Testimony of Aaron Yelowitz, University of Kentucky — Senate Small Business Committee, March 16, 2022

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Testimony of Aaron Yelowitz, Professor of Economics at the University of Kentucky and Senior Fellow at the Cato Institute, for the U.S. Senate Committee on Small Business & Entrepreneurship hearing on small business franchising, March 16, 2022. It reports that franchising covers roughly 730,000 establishments and 8.4 million workers in about 300 business lines, and summarizes an Oxford Economics survey of more than 4,000 franchisees in which 32% said they would not own a business otherwise. It states that wages for newly hired workers were similar at franchised and independent businesses, rising from about $10.30 to about $11.10 an hour over 20 months. It presents SBA lending data, including nearly 650,000 7(a) loans with 9.7% to franchisees and nearly 90,000 504 loans with 10.1%, and reports modest differences in charge-off rates. Two tables of loan data are attached.

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                                               Testimony of:
                                               Aaron Yelowitz
                               Professor of Economics, University of Kentucky
                                        Senior Fellow, Cato Institute

                                               Hearing for:
                                       Small Business Franchising:
                     An Overview of the Industry, SBA’s Role, and Legislative Proposals
                      U.S. Senate Committee on Small Business & Entrepreneurship
                                             March 16, 2022


Chairman Cardin, Ranking Member Paul, and Members of the Committee, thank you for the honor of
participating in today’s hearing. My name is Aaron Yelowitz, and I serve as a Professor of Economics at
University of Kentucky and a Senior Fellow at Cato Institute. My views expressed here today are
informed by my research and reading of the literature on franchising and the role of the SBA in lending.

The franchising model – which allows aspiring entrepreneurs to adopt a business format that has proven
to work while avoiding many of the growing pains and mistakes associated with a new business –
impacts approximately 730,000 establishments and 8.4 million workers in the United States. Although
many people associate franchising with the fast-food industry, there are thousands of franchise brands
in approximately 300 business lines, including automotive, business-to-business services, cell phone
repair, fitness, hair care, home repair services, tutoring, spas, childcare, pet care, and senior care. 1
Quick-service restaurants make up 25% of franchised establishments in the U.S., meaning the reach of
the franchising model goes far beyond fast food. 2

In a variety of contexts – from entry into markets, to jobs and wages, to the use of SBA business loan
guarantee programs – emerging evidence shows that the conditions that franchisees operate under are
not substantively different than owners of other small independent businesses. I’ll review pertinent
numbers today from some compelling studies, which leads me to conclude that the motivation to single
out the franchise model for additional regulation is unnecessary. Such regulation would likely increase
costs and make the franchising model less viable, in turn leading to less entry, more exits, and ultimately
less competition. Reduced market competition will increase consumer prices at a time when inflation is
already at 40-year highs, thereby harming the American public.

The degree to which the federal government should be involved in regulating private businesses and
subsidizing business loans is a legitimate question but singling out the franchisor-franchisee relationship
is unwarranted. Furthermore, proposals to further regulate franchise disclosure that are solely confined
to the SBA are misplaced from a policy perspective. 3 Franchise sales and disclosure is heavily regulated


1
  https://www.census.gov/library/stories/2018/03/franchises.html and https://openforopportunity.com/wp-
content/uploads/2021/09/IFA_The-Value-of-Franchising_Sep2021.pdf
2
  https://openforopportunity.com/wp-content/uploads/2021/09/IFA_The-Value-of-Franchising_Sep2021.pdf
3
  See, for example, S.1120, the Small Business Administration Franchise Loan Transparency Act – a bill that would
require franchisors to disclose in Item 19 of Franchise disclosure documents required to be furnished by the
franchisor to any prospective franchisee average and median first-year revenues for all businesses operated under
franchises for the preceding three years, and would hold a franchisor liable for the balance of any SBA backed

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by the Federal Trade Commission, which administers the FTC Franchise Rule, and requires franchise
brands to offer disclosure in 23 areas.

Franchising and Economic Opportunity

Given the paucity of data to study the franchisor-franchisee relationship, Oxford Economics published a
comprehensive study in September 2021 that offers many insights on the issues we are discussing
today. The Oxford research team surveyed more than 4,000 individual franchisees across a vast array of
industries, and asked about compensation, franchisor support, and involvement in the local community.

The first key takeaway is that franchising offers a path to entrepreneurship but is especially valuable for
new entrepreneurs, veterans, minorities, and women. Some popular books describe the franchising
model as “running a business with training wheels” – franchisors provide a set of training wheels to keep
new franchisees balanced until they can pedal on their own. 4 This viewpoint is robustly confirmed in the
Oxford study. Overall, 32% of respondents report they would not own a business if they were not
franchisees. The Oxford team calculates that without franchisor support, approximately 223,000
establishments employing some 1.8 million workers wouldn’t exist if franchising was not an option.
The survey found that franchisees valued the franchisor’s support in the areas of training, meetings and
events, and technology platforms. These are areas where a new entrepreneur running a small
independent business would likely encounter growing pains and make mistakes. 5 Intuitively, these
responses are consistent with the idea that franchising provides a path to entrepreneurship, and many
owners wouldn’t have gone down that uncertain path without such support. 6

Franchising, Jobs, and Wages

Critics of franchising such as Professor David Weil often focus on the wage structure and labor
violations. 7 Weil’s central thesis is that in contrast to an idealized past in which large, vertically
integrated employers dominated the American economy, today’s labor markets are characterized by a
“fissured workplace,” in which employers have shed all non-core employees in order to reduce wages.
Weil presents anecdotes of a handful of horror stories, but he doesn’t produce any evidence that
franchise businesses pay less. In fact, there is evidence to the contrary.

One of the mechanisms in the fissuring thesis is that franchisees have incentives to take short-cuts –
including low wages – because they can free-ride off the brand’s reputation. The Oxford analysis of
wages and wage growth compares franchised businesses to individually owned-and-operated
businesses in 2018 and 2019, prior to the pandemic. The analysis used arm’s-length data from the

loans obtained while violating these requirements and S.2162, the SBA Franchise Loan Default Disclosure Act – a
bill to require the SBA to publish loan default rates by franchise brands during the preceding 10-year period.
4
  Michael Seid and Dave Thomas, “Franchising for Dummies, 2nd Edition,” 2006.
5
  Lafontaine et al. (2019) examine survival and growth prospects of franchised and independent businesses. They
find that franchised businesses on average exhibit slightly higher survival rates than independent businesses,
although the effect appears to be short lived (one to two years). This is however still very relevant, considering
that one third of new businesses are estimated to fail within their first two years. In addition, the authors find that
franchised businesses grow faster than independent businesses in the first two years, but no difference is detected
beyond that point. See Lafontaine, Francine, Marek Zapletal, and Xu Zhang. "Brighter prospects? Assessing the
franchise advantage using census data." Journal of economics & management strategy 28.2 (2019): 175-197.
6
  https://openforopportunity.com/wp-content/uploads/2021/09/IFA_The-Value-of-Franchising_Sep2021.pdf, p. 5.
7
  Weil, David. The Fissured Workplace. Harvard University Press, 2014.

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payroll company Homebase. Small, independent business owners have strong incentives to maintain
their reputation, especially where social media postings claiming worker mistreatment can lead to viral
stories, the loss of customers, and, paradoxically, make it even harder to recruit and retain staff. Yet
wages and wage growth were virtually the same for newly hired workers in franchised businesses and
independent ones. Wages grew from approximately $10.30 per hour at the start of employment to
around $11.10 per hour after 20 months, with no more than a 13 cent difference in any month.
Moreover, newly hired workers in franchised businesses were more likely to be promoted to manager.

Finally, the Oxford survey of 4,000 franchisees found that the share of workers offered various benefits
at small franchise firms was on par with the share at small non-franchise establishments. This data-
driven descriptive evidence presents no support for the fissuring hypothesis.

Franchising and SBA Lending

SBA loans are a tiny share of the total banking business, accounting for about 1% of all small business
loans. 8 A recent peer-reviewed Journal of Finance study links SBA loans to the Census Bureau’s
Longitudinal Database, to compare similar businesses that either received or did not receive an SBA loan
guarantee. SBA loans did encourage job growth of 3.0 to 3.5 jobs per million dollars of loan, suggesting
real effects of credit constraints. Over the 1992 to 2007 period, the study estimated total job creation in
the range of 690,000 to 813,000 from SBA loans in the 7(a) and 504 loan programs. However, this is
about 5 to 10 times smaller than the 5.6 million job figure that applicants predicted as part of “jobs
supported.” The taxpayer cost – from loan default charge-offs and other administrative costs – ranged
from $21,580 to $25,450 per job created. To put this in perspective, the study estimates that the jobs
created by the SBA program pay an average of $30,000 per year.

Business lending is important to franchisees; the Oxford survey finds that 21% of respondents report
being capital constrained when starting their first franchise business and that being a franchisee
provided them with access to capital. Nonetheless, there are concerns about default rates among
franchisees. 9

I’ve recently analyzed SBA loans from publicly available data on the SBA webpage; I will caution that this
analysis is preliminary. 10 The tables show loan performance from Fiscal Year 2010 onward based on
franchise status – essentially a comparison of franchisees and independent businesses. 11 For technical


8
  Brown, J. David, and John S. Earle. “Finance and Growth at the Firm Level: Evidence from SBA Loans.” The Journal
of Finance 72.3 (2017), 1039-1080.
9
  A 2013 report by the United States General Accountability Office notes very high loan defaults in the SBA 7(a)
program among select franchisees from 2003 to 2012. The findings were recently cited in a report critical of
franchising lending. See United States Government Accountability Office. Small Business Administration Review of
7(a) Guaranteed Loans to Select Franchises. GAO-13-759 (Washington, DC: Government Accountability Office,
2013). Accessed from: https://www.gao.gov/assets/gao-13-759.pdf . See also: From the Office of Senator Cortez
Masto, “Strategies to Improve the Franchise Model: Preventing Unfair and Deceptive Franchise Practices.” April
2021. Accessed from:
https://www.cortezmasto.senate.gov/imo/media/doc/Franchise%20Report%20from%20the%20Office%20of%20S
enator%20Cortez%20Masto.pdf .
10
   See https://data.sba.gov/dataset/7-a-504-foia , accessed 3/11/2022.
11
   This uses files “FOIA - 504 (FY2010-Present) asof 211231.csv”, “FOIA - 7(a)(FY2010-FY2019) asof 211231.csv”,
and “FOIA - 7(a)(FY2020-Present) asof 211231.csv”. Loan performance was evaluated as of December 31, 2021 in

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reasons dealing with how lenders input franchise status during the loan process, any difference in
charge-offs for franchisees is likely overstated for loans prior to 2018, yet even with these technicalities
there is virtually no difference in charge-offs. 12 For SBA 7(a) loans, there are nearly 650,000 loans, of
which 9.7% were to franchisees. For SBA 504 loans, there are nearly 90,000 loans, of which 10.1% were
to franchisees. As more time lapses, there is greater possibility of charge-offs, although the charge-off
rate for 2020 through 2022 may be misleading because there has been debt relief forbearance for
existing and new 7(a) and 504 loans from the CARES Act.

In my view, the tables show very modest differences in charge-offs in the SBA data. Between fiscal years
2010-2014 as well as 2018 onward, the difference in charge-offs between franchisees and independent
businesses is statistically insignificant for the 7(a) loan program. For example, in FY 2010, 7.8% of
franchisees’ SBA loans were charged off, slightly lower than the 8.0% for independent businesses.
Between the years 2015 and 2017, the difference is significant with an estimate of around 1.0
percentage point (pp). The same patterns emerge in the 504 loan program, where charge-offs were
nearly the same for all years after 2011. In contrast, the jobs supported by franchisees – for both the
7(a) and 504 programs – are markedly higher for franchisees than independent businesses.

In conclusion, there is no clear motivation to single out the franchisor-franchisee relationship. Much like
the out-of-context characterization of franchisee wages and wage violations in Weil’s book, the SBA
data do not support the characterization of franchisee loan charge-offs in Senator Cortez Masto’s
report as anything out of the ordinary. 13 Rather than being squeezed by corporate franchisors to
commit wage violations and default on loans, the data paints a picture of franchisees performing much
like small independent businesses.

Franchising Legislative Proposals, Competition, and Consumer Prices

Small businesses such as those created by franchising promote competition and increase the variety of
goods and services for consumers. Some recent legislative proposals would impose new regulatory
burdens on the franchisor-franchisee relationship, which is a private, voluntary, and mutually beneficial
agreement. For example, the proposed “Protecting the Right to Organize” Act, or the PRO Act, would
codify into law an expanded “joint employer” standard, whereby franchisors can be held responsible for
actions taken by their franchisees. 14 The so-called “ABC test” – also included in the proposed PRO Act –

the files and arranged by loans originating each fiscal year, which runs from October to the next September for any
year.
12
   Personal correspondence with Darrell Johnson, franchise economist and CEO of FRANdata. The accurate
identification of franchise loans historically was corrected only for loans in default. Prior to 2018, SBA did not
require lenders to identify franchise loans separately (technically it was on the input form but it required
supporting work and many lenders skipped doing it because there was no impact on the guarantee) so lenders
often didn't report franchise loans they put on the books. That led to underreporting of franchise activity until
loans defaulted, making the percentage of franchise loans that defaulted overstated, often significantly. With the
changes in SBA rules regarding franchises instituted in 2017, that should no longer be the case but any loan
comparisons prior to 2018 are suspect.
13
   My tabulations of the SBA data, in fact, virtually replicate some of the findings in the Cortez Masto report (p. 12).
The report finds 51,907 business 7(a) loans, of which 6,874 loans went to franchise businesses in 2019. My
tabulations showed 51,907 and 6,882 (differs by 8 loans) for FY 2019, respectively. The Cortez Masto report shows
6,099 business 504 loans, of which 621 went to franchise businesses in 2019. My tabulations show 6,099 and 623
(differs by 2 loans) for FY 2019 respectively.
14
   https://www.congress.gov/bill/117th-congress/house-bill/842 .

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could potentially classify franchisees as employees of their brand, instead of small businesses, which in
reality they are. This would essentially eliminate the entire concept of franchising as a business model.
Both provisions would discourage entry, encourage exits, and ultimately lead to fewer franchised
establishments in the marketplace. In turn, this would lead to reduced competition and higher
consumer prices.

About the Witness

Yelowitz is a professor in the Department of Economics at the University of Kentucky. He is also a joint
faculty member in the Martin School of Public Policy and Administration at the University of Kentucky, a
senior fellow with the Cato Institute, and a research fellow with the Institute of Labor Economics (IZA).
Yelowitz has received compensation as a consultant to the International Franchise Association. All
opinions expressed here are those of the author, and not necessarily those of any coauthors, funders, or
institutions.

Contact information: Aaron Yelowitz, Department of Economics, Gatton College of Business and
Economics, University of Kentucky, 550 South Limestone St., Lexington, KY 40506, USA. Email:
aaron@uky.edu Phone: 859-257-7634 URL: www.Yelowitz.com




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                                               Table 1
                                  SBA 7(a) Loans (FY 2010 onward)
                         Charge-offs                             Jobs Supported by Loan
   FY Franchisees        Independent     Difference    Franchisees    Independent      Difference
 2010       7.8%             8.0%            -0.2 pp        18.6             11.3         7.2 jobs ***
 2011       6.2%             5.8%             0.4 pp        21.0             12.2         8.8 jobs ***
 2012       5.2%             5.4%            -0.2 pp        20.7             11.7         9.0 jobs ***
 2013       5.0%             4.8%             0.2 pp        19.4             10.6         8.8 jobs ***
 2014       5.4%             5.0%             0.4 pp        17.9              9.7         8.2 jobs ***
 2015       5.9%             4.8%          1.2 pp ***       18.3              9.8         8.5 jobs ***
 2016       5.4%             4.3%          1.1 pp ***       17.8              9.0         8.8 jobs ***
 2017       4.9%             3.6%          1.3 pp ***       17.3              9.0         8.3 jobs ***
 2018       2.7%             2.6%             0.1 pp        16.6              8.7         7.9 jobs ***
 2019       1.3%             1.1%           0.2 pp *        16.5              9.1         7.4 jobs ***
 2020       0.2%             0.2%             0.1 pp        15.6             10.0         5.7 jobs ***
 2021       0.0%             0.0%             0.0 pp        16.8             11.2         5.7 jobs ***
 2022       0.0%             0.0%             0.0 pp        17.4              9.5         7.9 jobs ***
Notes: Yelowitz’s tabulation of SBA 7(a) loan data. N=648,809. 9.7% of loans are to franchisees.

Definitions:
Charge-offs – “Current status of loan is charged off. Other options are undisbursed, paid in full,
cancelled, and exempt.”
Jobs supported – “Total Jobs Created + Jobs Retained as reported by lender on SBA Loan Application.
SBA does not review, audit, or validate these numbers - they are simply self-reported, good faith
estimates by the lender.”

Source: https://data.sba.gov/dataset/7-a-504-foia
*** p>0.01, ** p>0.05, * p>0.01




                                                    6
                                             Table 2
                                 SBA 504 Loans (FY 2010 onward)
                        Charge-offs                                   Jobs Supported
   FY Franchisees       Independent    Difference     Franchisees      Independent        Difference
 2010       4.1%             2.3%         1.8 pp ***       15.5             10.7         4.8 jobs ***
 2011       3.3%             1.3%         2.1 pp ***       15.4             10.9         4.4 jobs ***
 2012       1.4%             1.4%           -0.1 pp        16.5             13.1         3.4 jobs ***
 2013       0.6%             1.0%           -0.3 pp        16.5             11.5         5.1 jobs ***
 2014       1.0%             0.8%            0.2 pp        17.2             10.9         6.4 jobs ***
 2015       0.6%             0.6%           -0.1 pp        15.1             10.4         4.7 jobs ***
 2016       0.6%             0.5%            0.1 pp        15.6             10.1         5.6 jobs ***
 2017       0.2%             0.3%           -0.1 pp        12.6              9.4         3.2 jobs ***
 2018       0.0%             0.1%           -0.1 pp        13.6              9.2         4.4 jobs ***
 2019       0.0%             0.1%           -0.1 pp        13.1              8.3         4.8 jobs ***
 2020       0.0%             0.0%            0.0 pp        11.8              7.7         4.1 jobs ***
 2021       0.0%             0.0%            0.0 pp        12.3              8.4         3.9 jobs ***
 2022       0.0%             0.0%            0.0 pp        14.7              9.9         4.8 jobs ***
Notes: Yelowitz’s tabulation of SBA 504 loan data. N=88,524. 10.1% of loans are to franchisees.

Definitions:
Charge-offs – “Current status of loan is charged off. Other options are undisbursed, paid in full,
cancelled, and exempt.”
Jobs supported – “Total Jobs Created + Jobs Retained as reported by lender on SBA Loan Application.
SBA does not review, audit, or validate these numbers - they are simply self-reported, good faith
estimates by the lender.”

Source: https://data.sba.gov/dataset/7-a-504-foia

*** p>0.01, ** p>0.05, * p>0.01




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