Is franchisee underperformance due to the model itself?

In workshops conducted by the Franchise Advisory Centre this month, I have explored the issue of managing franchisee underperformance.

Many workshop outcomes were not surprising, and revolve largely around improved support by franchisor field support staff, and improved monitoring and benchmarking of franchisees’ sales and costs.

While the idea of field support and performance monitoring is widespread in the franchise sector, the execution of these concepts differs greatly from one system to another.

The diversity of support and monitoring appears to vary according to the relative size and age of a franchise system, with mobile service systems generally unable to match the levels of support provided by retail systems. There is also a significant gap in the investment required by a franchisee to join service franchises, compared to the much greater investment required to join a retail franchise.

In short, systems which are older, larger, and more expensive to buy into, generally have higher levels of support for franchisees, and better overall monitoring of individual franchisee performance.

Newer or smaller systems, regardless of investment level, will often have less-developed procedures for managing, supporting and monitoring the performance of franchisees, and consequently be less capable of identifying and modifying underperformance before it becomes a problem.

The workshops revealed the significant differences that exist in the support resources available among franchisors, with field support ratios ranging from one field support officer for every 10 franchisees at one end of the scale, to one officer per 50 franchisees at the other.

Aside from the upfront investment to join the franchise, a chief factor to explain the significant differences of franchise support available between franchise brands is the nature of the franchise royalty itself.

In previous articles, I have explained the nature and structure of the three most common types of franchise royalties, which each have their advantages and disadvantages.

The royalty which delivers the greatest income to the franchisor, and which in turn allows for more extensive franchise support systems, is that which is calculated as a percentage of a franchisee’s turnover.

This royalty provides the greatest common ground between the shared destinies of the franchisee and the franchisor – the greater a franchisee’s sales turnover, the greater the income to the franchisor.

However, there is a perception among potential franchisees that royalties to the franchisor are paid on profits, not turnover. Not only is this perception incorrect, but it is also dangerously naïve.

With the exception of one franchisor that is rewarded by a share of its franchisees’ gross profit, I am yet to see another franchise brand that rewards itself on either the gross or net profitability of its franchisees.

So with a royalty as a percentage of the franchisee’s sales turnover, a franchisor is only rewarded on a franchisee’s top line sales, not their bottom line profit.

At the outset of the franchise relationship, franchisees expect that profits will follow in due course, but that they will need to work hard at the outset before they can be achieved.

During this start-up period, franchisors often provide very high levels of support to franchisees, at a time when franchisees’ sales turnover is low (but growing) and therefore the royalty paid to the franchisor is low.

But as franchisees’ turnover increases and they become more proficient in the operation of their businesses, the volume of support required from the franchisor decreases.

At the same time, the franchisees’ increasing turnover results in larger royalty payments to the franchisor – an inverse relationship compared to the support they are receiving.

The inverse relationship between support provided and royalties paid can lead to (among other things) attempts by franchisees to seek attention from the franchisor beyond basic operational support, which the franchisor may or may not be equipped to provide. It can also lead to franchisees underdeclaring their turnover so that they can minimise the royalty payable to the franchisor, notwithstanding the risks attached to this behaviour under the terms of the franchise agreement.

If a franchisee’s business is otherwise going well, franchisee behaviours outined in the paragraph above can lead to perceptions of underperformance by the franchisor. If, however, the franchisee’s business is not otherwise going well, these behaviours mask other underlying problems with the franchisee’s execution of the business model, or the business model itself.

If this is the case, franchisors need to revisit their business model, and monitoring and support systems to ensure they are adequate for the task today, rather than back when the franchise model was first created.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and adviser level.