Behar, Richard. Why Subway is 'the biggest problem in franchising. Nova Iorque: Fortune;
Vol.137, Art.5, pg.126; 16 de março de 1998.
Why Subway is 'the biggest problem in franchising'
Fortune;
New York; Mar 16, 1998; Richard Behar;
Abstract:
Frederick DeLuca's chain, Subway, sells sandwiches from 13,136 franchised stores in 64
countries, a number of outlets 2nd only to McDonalds. DeLuca has used methods all his
own. The result has been not just enormous wealth but also a set of problems unmatched in
the business, including unhappy franchisees, disputes with landlords, and run-ins with
regulators. When staff economist Dean Sagar of the House small-business committee says
Subway commits every abuse you can think of, the company's extraordinary franchise
agreement is a logical place to look first. Franchisees must pay the company 8% of gross
sales, the highest royalty in the food franchise industry. An estimated 1/3 of new
franchisees may be ignorant of having to pay Subway any royalties at all. For years DeLuca
allowed the company's food vendors to overcharge franchisees and then return money to
them for local advertising. Franchisees, fearing a rip-off, formed a purchasing co-op in 1997
that is already saving some $55 million annually. Franchisees and agents have a big list of
demands: more professional management at headquarters, lower royalties, better
contracts, more communication, and more ad money.
Full Text:
Copyright Time Incorporated Mar 16, 1998
[Headnote]
Thats the assessment of a congressional staffer who studied the industry. Founder Fred DeLuca's
unique approach to the sandwich business has brought him staggering wealth-and big troubles.
TALK ABOUT AN ENTREPRENEUR'S DREAM. FREDERICK DeLuca was 17 when he
borrowed $1,000 from a family friend to open a submarine-sandwich shop in Bridgeport, Conn.
It didn't do too well, so he opened a second one-"to create the image of success," he recalls with
a smile. Apparently it worked: By the fifth store he had a clear winner, and after nine years he
started selling franchises. Today DeLuca's chain, Subway, sells sandwiches from 13,136
franchised stores in 64 countries, a number of outlets second only to McDonald's. More than
10,000 of them have opened in the U.S. in the past decade, a burst of development unmatched in
franchising. Systemwide sales exceed $3 billion a year. And Fred DeLuca, now 50, is a
billionaire.
It's an inspiring story. But look more closely and you'll see that Subway wasn't built in quite the
same way as the other franchise empires-McDonald's, Kentucky Fried Chicken, Burger King,
and the rest. DeLuca has used methods all his own, creating a corporate reflection of his own
complicated personality. The result has been not just enormous wealth but also a set of problems
unmatched in the business, including unhappy franchisees, disputes with landlords, and run-ins
with regulators. Every big franchise operation has such problems, of course, but what sets
Subway apart is scope: It faces so much more trouble than its competitors on all these fronts that
it's simply in a league of its own.
Now conflict and rebellion greet DeLuca from every side: * Legal disputes disclosed in an
annual report required by the Federal Trade Commission total 160-more than the combined total
listed by Subway's seven largest competitors (McDonald's, Burger King, KFC, Pizza Hut,
Wendy's, Taco Bell, and Hardee's). The number has nearly doubled in four years and doesn't
include 50 cases in Milford, Conn., the company's hometown, against various dummy entities
DeLuca has used to conduct business.
* A growing number of Subway's development agents-the 220 salespeople who peddle these
stores to first-time entrepreneurs-say Subway has broken contracts with them. Angry agents last
summer organized a union to gain power against DeLuca. Earlier they had tried to get rid of him
by offering around $1.5 billion to buy Subway in an LBO; he turned it down but acceded to their
demand that he hire outside consultants to analyze company operations.
* Many Subway franchisees insist bitterly that the company has defrauded and damaged them,
sometimes by opening too many franchises in their neighborhoods. Against DeLuca's wishes,
they have started a food-buying co-op to lower their costs, and now they also are fighting mad
and want to organize. Average revenues per store are down some 8% from their 1994 high of
$280,000.
* Judges and juries in several cases have found that the company has conned or misled landlords
by using shell companies.
The U.S. House of Representatives' small-business committee studied the franchise industry for
six years, and staff economist Dean Sagar concludes: "Subway is the biggest problem in
franchising and emerges as one of the key examples of every abuse you can think of." Says Cliff
Marshall, a franchise consultant for more than 30 years: "If anyone in my family ever asked
whether they should buy a Subway, I would say absolutely not, no way."
It's hard to say exactly how many Subway owners are angry or in trouble. Certainly hundreds are
prosperous, particularly if they have excellent locations and more than four stores. But owning
one store usually means "you bought yourself a middle-paying job," says Steve Sager, a recently
departed Subway agent from New Jersey. Consultant Marshall estimates that 25% of franchisees
are unhappy and suffering, while about 40% are "just getting by and making a few dollars," and
30% to 35% are happy and doing fine-though many of the happiest owners are also agents, who
can control the number of competing Subways in their vicinity. Sager estimates that half the
franchisees in the Northeast are suffering. FORTUNE tried hard to find happy franchisees, but
even those who were doing well complained about the company's practices. Franchise experts
agree that anger and unhappiness are far more prevalent among DeLuca's franchisees than those
of any other major chain.
In a series of interviews with FORTUNE, DeLuca insists his system works. "I really feel terrific
that so many people have done so well," he says, after touring several stores in Southern
California. "But there are risks. People can lose money. It bothers me that people lose money,
but I don't lose sleep over it. This is America."
When Sagar of the House small-business committee says Subway commits "every abuse you can
think of," the company's extraordinary franchise agreement is a logical place to look first. Florida
attorney Keith Kanouse, who was asked to chair a national commission in 1995 that developed
fair franchising standards, says, "I've seen over 300 franchise agreements, and Subway's is the
worst. Fred DeLuca happens to be a friend of mine, and I've told him this to his face."
How bad is it? Some of Subway's franchise terms are illegal in certain states. The agreement
requires arbitration of all disputes in Connecticut-it doesn't matter if your store is in Canada or
Costa Rica-and caps awards at $80,000. (Subway has found a way to skip arbitration by signing
leases with landlords and then subletting stores to franchisees; as de facto landlord, Subway can
quickly evict owners in a dispute.) An Illinois court has called the eviction/ arbitration provision
"unconscionable" because it "lacks mutuality." In Michigan, officials discovered in 1989 that
Subway was not registered to do business there. When it did register, it listed only two of nine
contract clauses that are unenforceable in that state. DeLuca calls it a "minor technicality" for
which he paid an $8,000 fine. "We considered it to be very serious," counters Robert Ward, an
assistant attorney general. "We had a restraining order for seven weeks when they couldn't do
business. Their general counsel was unwilling to reach any accommodation. I think you'll find
that's their attitude with everything they do." The U.S. Small Business Administration stopped
lending to Subway owners until DeLuca removed a contract clause that gave him the power to
seize and purchase any franchise without cause.
[Photograph]
Caption:
Then there's the royalty: Franchisees must pay the company 8% of gross sales, the highest
royalty in the food franchise industry. They also pay a 3.5% advertising fee (recently hiked from
2.5%). By contrast, the healthiest franchisors usually keep both figures around 4% or 5%; the
total is lower, and far more of the money builds business through advertising, while less goes to
the franchisor. At Subway, DeLuca and Peter Buck-the friend who loaned DeLuca $1,000 three
decades ago and owns the company with him fifty-fifty-now split about $160 million a year.
Most restaurant chains provide protected areas for their franchisees. Not DeLuca, whose
franchise agreements state that he may compete with his owners and "adversely affect" their
sales. But DeLuca is convinced that clustering Subways together usually creates more awareness
and raises everyone's revenues. As proof, he faxes over a graph created by his 24-year-old son,
who has a bachelor's degree in economics. The graph purports to show that for each additional
store (per million population), average store revenues in the region rise $20 to $60 per week.
FORTUNE showed the analysis to economist Ralph Bradburd, a franchising expert at Williams
College in Massachusetts. "In my view this tells us absolutely nothing," says Bradburd. "It's
missing too many variables. If this [theory] is true, then why not have 15 Subways on the same
block? Wouldn't they all be doing splendidly? The answer is, obviously not." Yet company
incentives spur dramatic growth. Agents must meet new-store quotas or they can lose their
territories. In most cases they must match the largest number of units held by the area's top rival,
typically McDonald's.
Under pressure from franchisees, DeLuca instituted a "site review" program two years ago. He
says a three-member panel at Subway will now halt the opening of any store deemed likely to
hurt the sales of a neighboring store by more than 10%. Many franchisees are skeptical about
how seriously he'll take the reviews. But before the program, the company showed no interest at
all in stopping the encroachment of new stores on old. "We did nothing," admits Subway
executive Tina Perazzini. "We put them up any f-ing place we could."
Why have thousands of franchisees signed an agreement as onerous as Subway's? Can't they
read? In many cases, maybe they can't. "I think a lot of these people are incapable of reading
these documents," says Subway executive Alexander Dembski, who designs the two-week
training sessions at headquarters for new franchisees. Dembski estimates that 30% to 50% of
franchisees are immigrants. Fifteen years ago he proposed proficiency tests in math and English
to screen these applicants, but his idea was rejected. DeLuca finally agreed last March, only to
discover that 35% of the trainees were failing the new tests.
Even those who can read adequately are unlikely to be sophisticated in business matters. As the
company stresses in its marketing, a Subway store costs much less to open than do other
franchises; while a typical Taco Bell demands a $1 million investment and a $600,000 net worth
(exclusive of residential property), a typical Subway purchaser must come up with just $100,000,
and no minimum net worth is required. Fewer than 10% of Subway franchisees bother to read
the contracts or FTC reports, according to a recent company survey. "One-third of the students
have no illusions," Dembski says. "The rest have huge gaps in knowledge, don't do their
homework, or don't know what questions to ask. It's mindboggling."
Dembski estimates that one-third of new franchisees are "clueless" that they have to pay Subway
any royalties at all. "They come to class and say, `Why didn't you tell us?' They claim the seller
[of the store] never told them." Many purchasers of existing stores have never even seen the
books. Why doesn't Subway require sellers to provide more data to purchasers? "We've thought
about that a lot in my department," says Dembski.
Another executive, sales director Don Fertman, coaches agents on getting prospective
franchisees to buy "Get them to make a decision on the spot," he urged agents at the company's
convention last summer. "Talk to them like they're already owners.... Trap them.... Get them to
say yeses.... Work the angles!"
DeLuca's lifestyle reflects his background as a factory worker's son who spent part of his
childhood in a housing project in the Bronx. For 25 years he signed virtually every company
checkuntil 1990, when his controller convinced him his time was too valuable, Ayear later, when
Connecticut instituted a personal income tax, DeLuca moved his home and company (at least on
paper) to tax-free Florida, where he drives a seven-year-old Lincoln and owns a modest twobedroom condo. "Most people are amazed that I fly coach," he says. "Sometimes I find it
astounding. I just have a hard time spending the money."
It's hard not to like DeLuca, at least at first. His IQ is so high that he's a member of Mensa. He is
handsome, gentle, and casual, and he drips honey when he wants to charm. During a recent
dinner at Subway's "franchise school" in Connecticut, female graduates were swooning over his
green eyes. Back in his school days DeLuca majored in psychology, and he still enjoys applying
it. All new employees and franchisees fill out a 172-question "predictive index." DeLuca says he
keeps these personality profiles in a file cabinet, where an ombudsman can retrieve them during
disputes in order to understand "where people are coming from."
DeLuca's own index might show a disinclination to deal with confrontation. Agents say that
when they told him they wanted to meet privately at the start of Subway's annual convention last
summer, DeLuca felt betrayed and insisted they do it in a separate hotel. He also disconnected
the agents from Subway's voice-mail system so that they could no longer communicate as a
group (he eventually reconnected them). By all accounts, DeLuca's failure to deal with conflict is
what leads to so much litigation. "Fred feels that if he gives in on one thing, everything else is
gonna come in the same way," says Ralph Slivka, who left in 1995 after six years as Subway's
controller and tax manager. "So he fights everything, and he loses a lot of them. It's a business
approach."
[Photograph]
Caption: Subway franchisees pay the highest royalties in the food industry but get little protection
against new stores entering their area.
Case in point: John "Mike" Weible, who received 20 sales awards from Subway after buying and
improving a low-volume store in Los Angeles. Despite his success, Weible started fighting with
his sales agent, who refused to let him buy a second unit. As a result, Weible withheld $25,000 in
royalties and started organizing franchisees. Subway retaliated with an audit of his books, which
showed that Weible had been underreporting sales and owed about $4,700. Weible demanded an
independent audit by an outside accounting firm, which concluded that Subway actually owed
him nearly $200. Even so, a week later the company evicted Weible, sold his store for more than
$70,000, and pocketed the proceeds.
Weible sued Subway for fraud and breach of contract. Subway spent $330,000 in legal costs
trying to collect the withheld royalties that Weible no longer owed (since Subway had kept the
proceeds from the store sale). A panel of arbitrators ruled in Weible's favor and awarded him
$220,000 in 1993, which he says barely covered his own costs. "I don't really know the story
with him," says DeLuca about Weible. "I don't recall any face-to-face meetings." But in sworn
testimony obtained by FORTUNE, DeLuca described "many meetings" with Weible stretching
over five hours at a Hawaii convention where they tried to settle.
DeLuca says the annual failure rate for the chain is just 2%, but that doesn't include the failure of
an owner if another franchisee buys his store. A more telling figure is the so-called transfer rate,
which includes resales, abandonments, and terminations. That rate runs roughly 10%, says
DeLuca, although a Chicago agent says that his turnover rate is closer to 20%. Subway's FTC
reports indicate that the store-abandonment rate has tripled since 1993. For troubled franchisees,
bailing out is a tough decision because their life savings may be tied up in the business.
"Truthfully, I don't know how some of these people continue to do it without saying, `Okay, I've
had enough,'" says ex-agent Sager. "It becomes like the battered-wife syndrome, where
tomorrow will be a better day. And people refuse to leave and accept the failure."
Franchisees may also fear trying to change the system. Consider Carolyn and Jim Greco, who
put in 70-hour weeks operating two Subways in Rhode Island. After about ten years in the
business they're taking home some $45,000 a year. "With my store doing $5,000 per week [gross
sales in 1997], I'm an average Subway owner," says Carolyn. "My development agent said that if
everyone ran their store the way I do, this area would be growing a lot faster. But I'm working
seven days a week as a sandwich maker to make ends meet. There are all these costs they never
tell you about when you start the business."
Greco says sales dropped five years ago after Subway opened another outlet nearby-a common
complaint from franchisees. At the time, the Grecos joined five other frustrated franchisees on a
pilgrimage to Subway headquarters. "We demanded to see Fred DeLuca," recalls Carolyn, who
claims he refused to receive the group. "That was a bad thing to do. All the franchisees that were
involved in that [trip] had a very hard time with their development agents after that. I'm still
afraid to talk to you." DeLuca says he doesn't recall the situation.
For years DeLuca allowed the company's food vendors to overcharge franchisees and then return
money to them for local advertising. Franchisees, fearing a ripoff, formed a purchasing coop last
year that is already saving some $55 million annually. "DeLuca wanted to kill us," says Illinois
franchisee Jim Troiani, who helped launch the co-op. Now Troiani talks about revolution. "The
only way we'll get Fred to the table talking sense is to just stop the royalty payments and put
them in escrow," he says. Troiani estimates that owners of perhaps 700 stores are willing to
participate, though that could take some doing, since Subway draws the royalties directly from
their bank accounts.
Subway's franchisees began organizing eight years ago, but DeLuca stopped the move by
forming a toothless advisory board. Now the board is talking about breaking away and going
independent. DeLuca didn't schedule any sessions over Subway's last five-day convention to
field questions from his franchisees. "He should let us hammer him and express how we feel,"
said California's Jeff Drucker, who had a PROUD OWNER OF FOUR STORES sign dangling
from his neck. "He should sell out or hire new management. He doesn't see beyond his
royalties."
[Graph]
Caption: The leader in lawsuits
[Photograph]
Caption: 13,136 stores and growing
DeLuca has unusually contentious relations with landlords as well. In 1995 an Illinois jury
awarded landlord Nicholas Jannotta $10 million in punitive damages after concluding that
Subway had defrauded him. Jannotta's mother had signed a lease with a dummy shell company
that she and her son had been led to believe was the corporate parent. After a franchisee failed
and moved out, Nicholas spent a fruitless year trying to collect the rent from Subway, where an
executive dared him to "sue us." But after Jannotta threatened to seek punitive damages, DeLuca
spent $1.3 million to resolve 72 similar claims from landlords. Subway has used more than a
dozen shell companies in much the same way.
In the courtroom a former agent testified that he attended role-playing sessions at headquarters
where agents were taught to tell landlords that the leasing firms were not shells. On the stand,
DeLuca was asked if he had any responsibility to tell landlords what kind of dummy companies
they were signing leases with. "No," he said flatly. "It's not a requirement under the law."
The Jannotta case also shed light on DeLuca's encroachment practices. The lease had a clause,
unusual for the company, that prevented any Subways from being placed within approximately
two miles of the store. Subway went ahead and put six stores in the zone anyway, helping to
cause two different franchisees to fail at the Jannotta location. Under oath, the company's top
lawyer, Leonard Axelrod-architect of Subway's contracts, nicknamed Lenny the Ax, who keeps a
collection of shark figurines on his desk-said he saw no problem since the Jannotta lease was
signed by a different entity from the ones that handled the new stores.
Thanks in part to Axelrod's testimony, an Illinois appeals court concluded last September that
there was "overwhelming" proof that Subway had committed "far-reaching fraud" in the Jannotta
case and that DeLuca "had a policy of using shell leasing companies" to avoid rental obligations.
But because of a technicality involving jury instructions, the court ordered a new trial on the
punitive damages. Separately, one of the judges stated that "the real losers here are the
subtenants who opened a Subway business only to be subjected to inevitable failure because of
the unwarranted competition-not from other fast-food chains, but from their own." Two days
after the court's decision, DeLuca wired the following E-mail to FORTUNE: "We got good news
on the Jannotta case. Our appeal was successful and the decision was reversed." Not exactly: The
decision stands, but he doesn't have to dig deeply into his pockets yet.
A California judge concluded in 1990 that Axelrod had misled a local landlord and given
statements that contradicted Subway's own documents involving a shell entity Axelrod's
testimony was "absolutely unbelievable," exclaimed Judge Harkjoon Paik from the bench. "I just
don't understand how an attorney could say things like that.... Everybody was in this kind of vast
conspiracy ... so long as the corporate entity made the money." Axelrod says the judge was a
"local yokel" who was "confused."
A New York landlord, Frank DeLeonardis, has had a judgment pending against a Subway
dummy company since 1993. "You're not going to find Burger King and McDonald's doing
business like this," gripes DeLeonardis, who is owed about $350,000. For years Subway
wouldn't even show up to defend these lawsuits in out-of-state courts, instead defaulting and then
waiting for landlords to sue in Connecticut. "I'm not going to say that ultimately we're very
proud of it," Axelrod once testified about this practice. Slivka, the former Subway controller,
says that landlords like DeLeonardis are "stupid" and don't deserve the money. "Why should they
[Subway] pay?" he wonders. "Are you talking about a moral or legal standpoint? Lenny the Ax
once said to me, `If you're looking for morality, leave it outside the door.' " Axelrod responds, "I
never said that to him."
At a meeting with agents and department heads in Florida last April, DeLuca announced he was
tired of all the fighting and litigation and wanted "everything resolved." But store revenues are
starting to creep back up, so he may lose the incentive to try. Franchisees and agents have a big
list of demands: more professional management at headquarters, lower royalties, better contracts,
more communication, more ad money, more control over menu additions. "I think he could be
more compassionate towards people," says longtime agent Earl McDaniel, whose territory
comprises 319 stores in the Midwest. "He has a group of development agents who would do
'most anything for him, including me. I only hope he appreciates that kind of loyalty."
Looking ahead-and beyond Subway-DeLuca says he wants to launch a micro-lending movement.
He hopes to recruit "missionaries" to open 1,000 chapters across the U.S. that will make tiny
loans to "disadvantaged" people so that they can launch businesses, just as he did with Peter
Buck's $1,000. "In a sense, it's charity," he says. "The best thing that will happen is you'll get
your money back and you'll feel good."
DeLuca is also putting his accomplishments on tape. He's starring in educational videos that will
be distributed to 500 colleges this summer. "Once students hear Fred's story, they really get
excited," says Jennifer Kushell, whose Young Entrepreneurs Network is coordinating the project.
"He was reluctant at first. He really had never looked at himself as a role model. I don't think he
realizes what effect he can have on a lot of lives."
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