Restaurant Franchisors May Regret Sweetheart Deals to Grow Businesses

By paul owers | 12/16/2020

Restaurant franchisors should think twice about loosening contract terms and lowering fees to expand operations during a recession even though lower fees may attract more franchisees, according to researchers at Florida Atlantic University and two other schools.

The study, published in the Journal of Retailing, is particularly timely as the restaurant industry seeks to regain its footing following the devastating impact of the COVID-19 pandemic that led to closed establishments and reduced capacity nationwide.

“We believe franchisors and restaurant operators can learn from this research to rebound from this latest crisis,” said Rajeev Sawant, Ph.D., an assistant professor of management programs in FAU’s College of Business.

Franchising contributed roughly $785 billion to the U.S. economy in 2019, according to the International Franchise Association. To expand their businesses, franchisors may be motivated to offer reduced fees and favorable contract terms to new franchisees, but the unequal treatment serves to alienate existing franchisees, according to the study by Sawant, Mahima Hada, Ph.D., of City University of New York and Simon J. Blanchard, Ph.D., of Georgetown University.

The perceived lack of fairness increases existing franchisees’ freeriding, which reduces franchisors’ performance. Freeriding occurs when franchisees obtain benefits from being part of the franchise system without assuming a proportional share of costs.

By contrast, franchisors that increase fees and offer less favorable terms to new franchisees tend to maintain perceived equity among existing franchisees, who work harder at maintaining the brand, the study found. That reduces freeriding and improves franchisor profits.

The researchers studied 131 public and private franchisors, including Subway, Wing Stop and Cinnabon, from 2007 to 2010, a period that included the Great Recession. Those franchisors that offered better terms to new franchisees experienced lower profits after the recession, even though they attracted more operators. Franchisors with a larger number of existing franchisees performed even worse after the recession.

But franchisors offering less-favorable terms to new franchisees during the recession performed better afterward.

“It seems counterintuitive, but chasing growth by offering new franchisees good deals doesn’t work in the long run,” Sawant said. “The much more effective strategy is to maintain fairness with existing operators, who are the lifeblood of franchising.”