When Franchisees Behave Badly

Posted Wed, 2008/10/22 - 00:22 by Jason Gehrke

At the Brisbane hearing of the current federal franchise inquiry recently conducted by the Parliamentary Joint Committee on Corporations and Financial Services, the term “franchisee opportunism” was raised in the context of problems in franchise relationships.

While many of the submissions lodged with the inquiry have dwelt on issues of opportunistic, unprofessional or even bullying behaviour by franchisors, this was a rare and unique reference to opportunistic behaviour by franchisees, and was mentioned by an academic (not by a franchisor in defence to any criticism from its franchisees).

Whereas discussion of opportunistic franchisor behaviour includes such things as churning, encroachment, unreasonably withholding consent to sell, termination, unilateral agreement variations and potentially disadvantageous supply arrangements, franchisee opportunism is an entirely different concept.

The most common form of franchisee opportunism is free-riding. This is where franchisees join a strongly-branded network but add little or nothing of their own entrepreneurialism or personal endeavour to the business, such that the brand and the franchisor’s efforts alone generate custom for the franchisee’s business.

Free-riding franchisees are unlikely to engage with the franchisor or their fellow franchisees, are perhaps unlikely to attend or actively participate in group meetings and discussions, and generally adhere to the bare minimum of compliance in order to stay in the system.

Free-riding is generally a term applied by academics, and the term itself can be found in franchising literature. Among franchisors, free-riding franchisees are more likely to be described as “lazy”, “bad” or “underperforming” franchisees, rather than free-riders.

Free-riding in itself is not usually a wilfully deviant behaviour, but rather the absence of the franchisee upholding their end of the deal in the franchise relationship by failing to exert the levels of motivation and energy generally expected of franchisees in an interdependent commercial arrangement.

In a 2006 convention paper on the issue, three US legal experts noted that franchisees have an incentive to free-ride and offer sub-optimal service as they don’t bear the full cost of the damage done to the franchisor’s brand (Klick, Kobayashi & Ribstein, 2006).

In other words, the relative anonymity of a franchisee within a network reduces their individual accountability for the performance and delivery of the brand promise at store or territory level.

The solution, according to the three legal experts, is to allow broad termination provisions to exist in franchise agreements so that underperformers can be excised from the network for the good of the rest, and that the risk of being excluded and forfeiting their investment is incentive enough for free-riders to improve their performance.

Part of the solution to the problem of free-riding franchisees is for franchisors to have better screening processes in place at the start, and to proactively monitor each franchisee’s performance across a range of financial and non-financial metrics.

Then with appropriate performance management techniques, the free-riding franchisee can be reinvigorated to engage with the network and their business. Alternatively, a mutually agreeable exit strategy may instead be developed.

But franchisee opportunism doesn’t end with free-riding. A great concern among many franchisors, particularly those that are still growing and maturing themselves, is that franchisees will take advantage of the access to their intellectual property to then go out and start up in competition to the franchisor.

This concern (and examples of this happening to potentially justify such concern) is more common in service franchises rather than retail franchises for a number of reasons:

Service franchises usually involve relatively simple, and often unskilled services that are easily replicated.
Many new franchisors lack highly-developed and efficient processes built around sophisticated and proprietary operating systems. As a result, their business models can be easily copied.
Capital considerations: The cost of establishing a rival service operation is far lower than setting up a competing retail business. Retail franchisors may also control or influence the supply chain, or go-alone franchisees have inadequate buying power, both of which potentially result in a higher cost of goods to any independent operators.

Some franchisors may not have the resources or capacity to enforce contractual restraints of trade when a franchisee goes out on their own, or are simply unaware that the franchisees have violated the restraint of trade clauses in their agreements.

Franchisees can also engage in opportunistic behaviour by using their access to the franchisor’s intellectual property for purposes other than for the operation of their franchised business (such as setting-up unrelated businesses on the side, etc).

Franchisee opportunism may also include territory squatting. An example would be if a franchisee is granted the rights to a large geographic region on the understanding they will sequentially develop as many units as possible within that that region.

However if this is not an ongoing condition of the grant; it is quite possible the franchisee will develop fewer, if any additional units (as there is often no penalty for them not doing so) and effectively lock the brand out of the potential remaining in the balance of the market.

Territory squatting can be the result of free-riding, or a conscious and subversive action designed to thwart the future ambitions of the franchisor while a competitor takes the ascendancy. (In such circumstances, the competitor may have an agreement with the franchisee of which the franchisor is not aware.)

Franchisee opportunism is not often discussed and is worth further attention. This article does not attempt to compare instances of franchisee versus franchisor opportunism, nor weight their relative impacts on the parties involved. If anything, an understanding of opportunistic behaviour by both franchisees and franchisors can help identify both good and bad practices used by each.

In the long run, this can help franchisors adopt best business practices, which provide for greater sustainability and equal opportunities (as opposed to opportunism) for both parties.

Reference: Klick, Jonathon, Kobayashi, Bruce and Ribstein, Larry. Incomplete Contracts and Opportunism in Franchising Arrangements: The Role of Termination Clauses. Berkeley Electronic Press, Paper 61, 2006 American Law & Economics Association Annual Meeting.

This article is cross-posted with permission by Jason Gehrke. This originally appeared as a blog in Australia's magazine for entrepreneur's, Smart Company. Gehrke is director of the Franchise Advisory Centre and has been involved in franchising for 18 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues.

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12 Comments

Franchisees Do Free-Ride by michael webster

Submitted by michael webster on Fri, 2008/10/24 - 21:57.

The most systemic and thought out view of free-riding by franchisees is to be found in Gillian Hadfield's Problematic Relations.

"From the franchisor’s perspective, the franchising relationship poses a substantial problem with respect to quality control. The franchisor has normally created a differentiated product or service or system with the expectation that consumers will be willing to pay for the added benefits of this creation. If the franchisor is to fulfill this expectation, that product or service or system must be implemented at the retail level as designed by the franchisor. A formula for a soft drink must be mixed correctly; a method of losing weight must be taught correctly; a procedure for serving food quickly must be followed correctly. The trademark encapsulates these concerns of the franchisor. The value of the trademark gauges the success of the franchisor in assuring that franchisees provide an otherwise valuable product or service or system according to the franchisor’s plan. The more valuable the trademark, the greater the price at which franchises can be sold and the greater the royalties collected.
The value of the trademark is, however, vulnerable to franchise free-riding. This is a problem that has already received considerable attention from scholars and the courts.87 A franchisee is inclined to make decisions about how much effort to put into the business based on the profits that will accrue directly to her in her own outlet. She is not inclined to take into account that, because customers will make judgements about the quality of the entire franchise system based on their experience at an outlet, cost-saving reductions in quality at her outlet will affect the overall value of the trademark and thus the profits of other franchisees and the franchisor. If all franchisees, facing the same incentives, act in this way, the value of this trademark will suffer dramatically.88
Free-riding is an example of the problem of control, known as the principal-agent problem in the economics literature.89 It pervades almost all organizational forms to a greater or lesser extent. If, for example, the franchisor decided to operate as a vertically integrated firm, owning the outlets itself, it would still face the problem of controlling its managers. The franchise arrangement changes the nature of the control problem but it does not eliminate it. To some extent, franchising simply trades one control problem- overcoming the incentives to “shirk” that face the salaried employee but not the profit-collecting entrepreneur- for another- overcoming the incentives to minimize cost that face the entrepreneur but not the employee.
At the heart of the control problem is a divergence in interest between franchisee and franchisor. A franchisee wants to maximize her profits from the operation of the outlet; she does not wish to undertake any efforts or expenditures that will not compensate the undertaking. On the other hand, once a franchisor establishes a particular franchise, it aspires to sell more franchises and increase royalty revenues. These objectives make the franchisor less sensitive to the costs of operating an outlet and prompt the franchisor toward maximizing revenues rather than profits.90 The greater the volume of sales under the trademark, the greater the likelihood that a consumer has had direct or indirect contact with the trademark, increasing its value. The greater the revenues of outlets, the greater are the royalties collected as a percentage of sales.
This divergence in interest goes beyond the basic free-riding problem to touch almost every aspect of the operation of the franchise. Franchisees, seeking to exploit their trademark license, want to limit the number of franchises granted: franchisors, having sold the first round of franchises, may want to saturate the market with franchises. Franchisees want to locate outlets in profitable area: franchisors, seeking to advertise the trademark and create the image of being on every street corner, may want to license additional franchisees in areas that will contribute to this reputation, even if a particular outlet may not be profitable. Franchisors may wish to have stores operate twenty-four hours per day in order to develop the trademark’s reputation for consumer convenience; franchisees, making few sales at night, may wish to save operating costs and close for a number of hours. From the franchisor’s perspective, bringing the franchisee’s interests in line with its own is the central difficulty of this method of doing business.

87 See Victor P. Goldberg, The Law and Economics of Vertical Restrictions: A Relational Perspective. 58 TEX. L. REV. 91 (1979) (analyzing problem of free-riding and discussing court cases).

88 More formally, free-riding is an example of an economic externality. A profit-maximizing franchisee will choose quality levels at which the marginal revenue at her outlet equals her marginal cost. The franchisee’s effort, however, will also affect marginal revenues for other franchisees and the franchisor. This external effect is ignored by the franchisee, leading her to choose too little effort relative to the level that would maximize joint profits for the entire franchise system. See generally R. PINDYCK & D. RUBINFELD, supra note 75, at 617-23.

89 See generally id. at 605-11.

90 The franchisor will place some weight on franchisee profits because new franchisees will be more likely to purchase profitable outlets. The point is that revenues will also figure significantly in the franchisor’s decisions."

Some may disagree with this characterization, but it is worth understanding.

Michael Webster, a franchisee attorney in Toronto, Ontario, who publishes a website on business opportunities and franchises, called "The BizOp News"

Michael Webster, a franchisee attorney in Toronto, Ontario, publishes a website on business opportunities and franchises called "The BizOp News"

At the point by Howard R. Morrill

Submitted by Howard R. Morrill on Sat, 2008/10/25 - 10:45.

we say that franchisees will attempt to maximize their own perceived benefit at the least cost (effort), we have simply described the human condition. Franchisors always say "we aren't your partner" and this is an "arm's length transaction". This "free riding" claim, which is suggested to be "misbehavior" by the writer, makes franchisors sound more like a disgruntled spouses than businessmen.

Free Riding: Management Issue by Guest

Submitted by Guest on Sat, 2008/10/25 - 11:58.

Very good point Mr. Morill brings up about "free riding", which in essence is a measure of how skilled the franchisor management is. Franchisors' responsibility is to monitor and manage the performance of small business owners that have a franchise relationship with the chain. From the book Franchising: Pathway to Wealth Creation by Spinelli, Rosenberg and Birley, the problem of Free Riding by franchise owners is brought up as essentially a franchisor management issue.

"Imagine if McDonald's did not monitor contractual requirements. If each franchise misallocated only a small amount of the required local advertising expenditure (e.g., $100/month) the systemwide impact would be over $30 million annually in reduced advertising."

Re: When Franchisees Behave Badly by Guest

Submitted by Guest on Fri, 2008/10/24 - 20:57.

Jason, your bias towards franchisors is undisguised once again and your recent appointment to the Board of the FCA adds little credibility. After writing a multitude of paragraphs outlining "franchisee opportunism/free-riding" which you drew initially from one submission you then added in your second last paragraph, as if to make an attempt at taking the 'franchisee bashing edge' off your comments, "this article does not attempt ..... etc". Your mates at the FCA are great at coming up stats but what are the 'qualified' statistics of the occurrence of this phenomenon? No doubt 'free-riding' will now become the catch cry of the FCA and certain franchisors. The majority of submissions received by the Committee overwhelmingly present cases of opportunism and misconduct by franchisors in various forms. What would class as having a carving knife waved at you during a meeting (whilst still a franchisee) or being followed in a shopping centre by the franchisor (some nine months after walking away from the business) - I guess 'hard bargaining'? - and this by one of the member franchisors of the Council you are now a Director. Perhaps an article of the same length as this one describing what franchisees have experienced with unprofessional rogue franchisors would go a long way in balancing your reporting scales. It certainly would be something out of the ordinary to read an article based on the franchisee's perspective. Submissions presented to the Committee should be able to give you a good basis to start the research for your article. Of course, you could actually speak with some of the aggrieved franchisees.

$1M fine? by Ray Borradale

Submitted by Ray Borradale on Sat, 2008/10/25 - 18:14.

The issue here is whether this should be topical at a time when the Australian government appears to be moving toward some form of cleaning up franchisor behavior and whether such an article from a board member of FCA is designed to distract.

In Australia we see a deluge of FCA propaganda designed to protect the status quo of the franchisor. FCA are well aware that their game plan needs to hit top gear once the Inquiry Committee hands down their recommendations in a few weeks and long before any parliamentary vote on franchising law reform.

We should not wonder why their hasn’t been any historical relationship between Inquiry submissions and the subsequent recommendations reflecting those submissions to the eventually compromised weak-as-piss changes to law. In 1997 we saw the franchisor “peak body” nullify submissions and recommendations to produce the almighty “Code” which did nothing other than to increase the level of opportunism. This was done using a constant flow of articles such as this one so they could then go and slap politicians around the ear saying “you don’t understand – let us explain”. And it worked.

"The ACCC submission to the Federal inquiry also suggests that consideration be given to amending the Trade Practices Act to enable a court to order significant pecuniary penalties (fines) for breach of the Code.

The FCA is less keen on this recommendation, particularly as the fines could be substantial based if the current penalty provisions in the Trade Practices Act are adopted.

Whatever the outcome, Code and Trade Practices Act compliance is likely to have more serious consequences.

Franchise systems would be prudent to begin auditing their own compliance to ensure that if these recommendations become law they can be confident that they will pass scrutiny.

It would be worth commencing this exercise now, as with the Federal inquiry reporting early December it is possible the changes could occur before the next chance to update the disclosure documentation in 2009."

Stephen Giles is national chairman of the Franchise Council of Australia and partner with law firm, Deacons.

What he is saying here is that FCA knows that franchisors don’t usually bother to comply with what they now have to contend with and which isn't much. The results have screamed that to the Inquiry.

What is a substantial fine for the systematic destruction of so many lives? $10k, $20k or perhaps the average cost for some of our worst victims - $1M?

Australian Franchise Opportunities, a common sense approach to franchising

"free riding"??? by Howard R. Morrill

Submitted by Howard R. Morrill on Fri, 2008/10/24 - 12:41.

"The most common form of franchisee opportunism is free-riding. This is where franchisees join a strongly-branded network but add little or nothing of their own entrepreneurialism or personal endeavour to the business, such that the brand and the franchisor’s efforts alone generate custom for the franchisee’s business.
Free-riding franchisees are unlikely to engage with the franchisor or their fellow franchisees, are perhaps unlikely to attend or actively participate in group meetings and discussions, and generally adhere to the bare minimum of compliance in order to stay in the system.
Free-riding is generally a term applied by academics, and the term itself can be found in franchising literature. Among franchisors, free-riding franchisees are more likely to be described as “lazy”, “bad” or “underperforming” franchisees, rather than free-riders.
Free-riding in itself is not usually a wilfully deviant behaviour, but rather the absence of the franchisee upholding their end of the deal in the franchise relationship by failing to exert the levels of motivation and energy generally expected of franchisees in an interdependent commercial arrangement."

This struck me as bizarre. (1) The ride is not "free" but rather, and especially with a valuable brand, it is paid for mightily. (2) The valuable brand franchisors (which are a minority of all brands) typically tell the franchisee how things are going to be--i.e., "check your entrpreneurship at the door thank you very much". (3) Buying a franchise isn't particularly entrepreneurial in the first place and if you don't want business novices, don't sell to them. (4) My experience tells me that people who have paid the kind of money you will pay for a valuable brand don't fail to participate in anything that adds value to them.

Congratulations Jason by Ray Borradale

Submitted by Ray Borradale on Thu, 2008/10/23 - 03:43.

Let me congratulate Jason on recently being elected to the board of FCA [little sister to IFA].

I don’t have any issue with the subject matter in this article, in fact I could write a book on this, but this article does emphasis the situation faced by FCA regarding the current franchising inquiry.

Here we have another article pushed out by Jason’s FCA where the subject is simply to distract from the real issues being faced by franchising in Australia. FCA has begun a campaign to sway our Aus politicians through the process of determining what recommendations from the Inquiry will be adopted. They want the whole bloody lot dismissed and we haven’t even seen them yet.

We have a committee that appears to be determined to find solutions where FCA and friends continue to claim that there is nothing wrong in franchising other than some loud ex-franchisee “poor operators” so there really isn’t anything that needs to change.

To summarise my response to the subject of this article let me simply say; Yep – such franchisees are a problem for legitimate franchisors and an easy target for rogue franchisors. This isn’t news. This Inquiry will not place legitimate franchisors in a position where non-compliant franchisees cannot be dealt with. They will just have to justify any treatment and that is the difference that is needed and fair. So the only franchisors that will have a problem will be those who cannot justify harsh treatment of a franchisee. In the present Australian franchising climate this subject of a franchisee’s ability to abuse a franchisor who has the ultimate and absolute power to squash a franchisee is beyond ridiculous.

Liz Spencer referred to “free riding franchisees” in her submissions to the Inquiry but to put her views in perspective; “These mechanisms generally are protected against in the contract”.

So what was the essence of Liz Spencer’s submission that was missed by Jason?

“We have great franchisors that behave beautifully and that never behave opportunistically, but there is an opportunity for franchisors to behave opportunistically.

We see many examples of this—I am sure you have in your submissions—in the areas of encroachment, in the areas of supply, kickbacks, advertising, churning, non-renewal, transfer, termination, and unilateral amendments. Those are the areas where franchisors can behave opportunistically.”

Or why didn’t Jason write an article on this reference by Mr Stuart Robert when questioning Lorelle Fraser [FCA academic] regarding her newly found confusion over any need for “good faith”;

“The importance of good faith—Calls have been made for the introduction of a statutory duty of good faith as part of a clear framework for the conduct of franchisees and franchisors. The SA inquiry received ‘numerous accounts where a threat of termination was apparently employed to force the under-value sale of a franchise outlet by a franchisee back to the franchisor’ (Lorelle Fraser SA Inquiry, P58).

Jason could have written about Murray Stewart’s [Eagle Boy’s Pizza] objection to “good faith” as being unnecessary and then admitting that Eagle Boys have a “good faith” clause – but he wasn’t sure why. Jason could have written about the committee’s amazement and amusement when Gary David from National Retail Association said he really couldn’t see any problems in franchising – none at all.

Or Anthony Conaghan from DLA Philips Fox who succeeded in making absolutely no sense at all about whatever his reasoning against any change and then he ramped down his drawn out effort in an attempt to put everyone to sleep. [seriously – this man has “mad cow”]

David Beddall [FAAi] offered some excellent recommendations for better education and regulation, but Jason missed it. Liz Spencer’s submission had so much more to offer across so much of what is critical to the identified needs in franchising; but Jason missed it. If Liz wasn’t a highlight worth reporting then Greg Fisher and Zali Steggall [IndCorp Franchisees Assoc.] offered a wonderful insight into one of the consequences of a lack of “good faith”;

“if you think about it, in the light of the operations manual changing on a constant basis, not only does the franchisee enter into an initial agreement and invest initial capital expenditure in their investment and develop the business, the argument is that the ongoing income stream then is the payment for that capital investment. When you get to the end of the 20 years, you have got your return from that initial investment. But the problem is that there is a continuing requirement to continually reinvest in the franchise through the changes to the operations manual. As the franchisee gets closer to the end of the term, there is less and less chance for any kind of return on the continuing requests for investment in the franchise. It is a completely one-sided situation where a franchisee has no choice but to continue investing in their franchise, which is their business, but they face absolutely no security at the end of the term.”

Or Jason could have simply written about Mr Bernie Ripoll’s determination to wade through any BS on offer; “Our job… is to ensure that good franchise systems are supported, while those abusing the success of franchising as a form of business investment are sent the strongest of messages”. Or Mr Stuart Robert’s oft used “pub test”; “Let us take the pub test of the average Australian again. If an agreement came to an end, at a pub test level, is it reasonable to assume that a franchisor would negotiate in good faith to allow a continuation?”

But Jason missed it.

Reference: Hansard - Brisbane [PDF 580KB]

HERE IT IS: Australia’s Franchising Survey 2008 Sponsored by the Franchise Council of Australia.

Australian Franchise Opportunities, a common sense approach to franchising

Franchising Survey by Guest

Submitted by Guest on Fri, 2008/10/24 - 20:20.

Did you here the joke about the FCA funded survey that said nothing is wrong in franchising? Even funnier...Mr Wright says 'The FCA is here to help all members of the Australian franchise sector – franchisors, franchisees and suppliers' Yeah right, and Santa will bring me a nice new Ferrari for Christmas, but wait....oh there it is....a pig flying past the window Get off the drugs FCA....you're disgrace!!!

ALSO WORTH NOTING.... by Guest

Submitted by Guest on Fri, 2008/10/24 - 03:16.

Worth mentioning that although they didn't appear officially (as yet), the FCA were in Brisbane in full force, with both the CEO and Chairman there keeping the troops in order, and adding some moral support!!!! Wouldn't it be nice if we could all follow the committee around the country and get in their ear to further our point, and even better, rebut anything we don't agree with or 'sounds' bad? Sorry FCA....you just have to realise that we don't all nominate you as our voice. You nominate yourselves!!!!

Incomplete Contracts by michael webster

Submitted by michael webster on Wed, 2008/10/22 - 21:59.

I have read Ripstein's article, and have serious disagreements with him about their overall methodology. We have had some email exchanges, but have not come to any satisfactory resolution.

The authors try to show that states with regulations which constrain terminations of franchisees do so at the expense of franchise growth.

Well, maybe, but California a mecca for franchising doesn't allow the enforcement of post term restrict covenants, with some exceptions. So, I don't find Ripstein's conclusion plausible.

On the other hand, I do agree with Gehrke that "Part of the solution to the problem of free-riding franchisees is for franchisors to have better screening processes in place at the start, and to proactively monitor each franchisee’s performance across a range of financial and non-financial metrics."

But I don't see franchisors generally interested in providing sophisticated screening processes.

Michael Webster, a franchisee attorney in Toronto, Ontario, who publishes a website on business opportunities and franchises, called "The BizOp News"

Michael Webster, a franchisee attorney in Toronto, Ontario, publishes a website on business opportunities and franchises called "The BizOp News"

Franchisor screening of franchisees by Guest

Submitted by Guest on Fri, 2008/10/24 - 12:17.

The entire issue of Zee abuse could be avoided if the state of franchisor screening in the world consisted of more than finding the answer to the question, "Did his check clear?"

Franchise Survey & Screening by Guest

Submitted by Guest on Fri, 2008/10/24 - 17:46.

Zors, IFA and it would seem that FCA almost always blame the failure of franchisees, and the trouble they often cause, on the Zee. One area to rely on is the failure to conduct intelligent due diligence. And I don't disagree, however, very few Zors undertake intelligent screening of Zees [other than to check their bank balance]. But it is rarely referred to in comparison to how often we criticise a Zee for his failure to perform Due diligence. This survey is a joke. Of 1,100 franchise systems they hoped for responses from 286; and didn't get anything like a 25% response [often much less than 20%]. I will refer to 2 aspects of this survey before I delete it. It relies on Zor input only and Zors lie. Hell most people that fill out surveys lie. It makes them feel better. Zees make up 98%+ of franchising stakeholders but they only look to the state of play through th eyes of the Zor. The other point is the reliance on the old Zor "failure to comply with the system" to explain franchisee disputes [#2 on the Dispute Hit List]. We all know that Zees are not necessarily angles but almost every time a Zee makes a legitmate complaint and the Zor takes offense [more often than not], the Zor then pursues the Zee for any [and all] infringements that are then classified as a "failure to comply". The original complaint gets lost in the barrage thrown at the Zee. Who would have guessed that #1 on the dispute list was "profitability". How many "profitability" disputes escalated to "failure to comply"? You see; this survey proves once and for all that most disputes are the fault of the Zee. Just ask any Zor.

When Franchisees Behave Badly

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