The recent ruling by the National Labor Relations Board’s general counsel that McDonald’s can be treated as a “joint employer” with its franchisees appears to have been shrugged off by investors and most participants in the industry after an initial flurry of press accounts.
Given that an appeal of the ruling will take some time to be decided, that reaction is rational. However, it is not too early for investors and operators alike to evaluate the repercussions of the ruling, which would make the franchisor responsible for labor practices of its franchisees, if it is upheld on appeal.
Ignoring its merits and some obvious fallout, such as a more favorable environment for organized labor, the ruling’s implications on the structure of franchising could be far-reaching. Some of the basic advantages to a franchisor would remain, including the ability to expand the brand’s reach with minimal capital investment. However, the franchisor would assume more risk as a result of taking on at least some of the employment responsibilities of the franchisee and would need to be paid for this risk.
According to an Aug. 4 press release from Fitch Ratings, “joint-employer treatment for employee claims will not change the economics of franchising as franchisors are likely to adjust terms, including ongoing royalty rates and franchise fees, of future franchise agreements to accommodate higher business risk from the sharing of potential employee-related liabilities.”
This conclusion is undoubtedly true from the franchisor’s perspective. But for a franchisee, any action raising fees reduces its profitability. That lower profitability would reduce the return on investment and increase the cost of capital. In order for a franchisee to maintain its return on investment hurdle, each restaurant would need to produce higher sales, leading to fewer potential locations to develop. Thus, the expansion potential of a brand could be reduced.
Franchisees would have the option to raise prices to compensate for the higher fees, an action that could have implications for the relationship of the cost of food-away-from-home and food-at-home, leading to reduced traffic. Higher prices in a franchised system could also result in a competitive pricing disadvantage between a brand that is heavily franchised and one that is predominately company-operated. So while raising menu prices could be a response, there is a risk that higher prices could result in a loss of traffic, clearly a negative for franchisees and possibly the franchisor as well.
Another point to consider is the makeup of the franchise system if this ruling becomes permanent. Many franchisees are fiercely independent. Any additional control over their business by the franchisor, especially over something as personal as their employees, with whom they interact and work on a day-to-day basis, may make franchising incrementally less attractive separate from the lower return on investment resulting from the higher fees. So a company that has relied on small, independent franchisees may find its franchise system evolves to one comprised of larger entities. In fact, franchisors could prefer larger franchisees because they would probably have the ability to establish more professional human resource practices that would mitigate the risk to the franchisors.
Some franchisors, especially those that are well capitalized, may choose to slow their franchising activities because of their exposure to the labor practices of their franchisees, preferring to take on more of the system’s unit growth. Earlier stage companies that use franchising as a means to achieve rapid expansion without the need to commit their own capital may find it more difficult to attract smaller franchisees for reasons mentioned above. Franchising could also be a less attractive alternative to growing the chain because of the financial exposure to the labor practices of its franchisees.
How will your business respond if the NLRB's ruling is upheld? Join the conversation in the comments below.
At the margin, this ruling could make franchising less attractive to both franchisors and franchisees and have significant implications for franchising and the industry. At the margin, returns on capital could decline, growth could slow and the balance of power shift to systems that are company-operated. In addition, franchising may become more concentrated in larger entities as franchisors seek to franchise to operators that have strong human resource practices and as entrepreneurs shy away from the potential for increased oversight by the franchisor.
While it is being appealed, investors and operators need to think through the ruling’s implications and develop a strategy to address their growth should it be upheld.
