Tag: due diligence
October 13th, 2016
Takeaway: Demonstrating our value to early stage franchisors, WTP public comments help eliminate proposed regulations that would have prevented new franchisors from providing profit information.
Generally speaking, the most important type of information that a franchisor can provide to prospective franchisees concerns the profits earned by businesses operating under their brand. This type of information, as well as information on gross revenues, is called a Financial Performance Representation (“FPR”) or “earnings claim” under the laws governing franchise sales in the United States. Unfortunately, while the FTC Franchise Rule requires certain disclosures to prospective franchisees (through provision of a Franchise Disclosure Document or “FDD”), and requires that any FPR that a franchisor provides be included in Item 19 of the FDD, it does not provide substantive guidance on what can and cannot be provided in an FPR. Instead, it simply requires that there be a “reasonable basis” for providing that information to prospective franchisees.
While the FTC does not require filing and approval of the FDD prior to selling franchises, several U.S. states require that the FDD be reviewed and approved before a franchise is sold in that state (a process called “registration”). Among the most prominent registration states are California, Illinois, New York, Maryland and Virginia. Those states’ review of FDDs are informed and guided by policy statements issued by the North American Securities Administrators Association (“NASAA”), of which each state’s franchise regulatory authority is a member. Since 2015 NASAA has been considering issuance of a Financial Performance Representations Commentary.
The original proposed FPR Commentary, issued for public comment on October 1, 2015, contained many useful provisions. However, proposed Section 19.7 would have drastically interfered with new franchisors’ ability to provide truthful, factual information to prospects. It read:
19.7 Item 19 — FPR Disclosing Gross Profit or Net Profit of Company-Owned Outlets When Franchisor Has No Operational Franchises.
QUESTION: If a franchisor has no operational franchises, can the franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?
ANSWER: No. A franchisor with no operational franchises cannot make an FPR disclosing gross profit or net profit based on company-owned outlet data alone.
The proposed commentary’s reason for this blanket ban was a concern that franchisees are likely to incur higher operating costs than company-owned locations, and without operating franchisees the new franchisor would not have a way to know if its costs were lower (or higher) than franchisees would experience. Therefore, to provide net profit information to prospective franchisees based solely on the company-owned data would be misleading.
This proposed commentary, if enacted, would have severely limited the ability for the many early stage franchisors that we represent to compete in recruiting franchisees – which is already tough enough for a start-up! Moreover, while it is appropriate for the commentary to highlight issues that franchisors need to consider when deciding whether its FPR has a “reasonable basis” and is not materially misleading, an outright ban under all circumstances deprives prospective franchisees of information they wish to know.
Accordingly, on October 27, 2015 we submitted our public comments objecting to proposed Section 19.7 on those bases. With our client’s approval, our comment included an early stage franchisor’s net profit FPR, redacted to remove the name of the franchisor and its principal owners. The numerical presentation was accompanied by a paragraph explaining why revenues and expenses increased over a period of years, and also warning about the franchisor principals’ level of experience in the industry and therefore why its business performance probably would exceed that of new franchisees. The public servant who leads the NASAA Franchise Project Group told the author that the example was “particularly helpful.”
On September 14, 2016, after lengthy internal deliberations among the project group members, NASAA issued a revised version of the proposed FPR Commentary for public comment. While not specifically addressing comments received, what is notable is that former Section 19.7 no longer exists. Instead, no distinction is made between franchisors with or without operating franchises, and rather new Section 19.10 reads in part as follows:
19.10 Item 19 — Gross Profit or Net Profit FPR Based on Company-Owned Outlets Alone
QUESTION: Can a franchisor make an FPR disclosing gross profit or net profit based on company-owned outlet data alone?
ANSWER: Yes. A franchisor can make an FPR disclosing gross profit or net profit based on company-owned data alone if it has a reasonable basis to make the FPR and includes the following information: (a) gross sales data from operational franchise outlets, when the franchisor has operational franchise outlets; (b) actual costs incurred by company-owned outlets; and (c) supplemental disclosure or adjustments to reflect all actual and reasonably expected material financial and operational differences between company-owned outlets and operational franchise outlets. These differences consist of fees and other expenditures required by the franchise agreement, disclosed in the Franchise Disclosure Document, or that are otherwise known or reasonably should have been known by the franchisor.
The remainder of the answer explains the need to adjust the presentation to disclose franchise royalties and other fees that a company-owned outlet does not pay, and also to adjust the costs of goods sold upward if the company-owned locations receive more favorable pricing from suppliers than franchisees will experience. The latter is a tricky issue and new franchisors either will need to be very careful to make sure that actual franchisee pricing is the same, or increase the costs of goods sold by a specific percentage in the presentation and explain the basis for the increase in footnotes.
Nevertheless, this is a major win for new and early stage franchisors, since they are likely to retain the freedom to provide prospects the information that they desire and to compete in franchise sales. It was our pleasure to be able to influence this regulatory outcome in favor of companies that want to use franchising to grow their brand and create entrepreneurial opportunities in the U.S.A.
June 10th, 2014
Take-away: If your franchise offering document is silent on key issues, you can be liable if your people “oversell” to a potential franchisee. Better to deal with the issue in carefully vetted writing than to be surprised by something your people say off the cuff.
The case: A recent Michigan Court of Appeals decision, reinstating a jury verdict against a cellular communications store franchisor, shows the potency of franchise investment and disclosure laws in protecting franchisees against misleading sales tactics, if the information provided does not contradict the franchise disclosure document presentation.
The facts: In Abbo v. Wireless Toyz Franchise, L.L.C., Abbo was a failed franchisee and area developer of cellular communications stores. Looking back, he alleged that an officer of Wireless Toyz provided misleading information in the “discovery day” presentation.
As background, you need to understand something about the business model of cellular franchises. Their profitability can be affected by “hits” (discounts given in the sale of phones); “chargebacks” that decrease store commission revenue; the franchisor’s bargaining power with cell phone carriers; the hidden costs of purchasing inventory from the franchisor; and ultimately the number of cell phone sales necessary to make a profit.
None of these issues was dealt with in any meaningful way in Wireless Toyz’s franchise disclosure document (“FDD”). Since the FDD was silent, that left wide areas about which prospective franchisees could ask for additional information, and left the franchisor’s executives, eager to sell franchises, vulnerable to providing answers outside the FDD. In this particular case, the franchisee directly asked a senior franchisor executive about revenue deductions from “chargebacks” and “hits,” and the franchisor executive apparently said that chargebacks constituted “only five to seven percent” of total commissions and that Wireless Toyz stores outside of Michigan (the home state) had been “subject to only ‘very minor’ hits.” In fact, neither statement was accurate.
The FDD’s Item 19 Financial Performance Representation said that there were 181 average new activation contracts each month, and an average of $222.31 in commissions per activation. However, the presentation did not mention “hits” or the minimal amount of revenue (net of the cost of cellular devices) earned by the stores, and it also did not detail the extent of chargebacks and how they impacted the actual net commissions earned per activation.
After a jury trial, the jury found that the franchisor had failed to provide material facts necessary to make the FDD’s statements not misleading under the circumstances of their presentation, and also that it was liable for creating false impressions when responding to the prospective franchisee’s direct questions regarding “hits” and “chargebacks.” The Michigan Franchise Investment Law (like its statutory cousin, the Maryland Franchise Registration and Disclosure Law) creates an affirmative legal duty to disclose all material facts necessary to avoid creating a false impression.
In this case, Wireless Toyz made a corporate decision not to provide information on the extent of chargebacks in Item 19 of the FDD, even though that information was clearly relevant to the picture of commission revenue generated per activation. The “gasoline on the fire” in this case was the “five to seven percent” estimate provided by the franchise salesperson in response to a direct question.
Initially, despite the jury’s findings, Wireless Toyz came out ahead: the trial court overturned the jury verdict because of the following, very common, franchise agreement provision:
Except as provided in the [Disclosure Document] delivered to the Franchise Owner, the Franchise Owner acknowledges that Wireless Toyz has not, either orally or in writing, represented, estimated or projected any specified level of sales, costs or profits for this Franchise, nor represented the sales, costs or profit level of any other Wireless Toyz Store.
The jury concluded that, despite this language in the contract, Abbo was reasonable in relying on the verbal statements on matters not addressed in the FDD. Moreover, because the verdict was for misleading omissions, the jury presumably found that the failure to provide additional clarifying information both in and out of the FDD presentation was what misled the franchisee.
The appellate court agreed with the jury, not the trial judge.
There was a dissenting opinion at the appellate level, and it is likely that Wireless Toyz will seek to have the Michigan Supreme Court review the decision. However, that court is not obligated to do so and may not want to substitute its opinion for that of the jury. As in many franchise cases, Wireless Toyz’s chances were not terribly good once it allowed a jury to deliberate regarding its actions.
In an era when about two-thirds of franchisors now provide written financial performance information in their FDD, this decision is an important reminder to franchisors of the risk of providing only partial information in the FDD – particularly if the franchisor has access to accurate (if not necessary encouraging) information on unit-level expenses or deductions from revenue.
For example, in a quick service food system, if a franchisor has a standard accounting system, then it should have access to franchisees’ costs of ingredients and packaging supplies as well as their labor costs. (And, since the franchisee will use these figures to calculate its tax deductions from gross revenue, the amount of those costs probably will not be understated.)
That sort of information is important to prospective franchisees and is almost certainly data that they will seek from the franchisor. It is better to disclose fully in the FDD instead of hoping your salespeople don’t get asked about it or that, if asked, they answer accurately.
January 3rd, 2014
The case of Wojcik v. Interarch, Inc., currently pending in the U.S. District Court for the Northern District of Illinois against the fast casual restaurant franchisor Saladworks, LLC, contains a factual scenario that should serve as a valuable reminder for existing franchisors who are updating their Franchise Disclosure Document (“FDD”) for use in 2014, for companies beginning the offer of franchise rights, and for prospective franchisees who are investigating opportunities. Bottom Line: Franchisors need to be careful not to underestimate site development costs, ongoing operating costs, and the challenges of opening locations in geographic areas not familiar with their brands.
During 2011, one of the plaintiffs, David Wojcik of suburban Chicago, investigated development of a Saladworks franchise restaurant. Saladworks is based in suburban Philadelphia, and the bulk of Saladworks locations are within 250 miles of Philadelphia. When Mr. Wojcik attended Saladworks’ “Discovery Day” to learn more about the franchise, Saladworks’ executives took him to their “Gateway” location, which they described as being typical in terms of physical appearance and menu offerings. They also told him that Saladworks’ designated commercial real estate firm Site Development, Inc. (“SDI”) and a designated architecture firm would help Wojcik find a location and design his restaurant.
After reviewing the FDD and going to “discovery day,” Mr. Wojcik convinced his wife Denise that they should sign the franchise agreement and that she should invest $90,000 that they used to purchase a single franchise license plus multi-unit development rights in suburban Chicago. However, it cost the Wojciks substantially more to open their first Saladworks location than the estimated initial investment cost stated in the FDD, and the business failed within six months – both opening and closing during 2012.
The court decision, denying Saladwork’s and SDI’s motions to dismiss for the most part, is interesting on a couple of legal grounds, including the court’s holding that Saladworks could have violated several franchise agreement provisions by failing to “exercise its discretion in good faith,” and also holding that the site selection firm SDI assumed legal duties to the franchisee not to misrepresent its qualifications to provide site selection advice in suburban Chicago. However, more instructive are the failed franchisee’s factual allegations concerning representations made to induce its franchise purchase, including those in the FDD. As the court wrote:
“According to Wojcik, Saladworks misrepresented, among other things, that:
A. “Saladworks had the experience and expertise to support a franchisee’s introduction of its brand in the Chicago market and that Saladworks would be committed to success in this market”;
B. “Wojcik’s Illinois restaurants would basically replicate what he saw on discovery day at the Gateway Restaurant”;
C. InterArch and SDI “would be . . . strong positive factor[s]” in helping him develop his restaurants;
D. Wojcik “would receive a `standard location,'” thus making the financial information Saladworks included in its FDD for franchised restaurants at “standard locations” relevant and meaningful for him.
Wojcik also alleges that Saladworks omitted a number of material facts, including the following:
(1) Saladworks based the projected construction costs disclosed in its FDD on “site locations that did not require any substantial changes in use, e.g., that . . . previously [had] a restaurant on the site. . . .”
(2) “[W]ithin any market there can be material differences between particular sites that will substantially affect the performance of any particular franchise, such that, by inducing franchisees to believe that he or she would receive a `standard location,'” the franchisee was being misled and deceived into believing that SDI and Saladworks had developed some sort of process that eliminated the risk of poor site selection. . . .”
(3) InterArch—Saladworks’ designated architect—”had insufficient familiarity with the local building codes of Schaumburg or the other Illinois communities in which Wojcik was planning to build and InterArch was not licensed in Illinois.”
(4) “[The Saladworks] brand was most successful in a core market area, which included the area covered by an approximate 250-mile radius of Philadelphia. . . . [but] beyond the core market area, most of [Saladworks’] franchises were substantially under-performing in relationship to those that were located within the core market area,” thus making Saladworks’ disclosures about the financial performance of franchised restaurants at “standard locations” deceptive and misleading to a franchisee in Illinois.
(5) The two restaurants for which Saladworks supplied information about average operating costs obtained free labor from new franchisees in training, thus making the average operating costs Saladworks disclosed in its FDD materially misleading.
(6) Saladworks “did not intend to do `brand development advertising’ in Illinois,” and thus, a franchisee in Illinois would receive no benefit from its required contributions to Saladworks’ “Brand Development Fund.”
(7) InterArch, Saladworks’ designated architecture firm, charged a $5,000 “supervision fee,” in addition to its design fee, if the franchisee chose to have InterArch supervise construction of the restaurant.”
This case decision was in the context of Saladworks’ and SDI’s motions to dismiss (the architect, InterArch, had already settled), and many of the allegations recited above may not survive a motion for summary judgment on the failed franchisee’s misrepresentation claims. For example, as the court also points out, the franchise agreement specifically warned the franchisee that its “Brand Development Fund” contributions did not have to be used to promote the franchisee’s restaurant (as opposed to other System restaurants), and a franchisee in a new region typically should negotiate that point.
However, some issues that renewing franchisors should carefully consider are:
(i) Do franchises outside of your core geographic area struggle, as compared to those in the core? If so, your Item 19 Financial Performance Representation probably needs to highlight those differences and conspicuously warn prospects considering a franchise that would operate outside of “the core.”
(ii) If your Item 19 disclosure includes operating costs disclosures, are those impacted at all by the use of trainees in place of paid staff?
(iii) if you feel it is necessary to designate a commercial real estate company or architecture firm, be careful about how you promote their abilities, and consider (a) requiring the real estate firm to work with a local firm with whom it would share its fees, and (b) for states where the architect is not licensed, consider allowing the franchisee to select alternative architects upon payment of a modest review fee to your designated designers.
(iv) Are your Leasehold Improvement or construction estimates in Item 7 based on certain positive assumptions? If so, carefully disclose them, and consider whether the high estimate should not include those optimistic assumptions.
From the point of view of a prospective restaurant or retail franchisee, the lesson of this case is to show the kinds of issues you should carefully consider in your due diligence before purchasing a franchise. While litigation may help you recover if the franchisor is not completely truthful, better to figure it out beforehand!
May 10th, 2013
Takeaway: Franchisors cannot rely on disclaimers in the contracts and FDD to protect against claims of providing false financial information.
The Case: In a recent decision, Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky once again showed the danger of a franchisor relying on disclaimers in its contracts and the Franchise Disclosure Document (“FDD”) to defeat claims that it provided false financial performance information in selling a franchise. The court denied summary judgment for the franchisor of A&W Restaurants, Inc. (“A&W”) and will allow the franchisee’s claims of fraud and violation of franchise sales laws to be decided at trial. The case is particularly noteworthy because the franchise purchased was the claimant’s fourth from the same franchisor.
A&W’s FDD had what is known a “negative disclosure” in Item 19 concerning the provision of information about the sales or profits at existing franchises, specifically saying “[w]e do not make any representations about a franchisee’s future financial performance or past financial performance of company-owned or franchised outlets.” The Minnesota-based franchisee alleged that, in connection with considering purchase of a franchise to open a new “drive in” model A&W restaurant, the franchisor provided “information, including financial projections, which was laden with false data.” These allegations, if true, would mean that A & W provided a financial performance representation (“FPR”) outside of its FDD, in violation of federal and state franchise sales laws.
A&W followed the usual route of trying to get the franchisee’s claims thrown out before trial on the argument that, in light of the disclaimers in Item 19 of the FDD and in various parts of the franchise agreement, as a matter of law the franchisee could not “reasonably rely” on the information provided. The court rejected the argument that the disclaimers could be used to flatly bar the franchisee’s claim that A&W provided misleading information in violation of the Minnesota Franchise Act, because that law (like the Maryland Franchise Registration & Disclosure Law) contains a provision making “void” any waivers of conduct contrary to the franchise sales law. Instead, the franchisor will be permitted to use the disclaimers at trial as evidence to persuade the jury that the franchisee could not have reasonably relied on the “projections.”
The court also ruled that the disclaimers could not be used to deny the franchisee a trial on its claim of common law fraud (under Kentucky law) with regard to its allegation that the projections were based on false data about other locations’ sales or earnings. In the words of the court, “A broadly-worded, strategically placed disclaimer should not negate reliance as a matter of law where A&W allegedly shared objectively false data to induce Defendant to enter into the Franchise Agreement.” Therefore summary judgment was denied and the franchisee’s fraud claim will proceed to trial, with A&W potentially liable for punitive damages if the franchisee prevails on that claim.
Further thoughts: Given that the franchisee in this case already owned three other A&W restaurants at the time it purchased the franchise at issue, it would hardly be surprising if it demanded and received specific financial performance information about the other “drive-in” models. A logical question is, if A&W had included sales and earnings data in Item 19 of the FDD that it provided to this franchisee, would it have been less likely to have faced the allegations made in this case? In this author’s opinion, based on more than 15 years of representing franchisors and franchisees, A&W would have been in a better position to defend itself if it had included such data in Item 19. The reason is that the data would have been reviewed by A&W’s attorneys and probably by upper management, who would have been more likely to make sure that the presentation was accurate and not misleading. Once the presentation is in the FDD, most franchise salespeople will be less likely to “go off script” and provide information that is more optimistic than Item 19.
However, even if the franchise seller did provide information beyond the written FPR, at trial the franchisor would have been able to point to the data provided in Item 19 and say, “Look, we gave the franchisee the data in the FDD and made it easy for him to investigate further, so it is ridiculous to believe he relied on something are franchise salesperson said.” In that situation it may be more likely than not that the jury would agree with the franchisor. By contrast, by denying its franchise seller use of an Item 19 FPR, A&W made it difficult to both comply with the law and convince qualified candidates to purchase the franchise – setting up a scenario where a jury may believe that the franchise seller “went over the line.”
November 7th, 2011
A recent decision in A Love of Food I, LLC v. Maoz Vegetarian USA, Inc. , Case No. AW-10-2352, Bus. Franchise Guide (CCH) ¶ 14,633 (decided July 7, 2011), the United States District Court for the District of Maryland, in denying a motion to dismiss, highlighted the need for franchisors to vigilantly update their government-required disclosure document to maintain its accuracy, while also providing a valuable reminder as to the geographic scope of state franchise sales laws’ application.
Misrepresentations in Franchise Disclosures
The franchise agreement at issue in the case was for a Maoz Vegetarian® quick-serve restaurant that the plaintiff opened and operated in the Dupont Circle neighborhood in Washington, D.C. The franchisee alleged that the startup cost estimates in the franchisor’s government-mandated disclosure document (then known as the Uniform Franchise Offering Circular, or “UFOC”) dramatically underestimated the actual startup costs for its franchise, and that the franchisor knew that the representations were inaccurate at the time it made them. They alleged that the franchisor’s actions constituted violations of the anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as fraud as a matter of the general common law of Maryland.
In a decision during 1999 in the case of Motor City Bagels, LLC v. American Bagel Co., Civ. No. S-97-3474, Bus. Franchise Guide (CCH) ¶ 11,654, another judge in the U.S. District Court for Maryland had held that a franchisor could have committed fraud by misrepresenting the initial investment costs in its UFOC by approximately 20 – 25%. By contrast, in this case the franchisee alleged that it had to spend more than twice the franchisor’s “maximum” estimate of $269,000 to open their restaurant, and that during 2008 the franchisor increased the “maximum” initial investment cost estimate in its UFOC by $225,000.
The UFOC specifically encouraged the franchisee to rely on the startup cost estimates in two ways. First, the UFOC specifically itemized various cost categories and provided sub-estimates for each category. Second, the UFOC pointed out that the estimates were based on the franchisor’s “15 years of combined industry experience and experience in establishing and assisting our franchisees in establishing and operating 23 [vegetarian restaurants] which are similar in nature to the Franchised Unit you will operate.”
The franchisor argued that cost projections were statements of opinion and could not constitute fraud because they were not susceptible to exact knowledge at the time they are made. However, the court held that erroneous projections could supply a basis for fraud under Maryland law in some cases. Whether projections were sufficiently concrete and material to qualify as statements of fact required a context-sensitive inquiry that could not be reduced to a single formula. An assessment of relevant factors—including the extent of the alleged discrepancy, whether the projection was based on mere speculation or on facts, and whether the projection was contrary to any facts in the franchisor’s possession—supported the conclusion that the franchisee had sufficiently stated a claim for fraud to proceed with factual discovery for its common law fraud and Maryland Franchise Law claims.
Jurisdiction in Maryland and Application of New York Franchise Sales Law
The franchise agreement in this case only permitted the franchisee to open a restaurant in the District of Columbia, and in fact that is where the restaurant has been operated. The defendant franchisor maintains its principal place of business in New York, and the parties’ first meeting concerning a potential franchise sale took place at the franchisor’s New York office. The plaintiff franchisee was formed by Maryland residents and, at the time of the franchise purchase, “maintained its principal place of business” in Chevy Chase, Maryland. The parties had numerous telephone conversations during which the franchisor’s representatives were located in New York and the franchisee’s representatives were in Maryland. The franchisor sent its UFOC and the proposed franchise agreement contract to the franchisee’s address in Maryland.
Based on those facts, the court found that those activities were sufficient to allow it to exercise jurisdiction, meaning that it could require the franchisor to defend itself in Maryland.
The franchisee filed a claim for violation of the New York Franchise Sales Act on that basis that the law applied because the franchise sale was made from New York. The court, following the express terms of that law and a decision of the U.S. District Court for the Southern District of New York, found that the New York Franchise Sales Act protects franchisees in other states where offer and/or acceptance took place in New York. The rationale for extending the statute to situations such as this was to protect and enhance the commercial reputation of New York by regulating not only franchise offers originating in New York by New York-based franchisors.
The anti-fraud provisions of the Maryland Franchise Registration and Disclosure Law, as well as those of other states such as California, also apply to franchise sales made from the state. However, to the author’s knowledge, New York is the only state that requires franchisors based within its borders to obtain state registration approval before selling franchises to out of state residents.
(1) Franchisors need to be vigilant to monitor the actual initial investment costs being incurred to open new locations (whether company-owned or franchised) and promptly update initial cost estimates. Prospective franchisees should not assume that the franchisor is doing this, and should ask existing franchisees about their initial investments before buying franchise rights.
(2) If a franchise seller is discussing a franchise sale with a person located in state with a franchise sales law, then the franchisor needs to determine if it needs to obtain pre-sale registration approval from that state before selling the franchise.
(3) New York needs to amend its law to exempt out of state franchise sales from its registration requirements.
August 13th, 2010
The final installment in this series focusses on the Franchisor’s selection of franchisees.
Evaluation of Franchise Prospects by Franchisors
In the recent economic climate, franchisors have been tempted to ease their qualifications for new franchise prospects. However, franchisors need to remember that they are investing in their franchisees just as much as their franchisees are investing in them, and must resist compromising their brand’s long-term growth for short-term cash flow.
The following considerations are frequently cited by industry experts as fundamental criteria for evaluating prospective franchisees. Regardless of the economic conditions a franchisor may be facing, it should remain loyal to these fundamental principles for determining the viability of candidates:
- Ability to learn and follow the franchisor’s system;
- Fitting with the franchise system’s “culture”;
- Having relevant business experience or general business acumen;
- Being located in a geographic and demographic area that favors the franchise concept;
- Having access to capital; and
- Having grounded and realistic expectations.
While the specific traits and skills needed to succeed in any particular franchise system obviously will vary, these fundamental requirements can generally be applied broadly across all franchise systems, regardless of the industry they are in.
The need to select quality prospects as franchisees is particularly important for new and early-stage franchisors, though it obviously remains critical for highly-developed franchise systems as well. While one “bad apple” may not be as detrimental to the brand image or the ability to sell franchises for larger systems, unsuccessful franchisees can cause significant administrative burdens, and quite possibly legal fees, for franchisors of all sizes. Signing an under-qualified franchisee as one of the first non-affiliated representatives of a franchise system may have dire effects on a new system’s ability to attract qualified franchisees. When counseling prospective franchisees, we recommend that they speak with as many existing and former franchisees as possible when performing their due diligence, and one or a few franchisees who are unhappy or unsuccessful, or who are simply unimpressive as people, can impact a prospect’s view of the franchise system as a whole.
By carefully screening and interviewing franchise prospects, franchisors can protect the quality and value of their franchise systems, enhance their ability to sell additional franchises, and avoid the headaches of franchise terminations and legal disputes. We regularly counsel our new franchisor clients that selecting quality franchisees must be a top priority for their long-term success.
Individual franchised outlets and franchise systems as a whole stand a greater chance of success if they are built around committed franchise owners who trust and believe in the franchisor and everything it has to offer. Franchisees and franchisors both benefit substantially when they carefully evaluate each other during the pre-sale courting process.
August 6th, 2010
Part 2 of this series focuses on how a prospective franchisee should investigate a specific Franchise Opportunity, after narrowing focus through self-evaluation:
After examining your capabilities and ambitions, the next step is to perform your due diligence and fully investigate the franchise opportunity you are considering. In addition to researching the opportunity directly, this also involves investigating competitive opportunities to make sure that the one you choose is the best fit for you. You should carefully read the franchisor’s Franchise Disclosure Document (“FDD”), and you should prepare questions and talk with the franchisor’s representatives regarding any issues or concerns you may have.
You also should contact existing franchisees to find out how their business is doing and what they feel the benefits are of being involved with the franchisor’s system and brand name. Franchisors are often willing to “assist” with this process, by referring prospects to their most successful franchisees. What may go overlooked, however, is the opportunity to gain information from former franchisees. The third table in Item 20 of the FDD provides valuable information concerning former franchisees. Franchisors are required in this table to list the numbers of terminations, non-renewals and reacquisitions during each of the three prior calendar years, as well as the number of franchisees who “Ceased Operations – Other Reasons”—which often means that the franchisee was simply forced to close their doors because they were unable to turn a profit. In addition, franchisors are required to provide contact information for all current franchisees and former franchisees who left the system during the past year. Both current and former franchisees can provide first-hand insight into numerous qualitative aspects of a franchisor’s system.
If the franchise system has been in existence for at least five years, also consider researching the availability of existing franchises through the Internet. It is a bad sign if many franchises are for sale and at low prices. It is a good sign if relatively few are for sale and at high prices. If you find no information through the Internet on this topic, then you should ask franchisees in locations near you about purchasing their business; and, if they express interest, pursue the topic to see their level of interest in “getting out” and their reasons for wanting to do so.
Other, often overlooked, aspects of a franchise system that can ultimately have a significant effect on franchisees’ profitability include supply and purchase arrangements established by the franchisor. A powerful purchasing cooperative can significantly improve a system’s franchisees’ bottom line. Among the required disclosures in the FDD, franchisors are required to state in Item 8 whether they receive rebates or commissions based on franchisees’ purchases of goods and services from suppliers. In a successful franchise system, the bulk of the franchisor’s revenue should come from franchisee royalties, and not from franchisees’ mandatory purchases from outside vendors. Moreover, quality franchisors do not force their franchisees to pay a premium over the fair market price for ingredients and other products central to the operation of the business.
Finally, is equally, if not more important to your potential for long-term success, to look beyond the FDD and the franchise system’s historical performance, and evaluate the current and future market for the franchisor’s goods or services. Just because you have a strong interest in a particular field or product and fall in love with a franchisor’s system and business methods does not mean that the general public will do the same. In addition, while joining a regional, national or international franchise system typically will have immediate name-recognition benefits, this may not be the case with a newer or smaller franchisor. If the franchisor’s name has little or no value, and the franchisor’s system is not unique or distinctive from the competition, then you should consider whether their franchise is worth the investment.
July 30th, 2010
A successful franchise relationship requires commitments and dedication on both sides of the table. Ultimately, franchisors and franchisees alike benefit from the franchisee’s operations only when those operations are profitable. Success in franchising requires matching the right franchise prospect with the right opportunity.
This series of posts discuss steps to be taken by franchisees and franchisors to help guide them to matches with real possibilities for success.
Self- Evaluation Comes First for the Prospective Franchisee
When evaluating the purchase of franchise rights and ultimately selecting a particular opportunity to pursue, a prospective franchisee should use a deliberate process that examines your personal aspirations and capabilities, and then the value and benefits associated with particular franchise opportunities in your geographic market.
Many prospective franchisees get caught up in the dream of owing their own business or in the hype of a franchisor, and they may rush into an opportunity without truly evaluating their own capabilities and the long-term consequences of entering into a franchise relationship. Before diving into evaluation of individual franchise opportunities, you should ask yourself questions like: “Am I prepared to take on the risks and stresses of owning a business?” and, “Am I ready for the long-term time commitment of owning a business?” In addition, while many entrepreneurs may say that, from an ownership perspective, “a business is a business,” when selecting a franchise opportunity that will become and support your livelihood, you should carefully evaluate what industries match your skills and interests. While building toward an exit strategy may be your ultimate goal, you will have a much greater chance at success if you enjoy working in the business that you are growing.
Equally important with answering these basic questions is making sure that you have the funds necessary to finance the business’s development and to support you and your family through the initial stages of operations. There are several financing methods available to start a new business, and some franchisors offer financing of the initial franchise fee. You should investigate all of your financing options and choose the one that makes the most sense for you. In addition, determining how well your franchise needs to do for you to make a satisfactory living should involve a critical analysis of your unique circumstances and the historical performance of the franchise system: How much money do you need to be able to pull from the business? What have other franchisees told you? What information were you able to obtain from the franchisor? What have financing companies said? What have you figured out in your business plan? Analyzing the answers to all of these questions will be critical to determining whether you will be able to succeed as a franchisee.
If the initial investment will be over $100,000, you should seek an SBA-guaranteed bank loan, not only because it can be a good form of financing, but also because the loan officer will provide valuable feedback on whether the particular franchise under consideration is a path you should pursue. It is true that many large banks will not make loans for start up businesses, even those backed by a franchise. However, iIf a bank funds start-ups in the franchisor’s industry, but dismisses your application out of hand, then perhaps you should consider alternate opportunities.
Next week’s post will discuss investigation of specific opportuntites by a prospective franchisee who has complete his or her self-evaluation.
September 29th, 2009
Working with Consultants to Select a Franchise Opportunity
By: David L. Cahn & Jeffrey S. Fabian
While most ordinary consumers can rattle off the most famous franchised brands, there are hundreds of smaller brands with promising franchise systems struggling to reach and identify prospective franchisees. For entrepreneurs looking to invest their life savings—and more—what resources are available to assist in the process of selecting a franchise that best matches their resources and aspirations?
Magazines like Opportunity World are a great place for the fledgling franchise prospect to begin navigating the sea of franchise opportunities, and the Internet also provides a wealth of information on available franchise opportunities. However, for those seeking more personal guidance, franchise consultants, often referred to as “franchise brokers”, can provide one-on-one, personalized assistance in the selection of a franchise opportunity. Examples of consultant networks include FranChoice, FranNet, The Entrepreneur’s Source, and The Entrepreneur Authority.
Why work with Franchise Consultants?
Franchise consultants are specially trained to conduct personality and financial analyses of franchise prospects, thereby narrowing the industries and types of franchises to which they recommend to their clients. In addition, the consultant networks typically limit the number of directly competitive franchised concepts in their inventories, thereby further limiting the overall scope of a franchise prospect’s necessary investigations. Importantly, the consultant networks also typically scrutinize the franchisors in their inventories for “red flags”, such as potential solvency issues, excess franchise terminations or unit turnover, or substantial litigation with franchisees.
Franchise consultants are generally paid on a commission basis by the franchisors in their networks’ inventories, and receive their fees once the client pays his or her initial franchise fee to the franchisor. Therefore, few franchise consultants can afford to waste their time conducting in-depth evaluations and then linking prospects with franchises with which they are unlikely to be compatible. If the consultant knows certain franchisors will be unlikely to consider you as a candidate, or that you will not be able to obtain sufficient financing for certain concepts, then these franchises will be left off of the table when you and the consultant discuss your opportunities.
What do I need to be Aware of if I work with a Franchise Consultant?
Franchise consultants are typically paid on commission based on their referrals of candidates who ultimately enter into franchise agreements with the franchisors in their network’s inventory. Thus, they have the inventive to direct you only to those franchisors that work with the particular network to which they belong. As a result, even if you work with a reputable broker, you need to independently research the opportunities they propose, and remember that there may be other opportunities out there that are equally or better suited to you and your unique situation.
Obtaining answers to the following questions can help you in the process of selecting a consultant to help you in your search for a suitable franchise opportunity:
- What tools and assessments does the network use to help determine the franchises that you should consider?
- Does the consultant have experience in franchising? In what capacity?
- How long have they been a consultant? Do they have credible client references?
- What percentages of their clients live within sixty miles of your location? Consultants with local clients are motivated to make sure that their clients succeed, since their reputation in the community is important for obtaining word of mouth referrals.
- Do they provide other consulting or business coaching services, or are commissions from franchising their sole source of income?
Finally, you should be wary of any consultant who talks too much about how much money you can expect to make if you purchase any particular franchise. Such comments are likely to be illegal under franchise sales laws, and experienced franchise brokers should know to steer away from any claims about possible financial performance.
In summary, franchise consultants can provide specialized and personalized assessments in order to better match you with franchises suited to your goals, experience and capabilities. By researching and selecting a reputable consultant, you can feel more confident that the franchise you ultimately select will be right for you.
David L. Cahn is the Managing Member of Franchise & Business Law Group, a law firm located in Lutherville, Maryland. Jeffrey S. Fabian is an associate with the firm. They can be reached at (410) 583-0099, or online at www.franbuslaw.com.