Franchise Failure Rates: An Assessment of Magnitude and Influencing Factors

Abstract

When aspiring business owners compare the options of franchise versus independent business ownership, an important consideration is the relative risk of business failure. To date, the primary referent for examining franchise failure rates has been surveys conducted by Andrew Kostecka (1988)(1) under the auspices of the U.S. Department of Commerce, which indicate that less than 4 percent of all franchises fail each year. This figure compares favorably with various estimates of independent small business failures (e.g., Dun and Bradstreet 1989). Before concluding, however, that franchising is generally safer than independent business ownership, Commerce estimates must be corroborated. This is essential for two reasons. First, some have argued that independent small business failure rates have been exaggerated (cf. Bates and Nucci 1989, Dun and Bradstreet 1989, Haswell and Holmes 1989). Using data from the U.S. Bureau of the Census, for example, Timothy Bates and Alfred Nucci (1989) found considerable variance associated with business size. Small businesses with 10-50 employees (the size of many franchised convenience stores, fast food restaurants, and other establishments), had failure rates averaging around 4 percent--comparable to Commerce estimates for franchises.(2) Dun and Bradstreet (1989) reported even lower annual failure rates for small businesses in general, ranging from 0.4 percent for personal services firms to 3.8 percent for business services firms. These figures pertain only to failures involving losses to creditors, not to total closings. Since the majority of failures do not involve losses to creditors (Gaedeke and Tootelian 1991), Dun and Bradstreet estimates cannot be used as indicators of the failure rate overall (i.e., both creditor-loss and non-loss situations). Second, Commerce estimates are based on voluntary responses to surveys, and thus reported failure rates may have a downward bias. Even with assurances of confidentiality, individual franchisors may be reluctant to air their dirty laundry by reporting excessive failure rates. Furthermore, it is in the best interests of the franchise sector as a whole to convey the appearance that franchising is a relatively safe form of business ownership. Therefore, it is conceivable that franchisors will volunteer failure information only if they are experiencing relatively low failure rates. Though important, knowledge of franchise failure rates on average is, however, of limited usefulness to aspiring business owners. The more germane question is How likely is it that my franchise will fail if I do acquire one? Keeping this in mind, we conducted a study of franchise failure rates with two primary goals: (a) to corroborate or refute Department of Commerce failure rate estimates and (b) to isolate some franchisor-specific factors influencing franchise failure rates. A failure was defined as closure of a unit within a franchise organization. Thus, our failure rate estimates for each franchisor included both company-owned and franchised units that closed. (See the Variables and Hypotheses section for the logic behind this definition.) STUDY SAMPLE AND DATA In this effort, we requested Uniform Franchise Offering Circulars (UFOCs) from a random sample of 140 franchisors listed in a directory published by the International Franchise Association (IFA), a trade organization representing franchisors and headquartered in Washington, D.C. Since many franchisors are IFA members and the IFA directory includes both members and nonmembers, the IFA directory is possibly the most complete listing of our targeted population, franchisors. Following this request, 103 UFOCs were received (a 74 percent response rate). To ascertain the representativeness of our sample to the U.S. franchisor population, we compared it to the much larger (996 U.S. franchisors) sample of franchisors in the annual listing by Entrepreneur magazine (1991) along two variables used in our study: (a) age (number of years since the company began franchising) and (b) size (number of company-owned and franchised units) of the franchisor. …