Risk / Reward
Executives who think it's safer to buy a franchise than start a business need to think again.
By Anne Fisher


After a long career as a senior executive in the automotive industry, Roger McCabe wanted a change. "I was tired of moving and tired of traveling," he says now. "I wanted to go back to my hometown of St. Louis and stay there." So when - the last three financed mostly by revenues from the first two.

The transition from big-company honcho to jack-of-all-trades franchisee has been bumpy. Even with 22 employees (not counting himself and his wife), McCabe is putting in longer hours than he expected. "In my previous life, I had a staff of eight vice presidents and an executive assistant," he says. "Those people take a tremendous amount of pressure off you. With this, it's you and you alone." He frequently logs ten-hour days, followed by evenings loaded down with paperwork -- "and I'm supposed to be semi-retired."

Still, McCabe's Meineke shops are making money, and a growing number of baby-boomers are jumping at the chance to follow in his footsteps. Franchising is an economic behemoth in the U.S., encompassing at least 650,000 individual businesses in more than 70 industries. It's also a much more perilous proposition than most people realize, probably even more risky than starting a company from scratch. That's partly because the franchising industry is so fragmented. Everyone knows the big names -- Blockbuster, Dairy Queen, and McDonald's -- but they're the exception. The median size of a franchise operation is tiny, just 25 units. Fewer than 20 companies have franchised as many as 5,000 units. Why does that matter? Because the bigger the franchise company and the longer it has been around, the more likely it is to have an established name brand and proven systems for producing profits -- in other words, the less dicey it is for the folks who buy into it.

But there's a catch. The big names have spent many years and many millions of dollars on advertising and marketing, and stellar brands carry big pricetags. McDonald's stores, for instance, are such money machines that, depending on location and other factors, opening one will set you back a minimum of $540,000. So typical franchisee wannabes -- with, say, $50,000 to $100,000 to invest -- frequently find themselves signing on with far smaller, lesser-known organizations that may or may not have a clue about how to help operators make money. They also may not be around long. According to the American Association of Franchisees and Dealers, companies that sell franchises go under at a rate of about 15% a year. That means, notes AAFD chairman Robert Purvin, that "in any given five-year period, 75% of franchisors disappear."

Even big-name franchisors that have been around for years can run into trouble when they try to grow too fast. Witness Krispy Kreme, the scandal-plagued doughnut store chain. As if the growing legal and regulatory hubbub over certain of the company's accounting practices were not trouble enough, Krispy Kreme, based in Winston-Salem, N.C., is facing a barrage of complaints from irate franchisees. These folks--and some Wall Street analysts who follow the stock--say that Krispy Kreme has revved up its revenues by squeezing all the profit out of its franchises, partly by charging exorbitant prices for doughnut mix and equipment that franchisees must buy from the company. Krispy Kreme, which declined to comment on pending litigation, says it plans to defend itself vigorously.

Anyone looking for reliable data on failure rates of individual franchise units faces a tough challenge, because the franchise industry uses a weird definition of "failure." Consider: If your business sank so deeply into the red that you were forced to give up on it and eat your losses, wouldn't you call that a failure? Most would. But the International Franchise Association, a trade group in Washington, D.C., that represents franchisors, sees things differently. When a franchisee doesn't prosper--indeed, loses his shirt--what usually happens is that the franchisor simply takes back the unit (without reimbursing the hapless franchisee one dime) and sells it to somebody else. That franchised doughnut shop on the corner of your street probably looks the same on the outside as it always did, but it may have run through ten operators in as many years. Never mind. As long as the shop doesn't close its doors, it isn't a "failure" as the International Franchise Association defines the word. That is why, when asked for the failure rate of franchised businesses, the IFA says it is 5% a year. Wow! Just 5%! Sounds as if making money on a franchise is practically a sure thing!

Time for a reality check: The scant research that exists suggests that, as risky as starting an independent business is, buying a franchise is an even bigger roll of the dice. In the early '90s Timothy Bates, a professor at Wayne State University, studied Census Bureau data on 20,000 new enterprises and found that 38% of franchise units failed over a four-year period, vs. 32% of independent startups. In some industries the gap was much greater. In retailing, for instance, 45% of franchised units lasted less than four years, while just 23% of independent retail stores flopped. And here's the jaw-dropping part: Bates notes that his figures on franchises are quite conservative, because he defined "failure" the same way the IFA does. If a more commonsensical definition were used instead, Bates acknowledges, the percentage of failed franchises would be far higher than his study shows. Okay, but his research is a decade old. Does he have plans to update it? "My God, no," he says. "After that paper came out, I was inundated with so many sad stories from bankrupt franchisees--they were so relieved to know they were not alone--that it interfered with my ability to live my life."

What is it about franchising that gives rise to so much woe? As with any phenomenon that involves 250,000 distinct individual circumstances and stores across 50 states, generalizations are tricky. Still, there's plenty of evidence that, in many respects, buying a franchise too often ensnares would-be entrepreneurs in the worst of both worlds: You get all the financial exposure, headaches, and stress of business ownership--but someone else collects royalties on every nickel that comes through the door, not to mention fees for marketing, fees for this, fees for that, more fees for anything you can imagine (and some stuff you can't); and all the while, the franchisor dictates virtually every detail of what you can do, including what kinds of signs you can put up, how you price your wares, how much overtime you can pay your employees, and who'll be your suppliers. Violate the agreement, even in some tiny particular, and the franchisor can--and often will--snatch your franchise back.

To hear the experts tell it, a fundamental misconception is the idea that running a franchise means being your own boss and running your own company--whereas in reality, you're just leasing a trademark, and the real boss is the company that has sold you the privilege. "If you really want to be your own boss, choose a business you'd like to go into, and go to work in that industry until you learn something about it," says Gerald Marks, a franchise attorney in Red Bank, N.J. "Then go and start your own company."

Given all the challenges of franchising, you may wonder why anybody signs on. These days part of the answer can be found among the peculiar blind spots and vulnerabilities of those boomers who have been laid off by or grown disenchanted with big corporations. Corporate America is sloughing off seasoned managers in record numbers. About 3.5 million Americans between the ages of 40 and 58 now fall into a category the Bureau of Labor Statistics calls "displaced workers," meaning that their jobs in middle management at large companies have simply disappeared. This group has a far harder time finding comparable work at similar pay than younger workers do. One consequence is a rush of corporate refugees into franchising. While nobody is counting how many new franchisees sport a few gray hairs, trend watchers in the franchising world report that rising numbers of corporate refugees are trying to, in effect, buy themselves a job.

At the same time, baby-boom-generation entrepreneurs who have built one successful business (or more than one) may be looking for a new opportunity to run something without having to start it from scratch. "The trend is definitely toward older, more experienced people going into this," says Peter Birkeland. The author of an intriguing book called Franchise Dreams: The Lure of Entrepreneurship in America, Birkeland travels around the U.S. running training sessions he calls "franchise boot camps" for those who are considering taking the plunge. "People in their 50s," he says, "often have more self-confidence and bigger nest eggs to invest than younger people do."

Franchisors are welcoming them. When Jan Lee left IBM after 29 years, she wanted to do something completely different--but she also liked the idea of getting lots of support and guidance while she did it. Franchising seemed the perfect solution, so she looked at several opportunities in Chicago, including a couple of fast-food franchises, before deciding to open a Slender Lady diet and exercise center in her home suburb of Hawthorn Woods, Ill. "I was attracted to this because it was a 'people' business. All the sales pitches talked about helping people, especially women, be healthier," she says now. "I'm an MBA, so I'm slapping myself silly for getting into this situation. But their business plan seemed sound."

Lee paid $30,000 for the right to open her Slender Lady franchise in Hawthorn Woods in October 2003. The franchisor convinced her that, because she could expect at least $5,000 net profit every month from the initial location once it was up and running, she would be making a mistake not to reserve five other territories in the surrounding area, at $5,000 each, so that she could open more facilities later. She then discovered, she says now, that the $30,000 franchise fee for the first location was just the tip of the proverbial iceberg. Another $40,000 went to securing a storefront in the kind of upscale mall where her prospective customers shopped, plus $9,000 for signs and window blinds. "Even the music you're supposed to play has to be downloaded from a certain source, and that costs extra," says Lee. "There was one expense after another that wasn't mentioned in the initial estimates--$10,000 in advertising, then payroll taxes--or payroll, period. To get any new customers, I had to hire a salesperson, who cost me $2,500 a month. That wasn't mentioned anywhere."

Yes, but in exchange, didn't she get help from Slender Lady's headquarters in San Antonio? She says not. Take, for example, marketing. According to Lee, the whole idea was to put up "drop boxes"--those boxes with a slot in the top where prospective customers can drop preprinted slips of paper so that they can be contacted with more information--in as many local restaurants and other high-traffic spots as possible. That might work in some places, but not, Lee discovered, in the suburbs of big cities such as Chicago, where shoppers are wary of leaving personal information lying around in public places. "I spent hours persuading restaurant owners to let me put the boxes up," Lee recalls. "And then they'd just be full of gum wrappers anyway." When she explained this to the Slender Lady folks, "they said, 'The drop boxes work!'" she says. "'Just keep using the drop boxes!'"

Meanwhile, Lee's $100,000 nest egg from IBM was gone, she had borrowed against her house to keep her business going, and competition from a Curves franchise a few miles away was making each new customer hard to get and harder to keep. Lee's response: Like any good corporate soldier, she worked harder and longer and harder and longer. "The exercise business is very emotional and labor-intensive. If a member doesn't show up for two weeks, you're supposed to call them and ask why not," says Lee. "So I was spending 12 hours a day on the phone with people, with them telling me all their personal problems, and they still didn't come back. Nothing in my corporate life prepared me for this. I was exhausted and depressed all the time."

More depressing still: Lee ran through her home-equity line of credit and, with her franchise still running at a loss, couldn't pay it back. Even before it became clear that she would lose her house, her marriage was in trouble. Her formerly well-ordered life in chaos, Lee signed the franchise over to an employee earlier this year for $1. "I just wanted out," she says. (Of course, because the location's doors are still open it doesn't count as a failure--does it?) Then she called Slender Lady and tried to get a refund, not for the initial franchise but for the other territories it had sold her for $25,000, which she had never used. No luck. Lee was told that two of the five territories had already been sold to other franchisees. Ka-ching!

Bruce Sharpe, Slender Lady's CEO, says Lee's experience isn't typical. "Some of our franchisees make $20,000 a month profit. It can be a great little business," he says. "But it's hard to tell in advance who really has the skills to make it work." Sharpe says that Slender Lady's marketing plan includes coupons, fliers, and promotional programs in schools, not just drop boxes. And as for those unused territories, he says, "there is a time limit clearly stated in the contract. If you don't use the territory within 12 months, you lose it, and you don't get a refund because you have tied up that territory for that time."

Ah, the contract. You know those bitter good-news-bad-news jokes? The franchising equivalent is this: The good news is, everything is explained in the Uniform Franchise Offering Circular (UFOC), which Federal Trade Commission rules require every franchisor to present to each prospective franchisee at their first face-to-face meeting. The bad news is, almost no franchisee reads it--or, better yet, hires an experienced franchise attorney to read it.

The UFOC is a contract between the franchisor and the franchisee that states who is in charge, what happens if the franchisee violates any terms of the agreement, and what legal recourse the franchisee has if there's a dispute (usually arbitration only and, if litigation, only in the franchisor's home state, which may be thousands of miles away). The UFOC also spells out what refunds are due to the franchisee (usually zero) if the party of the second part goes belly-up. Jan Lee's contract with Slender Lady, for example, "has an airtight 'no-refunds-ever' clause," she says. "I overlooked that somehow."

Most franchisees do. Says Eric Karp, a Boston lawyer who teaches graduate courses in franchising at Babson College: "The typical UFOC is about the size of a telephone book, and it is enormously complex because it's so multifaceted. Everything related to the business--construction, brand management, employee training, etc.--is all rolled into one vast document. Those are things that an independent entrepreneur would handle in at least a dozen different deals with different suppliers and so on, but here it is all in one place. The irony is, you can say there should be more information, but the more information is laid out for people, the more we risk overwhelming them, so that they don't read it at all."

Let's say Karp had to distill this hydra-headed document down to one essential element. What would that be? "There are really two," he says. "First, people buy a franchise because they think they'll finally own their own business and be the boss. Ha! I laugh. Everything you do in a franchise will be dictated, from the moment you turn the key in the door in the morning, and if there is any variation, you are in default of the agreement. The franchisor can terminate your contract, and any value you have built up is lost." Oh. Okay. Anything else? Just this: Beware of those whose job is to sell you a franchise. "One of the hardest things to do is to get any real information about what you can expect to make from a franchise," notes Karp. "The Securities and Exchange Commission has made sure that you can't buy a single share of a penny stock without detailed financial disclosure. But you can invest your entire life savings in a franchise on the basis of no [projected earnings] information at all. It's crazy." Most franchisors are careful to instruct their salespeople not to give any specific financial projections that could come back to bite them later. "But many salespeople do give out numbers anyway," Karp says. "They're just highly selective about the projections they give out, and of course nothing is ever in writing. It's called the 'cocktail-napkin exception.'"

The what? Well, you can guess: It's just the salesperson and you, the soon-to-be franchisee, and you're such buddies that she is going to share with you here at the bar, or perhaps over a mocha grande at your local Starbucks, exactly how exciting your deal really is! That is how Jim DiGiovanni says he came to write a $40,000 check to Quiznos, the second-biggest sandwich shop chain in the U.S. after Subway, for a franchise he wanted to open in Hazlet, N.J. DiGiovanni was looking to change careers after a 20-year hitch as a computer programmer in the telecom industry. "Once you're nearing 40, it's hard to make it as a programmer in an industry that's totally changed," he says.

Now DiGiovanni is one of 24 plaintiffs in a lawsuit against Quiznos, all alleging essentially the same thing: The Denver-based chain raked in would-be franchisees' savings after promising them (but never in writing) certain prime retail locations. Once the checks had cleared, DiGiovanni says, the locations suddenly became unavailable. The sticking point was that, according to Quiznos's contract with its franchisees, no franchise could be built--let alone open for business--until the parent company approved its location. If a year went by with no approved location, Quiznos could take back the franchise.

Would you like to guess whether that contract also featured a no-refunds clause? Do you need to ask whether DiGiovanni ever got a location approved? "I didn't need this kind of risk. I have two little kids. The contract seemed very one-sided to me at the outset," DiGiovanni says. "But they already had over 3,000 stores elsewhere in the country. And they promised a team would be there to help me. It was based on trust."

Like most companies, Quiznos declines to comment on pending litigation, but the franchisor did give FSB a statement that says Quiznos "believes the New Jersey lawsuit has no merit." The contracts that franchisees sign, the statement continues, "clearly provide that franchise owners are responsible for finding an acceptable site for their restaurant. Quiznos has the right to approve or disapprove proposed sites, which protects the Quiznos brand and protects everyone in the Quiznos system."

Sometimes, critics say, franchisors are too clever for their own good. Consider the strange tale of how Snap-on, the tool company in Kenosha, Wis., may have tripped over its own cocktail napkin, so to speak. Snap-on sells sales routes to franchisees, who also buy a special van and an inventory of tools. A couple of years ago Matt Setser had enough of his old job at FedEx and decided to move his family 1,100 miles, from Fort Smith, Ark., to the Tampa Bay area, to take on a route that, he says, a Snap-on franchise representative had assured him (never in writing) would gross $30,000 a month.

As soon as he set foot on Florida soil, Setser--whose wife, Suzanne, was expecting their second child at the time--knew something was wrong: The district manager who showed him around started commiserating about what a lousy route Setser had been sold. Fast-forward a year, and sure enough, the route paid almost nothing, Setser says, despite his long hours of work and worry, in large part because too many other Snap-on routes had been sold (at $30,000 a pop) right in his backyard.

But here's the twist: Somebody at Snap-on may have given the game away. When the Setsers first got to the Tampa area, they rented an apartment. Because they weren't local, the landlord asked for some evidence from Matt Setser's employer of his projected income--and because Snap-on was the closest thing to an employer that the couple had, Suzanne called Snap-on and got that $30,000-a-month figure committed to writing. The Setsers decided to give up on a losing proposition last fall; Matt now sells real estate. But their former landlord had filed Snap-on's fax predicting Matt's route would yield $30,000 a month, and Suzanne had the presence of mind to ask for a copy. It is now an exhibit in a class-action suit of Snap-on dealers against the franchisor.

Nor is this the first time Snap-on and its franchisees have crossed swords. A Snap-on dealer in New Jersey named Brian Casey says he ran into the same trouble with Snap-on that the Setsers did. Last summer an arbitrator awarded Casey $314,000 in damages. Says Gerald Marks, the Red Bank, N.J., franchise attorney who represented him: "Snap-on's policy of 'more feet on the street,' which places too many dealers too close together, is ill-conceived and a financial disaster."

A Snap-on spokesperson responds that "a franchise is like any other business in that there is no guarantee of success." A company statement reads that before any franchisee signs on the dotted line, he is given plenty of information. Snap-on provides contact data for all active dealers in any given region, as well as for franchisees who have left the system in the previous 12 months. In other words, do your homework, then decide.

More often than not, it seems, companies that sell franchises are so much more sophisticated than the buyers that the franchisors hold most of the cards. A couple of nonprofits are trying to change that. One, the American Franchisee Association, is pushing for legislative changes that could help protect--or at least alert--hordes of the unwary. Another, the Association of Franchisees and Dealers, has a set of standards--for example, franchisors may not strip franchisees of their constitutional right to a jury trial--intended to make franchising fairer. That's nice, but it's likely that the rule for would-be franchisees will be caveat emptor for years to come.

Corporate refugees and former business owners who have succeeded at franchising--and yes, there are thousands--suggest you do thorough research on the territory you're thinking of entering. When Terry Tryon bought his Tutor Time day-care franchise in Wyomissing, Pa., a few years ago, after 30 years at Aetna and other insurance companies, he pored over his market's demographics. "I looked at statistics from the U.S. Department of Labor on the rising need for child care in two-income families, and then I looked at this part of Pennsylvania to see what demand was and who my competitors were likely to be," he says. "A gut feeling is fine, but the more knowledge you have, the better off you are." Tryon adds, "I also talked to lots of other franchisees, both some who had succeeded and some who had failed. I got more insights from the ones that failed."

A foolproof way to get to know a franchise intimately before you invest is to get a job in one of its stores, which is what Tiffany Newman has done. An Army veteran who served in Desert Storm, Newman has spent the past few months scooping ice cream and supervising fellow employees at a Cold Stone Creamery shop in Mamaroneck, N.Y., which she says has given her "a hands-on understanding of the system here." Newman is weighing the pros and cons of either starting a catering company or buying her own Cold Stone franchise. At the moment she's leaning toward the latter. She's impressed with the thoroughness of the training as well as the support the franchisor offers.

Once you decide on a franchise--if indeed you do--be ready to sell, sell, sell. Karen Brinker, who left a marketing career in the apparel division of Playtex and used her severance pay to buy an AlphaGraphics print shop and web-design franchise in Greenwich, Conn., says the first thing she did was to "go out knocking on doors. I wore out a lot of shoe leather. You really need to be ready to do that--at least until you can hire someone else to do it." After a decade in business, Brinker says of her 6,000-square-foot shop, with annual revenues of more than $2 million, "I love what I do here every day. My advice would be to find something you can get passionate about, and then proceed with caution."

One more thought: If you have lots of creative, original ideas about how to start and grow a business, franchising probably isn't for you. "Franchising is built on a system, and the system works if you follow it," says Slender Lady CEO Bruce Sharpe. "But one of the biggest causes of franchise failure is that people go off on tangents--they spend more than they need to on the initial facility, they don't budget enough for ads, and so on. If you don't want to follow the system the franchisor has set up, then buying a franchise is insanity." Indeed, it would be a waste of both the franchisor's time and money and your own. Top of page

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.