Few topics provoke greater debate in the franchise sector than the issue of churning. It is a hugely controversial issue that has the capacity to draw strong responses from both franchisors and franchisees alike, though from entirely different perspectives ranging from denial to claims it is endemic in the franchise sector.

But what is churning and why is it such an emotional issue?

The reasoning behind this view is that a franchisor who is able to reclaim and resell the business will enjoy greater profits than from any ongoing royalties that might have been generated by the business. The more times the business sells, the more the franchisor makes. In other words, the franchisee’s failure is a planned outcome designed to unjustly enrich the franchisor, irrespective of the financial and other costs incurred by the franchisee.  

At the other end of the scale, churning has also been used to describe the practice of franchisors buying back profitable franchise operations at lower-than-market values to increase their portfolio of company-owned outlets in a strategy also designed to increase their own ongoing profits. (After all, 100% of the profits of a successful outlet may be substantially greater than a much smaller percentage of the outlet’s gross turnover).

The reason that churning is so controversial is because it is totally contrary to good franchising practice, which views the relationship between franchisor and franchisee as one of economic interdependence where both parties are able to profit by working in partnership – one to provide the brand and operating systems for a successful business and the other to provide the human and financial capital to operate such a business.

As utopian as the concept of mutual economic interdependence may sound, it is also somewhat naïve. In reality, the partnership is not one of equals coming together. In order to be given access to the franchisor’s brand and systems, the franchisee agrees to forego his or her independence, and once the decision is made to join a system, the franchisee’s choices thereafter are substantially constrained by the terms of the franchise agreement they have signed.

In itself a limitation of choice is not always a bad thing and a vast number of franchisees profit from this limitation of choice through structured, viable and well-managed franchise systems. However in the context of churning, the choices available to franchisees captive to loan and lease payments frequently boil down to take it or leave it options which can both result in losing money - the franchisee’s choice is limited to losing a lot now, or even more later.

Franchisees who attribute their business failures to churning are a vocal and passionate group who seek recompense, revenge or both for the traumas they have experienced, and former retail franchisees in particular are the most vocal as generally their losses through a business failure are far greater than those of a service franchisee.

The cost of churning to a franchisee affected by it is staggering. They can suffer massive financial losses, including their home and position in society. Worse still, they lose hope for a bright future, are consumed by fear, doubt and anger, crippled by debt, and rarely (if ever) consider franchising again even if they are able to financially recover.

Where churning exists as a deliberate franchisor strategy designed to hasten the failure of franchisees so that stores or territories can be sold again and again, it should be prosecuted to the full extent of the law.

Unfortunately proving that a franchisor deliberately intended to cause the failure of a franchisee is vastly more difficult than alleging that this was their intent.

While dishonesty can be found in all walks of life (and franchising is unlikely to be immune from this), it is difficult to imagine that a serious and committed franchisor would endanger the integrity of their brand by engaging in such activity. If they do, it is only a matter of time before they will come undone.

In the main, I believe (however naively after 18 years in the franchise sector) that franchisors have the best interests of their brands at heart, and therefore would reject the deliberate churning of franchisees for the inherent risks such a practice poses to the long-term credibility and therefore viability of their brand.

However such lofty principals can be easily undermined by a franchisor’s lack of talent or capacity to manage a growing franchise network. Poor internal controls, inadequate procedures, poor staff or franchisee selection, little or no training, overly ambitious growth targets, unscientific methods of site or territory selection, bad marketing, unfavourable leasing deals, cost overruns, greed, etc, by a franchisor can all profoundly impact the viability of the business model and the success (or lack thereof) to be derived from it by a franchisee.

Just one of these factors may be enough to set in place a sequence of events that could lead to the failure of a franchisee (in addition to any of their own potential shortcomings, such as unsuitability to the business, inadequate working capital, etc), but if any combination of these factors are present, then the negative consequences for franchisees can increase exponentially.

Most franchisors have a clause in their franchise agreement that gives them first option to buy a franchisee’s business as a going concern, or to buy the fit-out, equipment or stock at its written-down value. For retail franchisors, a franchisee failure resulting in a closed store is seen to be hugely damaging to the brand. Furthermore, the franchisor may be exposed to the lease if they were subletting to the franchisee. These two factors can easily lead to a situation where a franchisor will continue running the store until such time as it can be resold. Unfortunately, if there is no material change to the store’s circumstances, a new franchisee may soon find themselves in the same financial distress as the previous franchisee, and the whole process begins over again.

This may look and sound like churning to an observer and to the franchisees involved, due to the net outcome of the same franchise being constantly resold, but what is absent in this scenario is the deliberate intent of the franchisor to cause the franchisee to fail.

Bad franchisor management decisions have consequences for franchisees. It is not unreasonable to expect some accountability for such decisions. However, the emotive issue of churning may not be the blanket term that should apply in such instances. Poor franchisor performance versus a wilful attempt to deceive are two different things, yet both are tarred with the same brush.

Where franchisors have robust and transparent systems and processes in place to make decisions that affect franchisees, and can defend those decisions if required, the perception of churning will fade. Until then, franchisors remain vulnerable to such allegations.

© 2008, Jason Gehrke