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Thursday / March 23.

Are franchisees becoming too confident? Know why this is a short-lived dream

McDonald

 By Jenny Buchan

Franchisees are unrealistically optimistic about risks of setting up their business, even after those risks have been disclosed to them, our research shows.

We tested this unrealistic optimism by surveying 205 current US franchisees from 26 brands. We chose the US because there is publicly accessible data about the identity of franchisees there (in Australia this does not exist). It’s this information US franchisers are required to provide that should alert intending franchisees to the risks of their agreement being terminated.

We asked individual US franchisees to answer the degree to which they are more or less likely to experience a certain risk than the “average” person operating a franchise in the same brand. This focused on the risk of the franchiser terminating their franchise agreement in two scenarios:

  1. Solely so the franchiser could sell their business to a new franchisee for higher franchise fees.
  2. So the franchiser could operate the successful unit themselves.

Our data revealed that for both scenarios, more than 80% of franchisees believed they weren’t likely to be affected, which is concerning, considering the serious consequences to a franchisee of either event occurring.

Policy makers assume that the presence of disclosure laws mean franchisees will do their homework before committing to a particular franchise. Our research shows that these assumptions are wrong.

The risks of early termination of a franchise agreement

A franchise is a complex, expensive, purchase that will commit the franchiser and franchisee to a business relationship with each other for several years.

A franchise is a complex, expensive, purchase that will commit the franchiser and franchisee to a business relationship with each other for several years. The franchiser has usually sold many franchises, and signed many franchise agreements but buying a franchise is something a franchisee may do only once in their life. To help franchisees avoid making such a significant decision on impulse, the law requires that franchisers provide a disclosure document replete with information. Although the contents vary from country to country, the disclosure requirement is widespread.

Disclosure laws are based on an assumption that franchisees are rational. They will read and understand the disclosed material, take professional advice on anything they do not understand and will not commit until they understand the risks and satisfy themselves as to how they will manage them.

US franchisees are alerted to the possibility that their franchiser might terminate their agreement in one of four ways. The franchiser has to summarise how it could terminate the agreement in a disclosure document by law.

This includes stating whether the franchiser has the right to terminate “at will”; meaning that the franchiser is not required to give the franchisee any opportunity to remedy defaults. The franchiser must disclose the annual number of franchisees terminated to date without compensation and must include the names and contact details of former franchisees whose agreements have been terminated by the franchiser.

Surely, equipped with all of this information, a prospective franchisee would realise that they too, could find their newly minted franchise agreement opportunistically terminated by their franchiser. Our research shows that most do not.

Locked Financial Contract

Contract in favour of franchise making the scenario worst | Visual Hunt

Optimism of franchisees

Franchisers do sometimes terminate franchisees’ agreements “at will”. A statistical analysis by Emerson of 342 US cases involving a franchise agreement terminated by the franchiser, shows in 49 cases the cause of termination is listed as being “at will”. Of these 49 cases, only 11 found in favour of the franchisee.

These results indicate that there is a real risk faced by franchisees that a franchiser will opportunistically terminate the franchise agreement. This information about US franchisees makes us wonder about Australian franchisees.

Franchisers in Australia provide pre-contract disclosure prescribed under the Competition and Consumer (Industry Codes—Franchising) Regulation of 2014. This includes information such as the identity and business experience of the franchiser.

It also discloses any litigation the franchiser is involved in, who the franchiser pays to introduce franchisees to the system, the number and business address details of up to 50 existing franchisees and key details of relevant master franchise agreements. It explains the status of intellectual property like registered trademarks that the franchisee will be allowed to use.

Under headings related to supply of goods or services to a franchisee, there is financial and logistical information that covers aspects like online sales. The franchiser’s policy and practice about sites or territories is explained.

Financial issues are disclosed, as are arrangements that will apply at the end of the term. The franchiser must provide a signed statement that it is solvent, although research shows that a small number of franchisers sign the disclosure statement confirming they are solvent when they are not.

All the information makes franchisees think the disclosure documents tell them all they need to. But, since there is no public database of franchise disclosure, franchisees can not opt for the best.

And, as our US-based research shows, even a detailed pre-contract disclosure document that clearly outlines real risks may not convince franchisees that franchising can be risky.


Jenny Bachan is a member of the Law Society of NSW and academic member of ARITA. She is also a member of the Australian Competition and Consumer Commission’s Small Business and Franchise and Consultative Committee.  
This article was originally published on The Conversation.
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