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How franchisees get blinded by unrealistic optimism

February 14, 2017
Business strategy

  ​Disclosure regimes don't stop people from hoping for the best

Anyone starting their own business needs a healthy dose of optimism. But recent research suggests that those buying into franchises are too optimistic and blind to some of the risks they are taking. 

Franchising appeals to a wide range of people who sometimes don't have experience in running a business – wage earners who have lost their jobs; retired, professional sportsmen whose careers have come to an end; military personnel who have left the services; and migrants who may have poor English but are keen to work. 

When it works well, franchisees buy into an already successfully franchised brand and receive training and support from the franchisor as they grow their own business.

However, research by Jenny Buchan, a professor in the school of taxation and business law at UNSW Business School, and her colleagues Uri Benoliel and Tony Gutentag, calls into question the effectiveness of disclosure regimes, which are designed to make potential franchisees aware of the risks. 

Franchisors – businesses that sell franchises to franchisees – are required to provide disclosure documents about the state of the franchise operations to allow potential purchasers to assess the risks associated with the business. 

The researchers discovered franchisees underestimated the risks of going into a franchise business, even after they received the documents. 

"Franchisees, despite being business people who make large investments in the franchise, suffer from an inherent cognitive constraint known as unrealistic optimism. 

"Due to them being overly optimistic about the future, it is expected that franchisees would systematically discount risk-related information disclosed under disclosure laws," the researchers write in Revisiting The Rationality Assumption of Disclosure Laws: An Empirical Analysis.

'You'll have independence, you'll have credibility, you'll have the pride of belonging to a well-known brand and so on - and that does heighten the sense of optimism'

– greg nathan

Prospective hazards

The researchers conducted an online survey of 205 franchisees in the US, which asked them to assess the risk that their franchisor would take back their franchise to either operate it themselves or resell it to another operator.

Such occurrences are not unknown in the franchise sector. The number of times either has happened in the franchise brand is specified in a mandatory US disclosure document.

A franchisee who does a good job of establishing their business in their area can find the business is taken back from them by the franchisor on some spurious grounds, yet which are allowed in the franchise agreement.

The researchers found that the surveyed franchisees believed the chances that their franchisor might opportunistically terminate their franchise were significantly lower than that of an average franchisee in their chain and state.

An assumption that underlies current disclosure laws is that those people who are receiving the disclosures are intrinsically rational. Thus they are presumed to be able to rationally assess the risks involved in contracts and avoid those risks.

"Our results ... cast significant doubts over the effectiveness of disclosure laws in protecting disclosees from prospective hazards," the researchers conclude.

While the study was conducted in the US, Buchan says the same concerns apply in Australia. Potential franchisees in Australia receive a wide range of documents.

According to the Franchising Code of Conduct Compliance Manual, published by the Australian Competition & Consumer Commission (ACCC), these include a copy of the Franchising Code of Conduct, the franchise agreement in the form in which it is to be executed, and information about the franchisor's solvency at the end of the past financial year.

They also receive the number of existing franchisees, their locations and contact details, and the number of franchised businesses that were transferred, terminated, bought back or not renewed in the past three financial years, and the owners' contact details.

Whole pile of cards

The ACCC requires franchisors to include in their disclosure document "a warning that, like any business, the franchise (or franchisor) could fail during the franchise term, and that this could have consequences for the franchisee".

But this leaves out a raft of risks, says Buchan. Along with losing the right to use the franchise brand, the franchisee could lose their retail lease and hence the right to trade out of a shop which they have paid to have fitted out.

The problem is even worse when there is an overseas franchisor, who in turn has a master franchisor in Australia selling local franchises. If the overseas franchisor fails, its liquidators probably owe no legal duties to the Australian master franchisor or its franchisees.

Second, franchisees usually aren't creditors of the franchisor, so generally don't receive anything from an insolvency.

"The whole pile of cards just falls to pieces," says Buchan.

It's not only those inexperienced in business who make bad decisions about buying into a franchise. There are many instances of experienced business people also losing their investment.

Despite the risks, franchising is a popular way to get into business for many Australians. In 2014, franchised businesses in Australia generated an estimated $144 billion in sales. There were 1160 business format franchisors and an estimated 70,000 franchisee-owned business units. More than 460,000 people were employed directly in franchising.

According to Buchan, disclosure is a good starting point, but it needs to be backed up with more education for potential franchisees. She recently ran an open access online course on international franchise law.

"And there is a real case for people to be forced to sit down [with their lawyer or accountant] and assess how it could personally affect them and their assets and their family if the risks that cause the greatest harm do happen," Buchan says.

Painting a rosy picture

Some optimism isn't necessarily a bad thing for franchise operators, says Greg Nathan, the founder of the Franchise Relationships Institute, which helps franchise companies better manage their people issues and conducts research into the industry.

A survey of nearly 3000 franchisees by the company found that those which were more optimistic performed better.

"People who had a tendency to be more optimistic were delivering better customer service and they were making more money – 14% more money," says Nathan, a registered psychologist.

Nonetheless, Nathan agrees that too much optimism can blind people to risks and he says part of the problem is franchise sales people or "franchise development managers".

"The franchise developer person paints a picture of what your life could be like as a franchisee. You'll have independence, you'll have credibility, you'll have the pride of belonging to a well-known brand and so on – and that does heighten the sense of optimism," he says.

He agrees with Buchan that potential franchisees should get a good briefing from their lawyer, but notes that they will be unable to change or negotiate the franchise agreement.

"If you go in with your eyes open and you've done your due diligence and you believe that you can make a better fist of the business being part of a brand and having systems behind you, then I think that's a business decision," Nathan says. 

'As much as governments regulate to prevent the exploitation of franchisees, nothing will prevent people making bad and ill-informed decisions’
– jason gehrke

Being your own boss

Jason Gehrke, a director of the Franchise Advisory Centre, which advises both franchisors and franchisees, says part of the problem is that for many people buying a franchise is an emotional decision.

"In Australia, we have two great Australian dreams – one is to own your own home and the other is to be your own boss," he says.

"After falling in love with the idea of home ownership or business ownership, we then seek to rationalise those decisions by the processes of due diligence that we undertake afterwards. Of course, with home ownership, one of the biggest processes of due diligence is whether or not the bank is going to lend you the money to buy it."

While the caution of a lender also exists when investing in a franchise, just because a bank lends money to a franchisee the money doesn't mean the bank is confident of the franchisee's success, just that it has enough security to protect its interests if the franchisee fails.

Gehrke says disclosure regimes will never overcome a blindly optimistic franchisee rushing ahead and says increased education can help only so much.

"You can lead a horse to water but you can't make it drink. As much as governments regulate to prevent the exploitation of franchisees, nothing will prevent people making bad and ill-informed decisions," he says.

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