Churning: The dark side of franchising

Poor franchisor performance versus a wilful attempt to deceive are two different things, yet both are unfortunately tarred with the same brush. JASON GEHRKE

By Jason Gehrke

Few topics provoke greater debate in the franchise sector than the issue of churning. It is a hugely controversial issue that has the capacity to draw strong responses from both franchisors and franchisees alike, though from entirely different perspectives ranging from denial to claims it is endemic in the franchise sector.

But what is churning and why is it such an emotional issue?

At its worst, churning is recognised as the deliberate setting-up of a franchisee to fail so that their business can be resumed and resold by the franchisor. The reasoning behind this view is that a franchisor who is able to reclaim and resell the business will enjoy greater profits than from any ongoing royalties that might have been generated by the business.

The more times the business sells, the more the franchisor makes. In other words, the franchisee’s failure is a planned outcome designed to unjustly enrich the franchisor, irrespective of the financial and other costs incurred by the franchisee.

At the other end of the scale, churning has also been used to describe the practice of franchisors buying back profitable franchise operations at lower-than-market values to increase their portfolio of company-owned outlets in a strategy also designed to increase their own ongoing profits. (After all, 100% of the profits of a successful outlet may be substantially greater than a much smaller percentage of the outlet’s gross turnover.)

The reason that churning is so controversial is because it is totally contrary to good franchising practice, which views the relationship between franchisor and franchisee as one of economic interdependence where both parties are able to profit by working in partnership – one to provide the brand and operating systems for a successful business and the other to provide the human and financial capital to operate such a business.

As utopian as the concept of mutual economic interdependence may sound, it is also somewhat naïve. In reality, the partnership is not one of equals coming together. In order to be given access to the franchisor’s brand and systems, the franchisee agrees to forego his or her independence, and once the decision is made to join a system, the franchisee’s choices thereafter are substantially constrained by the terms of the franchise agreement they have signed.

In itself a limitation of choice is not always a bad thing and a vast number of franchisees profit from this limitation of choice through structured, viable and well-managed franchise systems. However in the context of churning, the choices available to franchisees captive to loan and lease payments frequently boil down to “take it or leave it” options, which can both result in losing money – the franchisee’s choice is limited to losing a lot now, or even more later.

Franchisees who attribute their business failures to churning are a vocal and passionate group who seek recompense, revenge or both for the traumas they have experienced, and former retail franchisees in particular are the most vocal as generally their losses through a business failure are far greater than those of a service franchisee.

The cost of churning to a franchisee affected by it is staggering. They can suffer massive financial losses, including their home and position in society. Worse still, they lose hope for a bright future, are consumed by fear, doubt and anger, crippled by debt, and rarely (if ever) consider franchising again even if they are able to financially recover.

Where churning exists as a deliberate franchisor strategy designed to hasten the failure of franchisees so that stores or territories can be sold again and again, it should be prosecuted to the full extent of the law.

Unfortunately proving that a franchisor deliberately intended to cause the failure of a franchisee is vastly more difficult than alleging that this was their intent.

While dishonesty can be found in all walks of life (and franchising is unlikely to be immune from this), it is difficult to imagine that a serious and committed franchisor would endanger the integrity of their brand by engaging in such activity. If they do, it is only a matter of time before they will come undone.

In the main, I believe (however naively after 18 years in the franchise sector) that franchisors have the best interests of their brands at heart, and therefore would reject the deliberate churning of franchisees for the inherent risks such a practice poses to the long-term credibility and therefore viability of their brand.

However such lofty principals can be easily undermined by a franchisor’s lack of talent or capacity to manage a growing franchise network. Poor internal controls, inadequate procedures, poor staff or franchisee selection, little or no training, overly ambitious growth targets, unscientific methods of site or territory selection, bad marketing, unfavourable leasing deals, cost overruns, greed, etc by a franchisor can all profoundly affect the viability of the business model and the success (or lack thereof) to be derived from it by a franchisee.

Just one of these factors may be enough to set in place a sequence of events that could lead to the failure of a franchisee (in addition to any of their own potential shortcomings, such as unsuitability to the business, inadequate working capital, etc), but if any combination of these factors are present, then the negative consequences for franchisees can increase exponentially.

Most franchisors have a clause in their franchise agreement that gives them first option to buy a franchisee’s business as a going concern, or to buy the fit-out, equipment or stock at its written-down value.

For retail franchisors, a franchisee failure resulting in a closed store is seen to be hugely damaging to the brand. Furthermore, the franchisor may be exposed to the lease if they were sub-letting to the franchisee.

These two factors can easily lead to a situation where a franchisor will continue running the store until such time as it can be resold. Unfortunately, if there is no material change to the store’s circumstances, a new franchisee may soon find themselves in the same financial distress as the previous franchisee, and the whole process begins over again.

This may look and sound like churning to an observer and to the franchisees involved, due to the net outcome of the same franchise being constantly resold, but what is absent in this scenario is the deliberate intent of the franchisor to cause the franchisee to fail.

Bad franchisor management decisions have consequences for franchisees. It is not unreasonable to expect some accountability for such decisions. However, the emotive issue of churning may not be the blanket term that should apply in such instances. Poor franchisor performance versus a wilful attempt to deceive are two different things, yet both are tarred with the same brush.

Where franchisors have robust and transparent systems and processes in place to make decisions that affect franchisees, and can defend those decisions if required, the perception of churning will fade. Until then, franchisors remain vulnerable to such allegations.

Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 18 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues. In his spare time, Jason is a passionate collector of military antiques.

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Comments

Sue Brown writes: Last year Graeme Samuel acknowledged, on air, that “churning” exists in Australia. For the chairman of the ACCC to make such a public statement, one has to assume he has evidence of this despicable conduct. The question then has to be asked of Samuel “why haven’t there been any prosecutions?”

It is naive to assume that the process of churning is limited to those systems with poor franchisor management as outlined. Submissions presented to the current inquiry will undoubtedly indicate this practice is being undertaken by some of the more prominent brands. These rogue franchisors have been around for some time and have recognised the ACCC will not respond adequately to complaints by former franchisees. They are aware many exiting franchisees are financially drained which will prevent them from mounting formal litigation and will often have exiting franchisees sign a deed which includes a waiver/release which releases the franchisor from claims, demands or actions against the franchisor. In essence, they have been getting away with it for years without fear of intervention or prosecution from the regulators of this industry sector.

Churning takes on different shapes and forms. In addition to those outlined in this article, it is also used to exit franchisees that have the fortitude to stand up to their franchisor on issues of lack of profitability etc. Therein begins a regime of bullying, intimidation and harassment to psychologically break their franchisees into submission. The franchisee feels trapped and the only escape is to sell or walk away (generally resulting in the franchisee being paid a pittance by their franchisor for their plant and equipment only). The exiting franchisee is invariably labelled a “bad operator”, a new unsuspecting franchisee enters and the cycle begins again. Fait accompli – another one “churned”.

Cher Borradale writes: Jason, you never disappoint me.  I cannot remember an article where I didn’t agree with something you wrote.  However, I consider some statements as extremely dangerous.  I hope we aren’t going back to another more subtle inference to the “statistically insignificant” victims whose lives are meaningless because the industry is big and full of people who don’t have their entire lives stolen from them.  

I too would feel sorry for the 900 odd franchisors who might have their reputation tarnished if it were not for the few thousands of victims [admittedly of tens of thousands] who lost a lot more than their reputation.  And the thousands before them in each of the preceding decades since the 70s and the potential for more thousands to follow in the coming decades.

Yes Jason; churning doesn’t make any sense.  Just as robbing homes means that eventually the robber will pay a penalty; it does not stop some people from being criminals.  And those who don’t actually plan to churn but insist on abusing the franchisor’s more powerful position to maximise their profit at the expense of the longer term value of the franchise can’t help themselves.  They may be in the minority but they are greedy, stupid and in larger networks; they are often corporate psychopaths.  They create great suffering and loss – and they don’t care.  In fact; they and their parasitic friends can justify anything.  That is; until the cycle catches up and their reputation is destroyed.  Then the franchise stagnates and when any business stagnates it will eventually die.

Franchise churning is obviously difficult to prove in this country where the regulator turns a blind eye to even the most incredible rates of franchisee turnover where those victim franchisees lose everything while the franchisor reaps massive profits through their destruction.  In small networks it may be genuinely tough to identify the cause and the intent.  In average to large networks where opportunism occurs it is the intent that is the cause and any suggestion of an excuse goes out the window by the sheer weight of unproportional numbers of victims. 

Yes there are those that make poor decisions and naively walk into the contractual trap of a poorly designed franchise system.  But you cannot confuse that situation with the system that is sold as being something it isn’t and which was always a professional con.  

“Poor franchisor performance versus a willful attempt to deceive are two different things, yet both are tarred with the same brush.”  A better law, a better regime that produces real regulation, full and transparent annual reporting of all franchise offerings including publically accessible disclosure documents and equal access to justice will be the only circumstances that protect quality franchisors from such “allegations”.

Without real reform from the current franchising inquiry we will see more victims; more Kleins and more Lenard’s, Bakers and Midas.  A few years ago you could not pick the rogue; now the internet is an amazing tool where a bad franchisor or a dangerous industry reputation sticks for a long, long time.

In this country we have seen examples of specific rogue franchisors that have been virtually stopped from selling franchises by those you refer to.  Innocent prospects have been saved.  The only thing standing in the way of similar campaigns to target all of franchising is the prospect of responsible and moral government producing effective regulation and law.  That should not be necessary except for the lobbying of those who profit from the conflict and the carnage; FCA lawyers and franchise brokers.   

Rogue franchising “should be prosecuted to the full extent of the law” is an insane and laughable statement in a country where the full extent of the law is a slap on the wrist and some homework.

Franchising in its purest form can and does work very well and it should be protected but its greatest danger comes from those bottom feeders that need weak law and regulation to grow their personal fortunes at the expense of wave after wave of the unsuspecting.  If government cannot deal with them then real disclosure in the form of the internet will be very expensive to this economy.  “Emotive”? Who said “emotive”?   

Deanne writes: Yes, churning is an emotive topic.  This is because people are suffering. Words cannot truly describe the cost to the churned franchisee. Quite simply the result is devastating, both financially and emotionally.

Your article appears to condone the behaviour of the franchisor who continues to run a failed store until they can resell it. It is too easy to blame everything on “bad franchisor management”. What you fail to mention is that the franchisor KNOWS that a franchisee failed in this store, and why, and sells it again anyway.

As the franchisor knows the history of this failed store, it is a calculated move they sell it, for profit, to an unsuspecting new franchisee. It is deliberate. It is calculated. It is dishonest. There can be no excuse.

You also suggest that it is hard for a franchisee to prove they have been churned. The unfortunate situation that many former franchisees find themselves in is not that they cannot prove it; it is that they cannot afford the cost of justice. Proving that their franchisor deliberately caused their business failure is hard when they are losing everything they own; their business, their home, their marriage. Most do not have the financial or emotional resources to fight on.

This is where the current inquiry comes in. I am sure that the committee will hear from a vast number of churned franchisees. I know that the committee will be provided with evidence to back up stories of franchisor abuse from a number of franchise systems.

This is the opportunity many former franchisees have been waiting for to tell their story and show their evidence. This includes evidence that the ACCC has failed to act on over the years; and evidence that cannot be brought out in court due to the financial cost of litigation.

Churning exists here in Australia. It is not “a term used by the uneducated” as the previous FCA chairman suggests. It is real. And it will be exposed, as will those who continue to use it as a strategy to grow their business.