor will acknowledge that a well-run company unit will be more profitable to the franchisor than an income based on a royalty stream.

There are two reasons why sharing is a good idea. First, the company may lack the capital to expand rapidly, and second, the commitment of a unit manager may not be the same as the commitment of a business owner. Thus, capital and labor may be more readily attractive in the franchise environment.

Each of these answers is valid. However, a successful business with a proven track record should be able to attract capital. The growth of the venture capital and angel financier markets in the last two decades has been the answer to the limitations that had previously plagued many successful businesses. As for attracting the right people to manage and operate the service and product distribution centers, creative structuring of employment arrangements and attractive economic packages can fill the bill. Phantom stock plans, incentive payment programs, good benefit packages, and financial stability can all be used to attract talented managerial labor that can eliminate the need for a franchisee. What's more, many talented people are frozen out of the franchise market because they themselves lack the capital necessary to purchase, open, and operate a franchise.

A second drawback to franchising is the issue of control. In a vertically integrated company, management has the ability to control how and when products or services will be delivered. The company can dictate who it will hire and the compensation of all its workers, it can set the prices at which its goods and services will be offered, it has the decision-making power on marketing, and it can assert significant control over all aspects of operations.

In the franchising model, most, if not all, of these managerial issues will belong in the bailiwick of the franchisee. If the franchisor does not like the way in which a franchisee is performing, it cannot walk into his office and hand out a pink slip, as is the case in the vertically integrated business. Also, if the franchisor does write a contract that gives it significant control, it may be subjecting itself to liability to third parties under various vicarious liability, agency, and other legal theories. One of the attractions of franchising is that a franchisor can escape these liabilities by giving control functions to its franchisees.

A third drawback of using franchising as a business model is the regulatory environment. The vertically integrated business can target its markets and move with speed to penetrate those markets. Not so under a franchise model. Disclosure documents must be prepared; in some cases, offerings must be registered; a complex agreement with the service or product deliverer will be necessary, and signing of this agreement may require a protracted period of negotiations. None of these allows swift action.

What's more, if the attempt at market penetration proves less successful than anticipated, market withdrawal is considerably more difficult under the franchise model. If the franchisee is adequately performing, under most arrangements the franchisor cannot come in and shut down the franchisee's operations.

Not only is franchising not the appropriate business model for many businesses, it is not well-suited for certain individuals who want to own their own businesses. Franchisors don't agree on the profile of the perfect franchisee; however, a good percentage of franchisors say that their franchisees should be willing to take orders, but also be able to adjust and control the worlds in which they operate. In the military, this description seems to describe the role of a captain. Those businesspersons who want complete autonomy would be probably be better served operating outside the constraints of a franchise agreement.

In contrast, the individual who shows no leadership skills might be best off as an employee. Of course, franchises are not all alike, and the business skills (as distinguished from operating expertise) required to own and manage a fast food restaurant with forty employees might be considerably different than those required to operate a coupon-mailing business out of one's own home. Also, many franchises allow for passive ownership, which means that the business attributes of the franchisee might not be nearly as important as his ability to find a suitable manager.

Make no mistake: I have an infinite respect on how franchising can effectively transform a small, local concept into a regional or national brand. But we must keep in mind that franchising is not in itself the end-all, be-all. Despite all the panache and rhetoric, it is, in the end, only one of several ways to grow a business.

Rupert Barkoff is a partner in the Atlanta, Georgia office of Kilpatrick Stockton, where he heads that firm's franchise practice. He is also a past chair of the American Bar Association's Forum on Franchising.

Published: November 1st, 2004

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