Buyer Beware of "Recession Proof" Franchises

As the recession grinds on, millions of people are losing jobs that will never return. Many of the newly unemployed are too young to retire, but may be 20 years or more into their careers. Sadly, this age group -- 40 and older --faces the steepest odds against finding another job at comparable pay, according to the government statistics.

These graying baby boomers, however, are highly coveted by thousands of franchise businesses, especially if the boomers have a sizable severance check, a six-figure 401(k) account or other assets. Since the downturn began, hundreds of franchises have been marketing themselves as "recession proof." That may have a special appeal for those who have lost their jobs and have nowhere else to turn in what amounts to the worst economic calamity since the Great Depression. But buyers beware.

Franchisors have always marketed themselves as a safer investment than an independent business. In theory, that makes sense. Franchises are supposedly based on proven business models and have the advantage of support networks, stronger marketing muscle and greater brand visibility. Typically, they also have well-developed, standardized business practices that lower the margin for error and increase the chances of success, especially for those without direct expertise in the business.

But a landmark study in the mid-'90s by Wayne State University economist Timothy Bates found that after four years, only 62 percent of franchised businesses had survived, compared with 68 percent of independent small businesses. And independent businesses proved to be far more profitable. Profitability was negative, on average, for franchised firms over the four-year period. Bates also found that the average capital investment for franchisees was $500,000, compared with $100,000 for independent entrepreneurs.

A separate, independent study in Great Britain found that franchisee survival rates were also similar to independent start-ups over a five-year period, and that 50 percent of franchisees failed over a 10-year period.

In fact, franchises may have even worse survival rates than independent businesses in the current downturn. Far from being "recession proof," franchises are being hit hard because this slowdown was triggered by a massive failure of the banking system, leading to declining asset values and a nasty credit crunch. Franchises typically require a large outlay of cash to get started and maintain operations. As such, many franchisees start out heavily in debt, and rely more on credit lines and loans.

Like a receding tide that exposes dangerous rocks just below the ocean's surface, the slowing economy is also exposing onerous or exploitive franchise agreements that, in many cases, are leading to bitter lawsuits and bankruptcies.

Among the sore points in the current downturn are franchisor estimates on startup costs and profitability. In a lawsuit against Noble Roman's Inc., 14 franchisees of its Noble Roman's Pizza and Tuscano's Italian Style Subs shops are seeking $8 million in damages, claiming the company misled them about costs and profit potential of its stand-alone restaurants.

One restaurant franchisee in Kentucky closed in August 2007 after failing to come close to the chain’s claim of $100,000 per year in profits, while startup costs exceeded the chain’s estimates by about $100,000. Another California plaintiff claims she suffered $450,000 in operating losses over a two-year period and said her startup costs were more than three times the chain's estimate of $236,000. Another franchisee lost $200,000 in savings and is still $219,000 in debt after his store failed.

Other franchise-agreement provisions, nettlesome in good times, can turn deadly in a downturn. Franchisees of Quiznos restaurants claim in a lawsuit that they are being hammered in the current economy by disproportionately high costs for commodities that they must buy from the organization or designated suppliers.

They also criticize Quiznos for lackluster marketing efforts, engaging in a promotional war with much-larger Subway, which is crushing their margins, and imposing a cost structure that isn't suited for the weak economy, according to the franchise Web site bluemaumau.com. Separately, the chain is being sued in three class actions for overcharging for food and other supplies, according to Advertising Age.

Many franchisees have been required by their agreements to locate in strip malls and other high-rent locations, which are proving problematic now. Landlords are often loathe to renegotiate leases and think franchises have deep pockets. In fact, franchisees may have less flexibility under their agreements to raise or lower prices or may see their margins crushed in other ways. One Quiznos franchisee said 40 percent of his sales had to go directly into advertising, royalties and food for the next week.

By one measure, last year was bruising for franchises. The number of franchise failures that led to defaults on Small Business Administration 7(a) and 504 loans increased by 43 percent, according to a widely quoted report by Coleman Publishing in La Canada, Calif. Franchise-related SBA loan losses topped $93 million in 2008, a 167 percent increase over the previous fiscal year.

Although franchisors and their trade groups routinely sponsor studies on the effectiveness of their industry, in reality many are nothing more than carefully crafted sales pitches. Franchise agreements almost always favor the franchisor, and may not be suitable or flexible enough for a franchisee to operate, especially in difficult economies. Contracts are binding and difficult to get out of.

The bottom line is not all franchises are created equal. Despite some general protections offered by federal and state franchise laws, it's still a buyer beware business.