Big Whopper Economics in Fast-Food Franchises
In August, Larry and Kathryn Baerns and their son, Christopher, filed court papers charging that the two new Steak ’n Shake restaurants they had just opened in the Denver area were under siege. Suppliers refused to make deliveries. Their computer system went dark. Desperate, they bought old-school cash registers and took orders by hand while seeking a restraining order against the forces trying to shut them down.
The Baernses were up against Steak ’n Shake’s own national corporate offices, from whom they had bought their two Steak ’n Shake franchises. The franchisor was taking actions designed to “cut them off at the knees,” the Baernses alleged, over a dispute about whether their two restaurants had to offer a $4 value menu.
The Baernses claimed that they been misled about the profitability of Steak ’n Shake franchises, and that their business would fail if they sold items at the promotional price. In the middle of the legal battle, the two sides even turned to espionage: the chain sent an undercover operative into the franchisee’s stores to try to prove that they were not selling at approved prices. In response, the Baernses sent their own undercover agents to St. Louis to investigate prices at other Steak ’n Shake outlets.
Two weeks later, the Baernses lost their restaurants—and, with them, their investment. A court found them in breach of their contract with Steak ’n Shake. The restaurants closed in the first week of September, leaving behind only handwritten notes that read “Sorry closed.”
The Baernses’ story might seem distinct from the mounting strikes and protests over low wages in the fast-food industry that have received so much national attention in recent months. But there is a strong and revealing connection. As the Baernses’ experience shows, the owners of fast-food franchises often have very little power over how their businesses are run. They must pay the prices franchisors demand for supplies and equipment, and usually have no control over the prices they charge customers in turn.
This means that they also have little control over how much they can afford to pay their workers. While being a franchisor is often highly lucrative, being a franchisee often means living on very small, or no, margins. Biglari Holdings Inc., for example, which owns the Steak ’n Shake company, last year paid its chairman and CEO, Sardar Biglari, just shy of $11 million in total compensation. But due to adverse court decisions, changing patterns of corporate ownership, and other factors, many franchisees, like the Bearnses, lose money or barely get by. Until the growing imbalance of power between franchisors and franchisees is corrected, there is little chance that wages for fast-food workers can be substantially improved. For workers to get a raise, we need to reform the franchised fast-food industry from top to bottom.
Most fast-food restaurants are not owned by the company with its logo on display. The signs might say McDonald’s or Burger King or Steak ’n Shake, but the restaurant itself is typically owned by local businesspeople under a franchise arrangement. These franchisees pay for the use of the franchisor’s brand, starting with an upfront fee per location, which can range from $15,000 for a Subway sandwich shop to $50,000 if you want to put Burger King’s name on your restaurant. Franchisees also pay for the entire cost of constructing and equipping the restaurant, which in the case of a new McDonald’s requires an investment of $1 million to $2 million. Franchisees then pay a fixed percentage of their revenues every month in royalty and advertising fees, while also often having to buy most of their supplies through the franchisor.
Done correctly, franchising can work well for everyone. Franchisees, many of whom are first-time entrepreneurs, benefit from the tested products and strategies of a large chain. They can also realize some economies of scale by purchasing supplies in bulk and spreading the costs of shared expenses, such as advertising. At the same time, as small business owners, individual franchisees are more responsive to their local communities than are large, distant corporations. Thomas Dicke, author of Franchising in America: The Development of a Business Method, 1840-1960, explains this confluence. Franchising in the mid-twentieth century, he writes, created “a system that combined the economic efficiency and security of big business with the independence of small business.”
Some franchise relationships today still reflect this ideal. Popeyes Louisiana Kitchen—formerly Popeyes Chicken & Biscuits—has been praised for working closely with individual owners to improve profitability, for example. Yet increasingly this relationship is fraught with inequity and even outright abuse. Franchisors often write very imbalanced contracts that squeeze individual franchisees at every turn, including charging high prices for supplies. Today, many franchisors earn high profits even as many of their franchisees are struggling or going out of business.
One of the major reasons such practices have spread is a big shift in how the courts interpret antitrust and contract law. For franchisees, 1997 marked a turning point on two fronts. InQueen City Pizza v. Domino’s Pizza, the owners of Queen City Pizza argued that they shouldn’t be bound by the language in their franchise agreement that required them to buy their pizza supplies exclusively from Domino’s. They argued that this language constituted a “tying arrangement,” and that the courts had long prevented franchisors from exercising such power over franchisees under antitrust laws. The 3rd Circuit Court of Appeals rejected this claim, however. Writing in the Franchise Law Journal, lawyer Andrew Selden notes that the Queen City Pizza decision “for all practical purposes sounded the death knell for tying claims in business-format franchises.” The decision left franchisors free to coerce franchisees into buying just about anything at any price so long as it was specified in their contract.
The same year, another ruling further limited the power of franchisees. The U.S. Supreme Court’s decision in State Oil Company v. Khan broke precedence by allowing franchisors to put ceilings on what franchisees could charge for specified items. This decision was affirmed in 2009 when Burger King franchisees sued the company for forcing them to be part of an unprofitable promotion. The franchisees argued that it was unfair to require them to sell double cheeseburgers, which cost more than $1 to make, for just $1. The courts ruled in favor of Burger King’s right to set maximum prices. Other court decisions have also limited the ability of franchisees to make their own decisions about cutting prices, giving franchisors near-total control over menu prices.
One might suppose that market forces would automatically correct any imbalance of power in franchising. It seems logical that franchisors would have an interest in seeing their franchisees do as well as possible. But that’s not necessarily true. The problem is that in a relationship of unequal power, reliance on contracts and the market has only made the imbalance of power between franchisors and franchisees worse. Bad franchisors have not gone out of business.
The sandwich shop chain Quiznos, for example, continued to sell new franchises even though its corporate management knew that 40 percent of the stores were failing and that they had oversaturated the market. In the most notorious case, one ruined franchise owner committed suicide and left a note that read, “Someone must do something about what Quiznos is doing to the trapped franchisees. I deeply regret getting into Quiznos. I wish I had never heard of them.”
More recently, the company has become entangled in a new round of lawsuits by franchisees who claim the company bilked them on the cost of food, paper, and other “mandated essential goods” that they were contractually obligated to buy from Quiznos. Meanwhile, 39 percent of its franchisees with Small Business Administration loans were in default in 2012. And Quiznos is not alone: the default rate for another well-known brand, Cold Stone Creamery, was more than 42 percent in 2012, costing the government millions and spelling financial ruin for franchisees.
Even at companies that are not explicitly abusive, though, the balance of power between franchisors and franchisees will never be equal on its own. A franchisee who has opened a new franchise with one company is now “locked in” to working with that company because they have a huge, illiquid cost. They cannot possibly ever face a level market.
Previously, courts understood this. Franchise “lock-in” was a key component of why some franchise arrangements were illegal. Since the Queen City Pizza ruling, however, lock-in is all but irrelevant. The courts have ruled that as long as a provision is written into the franchise contract—regardless of the imbalance of power at play—it is perfectly legal.
John Gordon, a fast-food-industry analyst with the Pacific Management Consulting Group, suggests that the courts’ pattern of favoring the big chains over their individual franchisees follows the political dynamic of the country. “It very much tracks to the Reagan revolution,” he says. “Court rulings were favorable [to franchisees] before that point, and then they were unfavorable.”
Consistent with this theory, these court decisions have made raising wages for workers more difficult. While franchisors don’t set wages directly, the fact that they set almost every other input and control the levels of fees paid to them means that they effectively determine what franchisees can afford to pay their workers. “The corporations set wages by setting everything but wages,” notes Jack Temple, a policy analyst with the National Employment Law Project. Individual franchisees cannot shift money from other costs to pay for higher wages because they do not control what is left.
Nor can franchisees use significant gains in productivity to pay for increased wages. According to data from the Bureau of Labor Statistics, the fast-food industry had essentially zero labor productivity growth over the last quarter century.
Without productivity or the ability to control most of the business inputs or outputs, any increase in wages would have to come from franchisee profit margins, which are often small or nonexistent. Analyst Richard Adams of Franchise Equity Group estimates that up to one in four McDonald’s are unprofitable. For fast-food franchisees as a whole, a profit margin of 4 to 6 percent is probably the norm, and it is not enough to raise front-line workers to a living wage without other changes to the system as a whole.
Another structural impediment to higher wages in the fast-food industry is the shift toward private equity ownership of many chains and the changes in business practices that have come with it. More than seventy chain restaurant brands are now owned by private equity firms. One of the main investment strategies utilized by private equity firms is called “refranchising,” which refers to selling off company-owned stores to franchisees in order to maximize cash and shift risk away from the company.
Burger King, while under the control of a series of private equity players—including Bain Capital and more recently a complicated investment vehicle called a special-purchase acquisition company, or SPAC—has sold off well over 1,000 of its restaurants since 2009. This has reduced Burger King’s revenues but raised its net earnings. DineEquity, which owns Applebee’s and IHOP, sold more than 150 restaurants to franchisees in 2012 and now retains ownership of only about 1 percent of the restaurants in the two chains. “There has been a massive sell-off of company-owned stores at franchises over the last few years, and, more broadly, over the last decade,” says Jack Temple. Rather than face the risks of owning restaurants that are barely profitable or may lose money, investors would rather sell these units to franchisees who will pay them royalties and other fees as well. Like other forms of corporate “de-risking,” however, this process does not eliminate risk—it simply pushes it onto franchisees while shielding the company and its investors from harm.
With the chains primarily focused on financial engineering and no longer in the business of running their own stores, the interests of the franchisor and franchisee quickly diverge in ways that hurt everyone in the industry except those at the very top. As a former Burger King supplier noted in an interview with the popular franchisee blog BlueMauMau, “The cost of goods … and what the specs are get to be less important if you don’t have a dog in the operational part. And so the store’s bottom line is not important to them at all. They don’t understand it.” In this model, the role of big business is not to create a symbiotic relationship with franchisees and their employees, but rather to extract as many economic rents, or unearned gains, as possible.
Today, the structure of the fast-food industry has in many ways come to combine the worst of all worlds for workers. In other sectors of the economy, large corporations often pay better than small businesses do. Big companies have more capital and can more easily pool resources and share risk in the event of a downturn. Employees are also better able to organize unions in large businesses. But in fast food, even though big corporations dominate the industry, most workers—and the number is still rising—are technically employed by small, often struggling franchise owners.
This holds down wages and benefits, as does the diffusion of responsibility for working conditions: as long as most workers are employed by individual franchisees, the big fast-food franchisor corporations absolve themselves of any responsibility—a “smokescreen,” as Service Employees International Union president Mary Kay Henry recently described it—which has solidified the low-quality nature of jobs in the industry.
Meanwhile, struggling franchised stores are also much more likely than company-owned ones to violate labor standards. Min Joong Wi and David Weil of Boston University found that compliance with the Fair Labor Standards Act was much lower at franchised outlets. Franchised outlets owed between $4,000 and $10,000 more in back wages per violation than company-owned stores. This makes sense, as franchisees with slim profit margins have less flexibility to pay decent wages when business is slow. But fast-food workers are stuck with the short end of the stick.
Raising the minimum wage would allow individual fast-food firms to pay their front-line workers more without their having to worry that this would put them at a cost disadvantage with their competitors. Each firm could simply pass on the extra cost to its customers. But there are limits to how much this approach can benefit workers so long as franchisors and the investment pools behind them are devouring the lion’s share of the industry’s profits through rents and fees.
One way of beginning to correct the imbalance of power in the fast-food industry would be to allow franchisees the right to organize and collectively bargain with franchisors. As John Gordon notes, “It provides some cover. Almost always in the franchise space, franchisees are afraid of speaking up and getting noticed by the brand.” In a franchisee association, just as in a union, the ability to pool resources generates more leverage that can lead to better decisions in the franchise relationship. For a franchisee, adds Andrew Selden, “If I have some leverage, then I have some voice—and my life is much better as a result.”
Currently, franchisors are free to ignore or undermine franchisee associations. As franchise attorney Erik Wulff wrote in the Franchise Law Journal, “A franchisor, unlike an employer under the National Labor Relations Act, is under no legal compulsion to meet, recognize, bargain with or do anything else with any group of franchisees that purports to be a franchisee association. In fact, franchisors are within their legal rights to ignore franchisee associations completely.”
In the last year, three states—California, Maine, and Massachusetts—have introduced bills with provisions guaranteeing the right of franchisees to form associations. These bills, along with an even more far-reaching one in Pennsylvania, would also require franchisors to deal in “good faith” with their franchisees. Good faith clauses are implied in every contract, but franchisors have added language into new contracts attempting to override this covenant, and the courts have too often gone along. As a result, according to lawyers John Baer, Michael Lockerby, and Dennis Wieczorek, “with few exceptions, franchisee claims for violation of the covenant of good faith and fair dealing have not fared well.”
Thinking more boldly, Congress or individual state legislatures could pass laws requiring franchisors to accept fiduciary responsibility for franchisees, thereby outlawing contract terms that are inherently predatory. New laws could also protect against arbitrary termination or a failure to renew a contract, which would protect franchise owners when a fast-food company does not renew their contract and also imposes a non-compete agreement. Federal legislation could also follow the example of Maine’s bill by explicitly allowing franchisees to set their own prices—thus overcoming the problem that condemned the Baerns family’s Steak ’n Shakes last fall.
In Colorado, the legal battle rages on. The Baernses are still suing to recoup damages, while Steak ’n Shake has taken over the shuttered stores and plans to unveil new stores in the region. The Baernses’ case might seem to be of little consequence in the wider scheme of things, but until the forces involved in driving them out of business are brought back into balance, America’s social contract will be an increasingly raw deal for the front-line workers behind the counter who are struggling with low wages and an uncertain future.
Published in ProPublica by Josh Freedman
*Image of a burger via Shutterstock