Why do franchisees stay in a money-losing ventures 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 WikiFranchise.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.

There was one glorious time when the truth about Big Franchising was revealed and recorded.

Four days in 2000.

March 6, 7, 8 and 9.

Public hearings into the franchise relationship. Four days of traveling public hearings: Toronto, Sault Ste. Marie, Ottawa and London. Ontario, Canada. Traveling public hearing: extremely rare, if not unheard of, under the Mike Harris government.

Approved by the former Ontario  Minister Robert Runciman over a beer with Tony Martin at the Queen’s Park members’ bar. Two men who share a love of democracy as expressed in the Legislative Assembly of Ontario.

• 35 life stories told in 20 minute chunks to the Standing Committee on Regulations and Private Bill.
• 4 expert witnesses given 45 minutes (John Sotos lawyer, Susan Kezios franchisee expert, Dr. Gillian K. Hadfield scholar and Richard Cunningham franchisor advocate).
• and me, Les Stewart, franchisee advocate.

I had the tremendous honour of traveling throughout Ontario as before these life stories were twisted into the Arthur Wishart Act (Franchise Disclosure), 2000. I seemed to have made an impression on the politicians.

Of the current MPPs (107), I know 29 of them. One Minister since I was 17 years old. 45 minutes from my house to their House.

It happened once.

It can happen again.

— The Legislative Assembly of Ontario, looking north to the main doors, University Avenue, Toronto Ontario

Undue Influence: The Case of the AUS Professor

Publicly funded institutions can become co-opted or captured by special interests.

Some university faculties have a better or worse reputation for pandering to special interests when compared to other disciplines. Business schools are not well respected by other faculties for their independence of thought.

I’ve seen it at my old school and confirmed it in other universities as well.

The Greeks defined 3 modes of persuasion:

• logos (reliance on facts and figures: can be true or false),
• ethos (authority, honesty of speaker, morality), and
• pathos (appeal to emotions, sense of injustice, outrage).

Franchisees appear in front of public hearings and rely almost entirely on the rhetorical device of an appeal to justice: “It’s not fair that they did this and that.” Policy makers listen and judge its “truthiness“.

• Generally, their narratives are concrete, visceral and credible.

Big Franchising responds if they have any remaining credibility, directly with at times shaky logos and ethos.

1. Consider the following article in Australia’s SmartCompany: Survey reveals drop in franchising disputes as franchising inquiry continues.

It says:

A new survey of Australia’s $130 billion franchise sector has shown disputes between franchisees and franchisors have declined, with just 2% of Australia’s franchisees classified as being in dispute.

Let’s stop there and list the persuasive assumptions that this single sentence relies upon:

• survey: a scientific, logical, rational, independently verifiable academic study that is reviewed by other academics [did it appear in a refereed academic journal? no],
• $130 billion sector: size matters: infers that big = successful, growth is good [uses social proof, is a huge credit crisis and run-away cancer growth good?],
• declining number of disputes: situation is getting better [what is a dispute? how many have abandoned? is the mean dispute big or small?],
• just 2% of franchisees in disputes: tiny problems, inconsequential, minuscule [can use anchoring to deceive].

This opening sentence is strictly a blatant misrepresentation, lacking in any connection to formal logic or any verifiable measure. The “just 2%” is a hallmark give away as to lack of any journalistic standards or any pretense of editorial oversight. Shame on SmartCompany but why is a university named?

If the 2008 Report is similar in method to the 2006 Report, it may be junk science: bought and paid for by its funders, the Franchise Council of Australia. Franchisor-controlled associations are well-known for blocking any changes to a statute, regulations and public regulatory body mandate.

You decide.

2. Next, let’s take a look at more detail into the role of the Griffith University. See the FCA’s media release: THE POWER OF ONE STRONG SECTOR REVEALED IN POSITIVE RESEARCH FINDINGS

Authority is clearly defined as another Weapon of Influence by social psychologist Robert Cialdini that can be applied to universities. They can be used to give the impression of academically rigorous research when really the work is simply a consultant’s report.

I don’t begrudge business admin profs or their peers earning the vast majority of their income from consulting to one or the other industry.

What I wonder is whether it is appropriate for an academic to overstates their conclusions (either intentionally or unintentionally) during a time of national lawmaking?

You decide if Professor Powell has exercised undue influence or abused his duty:

“The continued growth and maturation of Australian franchising is impressive, particularly considering the current economic outlook, a recent change of government, and a franchising sector that has faced close government scrutiny” said Professor Michael Powell. Pro-Vice Chancellor (Business), Griffith Business School.

Did Professor Powell interfere with the Parliamentary Joint Committee on Corporations and Financial Services’s Inquiry into the Franchising Code of Conduct? I checked the 140 written submissions and didn’t see his name.

The test could be: Did he know or would he be reasonably been expected to know that his publicly funded authority could be used used to influence [inappropriately interfere?] with the operation of a  parliamentary committee?

1. True scholastic work is published in refereed professionally-recognized journals to ensure high quality (an editor and reviewing peers, correct methodology, usually a very, very narrow scope, transparent auditing, meets ethical and conflict of interests standards, vetted before publishing, etc.). There is a whole series of checks and balances to weed out biases [innocent and not so innocent].
2. Consulting work, no matter how many PhDs are piled up, has none of these centuries-old safeguards in place.

• Blurring these lines is not fair, especially during a time of a fairly controversial public lawmaking process.

Academic research is a credence good and as we have seen, is susceptible to cheating because “Joe Public” cannot determine if it is the appropriate quality or quantity.

I have read enough articles and progressed far enough in a good school to seriously question the validity and reliability of this work. I imagine any academic that values their reputation would not rely or quote this report in their submission to the Joint Committee.

Unfortunately, some scholars are more closely attuned to serving dominant commercial objectives rather than the pursuit of reality-based truth (as opposed to power-based truth) as is their duty as a tenured academic.

My qualifications only go so far to speak on behalf of academic rigour and the arguments not made [eg. sunk costs as the primary and unique source of franchisor opportunism] in the current Australian public hearing.

If a second opinion were to be sought, I believe Gillian K. Hadfield might be an appropriate candidate. pdf CV

Incomplete Contracts: You will Pay me what I tell you to pay me, after you sign

All contracts are not the same.

Most people think of contracts as a “promise for a promise” and that’s not a bad rule-of-thumb. Sort of “I agree to pay $x for you to perform y service for me.” This is what is called a complete contract.

So far so good.

However, some contracts aren’t so simple and they tend to cause all kinds of grief. They’re are called incomplete contracts.

They in effect say: I will tell you what you will pay me, when I (maybe, unilaterally) decide to.

• Sounds pretty dodgy, doesn’t it?
• Who in their right mind would sign such a deal?

However, there are very good, sound reasons for entering into an incomplete contract. The strength of franchising is its ability to adapt to changing market conditions. This is the ability that you are paying for.

There is a defined reliance nature (superior:subordinate roles in both economic power and information) that creates a risk of overreaching or opportunism by the dominant party.

There is nothing personal or brand-specific about it: It’s just the nature of the beast. All franchisors are carnivores. Some have better table manners, that’s all

• This is where the core problems in franchising arise and why there is so much trouble.

Without understanding the difference between a complete and incomplete contract, discussing potential remedies is foolhardy.

The definitive academic work in this field continues to be Problematic Relations: Franchising and the Law of Incomplete Contracts by Gillian K. Hadfield.

Download Problematic Relations

The problem is the regulators and Courts (because they are not given specific enough instruction by law-makers) only see the one-sided contract and interpret narrowly only what is within the “four corners of the contract”, to predictably one-sided results.

Hadfield:

Predictably, the franchise disputes that appear in court center on the franchisor’s exercise of its significant, relationally constrained but formally unfettered powers. And unfortunately, drawn to the model of the complete contract, courts tend to view the formal written contract as representing the entirety of the commitments structuring the franchise relationship. In practice, this approach amounts to a “business judgment” rule of enforcement: Provided that franchisor articulates some plausible business rationale for its actions, courts will not interfere.

In doing so, however, the courts fail in their traditional task of enforcing the true exchanges reached by the contracting parties.

There are solutions to this short-sightedness but they require tremendous discernment by parliamentarians.

Defining Unconsciounable Conduct: Is Opportunism present?

The franchisor says that his decision is allowed under the contract and is a legitimate exercise of their discretionary power.

The franchisee screaming bloody murder says that’s only an excuse and the real reason is…

• Who do you believe: is it an excuse or a reason?  Is he a saint or a sinner?

This is a very real problem for not just judges, regulators but franchisors and franchisees. Luckily enough, a test was proposed (but not used) by a Canadian born business and law academic, Gillian K. Hadfield in 2000.

Gillian Hadfield was an expert witness at the Ontario, Canada public hearings that led up to the Arthur Wishart Act (Franchise Disclosure), 2000. Ontario Legislative Assembly Hansard, download testimony pdf

Hadifield starts off by saying that franchising has a distinct nature and a vulnerability to franchisor opportunism:

Franchising is characterized by a separation of ownership and control over the assets in the business. Franchisees own the assets; the franchisors control them…

That separation of ownership and control, however, also creates vulnerability. The fact that somebody else is controlling your assets means that you’ve got to be a little bit worried about whether they’re going to be putting them to the best use for you, or whether they’re going to be taking advantage of them.

Hadfield then explains about the sunk cost problem that franchisee’s face and provides an example of how $30,000 could be stripped away via exercising their discretionary powers opportunistically (eg. forced renovations). Free pdf

Hadfield argues that whatever you call a duty to protect against opportunism (good faith, fair dealing) what is important is what you instruct the Courts to have it mean.

One of her main recommendations is an Opportunism Test:

What’s important here is not what you call it but what you understand it to mean and what eventually courts or other enforcers understand it to mean, including what franchisors understand it to mean.

What I’m going to suggest to you is that what it needs to be understood to mean is that franchisors are explicitly obligated to exercise their discretion as if it were their own assets at risk.

Because if they’re not, that means they’re taking advantage of the fact that there is a separation of ownership and control and making a decision that, if they were the ones who had to renovate the outlet, would not be a good business decision.

Sometimes it will be, but how do you decide if it’s a good business decision or if it’s advantage-taking? You ask, “Would the franchisor have done it with their own outlet?”

Any unconscionable conduct inclusion should include Hadfield’s opportunism test:

Would the franchisor in a disagreement have acted differently IF the ownership of the assets were switched?

• NO? Then it probably is a legitimate franchisor decision.
• YES? Then the franchisor is probably using the frnachisee’s sunk cost investments to unfairly squeeze more cash from the franchisee.

Without direction to regulators and the Courts, unconscionable conduct will be as hollow a term to investors as good faith, fair dealings and commercial reasonableness have been in North Amercia.

Credence Goods attract Experts who Cheat

If I had to choose the second concept that was critical to know in the study of franchising, it would be This one.

HINT: If they’re talking about protecting franchisees and not talking about credence goods, they’re all hat and no cattle [all show and no go].

Some goods and services, by their very nature, come with much higher risks than others. These risks can be compounded and therefore astronomically high if:

• there are few experts to choose from in a market,
• the costs of switching experts is very high,
• this is the first time you have contracted for these expert services, and
• the experts organize themselves to protect one another.

As we shall see, franchising has compounded, interdependent and very aggressive expert stakeholders [see Big Franchising: franchisors, franchise bar, lenders, sales agents, consultants, politicians, media, etc].

• As a franchise investor, you are at a severe disadvantage because of credence good service providers.

A Credence good is a good or services with the following 3 characteristics:

1. the value is difficult or impossible for the buyer to determine accurately before they buy it,
2. the buyer can’t know if it was useful [even after they did buy it] and
3. also, the seller does know the value of #1 and #2 [could therefore exploit this ignorance for their own self-interest: information asymmetry leads to opportunism risk]. Wikipedia

Uwe Dulleck and Rudolf Kerschbamer:

Consumers’ concerns about being defrauded seem not to be unfounded: Emons (1997) cites a Swiss study reporting that the average person’s probability of receiving one of seven major surgical interventions is one third that of a physician or a member of a physician’s family. Wolinsky (1993, 1995) refers to a survey conducted by the Department of Transportation estimating that more than half of auto repairs are unnecessary…These examples reveal that infomational asymmetry matters. Free download: On Doctors, Mechanics and Computer Specialists – The Economics of Credence Goods

Gillian K. Hadfield, University of Southern California:

Economists refer to a good as a credence good if it is provided by an expert who also determines the buyer’s needs. Buyers of credence goods are unable to assess how much of the good or service they in fact need; nor can they assess whether or not the service was performed or how well. This puts buyers at risk of opportunistic behavior on the part of sellers: they may be sold too much of a service or billed for services not performed or performed poorly. Theoretical work on markets for credence goods predicts that markets for credence goods may be characterized by fraud (billing for unnecessary services or services not performed) and a price mark-up over cost…Legal services are credence goods… Free download: The Price of Law: How the Market for Lawyers Distorts the Justice System

Winand Emons, University of Bern:

With a credence good, consumers are never sure about the extent of the good that they actually need. Experts such as doctors and lawyers, as well as auto mechanics and appliance service-persons (the sellers) not only provide the services, but also act as the expert in determining the customer’s requirements. This information asymmetry between buyers and the seller creates strong incentives for the seller to cheat. Free dowload: Credence Good Monopolists

We will come back to credence goods and how these types of services really help value being stripped from investors with deceit [opportunism].

Oz Churning “Debate”

Jason Gehrke writes a weblog called Franchise tips and trends in http://www.smartcompany.com.au. His latest article, Churning: The dark side of franchising, is predictable.

I tried to submit a comment but was unable.

Here is what I would have submitted:

First the industry experts said “There is no churning.” Second, they say, “Well, yes, there is but…There’s just a few bad apples.” And, now, they add: Proving how bad a franchisor abuses their franchisees is difficult anyway (so why bother?).

Who are Australian small business investors going to believe: Franchise experts who keep changing their stories or returning foot soldiers from the franchise front? I have every confidence that people recognize BS when they see it.

1. Churning is a cluster of franchisor behaviors that results in financial catastrophe for the investor. These exercises of discretion within the incomplete contract are perfectly observable, auditable and quantifiable.

How often the abuse happens is irrelevant. Every franchisee knows what happens when you step out of line. Crucifixion was a very effective behavior modification technique.

2. There are no “good” systems or “bad” brands. The ability for franchisors to exercise their discretion in an abuse way (opportunism) arises from the very heart of the relationship. In franchising, the franchisee owns the majority of the store’s assets but the franchisor controls them. It is its great strength and its great source of abuse (it’s someone else’s money).

Attributing intentions (Oops sorry to cut your head off, there buddy. Does it ease your pain that I, admit, am an idiot?) means less than nothing. A family’s bankruptcy forms do not list someone else’s intentions.

3. To say that it is difficult to prove predatory business practices is a misrepresentation.

In Ontario, Canada, Gillian K. Hadfield presented a very simple rule to determine if a franchisor’s behavior was opportunistic: Would the decision in question have been made IF the franchisor HAD owned the franchisee’s assets THEMSELVES? If no, then the franchisor likely abused their dominant contract and economic position.

Example: Would the franchisor voluntarily pay the same price for the products that they FORCE their franchisees to buy from head office? Yes or no. Would they buy or shop around and get better value from another source of supplies? Is the contract being used to squeeze a hidden franchise tax from captured investors? Same thing with head leases, equipment purchases, renewals, etc.

Big Franchising wants everyone to stay asleep and they have a +30 years Oz history of saying anything to maintain their dominance. Get Smart.

Franchising is Unsafe at any Brand.

Les Stewart MBA
Midhurst Canada
lesstewart.wordpress.com

Hadfield on Opportunism

Gillian K. Hadfield wrote Problematic Relations: Franchising and the Law of Incomplete Contracts in 1990. It remains the gold standard of defining why franchising remains such a difficult area for the law to deal with.

See here’s the rub: Franchisors legitimately require discretion because no contract could ever be written that would exactly specify, to the penny over many years, through market changes what each party will do. That’s fair.

What is not fair is when a franchisor exercises his discretionary powers in a way to strip a franchisee’s [and their family’s, usually] labour, life savings, credit worthiness and future earnings. This is possible largely because the investment is trapped [sunk cost] and dependent on the franchisor’s whim.

The Problem for the Law: Did a franchisor have a legitimate business reason for doing what it did OR is it just acting as a predator? This is what judges have a hard time dealing with.

You can can download a copy here.

Hadfield’s 2000 expert testimony to the Ontario government is also presented here. She presents an excellent judicial test for opportunism and I got to help with the overhead projector.

• Opportunism fueled by sunk costs: the most important and distinguishing characteristic of franchising. If you aren’t talking about opportunism, you are wasting your time.

A very useful thumbnail sketch of Problematic Relations is provided by Michael Webster here. The franchisors problem is quality control but that is fairly easily solved.

The franchisee’s concern is defending against opportunism.

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.

It is this point: franchisees will continue operating a losing business [long past the time an independent business would have abandoned it] because of their sunk costs.

 

Bothams WA Inquiry Sees no Evil…

Chris Bothams released his final report this week entitled: “Inquiry into the Operation of Franchise Businesses in Western Australia”.

You judge for yourself: How close to your experience is it? (free download).

Pro:

1. a national franchisor registration would be nice (including the sunk cost-captured franchisees, of course), and
2. make proposed government-submitted disclosure documents accessible on the internet (just like Caleasi in California is now).

Con:

1. it is +30 years behind the times,
2. potentially misleading, and
3. mostly irrelevant.

As far as intellectual rigour goes, let’s compare Botham’s report to a Canadian report. In 1971 Samuel Grange who retired as an Ontario Appeal Court justice, said this about franchising:

Throughout the evidence it was a recurring complaint that the franchisee is constantly plagued with the threat of termination of the franchise…

Further…

…the franchisee has invariably invested time and money, and he knows that he will lose it all if the franchise comes to an end. Naturally, he is prepared to be servile, and if not, he is generally not long for the franchise family. p. 40 [my emphasis] [Grange Report full monty]

Unlike Mr. Bothams, Grange did his insightful work without the benefit of reading Gillian K. Hadfield’s work, especially Problematic Relations: Franchising and Law of Incomplete Contracts [BTW: 49 of the most important pages ever written about franchising].

Mr. Bothams ignores the unique vulnerability that franchise investors suffer from (vis-a-vis independent business):

Franchisees own the unit’s assets but their life savings are controlled by someone else (the franchisor).

This ownership/control separation is makes the relationship totally unique.

The franchisor can further use their 101 discretionary powers to further strip time and money from the investor during the course of their relationship.

To mention only once and in an extremely narrow reference, the central fact of franchisor opportunism, suggest the inherent bias of this report.

My Contributions: Please also note on page 68 (Appendix 3: List of Submissions), Number 2: Les Stewart Consulting. That’s me. For what it is worth, I sent the most current, internationally recognized academic research to Mr. Bothams’s office.

This report goes out under his signature to Minister Margaret Quirk. My guess it will quickly sink out of sight.