Conflict Shouldn’t Surprise Franchisors and Franchisees

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A recent Wall Street Journal article described several conflicts between Burger King and its franchisees. In one of these disagreements, three franchisees sued Burger King over the franchisor’s effort to get them to keep their outlets open later at night.

While the courts will have to decide the legal question of whether franchisors have the right to mandate franchisees’ hours, the case points to a bigger problem. Many franchisors and franchisees don’t seem to understand why they often end up in conflict.

The economics behind the conflicts
The basic economics of the franchise arrangement is behind many franchisor-franchisee disputes. Franchisees run outlets according to systems sold to them by franchisors. Under the standard arrangement, franchisees pay franchisors a royalty of a few percent of their gross sales for access to an operating system and a brand name, which is how franchisors make money.

Like most businesses, franchisees earn a profit when their revenues exceed their costs. The difference in how franchisors and franchisees make money is behind much of the conflict between franchisees and franchisors.

Because franchisors earn royalties on franchisees’ sales, anything that increases franchisees’ revenues benefits franchisors. If, as the Wall Street Journal reported, franchisees generate an extra $30 in revenue for each additional hour they are open, the franchisors benefit from longer operating hours. More revenues equate to higher royalties.

Franchisees, on the other hand, don’t necessarily make money when their revenues increase. Consider operating hours again. According to the attorney for the franchisees suing Burger King, staying open late costs the typical franchisee $100 per hour. Assuming these numbers are true, franchisees lose $70 each hour they are open late at night.

If a particular policy makes money for a franchisor, but loses money for his or her franchisees, conflict between the franchisor and franchisee over the policy shouldn’t surprise anyone.

Other types of conflict
Hours of operation aren’t the only thing that can increase franchisor earnings while decreasing franchisee profits. Expansion of the number of outlets in the chain is another example. If a franchisor adds another location near an existing franchisee, the chain’s overall sales often go up because more customers can be served by the two locations than by the original one alone.

The higher overall sales mean more royalties to the franchisor, but not necessarily greater profits for the original franchisee. If the new outlet cannibalizes some of the first franchisee’s sales, the franchisee might end up with lower revenues than before, but with little reduction in costs. In short, adding locations can boost franchisor earnings at the expense of franchisee profits, leading to conflict between the parties.

The franchisees’ surprise is surprising
When conflicts between franchisors and franchisees emerge, franchisees often seem genuinely surprised. Their surprise is disconcerting because many books explain how these conflicts emerge naturally from the franchise structure.

Before people buy a franchise, they should read something about the economics of franchising. Knowledge of the economics of the business might well save them from needing a later education in franchise law.

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Scott Shane Scott Shane is A. Malachi Mixon III, Professor of Entrepreneurial Studies at Case Western Reserve University. He is the author of nine books, including Fool's Gold: The Truth Behind Angel Investing in America ; Illusions of Entrepreneurship: and The Costly Myths that Entrepreneurs, Investors, and Policy Makers Live By.

11 Reactions
  1. Jeff 'SKI' Kinsey

    Nice article. And good advice. However, conflicts (or constraints) are most everywhere in business. To learn more about dealing with all constraints in a system (like a franchise), consider investigating the business methodology known as Constraints Management. As Shane points out, “the numbers” may say one thing, yet still cause a loss of profits.

  2. Properly aligning incentives is tough to do and this demonstrates how franchisee and franchisor incentives can be counterproductive.

  3. I have been in that very business situation and it is tough-Knowledge is power though!

  4. Local Business Marketer

    I’ve noticed that a few franchises with corporate-owned stores will use their franchisees as “market research”. If your franchise location starts taking off, they’ll open up another location across the street and stop providing quality support. It’s important to check out the franchise history before signing up… talk to other successful affiliates.

  5. Shane,

    Thank you for writing this post. It’s really important that would-be franchisees realize that franchise ownership can involve some headaches.

    Reading the agreement is important, and advised, but some things are out of a franchisee’s control.

    For the right person, with the right resources, and the correct mentality going in, being a franchise owner can turn out well.

    The Franchise King

  6. I guess this goes along with Joel’s thinking: If you pick the right franchise and spend a bunch of time understanding how they plan to grow, then you can come out ahead. But, like any business, stuff upsets the apple cart and you have to roll with it somehow. If it isn’t a a policy, it’s something else. Plan to be adaptable and radical so that you can come up with alternative ways to make money, despite the rules.

  7. Martin Lindeskog

    Could you explain the reason for “staying open late costs”? Does it have to do with over-time, utilities, etc? On a free market and with guidance by experts like Joel Libava, these conflicts will be taken care off in a good way.

  8. It is naive to simply say that franchisees should read up on the agreements and that this will prevent problems later. The bigger problem is the culture of fast food in general, which causes Burger King to behave in ways detrimental to customers and franchisees because they can make slightly more money in the short term. One reason Five Guys is successful is that they don’t play games with their franchisees (I am one). They do a great product made with real food with a business model that works for everyone. The result is high growth and very happy customers.

  9. The bigger problem is that the failure rate of ALL small startups is obscured intentionally from prospective franchisees in order to maintain the pool of naive investors who provide the cheap labor and cheap venture capital to grow the franchisors’ chain operation.
    Prospective franchisees invest not knowing that they have a 50% chance of failure sometime within the first five years. They don’t understand that a franchise is a “wasting” asset and few survive past ten years uner the original owner.
    CHURNING AND TURNING is what has made franchising so durable in the economy. Read a true Franchisee Website – and make up your own mind.

  10. Carol – You have a really well-researched and important viewpoint. I actually don’t agree with the main direction of it as franchisees have free will and should do their diligence on any business before jumping in, especially since many put their houses up as collateral for the hard assets. Personally, I think franchising is best done by larger, better-capitalized groups with more resources and negotiating leverage. But I applaud your bringing the issues to light and hope a lot more readers consider your opinion carefully. Thank you.

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