Tag: financial performance representations
May 10th, 2013
David Cahn
In Long John Silver’s Inc. v. Nickleson, decided February 12, 2013, the U.S. District Court for the Western District of Kentucky issued another decision demonstrating the danger of franchisors relying on disclaimers in their 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 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. The franchisor will be permitted to use the disclaimers in the contract and the FDD 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 claim that the projections provided 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.
Given that the franchisee in this case already owned three (3) 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, was it less likely to have faced the allegations made in this case? In this author’s opinion, based on more than fifteen (15) years of representing franchisors and franchisees, A&W would have been in a better position to defend against the allegations had it 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 be 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 will be 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 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.”
August 30th, 2010
David Cahn
(This is the conclusion of the August 23, 2010 post on this Blog.)
Franchising vs. Other Methods of Expansion
The main advantage that franchising has over expanding a business on your own is that you get to invest other people’s time, skills, and money to growing the business instead of borrowing against your business and personal assets or granting stock to outside investors. Having franchisees allow a business to play off of a diverse pool of talent that may attract different types of people to the business.
Many businesses have found that, by granting franchises, they can recruit talented individuals who will be driven to tremendous lengths to make their business a success. While incentives to the managers of company-owned remote locations can drive good short-term results, franchisees who risk their net worth on the enterprise have the ultimate incentive to develop the businesses for long-term profitability.
As the franchisor, your business will be less likely to be held liable for any claims of personal injury or employment discrimination that that may happen on the premises of a franchised unit, as opposed to one opened with borrowed or equity capital. Making sure that this liability shield is effective takes careful planning, but when properly executed it is a substantial benefit of franchising.
It’s not all good news however. After outside lenders or investors are repaid, company units may yield more profit to the brand founder than franchises. It can be more difficult and costly to terminate a misbehaving franchisee than a location manager. Finally, company owned units located near franchises could suffer revenue losses through competition with the franchises.
So You’ve Decided to Franchise…
With all of that in mind, and you’ve decided that your business is ready to franchise, there are a few things you should do before looking for your first franchisee.
- Develop the operating manual and training plan. Owners often create these items with the help of a consultant and with overall legal guidance.
- Put money aside. A thoughtful and responsible business owner should have at least $100,000 available for franchising purposes, including legal, development of training programs and operations manuals, and advertising for franchisees (both creative and placement). Also, a shrewd businessman might put away that money, spend half on the aforementioned items, and keep the rest on hand to show sufficient capitalization to obtain state franchise registration on favorable terms.
- Be prepared to do some hand-holding. Business owners that are looking to franchise need to be realistic when they look at the additional operating costs of getting a franchise up and running. They must spend money and time recruiting and supporting the new franchisees. Time away from the core-business means money for managerial costs for the original businesses that form the “prototype” for the franchises.
Conclusion
Potential franchisors need to accept that franchising successfully will require some short term sacrifices in terms of time and money. Done correctly and thoroughly can mean the growth of your business to larger regional or national markets. Improperly, underfunded, and rushed could mean the loss of the business entirely. Early investment in franchise resources and assistance will give the business a better chance at success and growth within your industry.
August 23rd, 2010
David Cahn
Do you think you’re ready to make your business a franchise? Ready to become the next Subway or Jiffy Lube?
In this column, I’ll outline some key factors to consider as you make the important decision of whether and when to franchise your business methods. Part 1 focuses on signs that a business is “franchisable”. Part 2 will focus on franchising vs. other methods of expansion, and steps necessary to franchise.
One thing is for sure – given the number of jobs lost over the past two years, there are many potential franchise owners “out there” who are eager to find their next opportunity. Becoming the owner of a franchised business (as the “franchisee”) can be a great option for someone who has entrepreneurial skills and motivation but doesn’t want to start a business “from scratch.” But before you take the plunge and dive headlong into becoming their franchisor, it’s important to keep in mind the most important factors that will determine your success.
Signs That Your Business Is Ready To Franchise
The first hurtle to “franchise-ability” is whether your business has been consistently profitable over a substantial period of time. Typically, if your business is in a mature industry, such as food service or printing, you need to have been in business at least three years and have a steady record of profits. You should also have multiple separate locations to disprove that notion that it’s only a local success.
A different rule applies to “new” industry or niche businesses. If a business presents a truly unique and innovative operating method, and has shown some profitability, then it may be in the business’ best interests to franchise quickly to gain regional recognition as the leader for that niche. For example, a fitness company that offers a new type of program and that has been developed locally should try to get into the market quickly and establish themselves as the dominant brand for that niche.
The second hurtle is having developed a business system that you can teach to franchisees and can be easily replicated in other locations. Disclosures that must be given to prospective franchisees under U.S. and state laws have essentially mandated that a franchisor prepare some sort of “Operations Manual” to loan to active franchisees, and also that it plan out a new franchisee training program in advance of offering franchises. Therefore, before franchising you need to carefully document both how to develop and operate the business you want to franchise, and also plan how you will train others to replicate your methods.
Another important question is whether you have a business name and/or logo that can obtain and maintain trademark protection. Having a “strong Mark” for both marketing and legal purposes is very important to the long-term success of a franchise system, and if that factor is not present then you should carefully consider whether to re-brand and obtain trademark registration in advance of franchising.
Last but not least, will your prospective franchisees be able to obtain the capital that they need to open and operate franchises? A prospective franchisor needs to talk with its bankers to develop a profile for a suitable franchisee that will have sufficient net worth (both total and liquid) to be able to personally qualify for financing. You should then obtain informal commitments from financial institutions to finance candidates who have meet those qualifications and secure suitable locations or geographic territories from which to operate the franchise.
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.