Would you loan someone money to buy a Cold Stone Creamery franchise if you knew that more than a quarter of those loans default? If you’re the U.S. government, the answer is yes.
Over the last decade, franchisees in the Cold Stone Creamery ice cream chain defaulted on 29 percent of working-capital loans backed by the government, costing taxpayers tens of millions of dollars, according to an analysis of Small Business Administration data published by the Wall Street Journal last week. The default rate for Quiznos, the sandwich chain that filed for bankruptcy in March, was 30 percent.
The franchising model offers would-be entrepreneurs the promise of a business in a box. Pony up some cash and get an established brand. Follow the franchisor’s instructions for running the business and sales should blossom—except when they don’t.
Cold Stone and Quiznos didn’t account for the worst failure rates, but their franchisees left taxpayers holding the biggest bills, with more than $72 million in charged-off loans between the two chains. Both brands remain eligible for SBA-backed loans, according to the website Franchise Registry.
Michael Serruya, chief executive officer at Kahala Brands, which owns Cold Stone, says in an emailed statement that the chain’s default rate was caused by “extreme growth” in the years leading up to the recession. Quiznos franchises failed due to “high rent, increased competition, and economic pressures,” among other reasons, according to an e-mailed statement from Elizabeth Sapp, vice president for communications.
Why does Uncle Sam keep guaranteeing loans for franchises that so often go bad? The agency’s inspector general found little attention paid to default rates in a report (PDF) last year: “The SBA continued to guarantee loans to high-risk franchises and industries without monitoring risks,” the watchdog reported. That lax oversight makes the government partly responsible for allowing people to invest in risky franchises, says Keith Miller, chairman of the Coalition of Franchise Associations, a franchisee group: “Banks wouldn’t have made the loans if it wasn’t for the guarantee.”
Franchise loans make up less than 10 percent of the SBA’s main program, known as 7(a), and overall they perform similarly to other loans, according to SBA press secretary Miguel Ayala. Private lenders that underwrite the loans appear to have factored in franchise chains’ high default rates, and “in many instances have stopped making loans to franchises beginning to lose their momentum even before the SBA loans started defaulting,” Ayala wrote in an email. The SBA backed 26 loans for Cold Stone Creamery and Quiznos franchises combined since the 2012 fiscal year, for a total of $2.3 million, according to Ayala.
It’s also true that no one forces franchisees to take out loans. Why would anyone buy into franchise systems with such high default rates?
Buyers may fail to do enough due diligence, and the law doesn’t require franchisors to share a lot of information that might help them. For example, franchisors don’t have to disclose default rates or average first-year store revenues with potential franchisees.
Nor does the SBA publicize the data. The Journal had to file a Freedom of Information Act request to get it. A handful of websites highlight chains with records for poor performance, but those watchdogs’ warnings can be hard to find.
Meanwhile, chains have a lot of incentives to sell new franchises. Franchisors themselves get upfront payments for selling new units, as well as a share of franchisees’ revenue. If a store goes bust, the franchisor can resell the license and collect a new fee. Beyond the franchisors themselves, there are a bevy of consultants and brokers who talk up the franchising model, for a price. Banks also profit from selling the franchising model—especially since the SBA limits lenders’ downside by guaranteeing as much as 85 percent of loans that go bad.