Franchise Fraud and Churn

To really understand franchise fraud, you must understand “churn.”

Churn, or disorderly attrition, is defined as (transfers + terminations + non-renewals + ceased operations) / the number of franchise units in any one franchiSOR’s system.

In a nutshell, churn is the number of franchiSEES who are not succeeding or who are leaving the franchise system… for whatever reason… divided by the total number of units in the system. It is generally calculated on an annual basis and is expressed as percentage.

The percent of total franchiSEES who are leaving the system each year is a big deal for a couple reasons:

First, in general, franchiSEES sign very dangerous franchise agreements, risking everything, to join the franchise system. FranchiSEES don’t want to leave, they invested in the franchise because they believed they would make money.

When franchiSEES leaves a franchised system, they may be losing their life savings and their homes. And when they leave within the first year or so, they have quickly gone from deciding to make a business decision to losing everything they own and possibly even facing litigation from their franchiSOR. For example, FranchiSORS can use the franchise agreements and contract law in the court system to collect future royalties the exiting franchiSEE won’t be paying. Those “future royalties” will be coming from the franchiSEES’ home equity, if the franchiSEE has enough. If not, it’s bankruptcy for the franchiSEE.

And with forced arbitration clauses that favor franchiSORS in many franchise agreements, many franchiSEES don’t ever get an opportunity to explain to a jury what happened. In forced arbitration, the franchiSOR just wins.

Second, According to an SBA-funded study,* “a franchisor must reach a minimum efficient scale to lower its (as opposed to franchisee’s) costs.” In other words, in order to succeed financially and spread its brand name into your life, a franchiSOR must reach a certain level of minimum efficiency. If it falls below that cusp, it will fail.

And… VERY IMPORTANTLY, the franchiSOR can meet that “minimum efficiency” necessary to succeed through…. churn.

Remember, every time a new franchiSEE joins a franchise system, the franchiSEE must pay a franchise fee to cover training and on-boarding. FranchiSORS are financially incentivized to recruit new franchiSEES and collect those large franchise fees. And, of course, to spread the brand name of their businesses.

Of course, theoretically, the franchiSOR should want its franchiSEES to succeed. But that’s just theory. The reality is that the success of the franchiSEE isn’t necessary for the franchiSOR to succeed. What’s necessary is the franchiSOR meeting the minimum efficiency cusp.

Collecting franchise fees helps the franchiSOR meet that minimum efficiency.

And “churn” can actually help the franchiSOR collect more fees!

You see, the franchiSOR doesn’t only collect that fee when a new franchiSEE comes on board to build out a new location. No. The franchiSOR also collects a new franchise fee every time an open franchised location changes hands. When a new franchiSEE comes aboard and purchases a unit, buying the assets of the previous franchiSEE, that new franchiSEE will (in most cases) be required to pay a new franchise fee. You know, to cover that new franchiSEE’s training and on-boarding.

So the franchiSOR wins when franchised locations change hands. Transfers mean more money to the franchiSOR. The old franchiSEE figures out that that the business is a losing enterprise, the franchiSOR blames the franchiSEE for the failure (even though in many cases the franchiSEE’s failure is no doubt the franchiSOR’s fault), and then the unit is sold to someone new.

That new franchiSEE pays a new franchise fee and the franchiSOR is closer to meeting its minimum efficiency standard. What many people don’t know is that even if on franchised location stays open for a decade, appearing, for all intents and purposes, to be successful, that location may have changed hands three or four times with the franchiSOR benefitting at every transfer.

And, of course, the franchiSOR can make money from the terminations and ceased operations by using the franchise agreement, contract law, litigation and forced arbitration to squeeze money out of franchiSEES’ home equity and whatever might be left of their savings accounts.

All of this money made through churn helps the franchiSOR meet the minimum efficiency necessary for it to succeed. Realistically (and even theoretically) speaking, then, what the franchiSOR needs to succeed is a few representative franchiSEES who are surviving, a very strong franchise development (sales) program to recruit new franchisees, and a lot of “churn.”

Many franchiSEES lose their investments and everything they own while franchiSORS intentionally churn in order to succeed.

In a nutshell, that means that many of the franchise brands Americans know and love are bolstered by the time, homes and life savings of franchiSEES who lose everything. That means that the low prices we all benefit from when we visit some of our favorite franchised outlets are subsidized by the loss of hard-working Americans and legal immigrants who, in many cases, never had a fair chance of succeeding in thei first place. In many cases, their franchiSORS brought them aboard to increase franchise fee revenue to meet a minimum efficiency standard… or to “churn” them.

If you’re considering purchasing a franchise, calculate the churn from the FDD you’ve received. But remember… the franchiSOR has no incentive to tell the truth in that FDD. The FTC isn’t enforcing anything and with aggressive litigation and/or forced arbitration, it’s unlikely that any previous franchiSEES have had the resources to uncover the franchiSOR’S untruths.

No… “untruths” isn’t strong enough of a word. I’ll use the correct terminology. We’re talking about good, hard-working people being defrauded into losing everything they’ve collected over lifetimes. When a franchiSOR puts inaccuracies in their FDD to convince new franchiSEES to come aboard, that’s a bald-faced lie.

That is the definition of fraud.

* Shane, Scott, “Why New Franchisers Succeed,” Small Business Research Summary, No. 178, August 1997, (U.S. Small Business Administration, Office of Advocacy), p. 1.

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