What can franchisors (and franchisees) do to reduce the risk of franchisee insolvency?

According to the Australian Securities and Investments Commission, 8,044 Australian businesses filed for insolvency in 2018.

People exploring new franchise opportunities typically consider various aspects including: the strength of the franchise brand, management expertise, and experience in franchising. Yet, franchisee insolvency is not an area likely to be evaluated.

While franchisee insolvency can be attributed to poor management of the franchised outlet, franchisor mismanagement can also cause this insolvency.

As an expert, I have conducted research in the area of franchising for over 10 years and I encourage franchisees and their franchisors to assess the risk of insolvency.

Along with my colleagues Professor Kersi D. Antia (Ivey Business School, Canada) and Professor Kenneth H. Wathne (University of Stavanger Business School, Norway), we analysed over 1100 US franchisors over a 10-year period, and we believe there are ways to reduce the risk of insolvency.

Both franchisors and their franchisees are joined at the hip. Understanding this is critical, as the success (or failure) of one has a direct impact on the success (or failure) of the other. Based on the research, it can be said that:

• A franchisee is nearly twice as likely to go bankrupt if at least one other franchisee within the same franchise system has gone bankrupt in the previous year.
• Franchisor insolvency is five times more likely to increase franchisee insolvency than when there is no franchisor insolvency.
• Franchisors do ‘feel their pain’, as evidenced by a 54 per cent increase in the odds of franchisor insolvency for a unit increase in franchisee insolvency.

So, the fundamental question that emerges is: what can franchisors (and franchisees) do to mitigate this risk of franchisee insolvency? From our research, we identify four recommendations for franchisors and their franchisees.

Offer incentives to franchisees

Franchisors can offer various incentives to encourage franchisee performance. These incentives are designed for franchisees to engage with the franchise brand. Franchisors may offer franchisees an opportunity to open additional stores, enabling franchisees to gain greater benefits from their efforts in the local market. Other incentives could include a lower initial fee to open additional outlets. Successful brands may have longer contract terms that provide greater stability and opportunity for the franchisee to invest in the brand.

Incentives help significantly reduce the risk of franchisee insolvency. Franchisors should provide incentives for existing franchisees to open additional outlets, to mitigate the risk of franchisee insolvency and in turn franchisor insolvency.

Find the right franchisee and then support them.

Franchisor selection criteria should include the business and industry experience of the franchisee, formal education, and financial net worth of potential franchisees. Franchisors also engage in various support activities such as providing field training, opportunities to interact with other franchisees through regional and national meetings to support the franchisees.

Franchisors that select the right franchisee and then support their franchisees to be an integral part of the franchise system can decrease the risk of franchisee insolvency.

When looking for new opportunities, franchisees should consider the upside of a franchisor’s stringent selection criteria. The stringent selection criteria suggest that franchisors are not rampantly growing the franchise network by sacrificing franchisee quality. Able franchisees with financial and managerial capabilities are the cornerstone of franchisor success.

However, merely selecting the right franchisees is not adequate. This should go hand-in-hand with franchisors’ on-going efforts to support the franchisee through formal training and informal social opportunities. A note of caution here, beware of franchisors that provide on-going support without any franchisee selection criteria. The on-going support though beneficial to franchisees and the system, can be costly. So, franchisor efforts to provide this support without stringent franchisee selection criteria can be burdensome to the system and can actually backfire. 

Franchisor involvement through company-owned stores and incentives to franchisees

Franchisors that operate a sizeable proportion of company-owned stores are better able to monitor their franchisees’ efforts. These franchisors also have a good understanding of the local market. They can clearly identify any franchisee missteps, as they understand the challenges of managing the outlets. But, monitoring alone can be costly to the system and we don’t find evidence that it reduces the risk of franchisee insolvency.

Instead, we find that monitoring along with the incentives provided by the franchisor to the franchisees reduces the risk of franchisee insolvency. When incentives are offered along with monitoring, the franchisees don’t feel burdened by the hands-on involvement of the franchisor. By considering the potential gains of a larger market share and an opportunity to open new stores, franchisees are better able to benefit from franchisor monitoring.

Franchisor involvement through company-owned stores and royalty rates

High royalty rates are usually considered a red flag by franchisees. However, franchisors can reduce the ill-effects of high royalty rates, by investing in franchisee monitoring.

Based on the findings of our research, franchisors that charge high royalty rates are better off doing so when they also engage in monitoring of their franchisees.

Franchisees may be de-motivated to invest effort when franchisors charge high royalty rates. However, when franchisors can actually monitor the behaviour of franchisees, the franchisees are unable to reduce their efforts.

Summary recommendations for franchisees

In conclusion, even though the franchise disclosure document doesn’t provide any information on franchisee insolvency, franchisees should ask franchisors information on franchisee insolvency, before they sign on the dotted line.

Franchisees should also pay particular attention to franchisor selection criteria and the support franchisors provide. Pick franchisors that have stringent selection criteria and also provide on-going support to their franchisees.

Franchisees should evaluate the incentives offered by franchisors, along with their efforts to monitor the system and the royalty rates.

Reducing the risk of franchisee insolvency and in turn franchisor insolvency is of significant benefit to the system and society.

Dr Sudha Mani is an expert in the area of governance of franchisor-franchisee relationships. She is a Senior Lecturer at Monash University. The Parliamentary Inquiry on franchising has cited Sudha’s recommendations. 

For further information or to discuss franchising, Sudha can be reached at:

Sudha.mani@monash.edu

https://www.linkedin.com/in/sudha-mani-2648666