The Fraught Franchise

Copyright © Luc Melanson 2014
Copyright © Luc Melanson 2014

Franchising was a marvelous business innovation when it began, sometime back in the mid-19th century, thanks largely to companies such as McCormick Harvesting Machine and I. M. Singer. But, as Timothy Noah asserts in an article for Pacific Standard, “being a franchisee can be a very swift and painful way to lose a lot of money.”

Noah zeroes in on the world of fast-food franchising, where stories of failure are common. “For many Americans, owning a franchise seems like a starter kit for being your own boss as a small-business owner,” he writes. “You have the benefit of riding on a well-established national brand, and all you have to do is manage the shop.”

But it often goes poorly. A big problem is that the conditions imposed on franchisees can be onerous. Some common terms of a franchising agreement: The franchisee must get his (or her) supplies from certain vendors, make his books available to the umbrella company twice a year, keep the store open during certain hours and answer the phone in a specific way. Displease the franchisor, and the franchisee may have his franchise revoked.

“When a franchise agreement is terminated, all investment by the franchisee—including acquisition cost, equipment and fees—is effectively flushed away,” Noah writes, concluding that it is past time to give franchisees more legal protections against “the franchising straitjacket.”

Peter Drucker saw franchising as a useful business approach—“in essence, a way to finance rapid expansion,” as he put it in Innovation and Entrepreneurship. But he also viewed it as a delicate and combustible arrangement, because the power dynamics were so tricky. In Concept of the Corporation, Drucker reflected at length on the franchising relationship between General Motors and dealers who got to sell the company’s cars.

“The right to sell one’s product exclusively is a unilateral grant of privilege and must be revocable,” Drucker wrote. “But the ambiguity in the economic meaning of the franchise puts the dealer into the power of the manufacturer who possesses a strong advantage in the threat of cancelling the franchise.” Drucker felt that “such a one-sided distribution of power must, unless counterbalanced, lead to an abuse of power.”

Does that mean franchising must be miserable? No.

Drucker noted that GM had implemented a policy of setting clear conditions for when a franchise could be revoked or not, with the non-compliant franchisee “given a chance to mend his ways,” and several months of notice before cancellation. Furthermore, in 1938, GM established an administrative appeals board so that franchisees could enjoy another level of review. “These policies of General Motors have largely removed the franchise as a source of friction from dealer-manufacturer relations,” Drucker observed.

What do you think are the pros and cons of franchising as a business strategy?