Do You Believe This? Under-Capitalization Is The Single Biggest Reason For Franchisee Failure

While I agree with Mr. Hayes that undercapitalization is not the only reason for failure, it is a huge reason and indeed in many cases it is the prime reason--no matter how good your mousetrap is, you need to pay the rent this month and not when Home Depot places an order for a million mousetraps.

I would also caution that Mr. Hayes conflates zees and zors in addition to glossing over negative history.The essence of franchising is that it is a means of procuring capital (and labor). As such, conflating zee and zor undercapitalization can lead to an erroneous conclusion.

When Gerry and I wrote our Penn State article, we discussed how undercapitalized franchisors can use franchising as a means of profiting from a bad business model which is sold to the franchisees as a "proven system."

One of the systems which we discussed in 2004 was Cosi, which Bob Frankman discussed here in 2006 , and which is the subject of an August 2008 article in Chain Leader which notes that Cosi "hasn't had a profitable year since it went public in 2002" and quotes analyst Nicole Regan of Piper Jaffray as approving the decision to franchise with the wonderful quote: "When you don't have any cash, what are you going to do?"

Another "proven system" is Coldstone Creamery, which Jim Coen discusses today on BMM, and Michael Webster has cautioned that Coldstone's lack of capitalization should give a prospective franchisee pause. Has Mr. Hayes looked at Coldstone's financials??? Take a look at them and tell me how a company can be wonderfully successful and have no capital. (Hint: one thing is to sell gift cards and then keep $2,800,000 so that you can show a profit of $250,000 for the year)

As to Subway, we should remember that a thousand dollars back in 1965 went a lot further than in 2008. Moreover, Mr. Hayes assumes that Peter Buck just gave Fred $1000 and then never put in any more money. While that may make for a great legend, I doubt it is the truth. And if you look at the phenomenal growth of Subway, it came from franchising--that is, using other people's capital to compensate for your own undercapitalization. Nothing wrong with that, as Nicole Regan points out. But it does not suggest that a lack of capital is something to be taken lightly; indeed the history of Subway shows quite the opposite.

I would also note that while Subway has made great strides in franchisee relations, a decade ago the top Congressional aide on the SBFA described Subway as the worst problem in franchising.

As to Jani-King, again this is an entire sector which has been built on other people's money and a lot of scandal and litigation. As to Jani-King specifically, it was not simply built by Horatio Alger and Mother Teresa working their fingers to the bone: the company was built on the capital of franchisees who were lied to .

Given the huge number of franchise systems out there which are built by people who have one unit (or sometimes no units) and little experience, to say that buying a franchise is ipso facto purchasing a "proven system" is worse than laughable, it is a false implication which can cost you your savings, your house, your marriage.

Franchising can be a road to success. But it is not a sure bet, and while I do agree with Mr. Hayes that many franchisee failures are the result of trying to reinvent the wheel, the canard that most failures result from failure to follow the "proven system" have not been proven by empirical research.

When a franchisor itself can not run in the black, and when franchisors themselves have a high rate of failure (as seen in the Purvin, Shane, and Bates studies) it is not helpful to franchisees to imply that franchising per se reduces risk, either by use of a "proven system" or otherwise.

Paul SteinbergFranchisee Attorney, New York City, Ph: 212-529-5400

I am thankful that Hays brought this up. He's right on the money

I’ve always thought that citing under-capitalization as the reason for franchise owner failure was a very lazy answer. Franchisors and franchisees should know better. It is an excuse that hides a number of problems and management sins.

I like this person's list of 11 reasons why small businesses fail, particularly their #1 reason:

"Choosing a business that isn't profitable"

I am thankful that Hays brought this up. He's right on the money

I’ve always thought that citing under-capitalization as the reason for franchise owner failure was a very lazy answer. Franchisors and franchisees should know better. It is an excuse that hides a number of problems and management sins.

I like this person's list of 11 reasons why small businesses fail, particularly their #1 reason:

"Choosing a business that isn't profitable"

 Paul,

 Very well said; but I don't necessarily agree.

If you have a good working system, you will survive. On the otherhand, a system that is a bad business model from the beginning will fail regardless. (Unless one has an endless supply of capital.)

What I would like to know is: 

Can anyone explain what it means to be a 'proven system'?  Is it based on years of operation, number of units, volume in the units, profitability of the units, or system profitability, etc..etc..? Since this phrase is used at most seminars, it becomes difficult to figure what qualifications are required to call yourself a 'proven system'.

 Paul,

 Very well said; but I don't necessarily agree.

If you have a good working system, you will survive. On the otherhand, a system that is a bad business model from the beginning will fail regardless. (Unless one has an endless supply of capital.)

What I would like to know is: 

Can anyone explain what it means to be a 'proven system'?  Is it based on years of operation, number of units, volume in the units, profitability of the units, or system profitability, etc..etc..? Since this phrase is used at most seminars, it becomes difficult to figure what qualifications are required to call yourself a 'proven system'.

If the businessis is not profitable, all the capitalization in the world will do nothing.  Except make the accrued losses higher when you DO fail.  One of the main points for franchising rather than starting an independant business from scratch, is to have it be profitable more quickly (like, from Day 1) due to having a recognized brand and good systems.

Too many FranchisORS are flash in the pan, hey we have 3 units, let's sell 300 franchises, trying to run before they can walk.  I had a guy who only had ONE restaurant, open less than a year, tell me how he was going to start franchising.  In another 6 months his one unit was closed.

All these crybabies, if you had a profitable biz, you could pay Home Depot out of your cashflow not your capital.  If you don't have enough $ to make it to your busy summer season, then don't open a new unit in the winter.  Or don't open a business (franchise or independant) that is seasonal.

Yeah yeah you need enough caiptal to open, but if the underlying business was any good, you don't need deeper pockets.

Paul, you were lucky

Not all of us are blessed with a generous ‘Bank of Dad’ or as I call it ‘The Family Bank’.

I do agree that you should have enough cash flow to get you through the first few years and in some cases it may take even more than two or three. However, once you establish a cash flow if you still need funds to stay afloat your problems may no longer be tied to under-capitalization.

 I don’t agree with Mr. Hayes in regards to his belief of the biggest reason for failure is not following a proven system. I believe until we identify what a ‘proven system’ is, there are simply too many other factors that can affect franchisee failure. 

Of course my belief stems from being part of a system that claimed to be proven.

Paul, you were lucky

Not all of us are blessed with a generous ‘Bank of Dad’ or as I call it ‘The Family Bank’.

I do agree that you should have enough cash flow to get you through the first few years and in some cases it may take even more than two or three. However, once you establish a cash flow if you still need funds to stay afloat your problems may no longer be tied to under-capitalization.

 I don’t agree with Mr. Hayes in regards to his belief of the biggest reason for failure is not following a proven system. I believe until we identify what a ‘proven system’ is, there are simply too many other factors that can affect franchisee failure. 

Of course my belief stems from being part of a system that claimed to be proven.

John,

I agree. I have long held that the two major reasons given for small business failure, knowledge and undercapitalization, are not the root of failure at all. The real seed lies in the entrepreneur's potential for good 'fit' with the business. I think your examples demonstrate that position.

Doing well in anything, business, career choices, etc. pretty much requires a good match between aptitudes, talents and the task at hand.

Now, I will say that independents, as in the examples you gave, often have an advantage over franchisees in that they can 'shoe string' an effort whereas it's all or nothing with a franchise. The most important thing is the 'desire' and the love of the venture that causes people to persevere.

Those who state that many (probably most) franchisors inadequately state start-up costs are, in my opinion, right. But that also goes hand in hand with my belief that most franchises are bad deals.

Nick Bibby is an international franchise consultant and a program developer dedicated to excellence in entrepreneurship. 

John,

I agree. I have long held that the two major reasons given for small business failure, knowledge and undercapitalization, are not the root of failure at all. The real seed lies in the entrepreneur's potential for good 'fit' with the business. I think your examples demonstrate that position.

Doing well in anything, business, career choices, etc. pretty much requires a good match between aptitudes, talents and the task at hand.

Now, I will say that independents, as in the examples you gave, often have an advantage over franchisees in that they can 'shoe string' an effort whereas it's all or nothing with a franchise. The most important thing is the 'desire' and the love of the venture that causes people to persevere.

Those who state that many (probably most) franchisors inadequately state start-up costs are, in my opinion, right. But that also goes hand in hand with my belief that most franchises are bad deals.

Nick Bibby is an international franchise consultant and a program developer dedicated to excellence in entrepreneurship. 

John writes: "I believe that not following a proven system is the single biggest reason for franchisee failure."

Well, interesting because that very proposition is at the heart of a lawsuit in Colorado: Colorado Coffee Bean, et al. v. Peaberry Coffee, et al. filed in 2006 in the district court of Denver.

Frankly, I don't believe that there is any legal duty for a franchisor to market a proven system.  Any old piece of poo will do - as long as you have "disclosed" the smelly stuff.

As Janet Sparks writes in the Franchise Times, 

"Michael Seid states in his documents that he knows of "no legal or industry requirement that a franchise opportunity must be tested in any particular manner, or that a franchisor cannot sell a franchise opportunity until it has been proven by prior franchisees." He writes that the Federal Trade Commission and state regulators have not established a franchisor "Duty of Competence." Instead, he states, they require franchisors to disclose accurately their experience and history, whatever that may be."

Michael Webster PhD LLBFranchise News

Offloading all business risks to the franchisee in exchange for a risk free royalty.