SBA Studies Say Franchises More Likely to Fail than Small Businesses

SBA Studies Say Franchises More Likely to Fail than Small Businesses

Posted Fri, 2009/08/28 - 00:06 by Mr. Blue MauMau

WASHINGTON - Separate studies by Professor Timothy Bates and now two studies by the Small Business Administration report that franchises fail more than independent small businesses.

Over the years, studies have emerged with opposing views when comparing “success rates” of franchising to independent business ownership. Franchise experts are familiar with the reports from the U.S. Commerce Department and those authored by Bates (1996). There are numerous private studies as well delving into franchise ‘success’ and franchise regulation, such as those cited and discussed in “Beguiling Heresy: Regulating the Franchise Relationship," co-written by Paul Steinberg and Gerald Lescatre.

However, two lesser known studies undertaken by the Small Business Administration have received little to no attention. In September of 2002, the U.S. Small Business Administration’s Office of Inspector General’s Inspection and Evaluation Division published a report comparing the failure rate of the SBA’s non-franchise loans to the SBA’s franchise loans. Titled “SBA’s Experience With Defaulted Franchise Loans," the SBA queried:

“If franchise-based businesses are indeed “safer”, then Section 7(a) and Section 504 loans to franchisees – hereafter called franchise loans – should perform better than non-franchise loans in terms of SBA having to purchase defaulted guaranteed loans. In other words, franchise loans should have significantly lower purchase rates than those of non-franchise loans.” (pg 1)

The SBA’s findings?

“Despite the popular view that franchisees are much more successful than non-franchisees, SBA’s experience with defaulted loans does not support this.”(pg. iii)

The SBA also found:

“There is also potentially more exposure per loan on franchise loans. In FY 2000, the average (mean) franchise loan origination was 40% larger than that of the average non-franchise loan. In FY 1991, the comparable figure was only 1%.” (pg iii)

Equally interesting was the following point:

“Moreover, a previously mentioned SBA-funded study [Shane’s 1997 study] found that a franchisor must reach a minimum efficient scale to lower its (as opposed to a franchisee’s) costs. Given this necessity plus the need to collect franchisee-paid fees, franchisors have an incentive to encourage as many prospective entrepreneurs as possible to become franchisees and find financing. Moreover, there is always a risk of some franchisors’ overly optimistic financial projections enabling under qualified prospective franchisees to obtain – and default on – SBA guaranteed loans.” (pg. 1&2)

Prior to publishing, the OIG’s Office of Inspection and Evaluation forwarded this report to the SBA’s Office of Financial Assistance (OFA) for review. In James Rivera’s, the Associate Administrator for the OFA, response to this request for review he stated “A member of my staff conducted a similar study and analysis of the SBA loan data base for the same period under inspection and came to the same conclusion supported by your finding related to the relative success of franchise verses non-franchise loans.” While a copy of this specific OFA’s report is not currently available, the aforementioned letter appears as Appendix C to the attached report.

Although not looking into franchisee success rates as the other studies did, Prof. Scott Shane and Foo conducted research (1997) that shone a light on the high mortality of franchisors, revealing that 1,292 franchise brands studied between 1979 and 1996, only 15% of the franchisors lived to be 17 years old, a rate comparable to independent start-up failures.

Editor’s note: This article was written by Blue MauMau member Oldsword, a former franchise owner-operator. This article has been edited and the facts verified by this journal’s editor.