How US franchises are weathering the storms of the Turbulent Twenties

October 22, 2022

Dawn Newton, Donahue Fitzgerald LLP

View Full Article

Dawn Newton of Donahue Fitzgerald offers an insight into the challenging situation for businesses in California and beyond.

• Franchisors are suffering on multiple fronts in the wake of the pandemic, with supply- chain issues and geographic upheaval behind a loss of customers to many locations
• California is accused of being anti-business, with proposed new laws and systems prompting companies to consider withdrawing from the state entirely
• In the face of the Great Resignation, inexperienced business owners are entering the franchising world at a precarious moment and will need help navigating their way to success

The 21st century’s answer to the Roaring Twenties of the 20th century might well be called the Turbulent Twenties – at least thus far. The last three years have been punctuated by extreme business disruptions, kicked off by the global pandemic in 2020, which forced business closures for the first time in living memory, crippled supply chain challenges, sparked labour shortages and prompted a massive shift in where and how many white-collar workers do their work. There has also been a deepening of social and political divisions both in the United States and across other nations in the western world. This has all been happening against the backdrop of the ongoing climate crisis, while significant inflation has slashed profit margins. Compounding these issues are customers, who, under stress from all of the above, are increasingly demanding and frustrated.

These issues are creating enormous hurdles for any business, and franchise systems are certainly not immune. Indeed, the franchise relationship can add its own additional stresses to that list, since independent business owners often push for different outcomes than what may be deemed prudent by the franchisor team.

Challenges for established systems

One key issue hitting trademark portfolios is supply-chain shortages. Many franchisors have been unable to obtain a variety of items that they used to sell regularly, forcing them to drop coverage in their trademark portfolio (at least in the United States) if a substitute cannot be sourced in time for maintenance or renewal filings. Some franchise systems have seen a similar impact from inflation; where branded to-go packaging has become cost prohibitive or an easy way to reduce franchisees’ overall expenses, franchisors have sacrificed their ability to put their names on these small items rather than cut back on other areas where customers will be more concerned.

Franchisors are also adjusting to supply-chain issues by modifying their offerings. As any customer who has recently tried to add avocado to their meal could probably confirm, some products or menu items are being taken out of standard offerings, while others are being marked up significantly. Many modifications are substitutions of an available product for one that is less or even unavailable. All of these can also have impacts on trademark coverage, sometimes prompting coverage of a new item or requiring deletion or cancellation of an item no longer being offered. Among the related challenges for franchisors in the restaurant space is management of pricing and menus on third-party delivery platforms and point of sale systems; adjustments to what is offered, what is available and at what price has become a full-time job in many systems, where it was once a matter of setting it up and ignoring it for long stretches.

Encroachment

Encroachment continues to be a hot topic in the franchising space. Although the franchisor and franchisee agree at the beginning of their relationship about the size of the territory that the former grants to the latter and the nature of the protection they will receive in that territory (ranging from a total prohibition on the franchisor doing business in that space, to broad permissions for them or other franchisees to operate in at least some ways there) a recent trend has seen franchisee claims of harm stemming from activities completely outside their territory. The argument is essentially that even if the franchisor promised to refrain from putting another branded unit within a four-mile radius of the franchisee, a location four-and-a-half miles away has had a material, adverse effect on the franchisee’s business and the franchisor is responsible. In some instances, franchisees argue that the franchisor did know (or should have known) that the neighbouring location would cause substantial harm by pulling customers away from the original business.

Many franchise systems have responded by studying the impact of new units on existing franchisees and commissioning studies of projected impacts. Impacts greater than a percentage deemed material will mean that the proposed new territory is rejected. Lesser projected impacts of a planned new territory would be disclosed to existing franchisees in the vicinity, with an invitation for them to challenge the conclusions if they disagree. This is intended to address potential disputes before a new unit opens and reduce friction between franchisors and franchisees with respect to encroachment. Systems without the means to meaningfully study projected impacts are protecting themselves by establishing larger territories or spacing units them farther apart to avoid these issues.

Geographic upheaval

Franchise systems have not been spared from the geographic upheaval that has played out with respect to office workers’ relocations and businesses converting increasingly, or entirely, to remote work environments. These changes have come at the expense of businesses that supported office workers through the old traditional Monday-to-Friday workweek: restaurants, gyms, convenience stores, dry cleaners and even daycare facilities located conveniently close to office high-rises. Before the pandemic, these businesses fed hungry workers, catered breakfast and lunch meetings and otherwise provided convenient services within almost immediate reach of the office. Today, many of these businesses are failing. The majority of their former customers now come in only two or three days per week – some are fully remote and no longer visiting the office at all. For their part, franchisors are facing tough questions about whether and how they can support the franchisee owners of territories that were enviable locations full of demand and opportunity just three short years ago.

One possible solution is relocation, but this is not always financially viable. The cost of building a new restaurant routinely exceeds $500,000 and a franchisee, burdened since March 2020 by poor performance and likely still subject to a long-term commercial lease may be unable to afford the move. Moreover, it may not even be in the franchisor’s power to grant relocation approval. In many instances, all neighbouring territories are owned by other franchisees and the only available territory is so far away that the offer is a meaningless gesture.

In some cases, franchisors are working with franchisees to get creative. The pandemic prompted many businesses to start offering, or to significantly expand, delivery options through third-party delivery platforms, and this became an easy habit for many customers. If a neighbouring franchisee has more demand during their dinner hours than their kitchen can support, turning the downtown business into a virtual kitchen that fills the gap to meet demand from the suburbs may produce a win-win. The same might be true of an expansion of catering options and outreach to local businesses that may be looking for opportunities to lure workers back to the office by offering lunches, snacks or catered special events. In some cases, this can represent a substantial pivot from the business’s typical pre-pandemic routine of meals cooked one at a time rather than in larger batches, but it could be the salvation of business locations that are no longer sustained by a robust weekday lunch crowd.

Government oversight

An even newer challenge in the form of additional government oversight is only starting to develop. On 5 September 2022, the Labor Day holiday in the United States, the governor of California signed the FAST Recovery Act into law, which aims to create a public agency responsible for oversight of workplace conditions in fast-food restaurants. The agency is empowered to create “standards on wages, working conditions, and training, as are reasonably necessary or appropriate to protect and ensure the welfare, including the physical well-being and security, of fast-food restaurant workers”. Among the agency’s specific powers is the authority to set a minimum wage for fast-food restaurant workers at establishments covered by the law, which can be as much as $22 per hour in 2023, and thereafter can increase 3.5% per year, unless the relevant Consumer Price Index increase falls below this. Assuming maximum increases, the minimum wage for a fast-food worker at a business subject to this law could rise to as much as $27.99 by 2030. For reference, the state minimum wage in California is $15 per hour in 2023, setting up the potential that in California a McDonald’s cashier will soon earn nearly 50% more than a convenience store clerk, a janitor or many construction workers. The agency can also set maximum working hours and other conditions for employment.

For franchisees, increased costs of doing business in California will likely lead to pressures to reduce other expenses that the franchisor controls, at least nominally, such as reductions in mark-ups on items the franchisor provides to the franchisee, or leeway for the franchisee to purchase a less expensive alternative product. It would not be surprising to see some franchisees demanding a reduction in royalties to help balance this. To accommodate work hour restrictions, some locations may reduce hours of operation, or raise prices precipitously to offset additional labour costs, both of which may alienate customers.

Because this law applies only to chains with 100 or more units in the United States, some smaller franchise systems may choose to strategically slow sales of new units in order to remain below that limit. Those on a trajectory to exceed 100 soon can expect that any California-based franchisees may reach out to them to protest further sales, on the grounds that hitting that magic number will cost those California franchisees in a way that it would not other units in the system. We are likely to see at least a few franchisees test the outer limits of the implied duty of good faith and fair dealing if their franchisor’s decision to sell more franchises triggers additional expenses for them.

For the law to apply, the rule on systems with 100 units requires said units to have the same branding. Because of this, it is also possible that we will see some companies with fewer than 100 units consider a different brand (limited to California) if their California operations total fewer than 100 units. This is really the nuclear option, as rebranding existing California units under a new name and decor would be a tremendous challenge, would sever existing goodwill and would cut them off from the benefits of nationwide branding and recognition. Nonetheless, if it saved those franchisees from compliance with laws viewed as onerous and unfair, and if they collectively felt that they could rebuild goodwill under the new brand, it might be viewed as a less harmful path.

The US National Labor Relations Board

One portion of the FAST Recovery Act omitted from the final law was a proposal to make franchisors responsible and jointly liable for the harmful working conditions endured by employees of their franchisees’ businesses. Although this proposal failed to make it to the final bill, on 6 September 2022 the US National Labor Relations Board (NLRB) issued a new proposal that may have a similar effect – and not just in California. Under the new proposal, a party including a franchisor would be considered a joint employer of an employee if that party “shares or codetermines those matters governing employees’ essential terms and conditions of employment”. Moreover, that control or determination might be indirect, or might be established by an unexercised right of control. All of this constitutes a more employee-friendly swing away from the NLRB’s current standards related to joint employers. Considering the amount of control a franchise agreement and operations manual typically grants to a franchisor with respect to issues such as job duties, hours of operation and brand-related required conduct to operate the business, it is likely that such a proposal could make many franchisors joint employers in a way they are currently not.

Regardless of whether the NLRB proposal is enacted, one reaction to the California law that will come as no surprise to most Californians is a heightened complaint among the business community that California is anti-business and is driving away commerce. Franchise systems outside of California have made this accusation repeatedly over the years in response to numerous issues, including:

• California’s refusal to enforce post-termination non-competition agreements, which leaves franchisees free to compete against their franchisor immediately after leaving the system; and
• California’s data privacy laws, which impose heightened obligations on businesses (including out of state franchisors) to safeguard data and give Californians expanded rights to control their information, more akin to many businesses associated with Europe than with the United

The heightened level of investigations carried out by the California Department of Financial Protection into franchisor practices have nearly tripled over the last few years. These have not helped either, even though the department is focused on enforcing laws that have existed for decades. It could well be the case that a few systems simply opt to stay out of or even retreat from California through a deliberate plan to stop franchising in the state by no longer offering renewals as individual franchise agreements come to the end of their terms.

These complaints have a lot in common with deepening societal divides, which have many consumers increasingly voting with their wallets. Consumers are increasingly purchasing from businesses that publicly align with their beliefs and eschewing those whose owners have donated to political causes that are antithetical to those of the consumer. Against this backdrop, more companies are becoming more openly partisan, whether they want to or not. Social media allows individual consumers to spread information about political donations, past actions, politically incorrect speech and other allegations. In response to this, many brands are increasingly focused on creating a brand perception that aligns with core customers, even at the risk of alienating others.

Another response we may see is increased mergers and acquisitions activity. System owners may no longer want to deal with the mounting challenges of running a franchise system in these challenging times and might look to sell to larger systems that are better equipped to adjust to legislative threats. Since the trademark portfolio is the heart of the franchise system, would-be sellers will want to ensure that they are avoiding any risks of fraud in their trademark procurement and renewal (even during the supply-chain crisis) and that franchisees remain relatively happy, so that the acquiring business does not fear a franchisee revolt as soon as the deal closes.

Considerations for start-up systems

People appear to have engaged in personal stock-taking on a massive scale since the pandemic. Workers took part in what has been called the Great Resignation, choosing to stop working jobs they did not enjoy, sometimes moving across the country and otherwise uprooting their status quo. Many of them, particularly those who might have always felt a pull toward owning their own businesses, decided to capitalise on the promises of franchising and purchase a business where they felt they would have significantly more control and less risk of a layoff or unwanted working conditions. As a result, franchise systems saw an uptick in franchisee prospects, although many of these lacked the criteria that many franchisors look for, such as robust financial backing and prior experience as a business owner. In many instances, these potential franchisees will look to leverage their retirement accounts and/or take on large debts in order to launch a franchised business.

At the same time, many business founders also appeared to decide that now was the time to consider the expansion they had never previously committed to. Many franchise attorneys agree that they are seeing higher volumes than ever before of businesses looking to franchise for the first time.

These new start-ups enter the world of franchising as it is a precarious environment. Many of them are new to the challenges of acquiring the same basic supplies, especially perishables, to businesses in numerous regions across the country or around the world. Some have little experience with negotiating contracts on a large scale and find it difficult to predict consumer demand in new markets.

Where they each need to start is by ensuring there is a sufficient opportunity for expansion under their existing trademark. The United States’ dual trademark recognition system, under which senior common law trademark holders can exclude junior trademark registrants from a geographic area, can spell disaster for unwary or unprepared franchisors. Every franchise system contemplating a launch into a new geographic market should evaluate whether there are any problematic businesses in that area before selling a third-party investor the opportunity to build a business under the brand. Systems aware that their name may be in use in various iterations by numerous senior common law users would be well advised to absorb the painful process of a name change before franchising than to face having to change names once the brand has become a nationwide name with substantial demand for new sales in territories that are off-limits.

Looking ahead

While franchise systems are facing numerous challenges, those that are flexible, creative and willing to put in hard work are continuing to innovate and meet the demands of today’s business environment.

Franchisors that can reduce their risk by identifying contingency plans for supply sourcing, staffing structures, revenue streams, and changing trends and consumer demands will be the most resilient in the current environment, as will those who work hard to keep franchisees satisfied and therefore willing to trust a system’s new programmes and creative problem solving.

---

The article entitled “How US franchises are weathering the storms of Turbulent Twenties” authored by Dawn Newton was published in the World Trademark Review.