The notion that franchises are a guaranteed path to success should already have been put to rest. Success rates aren't measurably bigger than other types of startup businesses. Some legal developments, like the potential of being considered co-employers of people working for franchisees, might even leave franchisors wondering whether staying in the franchise end of the business is worth the trouble.

If that wasn't enough to make you sharpen your analytic skills, here's the newest development: There's much higher turnover, which can indicate problems with the opportunities, in franchising than you might ever have thought, according to an analysis by franchise analysis firm FranchiseGrade.com.

Between 2010 and 2013 in the U.S., 135,289 new franchise outlets opened. At the same time:

  • 58,104 ceased operations
  • 40,113 were terminated by the franchisors
  • owners of 11,997 decided not to renew
  • 8,431 were reacquired by the franchisors

Out of those 135,289 additions, only actual gain was only 16,644 net units.

"We were really surprised when we started looking at the numbers," FranchiseGrade.com CEO Jeff Lefler told me. "We know a lot of times in the industry people talk about having to close the doors, so we expected to see ceased operations, but it was more than we expected."

In the last four years, the annual turnover rate--or the percentage of existing locations that were no longer going concerns of their previous owners--has been almost 10 percent. The problems aren't across the board, but "25 percent of the franchise systems are performing poorly and dragging down the industry," according to Lefler.

Kevin Burke, a managing partner at boutique investment bank Trinity Capital, told me earlier this year that location openings should be a "significant multiple" of closings. If the numbers become comparable, it's a bad sign.

That rule of thumb can't apply completely across an entire industry because some concepts are popular and growing while others may have hit a stage of maturity. Also, there is some degree of turnover that would be natural, as some people fail while others look to pocket their gains.

For example, Lefler mentioned a chain called Jani-King. "In 2011, there were 795 new outlets opened, 922 ceased operations," he said. "In 2012, it was 518 opened, 1276 ceased operations. In 2013, you had 496 open and 889 cease operations. If you're a prospective franchisee looking at something like this, why isn't that a red flag for you?"

But old and established names can see a fair amount of turnover as well, even if the closings don't outnumber the openings. In 2011, 180 opened, 33 were terminated, 18 closed for non-renewals, 29 reacquired, and 27 ceased operations. That's a total of 107 that closed. In 2012, 249 opened, 60 were terminated, 80 closed for non-renewals, 29 were reacquired by the main company, and 23 ceased operations.

Contrast that with Subway, where 2011 saw 1368 open, 29 terminate, and 168 cease operations. In 2012, the numbers were 1038 open, 100 terminate, and 141 cease operations.

There is enormous variability across franchises, even those in the same operating category, and you need a close read to know you're getting what you think you are for your investment. For example, a franchisor might insist on a royalty rate of 8 percent against a $5,000 minimum monthly fee. Do the math and see that it means the minimum is equivalent to a monthly sales rate of $62,500. That's a big nut to hit.

It all ultimately comes down to due diligence. Hit those numbers hard and see what the franchisors are actually offering you. And if you can't get all the info you need from one, find another potential franchise. There's always another opportunity, and too little time to get over a bad one.

Published on: Oct 15, 2014