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Are Franchises Commercial Marriages from Heaven or Hell?

Heaven or hell?SYDNEY, Australia — Since it flourished in the early 1970s under the influence of American fast food outlets such as McDonald's and KFC, franchising has become one of the most dynamic aspects of Australia's small business sector.

Per head of population, Australia is now the most franchised nation in the world, according to peak body the Franchise Council of Australia (FCA). There were about 1,025 business format franchises in Australia in 2010, the council says, and sales turnover of the franchising sector was estimated at A$128 billion in 2009.

Readily described as a relationship in which a business owner (franchisor) assigns an independent party (franchisee) the right to market and distribute goods or services under their brand, franchising can offer substantial rewards for both. Its mere proliferation – substantially promoted by the growth of shopping malls – attests to widespread success of the business model. But what happens when a franchisor and franchisee do not see eye to eye or when a franchisor fails or hits hard times? There are plenty of headlines that regularly highlight some difficult aspects to franchising. Take, for example, the recent collapse of the Angus & Robertson and Borders book chains in Australia.

Despite the keen embrace of franchising, statistics show more than 70% of franchise systems operating in Australia in the late 1990s are no longer in business. Now, with Australian retailers reporting a downturn, many prospective franchisees and franchisors have additional reasons to look before they leap.

"Superficially franchising is a very straightforward business operation; someone has a brand, licenses people to use their brand and their system, and collects royalties. In actual fact, it's probably the world's most complicated and intricate method of doing business," says Andrew Terry, an emeritus professor at the Australian School of Business.

He warns the potential complications involved with franchising cannot be underestimated. "Franchising is both legally and commercially challenging," says Terry. "The franchise contract enshrines a continuing, co-operative and interdependent relationship. By necessity, it is 'incomplete' in the sense that it is impossible to prescribe in advance the system adaptions that will be necessary to accommodate changing consumer tastes and competitive pressures during the life of the relationship. Franchising is often referred to as a 'commercial marriage' for these reasons, despite typically being characterised by both information and power imbalances."

The biggest pitfall for a franchisor is they are seduced by franchising as a convenient, easy method of expanding a business, says Terry. From the franchisor's perspective, it's a potentially winning growth strategy, a means of expanding a business network using the financial and human resources of the franchisee without having to bother with the day-to-day running of the retail-level operation.

It is a very effective distribution channel, states Jenny Buchan, a senior lecturer and expert in franchising law at the Australian School of Business. "For a manufacturer or distributor, it's a great way of getting a product out to the market without having to own all the distribution outlets. Franchising gives you huge control over how your products are displayed or presented in the market. Landlords and suppliers like its efficiency and convenience, they can negotiate with a single franchisor without having to deal with large numbers of individual business owners."

The model also allows franchisors the potential for rapid growth with a smaller capital outlay than otherwise would be required if expanding independently, Buchan points out. "Franchisees are a great source of equity and debt funding. If the franchisor hasn't got business assets against which to borrow, and they don't want to borrow against their personal assets, they can advertise for franchisees and they will put in their own funding. Once you have a collection of people with their own money on the line then they are going to work particularly hard to ensure that their investment pays off for them. When the model works well it works really well for franchisors and franchisees."

Franchisees like the model because they are able to capitalise on a business with a proven track record, loyal customer base and established brand while receiving assistance with training programs, ongoing operational support and real estate leasing. This allows franchisees to gain from having access to the tools of a big business in the crucial, often volatile stages of early development."

Terry concurs that franchising works when dealing with proven brand names, systems, training and support, "but it only works if the businesses adhere to the proven drivers of it". "Franchising isn't a magic wand or something that will automatically turn a bad business into a good business." While franchising in Australia remains an attractive proposition to many businesses, Terry cautions that it's no "get-rich-quick solution".

Unresolved Issues

Among the many challenges, Buchan has identified three major unresolved legal problem areas of the business format franchise model.

First is the issue of the franchisor's disclosure document that must be presented to all new franchisees in compliance with the Franchising Code of Conduct. It provides the franchisee with relevant details; from lease arrangements to information on litigation that the franchisor might be involved in, or particulars on the intellectual property the franchisee will be able to use.This document can be expensive for franchisors to maintain and update, Buchan points out. If omitted information turns out to be misleading, franchisors risk being sued. On the other hand, franchisees faced with reading extensive documents might find the sheer volume of information indigestible, she notes.

Disclosure does not necessarily tell franchisees what they need to know, according to Buchan. For example, what rights would they have to retain the use of their premises and to access suppliers if the franchisor failed? It also does not outline the full extent of the franchisor's network of companies, any or all of which might be integral parts of the franchise operation. An example is Kleenmaid, the Queensland-based kitchen and laundry appliance business with 15 franchises that collapsed with A$82 million worth of debt in 2009. Until it was put into voluntary administration, the operation-- was supported by a network of two groups of companies, one of which was insolvent, while the other was selling franchises that had been "propping up" the insolvent group.

Governance is another problem pinpointed by Buchan. Franchisees are not stakeholders in a franchisor's business in the same way that shareholders and employees would be in a non-franchised business. Franchisees thus have no right to be involved in their franchisor's strategic decisions and are not owed any statutory duties under the Corporations Act. "The only rights franchisees are afforded are those in their contract with the franchisor or under the code of conduct. They miss out on the statutory protection they would get as shareholders or employees of the franchisor's company if – for instance – a franchisor goes out of business," says Buchan.

In the event of a franchisor failing, a further problem is that franchisees are left out in the cold, because "the insolvency law (in the Corporations Act) trumps the other regimes, meaning any rights franchisees may have been entitled to (under contract law, the Competition and Consumer Act 2010 or the code of conduct) will be addressed through the prism of the statutory obligations on liquidators". "When franchisees are not creditors, a franchisor's liquidators do not owe them anything," Buchan emphasises.

The magnitude of the problem shows up in the survival-rate statistics. The 1999 Australian Franchising Yearbook and Directory listed 347 franchisors. However, by 2011, 251 or 72% of these were no longer franchising. When analysing these statistics, Buchan says these exits included franchisors who had made a departure from franchising, but still remained in business.

Adaptability and Innovation

Legal problem areas aside, there are common mistakes on both sides when setting up new franchises. The desire to grow too fast or spread too thin geographically can have negative consequences, with franchisors putting too much emphasis on selling franchises and not building and supporting existing franchisees. Another stumbling block is trying to franchise into an already saturated market – as seen in Australia with a host of unsuccessful copycat chains following the success of Boost Juice, the juice and smoothie chain that started in Adelaide in 2000. There is a need to adapt, innovate and re-invigorate products to keep up with a constantly evolving market.

"Franchisors need to attract people who are sufficiently compliant and franchisors themselves must be flexible and keen to move with the times," insists Buchan, who cites examples, including Kleins jewellery chain, which collapsed in 2008, and the book retailers Borders and Angus & Robertson, which were placed into administration in February due to the collapse of owners REDgroup Retail. These companies maintained expensive retail premises around the country, but did not respond with sufficient urgency towards the escalating trend in online purchasing.

Keeping on top of shifting market trends is essential for any business, but Buchan believes it may be easier for independent operators to bounce back from a delayed reaction. "A non-franchise business may be quicker to turnaround because the operators might be more connected to the customers," she says. "In a non-franchise business, it's your own money that's on the line as an owner, whereas with a franchised business it's the franchisees' money that is at risk and so the imperative for re-inventing may not be quite as compelling or urgent." Some franchisees are also extremely resistant to change, notes Buchan, who previously worked as a commercial lawyer advising franchisors, franchisees and shopping centre owners.

While the desire to franchise remains strong on home turf, many Australian businesses are now eyeing off China and other parts of Asia as a potentially lucrative market. Terry believes this is due to many factors including the sheer size of China's population, the entrepreneurial culture, growing middle class, increased urbanisation and interest in standardised quality. But he also warns that in spite of the enthusiasm with which parts of Asia have embraced franchising, it is by no means a market for the smaller, younger franchise systems. Companies looking to franchise in China, for example,will have to cope with unfamiliar cultural, social and regulatory restraints, as well as a different legal system and language, he points out.

"Franchising isn't any guarantee of success, franchising works because someone can license a proven brand, system, product, training and support. From the franchisor side what you would expect to see is not someone who is franchising an idea or concept but a successful business with a proven model that can be replicated in other places under other managers through a series of other outlets. What a franchisor is really selling is the experience that the franchisor has gained in operating a business," Terry concludes.

This article has been re-posted by permission of the Australian School of Business to Blue MauMau. This was written and first published in Knowledge@ASB. Read more articles that give insights into business there.

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