How efficient and effective are the best franchisors in using their franchisees’ store investments?

Of the investment resources they attract, do they use them effectively or are they squandered?

I chose some of the more “blue chip” of the U.S.-based systems and chased down their 2013 FDD (thank you the state of Wisconsin).

Opportunism is when someone in a position of advantage, uses that position against another. In franchising, the situation that the franchisor controls the store’s sunk cost investment, can be exploited. A very good test of opportunism is: If the ownership of the assets were reversed, would the alleged “opportunist” likely change their decision?

While the 5 systems grew by 4,342 new stores (adding +$6-billion to franchisors’ coffers), there was also a loss of 1,738 stores or $2.5-billion of franchisee store investment that left the industry.

How “sticky” are franchisee investments in these systems? On average for every $1.00 of new franchisee that enters the market 42.2% was lost from 2010 to 2013.

 

Measured from the best practice level of Dunkin’ Donuts, there is some very large variation in these systems as they purport to take care of “other people’s money”.

Losing over 40% of the invested capital in 4 years? It seems the franchise industry is a bit of a leaky bucket.

• Fairly apparent when the information is publicly available.

Kudos to the states of California, Wisconsin, Minnesota, Washington, and soon-to-be New York for their online repository of franchise disclosure documents.

Is it fair to force franchisees to prove that their franchisor has acted in “bad faith”?

No. Since 1971, there have been recommendations in Ontario that franchisors should have the burden of proof when challenged about acting unfairly.

The first one was by a retired Superior Court Justice and the next one a former partner to the actual Arthur Wishart, a lawyer from Sault Ste. Marie.

1. The Grange Report

Legislative approach

(iii.) Contractual v. equitable approach

3. In these dealings also, placing the burden upon the franchisor to prove,

(a) that the contract is fair; and

(b) that the franchisor’s exercise of his rights under the contract is justified in the circumstances.

Report of The Minister’s Committee on Franchising, The Honourable Arthur Wishart, W.C., M.P.P., Minister of Financial and Consumer Affairs by S. G. M. Grange, Q.C., June 1, 1971.

2. Public Hearing testimony

I think it’s interesting that in that circumstance the Grange report does a reverse of onus. It says there has to be fair dealing, and if there isn’t fair dealing, then it’s up to the franchisor to show, and I quote, “that the contract between the parties was fair.” In other words, the onus shifts, not from the franchisee to prove they were treated unfairly but to the franchisor to prove that franchisor dealt with this individual fairly. I think that’s an extremely important concept. It goes on to say that the franchisor’s conduct was “equitable in the circumstance.” So you have this onus on the franchisor, at that point, to prove they dealt with this person fairly.

Mr. Gerald Nori, Wishart and Partners, March 7, 2000.

One of the greatest barriers is franchisee access to information.

 

Why is it so hard for Canadian entrepreneurs to access franchise disclosure documents in Canada?

Perversely, much more information is available via U.S. internet sources for Tim Hortons franchises than can be found north of the 49th parallel by an independent researcher.

Since 1979, the U.S. Federal Trade Commission has required all franchise disclosure documents to be publicly available (the Franchise Rule). As an example, this is the first of 555 pages of the free online copy of the 2013 Tim Hortons Traditional FDD. This is critical information; similar to financial market prospectuses.

It’s as easy as going to the Wisconsin site, typing in the name of the system, and more-often-than-not a free pdf shows an unbelievable amount of investment disclosure information.

How about getting the most recent filing for Tim Hortons in Canada? On Feb 17th, I emailed the new owners and asked for a copy and received this reply:

Dear Les Stewart:

Thank you for your message. All of the information we are able to provide the general public is available on our website. If it is not on the website, we regret to inform you it is proprietary in nature and we are unable to fulfill your request.

Sincerely,
The TDL Group Corp.
Angelee ,
Franchising Canada Representative

The Ontario law is called the Arthur Wishart Act (Franchise Disclosure), 2000. It’s disclosure requirements were modeled on the U.S. model.

Disclosure requirements (standard format, both U.S. and Canada)

• bankruptcies (p. 17 of the U.S. Tim Hortons Traditional FDD),
• litigation history, (p. 15),
• corporate-, franchisor-owned outlets (p. 72),
• franchised stores: terminated, non-renewed, re-acquired, ceased operation, transferred, and sold-but-not-opened (by category for 3 years, p. 72),
• fees (royalty, advertising, computer, other, p.17),
• franchisor’s financial statements (p. 85),
• list of current franchisees: name, address and telephone number (Exhibit O: p. 333),
• list of recent former franchisees: name, address and telephone number (Exhibit P: p. 387),
• restrictions on sources of products and services (and amount $ franchisor receives, Item 8: p. 32),
• entire franchise agreement (p. 133), financial representations (Item 19: p. 69) and
• leases, trademarks, etc.

The Ontario government/Wishart currently does not require either (1) public filing or (2) an online repository of documents.

I believe Canadian small business investors deserve as much access to this financial information than do our United States neighbours.

How can we have informed public policy without publicly-available, agreed-to data?

How frequently does Tim Hortons terminate their franchised stores in the United States?

Termination of a franchise agreement is the most financially devastating action a franchisor can take.

It is the “weapon of mass destruction” for mom-and-pop franchisee life savings and employment

 

Responsible franchisors avoid this too because it is such a red flag to the investment community.

It is only fair to compare it to their peer group and to best practices.

ie. Tim Hortons terminated their U.S. franchisees 22.9, 1.1, 2.1, and 9.4 times more frequently than McDonald’s had done in the same year (2010 to 2013).

The frequency that the franchisor chooses to terminate a franchisee is a material fact to any buying or renewing franchisee.

Source: Information from Franchise Disclosure Documents (see for example Wisconsin Department of Financial Institutions). Free download for U.S. filed documents. One of 4 online sources.

Canadian information is unavailable because no provincial law requires these CDN documents to be (1) publicly filed or (2) put online.

Alberta, Ontario, New Brunswick, Prince Edward Island, Manitoba and soon-to-be British Columbia

Posted also on ConcernedTimHortonsFranchisees.ca.

Will “brand strength” or hard fought-for legal provisions likely preserve Tim Hortons franchisee, staff, supplier and communities relationships?

In 2000, Tony Martin asked Tim Hortons VP Nick Javor which of their franchise agreement terms protected franchisees when a merger happens.

In his public hearing testimony which lead up to Ontario’s 1st franchise law, Mr. Javor seems to suggest the “brand” is strong enough. He was silent on the contract provisions needed.

Mr Martin: I don’t think there’s anybody who’s suggesting that there aren’t good franchise systems around, and certainly Tim Hortons presents at this time as one of those good systems, for all the reasons you’ve laid on the table here today. What you have we want for all the systems, because when a system goes sour, as you suggest in the Pizza Pizza case, you’re all painted with the same brush. That’s unfortunate. It affects a good business relationship and ultimately probably affects the franchisee the most because they’re the most exposed and vulnerable.

My concern is when good systems get sold, and that’s happening. There’s a trend today where the bigger guy eats up the smaller guy and the relationship changes. We had that experience here in Sault Ste Marie where Provigo bought out Loeb and wiped out two of our best corporate citizens overnight. They slept in their stores for two weeks to protect their interests. That’s how difficult that was.

We’ve heard that 241 Pizza has just bought out Robins Donuts. What happens if tomorrow Pizza Pizza buys out Tim Hortons? Do you have anything in your agreement with your franchisees that protects them in that instance?

Mr Javor: That’s a very good question, Mr Martin, because this is the day of mergers and acquisitions. This is the business strategy of a lot of folks. I would answer your question with perhaps a description of our franchisee relationship. I think successful franchisors and chains and brands get successful not by accident but because of the hard work and everybody’s focused on a mutual goal. The mutual goal in our organization, and other franchisors who have been privileged to be as successful as us, is clear: to deliver customer service and realize that the way we get excellent customer service is by having franchisees who are committed to that. We have a strong culture of excellence and commitment. I think it would be very difficult for a new ownership group to come in and absolutely take away what’s taken us 30 years to earn and to grow together with our franchisee ownership.

The fact that we involve our owners a lot in our business at the advisory board level and committee level that I mentioned earlier I guess is a testament to the strength of that commitment we have to ourselves in the marketplace, and that is bigger than the contract. It takes many years to change cultures at corporations. Those of us here who have been in private business over the years understand that. Truly, yes, the top of the house or the CEO and president help set the tone – that’s well-documented research – but also when you have a strong commitment at the grassroots level in your community, where your franchisees are absolutely actively involved in supporting your community, because they know where their bread is buttered. It’s not downtown Toronto, it’s all the communities where we have stores in our particular chain across the country.

I honestly think that when a merger and acquisition comes along the strength of the brand will come through based on these types of commitments and relationships.

Mr. Javor and Tim Hortons were active in the spirited behind-closed-doors debate of the proposed amendment to the Arthur Wishart Act, Bill 102 in 2010: here, here and MPPs seek anti-swindling law for franchises.

Mr. Nick Javor, LinkedIn

Where will the real “fat” be trimmed at Tim Hortons: the head office or on franchisees’ bottom lines?

The Globe and Mail reports on the new Tim Hortons president, Mr. Diaz Sese:

…Mr. Diaz Sese, who has law and business degrees and previously worked for French sporting goods retailer Decathlon, is moving from Singapore to Oakville, Ont., to take the Tim Hortons job, the company said last month.

Mr. Diaz Sese’s experience heading up Burger King’s expansion overseas fits in with Burger King’s goal of global expansion for Tim Hortons. The company says he tripled Burger King’s annual rate of restaurant growth in Asia.

Mr. Fisher said the new CEO, Mr. Schwartz, is part of a new breed of young leaders in the food service industry. “He’s got a reputation for cutting the fat and running lean operations.”

Yes, 3G Capital cut head office costs at Burger King in that takeover in 2010. But they had also had many corporate stores to sell for a quick cash hit.

This time, there are almost no Tim Hortons corporate stores to sell.

Just 3,800 franchised stores.

Originally posted on ConcernedTimHortonsFranchisees.ca.

Why do franchisees stay in a money-losing venture much longer than an independent business person would?

It’s because of the actual nature of franchising.

Specifically the sunk cost investment dilemma that manifests itself in franchisor opportunism.

B. The Franchisee’s Problem: Opportunism
… An unrestricted exercise of control by the franchisor will favor the franchisor’s interests over the franchisee’s and create an equally significant problem for the franchisee: risk of opportunism.

For the franchisee, the most significant economic feature of franchising is the allocation of capital investments. Franchisees are distinct from ordinary employees because they have made capital investments in the business. These investments, however, are normally highly idiosyncratic, meaning that a large fraction of the franchise assets often have a greatly diminished value if employed in another line of business. Consequently, the costs of establishing a franchise are effectively sunk costs, which, once expended, are not easily recovered if the franchise goes out of business.

Sunk costs play an important role in creating the incentives that operate within an established relationship. This is best understood by considering the difference between fixed costs (overhead or up-front costs) that are sunk and those that are recoverable. For example, consider a business in which a variable cost of production has increased dramatically, so that the highest price in the business can charge for its product covers only the marginal cost of producing it, leaving nothing to contribute to fixed costs. Although the business can cover its variable expenses, such as wages and ingredients, it is making negative profits because it has nothing left over on its investment in overhead assets. If the business can resell these assets to recover its fixed costs, then the business can raise its profits to zero by shutting down and selling off the assets. If, however, these assets are sunk assets, then, by definition, their sale will not recover their full cost; shutting down will still leave the business with negative profits. If the business has any revenue left after paying variable costs to defray the cost of these assets, the profit-maximizing decision is to continue to operate, instead of junking the assets entirely and losing the whole investment. The key difference is that a business with recoverable fixed costs will shut down as soon as it shows losses, employing its capital more profitably elsewhere. A business with sunk costs, on the other hand, will continue to operate even though it has never recovered its investments in fixed costs, and it will not shut down until the amount it is losing exceeds what it would lose by simply abandoning the investment. [my emphasis]

The incentive that causes a business with sunk costs to stay in operation despite losses makes franchisees vulnerable to franchisor behavior known as “opportunism.”. Because the franchisee will continue to operate even if it is not recovering its sunk investment, the franchisor can make decisions that induce such losses without the franchisee going out of business. When these decisions benefit the franchisor at the expense of the franchisee, the franchisor opportunistically extracts a portion of the franchisee’s sunk costs. A franchisor can potentially extract this value from the franchise directly in a number of ways: it can raise the price of goods sold to franchisees, increase rent, boost royalties through an increase in the required volume of a franchise, levy fees, or divert advertising funds to general corporate uses. Extractions can occur indirectly as well. To increase the price of new franchises, a franchisor could require franchisees to make excessive advertising investments, to participate in promotional programs which are not cost-effective, or to undertake unnecessary renovations.

Just as the risk of free-riding makes control a central concern for the franchisor, the risk that franchisors will extract sunk costs makes opportunism a central concern for franchisees. These concerns meet head on: Where franchisors seek to expand their control, franchisees seek to erect boundaries. In some circumstances a franchisor’s decision to require increased advertising by franchisees, for example will reflect a legitimate exercise of franchisor control to overcome free-riding. But in other circumstances, it will reflect only opportunism.

Excerpt from Problematic Relations: Franchising and the Law of Incomplete Contracts, Gillian K. Hadfield. See full 1990 Stanford Law Review article on WikidFranchise.org

Many decades of very profitable franchisee relationships can

turn on a dime

when the franchisor decides to exercise their discretion in a more self-interested way.