When Franchisees Behave Badly

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" 

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.

"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.

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.

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"