Franchising has become the dominant mode of retail entrepreneurship in the United States. There are 1.5 million franchised outlets, accounting for approximately one-third of all U.S. retail sales. Franchising is growing at roughly 6 percent per year, as franchises replace independent businesses in industries as diverse as fast food, banking, and Internet services.1
In each of the past several years, more than 200 new franchise systems have been born.2 Eager franchisees pay franchisors large up-front fees, sometimes more than $1 million, to buy the rights to establish a new outlet. The franchise fee is just the beginning of the investment. New franchisees are often required to purchase specific assets, like signs, menus, equipment, and training, that cannot be recovered or easily put to other uses.
While all investments have an element of risk, many people assume that franchisors are selling a formula for success. However, roughly three-quarters of all new franchise systems fail within twelve years.3 Since the average initial franchise contract is for fourteen years, fewer than one in four new franchise systems survives until the end of the contract. Because an investment in a failed franchise system has little value for the investor, this failure rate means a high level of risk for the thousands of Americans who buy franchises every year. Potential franchisees need a way to identify new franchisors who are likely to succeed.
In our research, we have developed a model to help identify sucessful new franchisors. By understanding the model, potential franchisees can find the franchises that are likely to survive and build valuable brand names. No matter the industry a franchise system starts in or where it’s located, these interrelated factors determine the new system’s probability of survival:
- Rapid growth means that the new franchise system reaches minimum efficient scale to promote the brand name competitively with established firms.
- Allocation of local managerial activity to franchisees and minimized support services speeds the rate of growth.
- Demonstration of trustworthiness and high quality of operating systems and other intangible assets through credible commitments attracts potential franchisees despite low support.
In our research, we studied 157 companies, in 27 industries, that first began to franchise in the United States between 1981 and 1983, and examined their performance from 1984 to 1995. We obtained information on 53 different dimensions of new franchise systems, both survivors and nonsurvivors, for each of the 12 years.