November 1998

How to Avoid Getting Burned on the Franchise Rotisserie

Frustrated middle managers, eager female entrepreneurs, and blue-collar workers who are looking for a large slice of the American dream -- beware. Trying to hitch a ride on the franchise boom to financial security may leave you plucked and basted if you aren't careful.

That's certainly what happened to investors and franchisees of Boston Chicken, the Colorado-based franchisor, which once boasted more than 1,200 stores, 150 on the West Coast.  It went public in 1993 at $10 more than doubled the first day of trading, then peaked in 1996 at $41.50.  But the soaring stock price masked the rarely reported reality.  Like many franchises, as an ongoing business, Boston Chicken was a turkey.

For years, only the company made money.  With bond debts rising north of $600 million and no turnaround in sight, Boston Chicken filed for bankruptcy in early October, closing hundreds of its 1,143 restaurants -- and leaving the fate of the rest, including more than 150 on the West Coast, in doubt.

"Despite the hype that franchising is the safest way to go when starting a new business, the research just doesn't bear that out," says Timothy Bates, a Wayne State University economist.  His analysis of more than 1,300 franchisees concludes that businesses started without the benefit of a parent franchisor generated higher profits and had lower failure rates. Those that succeeded recouped their initial investments more quickly.

Bates' findings underscores LANDMINE #1:  Many franchisees never make much money.   Boston Chicken, the parent company, which also owns Einstein Brothers and Noah's Bagels, operated more as a financing company making development loans to its franchisees who once owned as many as 750 of the stores.  The franchisor made money on the loans and supplying food and supplies to its captive franchisees.  While the founding partners rode the frenzy all the way to the bank, franchisees never could cover start-up costs upwards of a million dollars a store.

"While it would be wrong to conclude that franchising opportunities across the board are pool," adds Bates, "the likelihood of success is much dimmer than the industry would have us believe."

How could that be?  "1,453 Businesses You Can Start Today," shouts the cover of Franchise & Business Opportunities billed as a "buyer's guide" for entrepreneurs.  "In less than six months, we returned our initial franchisee investment of 150 percent," reads an enticing ad in Entrepreneur magazine.  Although these magazines are filled with caveats about due diligence and the like, headlines tout a study by the International Franchisee Association that nearly 97 percent of all fanchises opened for a five-year period are still in operation.

LANDMINE #2:  The oft-cited "study" was authorized and paid for by franchisors  who, by the way, purchased virtually all of the advertising in the magazines that regularly hype the industry.  Don't confuse these with consumer guides.  While Entrepreneur may rank the most profitable franchises, that's from the franchisor's perspective -- many companies that top the rankings of fastest-growing franchises also lead in another category -- franchisee lawsuits.   Boston Chicken has had a slew of them and may get some more now that it has cut off funding of convertible loans to Boston West, LLC, the franchisee that operates the Southern California restaurants.

Does that mean that everyone should avoid franchising and go it alone? Certainly not.   At least part of the high failure rate can be attributed to the fact that many naive franchisees are enticed by the apparent glamour of well-known brand names. 

Who hasn't heard the aprocryphal story of the guy next door who opened up a burger-flipping joint only to retire on his vacation yacht in the Caribbean.  Yet, Subway, Mail Boxes, Etc., and Decorator Den -- the kind of eateries and retail stores that make up most new franchises -- are classic high-risk, low-return businesses.

That brings us to LANDMINE #3:  Because of a scarcity of reliable financial information, many franchisees fly blind and have limited legal protection against fraud.   Fewer than half the states have 'business opportunity laws' that require franchisors to provide pre-sale financial disclosures called offering circulars.  But even those states that do -- California is one -- warn that the information is limited and frequently not complete enough to guide potential investors.  Fewer still -- again California is one -- allow aggrieved franchisees to sue for fraud.  Attempts to pass a federal code of ethics for franchisors has languished since the Republicans seized control of Congress.

Yet, in spite of the potential problems, franchising can still be the right choice for realistic and passionate entrepreneurial wannabees.  "The key is to buy a business in which you, not the franchisor, determines whether you succeed or fail," says Harris Sternberg, who has owned a successful Closet Factory franchise in Oxnard for eight-and-a-half years.  A heating and air conditioning engineer and salesman, Sternberg had long fantasized about running his own business.  When he hit 50, he decided to do just that.

"We shopped around," he says, going so far as to put down a deposit on a coffee and fudge shop.  He and his wife pulled out when the store lease costs proved too steep.  "We then got very focused.  We wanted a franchise in which we would succeed or fail based on our own efforts.  Closet Factory supplied the concept, the brand name, and the training.  In return, we pay them a portion of our revenue.   The rest is up to us.  We own our factory and buy all our supplies, including the lumber for the closets."

Any final tips?  "Just one," adds Sternberg.  "Don't put yourself in a position of depending on a franchisor for success.  If it gets the sniffles, you'll get pneumonia."

California Franchise Information:

Consumer Law Section
Attorney General's Office
1515 K Street
Sacramento, CA 92101
(916) 445-9555