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Why Franchisees Fail

Franchising makes owning a small business easy. One buys into a proven business model, follows the instruction manual and, voila, presumably experiences financial success.

That's the myth, anyway. The truth is that hundreds of franchisees fail each year. The most frequent causes: lack of funds, poor people skills, reluctance to follow the formula, a mismatch between franchisee and the business, and -- perhaps surprisingly -- an inept franchiser.

Here's a look at some of the most-common mistakes that can befall franchisees -- and what they can do to avoid them.

Undercapitalization

Insufficient funding is a prescription for failure in any business. With a franchise, the initial fee is clearly stated, but newcomers often underestimate operating costs. A slow beginning or unanticipated event can quickly drain and doom an undercapitalized franchise. As a safety net, Minneapolis hair-salon franchiser Great Clips suggests newcomers add as much as $160,000 to their estimate of likely start-up costs, on top of the company's upfront franchise fee of $25,000. Great Clips seeks prospects with at least $300,000 in net worth and $75,000 in available cash.

Unrealistic optimism also can be a recipe for financial distress. Several years ago, many fast-food franchisees borrowed heavily to buy more restaurants during what turned out to be a frothy market. Some financed the expansion with easy-money nonrecourse debt, using the new properties as collateral. When a downdraft led to hundreds of defaults, lenders seized those properties and some franchisees were forced into bankruptcy. Bankers today are more cautious about the leverage a franchisee takes on, insisting on more collateral upfront or simply being more hard-nosed about who qualifies as a borrower.

Weathering unexpected situations without a financial cushion can be problematic even for an established franchise. Ed Moran, an accountant in Tucson, Ariz., recalls a McDonald's Corp. franchisee whose dominance of a small California community was suddenly challenged by the arrival of a competing burger restaurant. The first year, the rival knocked 30% off the McDonald's store's sales. Unwilling to scale back on his lifestyle, the McDonald's franchisee instead reduced his labor overhead and raised prices. "He went into a spiral and never came out," Mr. Moran says.

To avoid such events, experts advise would-be franchisees to assume they will lose money the first couple of years and have a nest egg they can tap in case of emergency.

Poor Management Skills

As with so many ventures, a franchise's success depends on the people involved. "Franchisers say the No. 1 reason for a franchisee's failure is that they don't get the right managers," says Dennis Monroe, a certified public accountant and franchising consultant in Minneapolis. If a franchisee is a poor manager, he might want to choose a business that could be run by just one or two people or hire someone skilled at motivating others.

Mr. Cohen is a big proponent of recruiting managers who use the word "we" rather than "I" when talking about their business experience. "People who say, 'I did this' and 'my store did that' are not as focused on team-building," he says.

Good managers create an environment where everyone can excel, or at least be made to feel important. Aslam Khan has become the largest operator of Church's Chicken restaurants in the U.S. by acquiring distressed properties, identifying their ailments and reviving them. When he takes over a failing store, he retains as many employees as possible in a bid to create team spirit. Even in tough inner-city neighborhoods, he doesn't do background checks on employees. "The honor system works really well," says the 53-year-old Mr. Khan, whose company, Falcon Holdings LLC, owns 102 Church's Chicken outlets in six states.

"If you can control the costs and give people an environment in which they can succeed, then you make money," says Mr. Khan, who began his fast-food career as a dishwasher at a Church's outlet in California.

Passive franchisees, who may or may not be on the premises every day, also are asking for trouble, industry experts say. That person doesn't know if the help is showing up, what customers are complaining about, or whether employees are dipping into the till. Theft can be contagious and contaminate an entire organization if not stopped immediately.

Follow the Rules

Franchises aren't designed for the independent-minded. They depend on a by-the-book execution of a business plan, adherence to time-tested systems and a willingness to follow directions.

"The worst thing a new franchisee can do is say to his franchiser, 'You guys don't know what you're doing,' " says Mr. Cohen. He likens that to someone taking over a McDonald's restaurant and deciding not to put sesame seeds on the Big Mac buns.

Making sure employees are properly trained and executing according to the rules is vital. After acquiring a struggling Great American Cookie outlet, another brand of Salt Lake City-based Mrs. Fields, Mr. Cohen discovered why the store was ailing: The baker was going home at 11 a.m., leaving the store without fresh goods to sell the rest of the day. At another store, cleaning and maintenance had obviously been ignored. Following a thorough scrubbing, the location, previously in default for lack of business, now does nearly $600,000 in annual sales.

A Suitable Fit

Among the most common mistakes new franchisees make is signing on before adequately researching the business. "In their excitement they forget about that," says Mr. Khan. Only later do they realize the amount of time and elbow grease the job requires, and they may be too embarrassed to admit it isn't for them.

When Charlie Simpson took over franchise development at Great Clips, he studied why some franchisees were doing poorly and concluded they had been miscast. In part, he blamed the company's marketing materials, which featured photos of a sailboat and a couple on a beach. "It was attracting people primarily interested in almost immediate gratification," Mr. Simpson says, adding that owning a franchise is rarely a get-rich-quick scheme.

To find appropriate candidates, Mr. Simpson turned to a software program called Franchise Navigator, which defined the attributes of ideal franchisees. Great Clips changed its printed and Internet marketing materials to appeal to prospects with more business experience, and raised the financial requirements for potential franchisees. The new approach is working, Mr. Simpson says, producing better-quality applicants and fewer washouts.

"You can have the best business model in the world, but if you sell it to the wrong kind of person it's not going to work," says Craig Slavin, whose company, Franchise Architects, created the Navigator software package.

Experts, meanwhile, advise prospective franchisees to hire a consultant to analyze whether they are a good fit with the business opportunity they are considering. They also should contact current and former franchisees to get their feedback. Names are listed in the Uniform Franchise Offering Circular, the disclosure document that franchisers must give would-be franchisees.

The Wrong Franchiser

Occasionally it is the franchiser who is largely to blame for a franchisee's failure. Aggressive expansion can stretch a system and shortchange franchisees, particularly when it comes to helping them address problems. "The franchiser is always optimistic about what they can develop," says Mr. Monroe, the CPA.

Experts also caution would-be franchisees to avoid overzealous brokers or consultants selling concepts. Too often they are more interested in a sales commission than in making a good match between business and franchisee. Never make a commitment based solely on information provided on the Internet or over the phone, they say.

Another potential hazard: signing up with a franchiser who is inexperienced. Entrepreneurs eager to capitalize on what they believe is a great idea are sometimes tempted to franchise their concept before making sure it works in a variety of markets and economic environments. Franchisers with only a handful of their own stores probably need more seasoning, experts agree.

"There should be wariness about new franchisers, no matter how they're set up," says Scott Shane, who teaches economics and entrepreneurship at Case Western Reserve University in Cleveland. Immature franchisers have a high failure rate, he says, citing his own research.

"Twenty years from their start, less than 20% of the franchisers will still be around," Prof. Shane says. "In fact, of the more than 200 new franchise systems established in the United States each year, 25% don't even make it to their first anniversary."

—Mr. Gibson is a special writer for Dow Jones Newswires in Des Moines, Iowa.

Write to Richard Gibson at dick.gibson@dowjones.com

Wall Street Journal Online, February 11, 2009

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