The Promise of Franchising

Franchising promises a better chance of success, and the purports lower failure rate results in a better assignment of economic resources

Published: Apr 20, 2010 06:35:47 AM IST
Updated: Apr 19, 2010 05:29:19 PM IST
The Promise of Franchising
Prof. Ramón Díaz-Bernardo, PhD, Professor of Marketing, IE Business School

A franchise system is a collaboration agreement between two independent business parts, the franchisor and the franchisee, whereby the franchisor allows the franchisee the right to use his brand name, products and services, and specific know-how in exchange for direct or indirect payments to the franchisor by the franchisee. In other words, the franchise system consists of multiple organizations that are legally independent, economically interdependent, and operationally indistinguishable to consumers.

The success of the franchise system is reflected in its spectacular growth figures. In the U.S., where the franchising system began in the early 20th century, there are more than 3,000 companies involved in franchising, accounting for more than 10% of GDP and an estimated 30% of retail sales.

In parallel with the rapid expansion of franchising, there is a growing interest among academics and practitioners in studying the franchise system. The literature on franchising has followed three major lines of research: franchising and the society, creating franchise systems, and managing a franchise system. In this article I will concentrate on analyzing the line of research known as franchising and the society.   Within this research line investigators have looked at the franchising issue from the viewpoint of public policy and considered the effect of franchising in the society as a whole. Researchers have analyzed the “promise” of franchising, that is the supposed benefits of franchising to society in general, to franchisees, and to franchisors.  

Franchising advocates maintain that society in general benefits from franchising because franchised businesses have lower failure rates compared to independent ones. Franchising thus seemingly promises a better chance of success, and the purported lower failure rate results in a better assignment of economic resources and therefore a benefit to society in general.

Business failure is of great significance to society and prospective entrepreneurs; the U.S. Dept. of Commerce data suggests that 67% of new businesses discontinued in their first five years. On the other hand, the alleged lower failure rates of franchises are one of the main selling arguments for attracting potential franchisees to the system. But, are the failure rates really lower? Is the franchising promise true? The empirical evidence is not clear.

Most empirical studies run by academics have concluded that there is no solid evidence which shows that franchisees have either a better or poorer chance for business survival than similarly qualified independent entrepreneurs. Furthermore, some empirical studies have even found that the failure rate varies by industry and that franchisees of older chains have higher failure rates.

Two industries where franchising is prevalent are good examples of this controversy: hotels and restaurants.

In the hotel industry, franchising is a major trend.  Nearly two thirds of branded hotels in the U.S. are franchised, but it is not clear whether the failure rate for franchised hotels is lower than that of independent hotels. Despite the fact that according to the research firm Dun & Bradstreet Corp. the U.S. franchised lodging sector has consistently maintained lower failure rates than the average U.S. independent hotel; a recent academic study of hotel failure rates in the US has found the opposite results, i.e., that the chances of survival are higher for independent hotels than for chain affiliated hotels.

In the restaurant industry, also an industry where franchising is very significant, a 2005 study conducted  in the US and Canada found that among franchised chains the failure rate was 57% over the first three years of operation, and among independent restaurants the rate was 4% at 61%; while other empirical studies found opposite results.

Despite the contradictory empirical evidences, in both the hotel and restaurant industries – and probably many other industries where franchising is relevant – there is a general perception that the failure rate of the franchised business is lower than that of an independent operation. Why?  Because, despite the unclear evidence, many people assume that franchisors are selling a formula for success, and the common understanding is that franchisees have more chances of survival than independent businesses.

Until we find a concrete evidence that concludes whether the franchising promise is true or false, it is important to remember that even when there is a lack of convincing statistics to tell us if franchising is indeed less risky for franchisees than operating an independent business, there is a clear empirical evidence which shows that banks offer preferential loans to franchisees based on their experience that franchising lowers the risk of failure. Regardless of whether the promise of franchising is true or false, the banks believe it to be true – and since half the battle for the entrepreneur is getting funding, people looking to start a business might as well choose franchising over an independent business, so they would assume the franchising promise is true.
 

[This research paper has been reproduced with permission of the authors, professors of IE Business School, Spain http://www.ie.edu/]

Show More
Post Your Comment
Required
Required, will not be published
All comments are moderated
  • Anurag Jaiswal

    Well, the basic idea of franchising is to replicate an established business model. Ideally, since the business model has worked at one location, it has a higher probability of working at another location as well. Even though localization factors may dampen the projected success of the franchise, it always stands a better chance of succeeding as compared to a new business model. That is the theory. It would be interesting to see the real figures.

    on Apr 28, 2010
  • Sibi John

    McDonalds, Pizzahut & KFC's are successful example of Franchising in Asia

    on Apr 20, 2010
Alstom Powers Up To Fight Climate Change
Poorly Made in China: A Reality Check