Franchising – will it remain a viable business model?


Posted By on 14/09/18 at 8:40 AM

This is the text of a presentation given by Peter Buberis to the Council for Economic Development in Adelaide recently.

The current atmosphere – media/senate inquiry

Why the fuss now?  Confusion with Finance Royal Commission – contract v bad behaviour. Concern from offshore investors. 

The franchising industry seems to be in a present state of turmoil evident from;

  • the media reporting which is largely negative
  • the establishment of the ongoing senate enquiry
  • the expressions of concern raised by overseas franchise systems in relation to the industry in a country traditionally considered a sophisticated and stable market.

Before briefly looking at the state of play let us keep one major economic concept in mind. This is the notion of MARGIN COMPRESSION, put another way, the erosion of profits due to rising business costs without offsetting profit increases.

This concept will invariably underpin feelings of dissatisfaction and feed stress in any business or industry as it is doing now. Secondly, it is a regulated industry, overseen by the ACCC so any view about franchisor behaviour also have to consider the discharge of the ACCC’s obligations.

Firstly, the media

The media feeds off stories of injustice. It can present news slanted to one perspective or it may engage in solid investigative journalism.

In the case of franchising, the weight of reporting over the past 12 months, probably favours good investigative journalism though there are clear examples of sensationalism as well.

As a reader of the Fairfax newspapers I have been impressed by the level of inquiry reported on well-known systems such as the Retail Food Group- the owner of Gloria Jeans, Brumby’s , Donut King and others-  Caltex, 7-Eleven , Domino’s and Red Rooster to name the main reported stories.

Underpayment of wage entitlements by franchisees seems to have started the flood of bad news but this has been exacerbated by stories of financial and personal stress caused by unfair pricing directions, supply chain overpricing and reductions in the quality of goods supplied for sale. The receipt of rebates by franchisors that don’t get shared with franchisees has also been noted.

Side by side with this is the common retail theme that leasing costs, especially in large shopping malls, are in many cases unsustainable with minimal landlord sympathy.

The “Sound and Fury” of these stories is probably well known to you and as we don’t have time to examine each issue in detail I will limit myself to some balancing or offsetting observations;

  1. Underpayment of employee salaries is a matter directly relating to the running of a franchisee’s business. Franchisors have, in some cases, contributed to the illegal practice through ignoring these practices and/or maintaining their royalty demands despite MARGIN COMPRESSION.  The Fair Work Act has now been amended to address this and irresponsible franchisors may now be held secondarily liable if they continue to permit such behaviour.   The current Senate Inquiry will therefore not consider this media dominant story that perhaps is the darkest story about the industry.
  2. Not all negative system reporting has survived analysis.   Initial reporting claimed that RED Rooster/Oporto franchisees were being pushed to the verge of bankruptcy by high costs and operating restrictions. There were also claims that the franchisor was intimidating franchisees to stop them making submissions to the Senate Inquiry.  Just as rapidly these claims were rebutted by a group of Red Rooster Franchisees who were reported as angrily hitting back at claims of financial distress, describing the complainants as a small group of “renegade franchisees”.  So there may not be commonality in franchisee’s views.
  3. There are over 1,000 systems operating in Australia yet the same few names get mentioned by the media. This permits the observation that many systems operate as they should to the benefit of all.
  4. Complaints have to be measured against the percentage of failures that occur in any industry through poor choices, lack of franchisee ability or increased costs. There is an acknowledged long term attrition rate in franchising businesses of 20%. This is much less than that of general small businesses.

Whatever observation that may be used to cut into the negative reporting there are cultural and profit issues at play which probably require a rethink to protect the viability of competent franchisees. Short term profit objectives have to be moderated- a statement that may cause shock to some publicly listed franchisor companies and certainly to the traditional Private Equity model that has taken a strong interest in the franchising industry.

Franchising

The Senate inquiry

Now, setting aside the cries for relief by the franchisee sector based on predatory franchisor behaviour, let’s consider the circumstances in which the current Senate Inquiry has been established.

The franchising Industry was last examined in detail in 2014 and modifications to the compulsory industry code covering franchising were made. These changes were intended to provide stability and additional protection to participants without the need for short or medium further change.

The expectation of a period of stability has not lasted.  Why is this so?

My list of the major factors include;

  1. Firstly, there has been increased equity take up of franchise systems by listed companies and Private Equity. This has put greater emphasis on extracting profit, often driven by incentivisation through bonus schemes. Cultural hardening has occurred as short termism has crept in.
  2. Secondly, the current Financial Royal Commission has highlighted bad behaviour by financial companies and banks in a shocking sense. This has exacerbated the feeling amongst smaller consumers that they are being exploited. This may be a mindset that has carried over to franchising despite there being clear differences in the models.
  3. Thirdly-general retail is not in good shape having to deal with on-line activity, lease costs and other factors where consumers may be closing their wallets at the same time. Remember the stress caused by margin compression.
  4. Fourthly, the media has played a pivotal role in raising concerns
  5. Lastly, there are elections in the wind, especially at the federal level. Voters with grievances need to be responded to. Whether lip service is followed by legislative change is another matter.

So what is the senate Inquiry considering?

The submissions to the Senate Inquiry are extensive – many claim bad franchise behaviour along the lines reported by the media, some defend the franchising model and others recognise improvements to the compulsory franchising code that may help moving forward.

The members of the Inquiry, and the report that is due in December, will presumably recognise that not every negative can be laid at the feet of the franchisors and that some, if not many franchisees are not sufficiently competent and can’t be protected from their own basic failings .It will recognise the resolution of the wages scandal through new powers given under the Fair work Act and will draw some comfort from clear enforcement statements made by the principal regulator, the ACCC.

It will however recommend some changes and I will finish off this presentation by speculating on what may be the more likely ones.

Overseas perceptions

As regular attendees at overseas conferences, especially in the USA, my partners and I know that this current state of affairs is having an impact on foreign franchising systems that area accustomed to treating Australia as a desirable location to invest in a local footprint.

Any foreign concerns have been mainly largely of fear that franchisors might be responsible for unpaid franchisee employee wages- matter now largely been put to rest by the Fair Work Act changes provided certain internal oversights are implemented.

Unresolved pessimism may remain due to the possibility of increased regulatory burdens coming out of legislative review and negative sentiment amongst potential franchisees. These matters need to be put to rest quickly.

If the Senate Inquiries recommendations lean towards being highly protective of franchisees will the Government adopt them with little regard to the broader impact this will have on the industry?

To anticipate a likely we need to put the franchising industry into an Australian economic context.

Putting franchising into an economic context 

Background

A helpful start is to explain why the franchising model exists? This can be shown by the following simple set of facts.

  • A business proprietor has a successful business concept together with some intellectual property protection such as a protected brand through trade mark registration
  • Those products and services are in demand and would be by consumers outside the catchment of the business.
  • The owner recognises this but does not have the capital to expand
  • The answer to take advantage of this potential is licensing of the business model and the brand.
  • To make this worthwhile there has to be an acceptable income stream but also, importantly, protection of the model, the brand and any confidential information. There has to be some control over the licencee’s use of these valuable components. This done through the franchise contract.
  • Others cotton on and even overseas expansion becomes possible. As the licencing system grows so does the brand value.
  • The system and businesses under it have an ongoing level of mutual reliance. Both expect to make a good profit.

Possible negatives

The model does not exclude possible negatives including;

  • A franchisee’s personal inadequacy- simply a poor business person
  • Fraudulent behaviour by either party
  • Failure to follow franchise system requirements and resultant breakdowns in the relationship between the parties
  • Margin compression
  • Franchisor lack of support
  • Disputes that sour the relationship.
  • Franchisees eventually resenting the system once they have learnt how to succeed under it- why should they tolerate franchisor control and pay out profit.

History in Australia

Franchising as a business model was, putting to one side the motor vehicle and petroleum industries, first seriously taken up in this country in the 1960’s through the arrival of Kentucky Fried Chicken. Australia’s first home grown system was LJ Hooker.

Business format franchising here has since grown to some 1000 plus operating systems, 500,000 plus employees, nearly 80,000 outlets and a value to the economy in the range of $150-$180 Billion per year.

As part of Australia’s GDP – some $1.69 trillion in 2017- it provides some 10%

To put those figures in another context the value add to the country of thousands of overseas students taking an education here is in the region of $50 billion – one third of franchising’s contribution.

So, it is clear that no government or regulator could ever take the position that the franchising industry should not continue.

But it can be fine-tuned and incrementally improved.

That should be the only acceptable result of any formal review.

Regulatory Interest

Because of the symbiotic relationship between the parties there has always been an inclination on the part of government to control aspects of the industry.

After all the franchisor has significant advantages over the franchise in terms of information, something called information asymmetry, and does have contractual rights to control the business model and its commercialisation.

The first federal government enquiry was in 1976 but a mandatory franchising code was not adopted until 1998.

This Code recognised the need to deliver prescribed information to franchisees, to give them time to consider it and to give them a time limited cooling off right. Dispute resolution was also a focus.

Since 1998 there have been further reviews and further iterations of the compulsory Code. Each improved on its predecessor with the final comprehensive review and legislative change in 2014.

I think it is fair to say that the focus of most change has been information asymmetry that is the gap in the respective parties’ knowledge. Closing that gap so that franchisees make informed decisions has always been an objective.

To do this properly the government also had to take into account the administrative burden the delivery of too much detail might impose on franchisors. The industry had to remain workable. For that reason independent advisors to assist franchisees in making a decision have always been recommended.  Up to now, taking that independent advice has not been compulsory- a fault I identify in the regulatory model.

Practitioners were not surprised in 2014 when obligations between the parties to act in good faith in their business dealings with each other were added. Nor did anyone think it inappropriate that Information Statements highlighting the risks of failure of franchises were to be a compulsory part of the signing up process.

While the 2014 Code may not have been all that franchisees might have wished for it did promote fairer dealings without descending to a nanny state outcome.

Any perceived failure in franchisee protection and claims of exploitation have to be carefully assessed against the 2014 Code objectives, the role of the ACCC as the government regulator in enforcing it and the weaknesses and foibles of individuals in particular cases though very bad behaviour can never be discounted or even controlled.

The issue of ethics and good business practice 

I would like to make some passing references to what I loosely describe as some of the ethical considerations that appear to have been partially forgotten by some franchisors.

The First is the guiding principle known in corporate law as the business judgement rule

This concept recognises that the decisions and behaviour of directors will be supported by the courts if the outcomes are seen to be objectively in the interests of the company and its stakeholders.

Its existence can immediately be seen to be potentially in conflict with the view that the purpose of management is to make profit and pay dividends.

For the moment Company executives seem driven by the need to focus on profit. A worthy objective, and one that helps defend against predatory takeovers, but not properly the sole purpose of directors and senior staff. Naturally much in this dominant view is also linked to the construction and pursuit of bonus pools.

Under this view of profit franchisees are expected to deliver the reliable flow of royalties they contracted for? It is their problem if there is little left for themselves after expenses.

The notion of profit as the driving motivation creates a sense of “moral immunity”.

To counter this companies need to be reminded of the business judgement rule.

Directors can and should take into account the interests of other stakeholders. In this context I identify franchisees, who provide the underlying cash flow into the corporate franchisor.

Surely if the focus is only on maximising shareholder returns and bonuses then the business will wither from the ground up as franchisees lose viability.

These non-shareholders must prosper and corporate culture must facilitate this through application of the business judgement rule as a matter of equal importance to the pursuit of profits.

For students of business history this parallel approach is best exemplified in the legal disputes engaged in by Henry Ford in the 1930’s when he was forced to defend expenditure on better worker conditions against the demands of shareholders for ever increasing dividends.

Finding and holding to a moral compass

This is the harder edged ethical issue.

The banking revelations of the Finance Royal Commission have clearly shown us that good people can do bad things egged on by their dominant culture and financial incentives.

Commentators have noted that moral compasses are swinging wildly and there must be a return to proper commercial values. If not the end game will be ruin.

Franchisors must exercise contractual rights fairly and take the other parties interests into account. This may be equated with a proper exercise of good faith which is a legal obligation but is far better done as an active step to achieve improvement in the culture of an organisation.

Happy constituents should produce better businesses.

Where will we be in 12 months?

There will be tweaking and likely better franchisor responses on margin compression

Some systems are already responding. The steps they take now will be beneficial in the near to medium term.

An example is the listed system aggregator Retail Food Group. Something of an unfortunate choice as its lenders have just announced increased pressure to pay down debt.

RFG have recently announced that they are completely reviewing their supply chain so as to get maximum cost efficiencies and at the same time raise product standards. They have also announced measures to relieve franchisees of certain financial burdens.

Systems that take leases with large landlords such as shopping centres and then sub lease or licence use of the premises to franchisees will be actively engaging in negotiations to seek better rental terms and possible rent concessions on existing tenancies.

I believe franchisors will take a much more active role in assisting franchisees with margin compression to enable them to preserve some reasonable profit.

Examples of hands on assistance might include;

  • Full transparency of data;
  • Assisting franchisees with financial literacy;
  • KPI’s that are adjusted to suit the maturity of the franchisee’s business rather than contractually prescribed with no flexibility;
  • Causing franchises to meet in groups to exchange information and trends as well as problem solving;
  • Analysing and responding to each outlets profitability.

The ACCC

As the regulator the ACCC will be under pressure to maintain proper oversight of the industry and to act through intervention and prosecutions on unacceptable or worse behaviour.  Breaches of the Code can carry fines of up to $63,000 per breach.

It is hoped that there will be adequate budgetary resources made available to make the biggest possible impact. Courts working to ACCC prosecutions and civil cases will be asked to respond meaningfully to create clear warnings against bad behaviour.

Information asymmetry

The Senate Inquiry is likely to recommend, at a minimum;

  • the provision of additional information to franchisees at the pre-contract stage;
  • expansion of the Unfair Contracts law to draw in more franchise agreements;
  • further warnings on the risk of failure taken up by each franchisee;
  • it is hoped, that compulsory, rather than discretionary, independent financial, legal and business advice need be taken by franchisees before signing final contractual documents.

If legislative change on just the above occurs, it will be of great value enhancing the industry and cause franchisees to go into arrangements with their even wider open and with less naïve optimism.

If not all of these steps are adopted franchise systems that do have a strong “moral compass” may make them a compulsory part of the terms of any final contract.

There will be continued media interest

If there is a story to be found in the success or otherwise of an industry review it will be reported on. The timing of any federal election may reflect on the tone taken.

I for one would be quite happy if sections of the media claim credit or what they may regard as crusading efforts.

Positive media and government action will hopefully reassure overseas investors.

Every contact point with overseas systems will be used by Australian practitioners to assure them that this country is not a sovereign risk and that as a focus of investment there is none better.

 State involvement

All reform or improved oversight failing State Governments may step in and take their own measures. Threats made in SA and WA in the past. This would be unfortunate as the single federal regulation of the industry is a major benefit to its viability through one set of clear rules without multi-jurisdictional overlays.

Listed companies/private equity

It is to be hoped that the notion of profit being the sole determinant of success will change and that bonus incentives may adjust to cultural as well as financial outcomes.

A more judicious recognition and understanding of the business judgement rule will hopefully convince Boards that the interests of stakeholders lies in the continuation of a profitable business model, not a once off profit.

I am pleased to note that there has already been some recognition of this and slightly less time/profit driven models are emerging.

Peter Buberis

Principal

Peter heads our franchise team.

Peter has extensive experience acting for both national and international franchise systems with a strong skill set around the expansion of franchise systems. ... Read More