Food truck encroachment: Why sunk cost investments and change kills mom/pop franchise life savings

September 10, 2010

A legal civil war will mask franchising’s unavoidable investment flaw: opportunism arising from inevitable change.

The #1 business risk is franchisor opportunism: the self-interested exercise of contractual discretion via deceit. This one risk comes cloaked in hundreds of types.

Systemic Factors: At one time, franchisees were granted a geographic monopoly but that ‘s history, mostly. Franchisees own the majority of the assets but franchisors control the use/exit of this capital. Franchisors take $ from the top; franchisees only from the bottom. Pre-sale due diligence is irrelevant because the franchisor reserves the right to unilaterally change the model. Sunk cost chains draw off-balance sheet capital in from all s0urces of “love money”.

High-end, branded roach coaches will be franchisors’ new crack cocaine:

  1. lower capital barrier to sales (easier financing),
  2. boost total market retail sales (royalties/ad fund %),
  3. product sales margin increases (tied buying provisions),
  4. same control via central commissary innovation and tied buying to outfitters,
  5. 100% flexibility (scaled territories),
  6. streamlines process when an intentional insolvency is chosen,
  7. centralized social media promotion, and
  8. margins by contracting with a secondary space rental company (more than make up for franchisors giving up hefty lease margins).

Benefits for traditional mom-and-pop investors?

At best, a generous offer from your franchisor for you to buy 3 new trucks to replace your outdated bricks-and-mortar store.

I would suggest that billions of $  existing franchisee-owned assets just shrunk. Permanently. Never to return.

Think: Dunkin’ Donuts, Tim Hortons,  Quiznos on wheels.

Thanks for the tip, Michael.

Sunk costs: Sucked under by a franchise

March 1, 2009

drowningPeople do not realize that there are hidden dangers in small business and especially franchises.

You stay in a failing franchised business much longer because of a concept called sunk costs.

Sunk costs are investments that cannot be recovered once they have been incurred. You can’t get out of the water or reach the shore safely.

Most franchise investments are even worse because the assets are very, very specialized.

They’re called idiosyncratic sunk costs: assets that are highly dependent on the situation and the control of others. They may have cost you $1,000 but on the free market you could only get $100 for them.

Some examples are:

  1. a sign with a logo you do not own,
  2. proprietary software used for a specific system,
  3. a customer list that the franchisor owns (constrained by a non-compete provision),
  4. a telephone number that is controlled by someone else,
  5. leasehold improvements that are only useful to another franchisee (who is controlled by you-know-who),
  6. a current account balance that can be accessed by your franchisor,
  7. a centralized telephone system that someone can cut you off from, and
  8. specialized vehicles, equipment or the always highly elusive proven business system.

Almost all assets in your business are practically worthless if you fall out of favour with your franchisor. You keep treading water in the false hope that by serving your master, he will let you realize a high percentage of what you have sunk into the business.

Franchisees very seldom ever achieve a tiny portion of what they imagine their business will be worth because they are renters, not owners.

Sunk Cost Reality: Post-signing relationship conversation

October 15, 2008

Franchisor to franchisee:

OR: Les the new poo-extraction technology will cost you $100.

EE: So the non-logoed dog poop scoop, in the real world, costs $5.00. Right?

OR: Right.

EE: But I have to buy this propriety equipment from you, right? [tied buying]

OR: Right.

EE: So I end up paying 20 times as much for the scoop, does that sum it up the situation?

OR; Yup.

EE: And if I don’t want to [as any sane independent businessperson would do]…?

OR: I can terminate you and refuse any potential buyers and other nonsense which deprives you of, say, 90% of the $100,000 you’ve sunk into your business. Sound fair, Les?

EE: So my decision is either:

  1. lose $95 by saying yes or
  2. lose $90,000 plus the exit costs by saying no. [Prospect Theory]

Is that a fair comment?

OR: Is that a fair comment, what?

EE: Is that a fair comment…sir?

OR: Yes, Les. You’re coming along.

Sunk costs as they compound business risk are a unique and little discussed aspect of franchising. Law makers are particularly negligent in not putting each post-signing franchisee buying decision in its appropriate context. Franchisees often look stupid in hindsight because sunk costs are not taken into account.

  • Context is everything in the bizarro world of a franchise relationship.


Get every new post delivered to your Inbox.

%d bloggers like this: