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 of finding another job at comparable pay, according to 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.

Franchise companies have always marketed themselves as safer investments than independent businesses. 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.

Are franchises really recession proof?

A landmark study in the mid-'90s by Wayne State University economics professor Timothy Bates found that after four years, only 62% of franchised businesses had survived, compared with 68% 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 by the British Franchise Association found that franchisee survival rates were also similar to independent startups over a five-year period, and that 50% 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.

Franchise lawsuits and bankruptcies on the rise during a recession

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 website Blue MauMau. Separately, the chain is being sued in three class actions for overcharging for food and other supplies.

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% of his sales had to go directly into advertising, royalties, and food for the next week.

More articles from AllBusiness.com:

• Five Reasons Why Franchises Fail
• 3 Biggest Challenges Every Franchisee Faces—And How to Overcome Them
• How Long Does It Really Take to Open a Franchise?
• The Power of Franchising
• Home-Based Franchising Is On the Rise

Even more bad news for franchises

By one measure, last year was bruising for franchises. The number of franchise failures that led to defaults on SBA 7(a) and 504 loans increased by 43%, according to the Coleman Report. Franchise-related SBA loan losses topped $93 million in 2008, a 167% increase over the previous fiscal year.

Although franchisors and their trade groups routinely sponsor studies on the effectiveness of their industry, in reality many of these reports 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.

RELATED: Buying a Franchise vs. an Independent Business: What Are the Pros and Cons?