When franchisees behave badly

An understanding of opportunistic behaviour by both franchisees and franchisors can help identify both good and bad practices used by each. JASON GEHRKE

By Jason Gehrke

This blog first appeared 22 October 2008

At the Brisbane hearing of the current federal franchise inquiry recently conducted by the Parliamentary Joint Committee on Corporations and Financial Services, the term “franchisee opportunism” was raised in the context of problems in franchise relationships.

While many of the submissions lodged with the inquiry have dwelt on issues of opportunistic, unprofessional or even bullying behaviour by franchisors, this was a rare and unique reference to opportunistic behaviour by franchisees, and was mentioned by an academic (not by a franchisor in defence to any criticism from its franchisees).

Whereas discussion of opportunistic franchisor behaviour includes such things as churning, encroachment, unreasonably withholding consent to sell, termination, unilateral agreement variations and potentially disadvantageous supply arrangements, franchisee opportunism is an entirely different concept.

The most common form of franchisee opportunism is free-riding. This is where franchisees join a strongly-branded network but add little or nothing of their own entrepreneurialism or personal endeavour to the business, such that the brand and the franchisor’s efforts alone generate custom for the franchisee’s business.

Free-riding franchisees are unlikely to engage with the franchisor or their fellow franchisees, are perhaps unlikely to attend or actively participate in group meetings and discussions, and generally adhere to the bare minimum of compliance in order to stay in the system.

Free-riding is generally a term applied by academics, and the term itself can be found in franchising literature. Among franchisors, free-riding franchisees are more likely to be described as “lazy”, “bad” or “underperforming” franchisees, rather than free-riders.

Free-riding in itself is not usually a wilfully deviant behaviour, but rather the absence of the franchisee upholding their end of the deal in the franchise relationship by failing to exert the levels of motivation and energy generally expected of franchisees in an interdependent commercial arrangement.

In a 2006 convention paper on the issue, three US legal experts noted that franchisees have an incentive to free-ride and offer sub-optimal service as they don’t bear the full cost of the damage done to the franchisor’s brand (Klick, Kobayashi & Ribstein, 2006).

In other words, the relative anonymity of a franchisee within a network reduces their individual accountability for the performance and delivery of the brand promise at store or territory level.

The solution, according to the three legal experts, is to allow broad termination provisions to exist in franchise agreements so that underperformers can be excised from the network for the good of the rest, and that the risk of being excluded and forfeiting their investment is incentive enough for free-riders to improve their performance.

Part of the solution to the problem of free-riding franchisees is for franchisors to have better screening processes in place at the start, and to proactively monitor each franchisee’s performance across a range of financial and non-financial metrics.

Then with appropriate performance management techniques, the free-riding franchisee can be reinvigorated to engage with the network and their business. Alternatively, a mutually agreeable exit strategy may instead be developed.

But franchisee opportunism doesn’t end with free-riding. A great concern among many franchisors, particularly those that are still growing and maturing themselves, is that franchisees will take advantage of the access to their intellectual property to then go out and start up in competition to the franchisor.

This concern (and examples of this happening to potentially justify such concern) is more common in service franchises rather than retail franchises for a number of reasons:

• Service franchises usually involve relatively simple, and often unskilled services that are easily replicated.
• Many new franchisors lack highly-developed and efficient processes built around sophisticated and proprietary operating systems. As a result, their business models can be easily copied.
• Capital considerations: The cost of establishing a rival service operation is far lower than setting up a competing retail business. Retail franchisors may also control or influence the supply chain, or go-alone franchisees have inadequate buying power, both of which potentially result in a higher cost of goods to any independent operators.

Some franchisors may not have the resources or capacity to enforce contractual restraints of trade when a franchisee goes out on their own, or are simply unaware that the franchisees have violated the restraint of trade clauses in their agreements.

Franchisees can also engage in opportunistic behaviour by using their access to the franchisor’s intellectual property for purposes other than for the operation of their franchised business (such as setting-up unrelated businesses on the side, etc).

Franchisee opportunism may also include territory squatting. An example would be if a franchisee is granted the rights to a large geographic region on the understanding they will sequentially develop as many units as possible within that that region.

However if this is not an ongoing condition of the grant; it is quite possible the franchisee will develop fewer, if any additional units (as there is often no penalty for them not doing so) and effectively lock the brand out of the potential remaining in the balance of the market.

Territory squatting can be the result of free-riding, or a conscious and subversive action designed to thwart the future ambitions of the franchisor while a competitor takes the ascendancy. (In such circumstances, the competitor may have an agreement with the franchisee of which the franchisor is not aware.)

Franchisee opportunism is not often discussed and is worth further attention. This article does not attempt to compare instances of franchisee versus franchisor opportunism, nor weight their relative impacts on the parties involved. If anything, an understanding of opportunistic behaviour by both franchisees and franchisors can help identify both good and bad practices used by each.

In the long run, this can help franchisors adopt best business practices, which provide for greater sustainability and equal opportunities (as opposed to opportunism) for both parties.

Reference: Klick, Jonathon, Kobayashi, Bruce and Ribstein, Larry. Incomplete Contracts and Opportunism in Franchising Arrangements: The Role of Termination Clauses. Berkeley Electronic Press, Paper 61, 2006 American Law & Economics Association Annual Meeting.

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

C May writes: I see, it’s the free-riding franchisees who are the problem. Is that what you are saying? People who have sufficient initiative and courage to put up the family home, which is usually everything they have, and then won’t follow the system and just sit on their bums and do nothing? As for adding their “entrepreneurialism”, most systems (particularly the really successful ones, such as McDonald’s) do not allow for that, but it also begs the question whether such people would choose to be constrained by the yoke of franchising; almost by definition, a real entrepreneur would not. Free-riding franchisees? I don’t think so. The only free-riders are bad franchisors.