How Franchise Statistics Can Lie: Subway versus McDonald’s Loan Defaults

Major news hit the franchise world last month when Subway announced that it had passed McDonald’s in the number of open locations. At the end of 2010, Subway had 33,749 restaurants worldwide compared to McDonald’s 32,737. For me, the first question that came to mind was how did they do it?

Of course, there were some fairly obvious explanations as to how Subway might have pulled ahead. For one, Subway has been hot and dominating “best franchise” lists for many years now. Also, Subway’s smaller model might allow for more territories than McDonald’s, thus permitting more units. Plus, a Subway franchise is a lot less expensive, meaning a larger pool of potential franchisees. Yet, one cynical question seemed to keep jumping to the top of my list: had Subway overbuilt their network?

In the end, it was a question I would never answer, but the research would lead me to some interesting data and eventually to creating this blog post.

How Franchise Statistics Can Lie

To investigate the possibility that Subway had overbuilt their network, I immediately set upon researching loan defaults, an excellent but not foolproof indicator of franchise health and possible overexpansion. My research led me to a very useful table over at the Franchise Hound’s website, The BEST and WORST Franchises to Own. The Franchise Hound had compiled SBA default rates for many big name franchisors, including McDonald’s and Subway.

According to this table, the default rate for McDonald’s is almost triple that for Subway. Obviously, Subway is a significantly less risky investment than McDonald’s. If either company had overbuilt their network, it must have been McDonald’s, right?

Not so fast.

In this case, a quick glance at the statistics can be deceiving. Look again and take note of the total loan number to the left. You will notice that hardly any McDonald’s franchisees use SBA loans for financing. Why? Because opening a McDonald’s is very expensive.

The ballpark investment range for a McDonald’s is $1M to $1.8M – well above what the SBA will typically back. SBA-backed loans top out at $750k and generally are a good bit smaller. The investment for a Subway franchise maxes out at about $250k – right in the sweet spot for SBA lending.

Based on the chart and the 2010 network numbers, SBA-backed loans represented a much higher portion of the Subway network than of the McDonald’s network. In fact, SBA-backed loans represent less than half a percent of McDonald’s units – a number that statisticians would describe as statistically insignificant. Additionally, if one considers the elevated cost of opening a McDonald’s franchise, it would stand to reason that the McDonald’s franchisees who had to resort to SBA-backed financing options might be among the least financially qualified and most risky in that network. The reality: the SBA default rate for McDonald’s is meaningless, and worse, might even be misleading.

How To Find Franchise Default Statistics that Don’t Lie (well… mostly)

While SBA default rates are a great place to start when looking at the failure rates of franchises, they should only be a first stop. The next stop is the Franchise Disclosure Document.

Item 20, Current Franchisee and Outlet Information, might be one of the most powerful sections of the Franchise Disclosure Document and is simply the best source of information for franchise failure rates. Item 20 tells you how many stores in a network have closed, providing a comprehensive list that includes all closings, regardless of whether or not a loan default occurred. Once you have reviewed Item 20, it is important to take the next step and find out why the stores closed. However, never forget:

All numbers can mislead. With data, context is king.

For instance, imagine that the FDD shows a large spike in unit closures in the previous year. That’s a huge red flag, no doubt, but what does it really mean? What if, upon further research, you found that all of the closures had resulted from an ill-considered international expansion, and that domestic stores were stronger than ever. That is important information which makes the data meaningful.

The only caveat I would offer concerning Item 20 is that it has the potential to provide out-of-date information. In a fast moving economic environment, a lot can happen in 11 months, and if you are on the tail end of an FDD (they are renewed annually), you may be looking at misleading numbers. I still wonder what kind of picture stale FDDs were painting for residential real estate franchises after the housing bust. The good news is that if there are major changes to the failure rate between FDD versions, you would almost certainly see red flags popping up in other sources during your due diligence.

So, Do SBA Loan Defaults Have Any Meaning for Franchises?

Absolutely. Like any other data, defaults on SBA franchise loans must be placed in context. What subsection of the franchise network do SBA loans represent? Has the rate of default increased over time or decreased? Do the defaults say something about the industry, the franchise, or both?

In a world of rapid information and quick-click research, numbers have more opportunity than ever to mislead. Good franchise investigations come down to questions, and questioning the meaning of data is never a waste of time.