Franchise Lawyer

Licensing, Technology Transfers,
Distribution and Franchise Solutions

More Franchise Articles

Econometric Strangulation - Pre Investment Franchise Due Diligence - Can The Gas Pipe Be Pulled Before The Franchisees Fail? - How To SPot The Practice.

Author Richard Solomon is a conflicts and crisis management lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

Many years ago I learned through instruction and experience that one may financially model a business segment or an individual company, and some of the many useful purposes of econometric modeling. It not only may be the answer to how to defeat the government in government antitrust enforcement cases based on size and market shares, but is also useful to franchisors in setting the limits of its revenue streams anticipation.

What is this? It is a system by which an astute franchisor may construct a financial model of its franchised businesses that depicts the cash flow potentialities of the franchised business, as an aid in setting what the franchisor may charge and add on charge staying just ahead of franchisee financial collapse.

What this produces in actual use is a dysfunctional franchise system in which the franchisees are hanging on financially by their fingernails and often doing so only to pay debt and stay out of bankruptcy. Coupled with a low renewal rate, the avaricious and conscienceless franchisor can milk the last nickel and dime out of the system, destroying any possibility that its franchisees ever make a decent living or have anything of salable capital value.

And when a franchisee owned business is resold after termination, that is accompanied by a new franchise fee, much higher that the transfer fee provided for in the franchise agreement.

I have seen this in actual clandestine practice in several franchise systems. The signals that this is what is going on may be detected with astute objective analysis, with no access to actually examine the books of either franchisee or franchisor. I use it often in my business risk pre investment due diligence consults. I will use two actual examples in this tutorial.

The first and most transparent arose in my work representing numerous 7 – 11 franchisees in several states. 7 – 11, because of its culture and the low financial performance of its franchisees, attracted bottom of the barrel franchisees, new immigrants and poorly educated people. They ran the franchise system much like a prison camp and with the stroke of a pen on an inspection report simply “took” whatever money they chose out of the franchisee’s bank account. Here is how it worked.

The franchisee lived or died by what was designated its “equity” account. The equity account was always minimal (with the occasional territory developer rare exception). Every operating need request of the franchisee could be granted or declined depending on the quality of the equity account (the larger the equity account balance, the less the assistance would be provided). The franchisee “leased” the premises from the franchisor, and needed repairs, upgrades, improvements were the landlord’s call and could be done as a landlord’s or as the franchisee’s obligation, at will or whim.

But the real micro management tool to syphon off the equity account’s balance was the franchisor’s Resale Price Inventory Value system. By this system, all inventory for resale was booked in at the item’s “suggested” resale price, not the cost at which the franchisee bought the product from the franchisor. If there were any failure to sell at the “retail” price, the shortfall would be subtracted from the franchisee’s equity account. When the account got to zero or close to it, the franchisee was deemed to be insolvent and that was/is grounds for termination.

To show how this worked in its most extreme mode, when the franchisee sold sandwiches, the ingredients for the sandwich came out of inventory held for resale and were treated as if the franchisee “sold” the ingredients to himself. Prepacked items, meats, cheeses, etc, in consumer take away small packs had to be used in the sandwiches. The retail price of a sandwich was often less than the retail price of the ingredients – under the 7 – 11 system – and the franchisee “lost” money on every such sandwich. That shortfall came out of his equity account balance. Any downward adjustment in “suggested” retail sandwich selling price, would make the sandwich lose even more money. The adjustments could be and were made on a store by store basis at the whim of 7 – 11. In this manner, any “lip” from a franchisee could result in his equity account being drained in short order and his being terminated for net worth violation of the franchise agreement. When I learned from my clients how this worked I was reluctant to believe it until I simply could not find any information to contradict this assessment. When I deposed an accounting manager of 7 – 11 on this subject, and she realized that this was the dynamic, she broke down and cried.

One does not always have access to such internal information when doing pre investment due diligence, and so must be sensitive to knowing where to look for the objectively observable signs of econometric modeling being used to keep the franchisees always on the edge of financial collapse. Since profitability is not disclosed in most Item 19 Financial Performance information, and sales are the basis on which the franchises are sold (plus outright lies in many instances not within the FDD), you cannot detect this in the FDD, with the possible exception of a rather sophisticated analysis of the information in item 20 (which is a clue but not conclusive).

The other example of economic modelling intended to keep franchisees’ as the ultimate pipeline for wealth transfer to their franchisor comes from my consults in pre investment due diligence regarding the Quiznos franchising system. In addition to the disclosed information via its FDD, the due diligence consult went also to the substantial history of Quiznos on as well as inquiries to business brokers regarding available Quiznos franchises for resale. This information led me to conclude the following.

The Quiznos franchisor apparently kept careful track of franchisee store performance and knew exactly what extra/increased charges the franchisees could absorb and still be able to meet their loan payments, whether they had any cash flow to live on or not. The franchisees ere always living on the ragged edge of bankruptcy.

I always include in my due diligence work a survey of business brokers so that I can show my clients the difference between buying a startup franchise in that system and buying a resale, thus avoiding start up risks. By doing that survey one gets to see actual federal tax returns for several years, which usually show what utter nonsense the FDD is trying to tell you.

Looking at the Quiznos Item 20 information dovetails into this assessment of the franchise as an investment risk.

One effect of predatory modeling is that it tends to keep franchisees too poor to afford effective resources to oppose destruction. They are rarely able to coalesce to provide funding of resistance to a deep pocket abuser.

Most of the time, franchisees form what they call a franchisee association, but it is configured more like a social club that a resistance movement. Its agendas are always known by the franchisor immediately upon being discussed, as the association web site is interactive and easily penetrable. In addition, there is always the Judas franchisee that will inform the franchisor of everything in the hope of currying favor. They avoid spending money on competent guidance, but the price they pay is total impotence.

To be sure, there are other indicia of predatory econometric modeling in franchising as well. Many more companies are rather obviously doing some variant of modelling for predatory purposes.

For over 50 years as a lawyer I have dealt with predation issues, representing franchisors and others who were accused of unreasonable aggression and needed effective representation just to see that they got a fair trial, as well as franchisees who were, as in the 7-11 cases, the victims of it. From that I believe I have an in depth understanding of the nuances of predation, not just theory but practice and subtleties – evidence of what is the truth and how to find it. I really do have a solid grounding in what I have been describing here.

If you are a franchisor facing predation accusations and need really sound assessment of your positions, without whitewash, and assistance in defending yourself against improper, untrue accusations based upon one sided interpretations of how your business can lawfully operate, I am your best resource. The same techniques of econometric modeling can derive optimum adjustments so that what may be changed is compensated for by other advantages that result in equivalent or better prospects going forward.

If you are a potential franchise investor and are using a lawyer to advise you on the “papers” without serious business risk due diligence, you odds of attaining a sustainable financial breakeven are far better in Las Vegas.

Whatever anyone may say about my firm, we do not mince words or put lipstick on any pigs.

Copyright 1997 - 2017 || Richard A. Solomon || Site Map

Franchise, Crisis, Antitrust, Counsel, Litigation, Due Diligence, Association, Strategy, Tactics, Fraud, Prevent, International, Analysis, Emergency, Franchising, Specialized Tutorials, Richard A. Solomon, Attorney, Law.

Licensing, Technology Transfers,
Distribution and Franchise Solutions