Becoming a franchisee is supposed to be an easy, less risky way to get in on being a small business owner. Typically, for the cost of a franchise fee and some other fixed expenses, you can buy into a powerful brand and run your own enterprise. 

But it turns out it's much riskier than you might think. Franchisees for some of the biggest franchise brands are among the top defaulters on Small Business Administration-backed 7(a) loans, according to a recent investigation by the Wall Street Journal

Some of the leading franchise names, including Quiznos and Cold Stone Creamery, were among the 10 worst performers in the SBA loan portfolio between 2004 and 2013, which collectively had a default rate of more than double that of other franchises, according to the investigation. Collectively, those brands were responsible for nearly a quarter of all charge offs among loan-seeking franchises, amounting to $121 million in losses for the SBA.

Not only have defaults cost the agency, and potentially tax payers, tens of millions of dollars, they underscore the lack of sophistication that many franchisees have when they enter the game. And the defaults are a reminder that when you run your own business, franchise or otherwise, it requires a lot of hard work and financial savvy.

A Sobering Perspective

And that's the aspect that's often lacking, says Mitchell Fillet, a finance professor at Fordham University who has worked on franchise financing deals in the private investment world.

"Franchisees generally can't take out a loan to buy the franchise, so they take a lot of money out of pocket to buy it, and then they need to put equity into the facility," says Fillet.

Generally speaking, Fillet says, franchisees take out loans to build out their locations, and then often don't have adequate working capital once they open their doors, and thus can't pay back the loans. It can cost from $50,000 to several hundred thousand dollars to buy a franchise.

The outsize default rates also expose some less savory aspects of the franchise industry, Fillet says, namely that many franchisors are primarily interested in the hefty fee associated with the initial franchise purchase. If one franchisee goes under after building out a location, the franchisor can often turn around and sell the location to someone else at a discount.

"It's sort of payday for franchisors when you go under," Fillet says. 

Positivity Persists

Since the Great Recession, franchising has been held out as an appealing alternative for laid off people seeking ways to support themselves. But that may be unsustainable. Industry statistics suggests the number of new franchises in recent years has outpaced the growth of the industries in which they operate. There are more than three quarters of a million franchise establishments in the U.S., according to an International Franchise Association's U.S. economic forecast for 2014.

Still, plenty of franchisees aren't going under. And David Cesarini, a Domino's Pizza franchise owner in Ann Arbor, Michigan isn't worried about legions of franchisees defaulting. He started out with eight stores in 2002, built his operations to 12, and then pared back to four stores following during the financial crisis. In his 11 years as a franchisee, he's had only one year that was not profitable. 

(Domino's was not on the list of top ten franchise defaulters.)

A big reason for his success is his training. Cesarini also worked for 12 years as a regional manager and operations director for Domino's, helping other franchisees grow their businesses, before striking out on his own. He turned to a local bank for a loan once he got started, and says the connection to Domino's helped him secure the financing, which was not an SBA loan.

Cesarini says that while Domino's is open to outsiders coming in to buy franchises, it emphasizes a one-year program where potential franchisees start out as store managers. 

"You have to manage a store successfully for a full year to franchise at Domino's, and then show them you can pay the [franchise or administrative] fees and have the resources" to successfully operate the business, Cesarini says. 

He's recently turned to bank financing again to remodel his stores. "Could I pay for this in cash? Yes. But taking on some debt is not always a bad thing," Cesarini says.

Published on: Sep 11, 2014