Why Subway Is 'The Biggest Problem In Franchising' That's the assessment of a congressional staffer who studied
By Richard Behar
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
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
--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
--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
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
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.
How bad is it? Some of Subway's franchise terms are illegal in certain
states. The agreement requires arbitration of all disputes in
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
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
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
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
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 m
Case in point: John 'Mike' Weible, who received 20
sales awards from Subway after buying and improving a low-volume store in
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
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,
Franchisees may also fear trying to change the system. Consider Carolyn and
Jim Greco, who put in 70-hour weeks operating two Subways in
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.
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 co-op last year that is already saving some $55 million annually. 'DeLuca wanted to kill us,' says
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
DeLuca has unusually contentious relations with
landlords as well. In 1995 an
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.
At a meeting with agents and department heads in
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.'
THE LEADER IN LAWSUITS
The FTC requires franchisors to provide prospective franchisees with data about relevant litigation. Here are the numbers of pending and concluded cases* for the eight largest fast-food chains over the past decade.
Pizza Hut 4 Taco