The Disadvantages of Franchising

While the franchising business model offers several advantages to people building retail chains (see my post last month), it also has several disadvantages.  Would be franchisees should be take these disadvantages into consideration when deciding whether to purchase outlets in franchise systems.

Unlike the owners and managers of outlets in a company-owned chain, franchisors and franchisees have conflicting goals.  Most franchisors make money from charging a royalty on the gross sales achieved by the franchisees in their systems, while franchisees make money from the profits of their individual outlets.  This difference creates three sources of conflict between franchisors and franchisees:

• Franchisors often seek to boost sales, even when such efforts reduce outlet-level profits, while franchisees oppose such efforts.
• Franchisors want a higher level of outlet density in a given geographical area than franchisees.
• Franchisors seek collective actions that boost the value of the system, while franchisees oppose policies that do not benefit their particular outlets.

The value to franchisees of participating in a system dissipates over time.  For instance, franchisees benefit initially from franchisor training and set-up assistance, but the value of such help declines as the franchisee gains experience.  As a result, over time, franchisees often think that they are paying too much for the right to participate in the system, especially if the value of the brand name has not risen, and the cost of purchasing inputs has not decreased.

Franchising suffers from several transaction cost problems not present with chains owned and operated by a single entity.  Franchisees have an incentive to free ride off the efforts of other franchisees to uphold the system brand name by underinvesting in advertising and quality control.  Franchisors have an incentive to capture a portion of the franchisees’ profits through opportunistic renegotiation of contract terms after the franchisees have made investments in system-specific assets. Franchisees under invest in outlets when compared with diversified shareholders in company-owned chains.  Finally, franchising is a poor mode of organization for businesses dependent on trade secrets.

Franchising is an ineffective organizational structure for frequent innovation.  Because franchisors and franchisees are independent companies, changing policies or adopting new products or processes that were not specified in the agreement signed by the two parties is difficult.  Moreover, franchisors often lack the necessary information about customer demand to come up with innovations, as well as the authority to compel franchisees to adopt innovations.

Would be franchisees should be aware of four fundamental drawbacks of franchising as a business model:  the goals of franchisors and franchisees are not aligned; the value to franchisees of participating in a franchise system dissipates over time; the business models suffers from transaction cost problems; and contract-based organizational designs aren’t good for innovation.