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LEXINGTON, Ky. — The Small Business Administration has declared yet again to the public that franchises have the same success rates as independent small businesses. "Survival among independent businesses and franchises appears to be similar," declares economist Brian Headd in the SBA's Office of Advocacy newsletter this month. It is one of a number of similar announcements the Administration has made over the last decade, with several private scholarly studies as well that have reached similar conclusions. But studies showing equivalent success rates for franchises and independent small businesses go against industry lore and have largely failed to catch the attention of sellers and buyers.
What is the survival rate of franchises?
It's about the same as small business establishments of 500 employees or fewer (see chart). "About half of all new establishments survive five years or more and about one-third survives 10 years or more," declares the September announcement of the SBA. "As one would expect, the probability of survival increases with a firm's age. Survival rates have changed little over time."
Franchise sellers muddy the statistical waters with misleading 90 percent success rate to woo buyers
The International Franchise Association, a trade group founded by sellers of franchises, thinks it can guide the Administration to use more agreeable numbers. "We have worked with the Small Business Administration in the past and continue to work with them to improve this data," says Alisa Harrison, the group's vice president of communications and marketing. "Our concern centers around [the fact] that many of the businesses are misclassified by the SBA."
The IFA dismisses the unflattering franchise success rates. It says that some franchises were not properly classified as such by the SBA. Its spokesperson explains the nature of the misclassification: "Not all franchise businesses are coded as such and the SBA data does not compare business segments in the franchise sectors to the same segments in the non-franchise sectors," says Harrison. "So we are hopeful that we can work with the SBA to improve the reporting so that we all have the best information available."
The problem is that this describes the wrong study. The statistics that Harrison seems to refer to are actually failure rates in the repayment of SBA-backed loans by franchisees. That data is collected from preferred lenders by the Small Business Administration to assist loan officers in assessing the default risk of different brands.
The IFA criticizes those statistics, pointing out that sometimes bankers misclassify a franchise as an independent small business, rather than placing it in the proper franchise category. For example, although loan officers may know McDonald's is a franchise, they may not know that Bella Bridesmaid is a franchise, or they may miss that a Quiznos unit is one. This might change a borderline franchise brand to appear slightly worse than their competitors, something that franchisors have a great deal of concern about. It might also shift the aggregate number of loan failures for franchises. But even here, the SBA's failure rate for bad loans to franchises either equals or is worse than small businesses.
That internal SBA report has nothing to do with the U.S. Census Bureau numbers which were the source for the research used for the September newsletter that declared yet one more time that franchised businesses succeed at the same rate as small businesses. Headd says that this most recent survey is from the Survey of Business Owners (SBO), part of the Bureau of Labor Statistics BED (Business Employment Dynamics) database. Unlike internal data from the Small Business Administration, the SBO does not rely on a loan clerk or officer to make the decision on whether or not a borrower is a franchise: business owners are asked directly if their business is a franchise.
Rather than these unfavorable numbers, the IFA prefers to use its own statistics and focus. Its president and CEO, Steve Caldeira, wrote to the Wall Street Journal in February about just how safe it is to buy a franchise. He declared, " . . . more than 90 percent of franchisees renew their contracts with franchisers at the end of their terms."
Attorney Bob Purvin, chairman and founder of the 20-year old American Association of Franchisees and Dealers, argues that the IFA statistics are bogus. "The IFA has consistently misrepresented that investing in a franchise means improved odds of success. The renewal rate claim is yet another example because it implies that 90 percent of franchise buyers are successful, meaning that they are profitable and happy."
The IFA's Harrison defends her association's survey and the 90 percent figure as if it reflects successes of franchise owners. "This is from a study we did a few years ago and we will be repeating the survey to review the years 2007-2011." She adds, "But the percentage has not changed much over the years."
Franchisors grab hold of such favorable numbers for seling to prospective buyers. They hope to persuade them that buying a franchise, any franchise, means less risk of business failure. Monkey Joe's, one among many franchisors, markets this hope. "According to the U.S. Department of Commerce, franchises have a 90 percent success rate, as compared to the failure rate for non-franchised business start-ups," declares the seven-year-old franchisor in a recent press release. This disproven "90 percent success rate" from the 1990's gives false comfort to both buyers and sellers.
Franchisees fail at similar rates as small businesses
Purvin, who is also author of The Franchise Fraud: How to Protect Yourself Before and After You Invest, has been monitoring bogus franchise success and failure rate claims for over two decades. "Our research is consistent with the SBA's conclusions. Most independent studies have concluded that franchised businesses close at a similar or higher rate than independent start-ups because they tend to have greater start-up costs and operating expenses to meet brand requirements as well as royalty burdens."
Keith Miller, chairman of the Coalition of Franchisee Associations, stresses that the IFA's 90 percent renewal rate could be true. It is quite possible to have both a high 90 percent renewal rate coupled with a high franchisee failure rate because the number of owners who actually make it to the end of their franchise term are likely a small subset of the original owners. "Only if the franchisee goes to the end of his term is there a renewal point," states franchisee Miller. The owner of several hoagie sandwich shops says that is the point when a franchisee must consider if he wants to give up his livelihood and settle his lease and loan obligations in order to exit. Many don't even get to that option. "Quiznos at one point was nearly 5,000 stores and now the chain is below half within a five-year period. Most of their franchise owners did not refuse renewal. Rather, many store owners found themselves broke and having to close. Those former franchise owners would not even count in the IFA's calculation of a renewal statistic."
Miller summarizes, "The real question for a franchise investor that is difficult to ascertain is — did the franchisees get a good return on their investments when they exited the system, including profits over the years as well as gains from the selling of their businesses?"
Purvin reminds prospective franchisees to invest in a proven brand that has a fair franchise agreement, respects franchisee rights and is profitable. "All franchises are NOT created equal and buying a franchise 'per se' is no panacea for success," he stresses.