Cost of a Failed Unit is Not Just a Franchisee Issue

By: Darrell M Johnson

Throughout my career I have observed that a strong alignment of interests between two business parties usually leads to good outcomes for both. All franchisors with any marketing savvy will say they are strongly aligned with their franchisees.  What is the evidence that a brand walks the talk?

We have lots of indicators, starting with a full and high quality support program, including disciplined prospect screening, training that measures results, site selection and opening assistance that is based on proven criteria, and field operations and compliance that are effective.  All these functions can be benchmarked against peers.  Then there’s transparency.  Brands that have a meaningful Item 19, that have system dashboards that compare unit performance in real time, that support capital access through SBA eligibility and Bank Credit Reports,  and that seek system feedback through independent third parties are further examples. Brands that “get it” tend to not only focus on these types of operational performance measures but actively compare how they are doing against peers.

In an absolute sense, all these indicators are aimed at a pretty simple concept, unit success or failure. Over the long term, the only reason a unit will stay in business is because it is profitable.  While we tend to acknowledge that there is a financial impact on franchisors of a failed unit, we rightfully focus mostly on the impact on the franchisee.

After all, for most single unit franchisees the cost of a failed unit is absolute and often devastating. It can represent the loss of a business, the loss of most of a franchisee’s personal net worth, the loss of a his/her own main source of income and job, the likely loss of other jobs, and the resulting impact on many families. For multi-unit franchisees, the cost of a failed unit usually isn’t quite as devastating personally or financially but it is real and negatively affects people. Until recently we didn’t even quantify it.  Now we are with a calculation of historical unit success rates.  After testing many versions of franchisee and unit success/failure formulas, FRANdata has developed one that not only works historically but is a good medium term predictor of future performance outcomes.  We are currently incorporating it in credit rating products for lenders and it is being well received.

This is an important start.  However, we must take it further if we are to gain a stronger alignment of interest between franchisors and franchisees and multi-unit franchisees can have a big influence on adoption.  We get what we measure.  If we measured the full impact of a failed unit at the franchisor and franchise system level, I wonder if we would have fewer of them.  We in franchising know that these impacts go beyond the franchisee.

The obvious impact on the franchisor is a loss of royalty revenue.  A franchisor has made an “investment” in finding, training, and supporting a franchisee as well as assistance in siting and opening a new unit.  In our comparative research on operations for brands we have found that the sunk cost incurred by a franchisor varies widely and can be a significant multiple of the net fees obtained up front.  Those upfront costs put unit breakeven for many franchisors more than two years out when compared to the unit royalty ramp up. Coincidentally, we also have found that most new franchise units hit breakeven in a 12 – 24 month time frame, based on our BCR data. From many years of providing brand credit analysis for lenders, we also have tracked the time from funding to loan failure (loan failure and unit failure are correlated but not as highly as is generally thought).  The significant rise in the loan failure bell curve starts after two years, about the time that franchisors have recovered their fixed costs in a unit.  Put all this together and it certainly creates an alignment of interest between franchisors and franchisees but there is much more that franchisors should consider.  If they did, I think we’d see more attention to developing effective selection, training, and support and end up with fewer failures.  Here’s why.

An under-qualified franchisee prospect requires more support.  A weak site selection program lengthens the time to unit breakeven.  An underperforming unit takes more field support time.  An underperforming franchisee also takes other franchisor staff and often management time. It almost always has an impact on other franchisees, often leading to system culture issues.  A closed unit is a big negative to the lending community and with even just a few closures often leads to banks staying away from those brands.  At the very least, it affects the terms that lenders are willing to offer.  A failed unit creates consumer brand perception issues and a failed franchisee often creates negative social media and even traditional media issues.

This brings me back to the beginning point about alignment of interests.  Wouldn’t brands that grasp this concept at all three levels, franchisor, system and franchisee, be the brands that will have the most success?  An important question that both prospective franchisees and multi-unit franchises should ask is which brands exhibit the best understanding of this concept?  Our research projects with franchisors are leading us to develop performance standards that measure the full cost of a failed unit and analysis of the causes.  With such an understanding franchisors should more efficiently allocate their human as well as financial resources.  The result for the industry will be fewer failures.