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Franchise Disclosure Is Really Non Disclosure - Here's Why And How

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.

Neither you nor your lawyer nor your accountant nor the three of you working together can assess the legal and financial risks of any franchise investment opportunity by examining the Franchise Disclosure Document package. The practices of configuring and selling franchises are calculated to cause you to make your investment decision on things like the taste of the food; generalizations about how many people use widgets; unproven claims of unique business concepts and pseudo issues/"facts", whether the franchisor has a positive net worth/made money last year, whether some franchisees said positive things about the franchise (but didn't show you any financial results) and things like that.

Disclosure documents in the sale of securities as well as in franchise sales are examples of hiding information in plain sight. Everything required, but less than what is needed, to be said is said. It is said so verbosely and so confusingly organized that whenever things have to be connected up in order to be understandable in context of the actual business operations, it is almost impossible for anyone other than someone who always does that with those kinds of documents. No franchise investor and no general business lawyer has that level of expertise. It is somewhat similar in that respect - though not nearly as godawful - to the tax code.

People with a successful history operating other franchises may have better insights, but they do not represent the normal person making these investments.

The result is that when a regular business lawyer is hired to advise someone about buying a franchise, all the client really gets is fluff commentary about how one sided the contract is plus inability to spot anything suggesting that what the investor has been told is not reliable. There is no competence to assess corroboration issues with the acknowledgement that if anything was improperly told to the investor about financial performance prospects, he didn't rely in it in making his investment decision. Many even go beyond that by having the investor also sign an acknowledgement that no financial performance information was given to him at all except for what is contained in Item 19 of the FDD.

I have been told by dozens of disgruntled franchisees that their pre investment lawyers, in retrospect, advised them of almost none of the risks that were hidden in arcane language, verbosity and calculatedly arranged segments of the FDD to make them extremely difficult to link up for the whole picture.

Most franchise investors will continue to opt for the less expensive general business lawyer's "aid" in "reading the documents". It would be foolish for franchisor attorneys to abandon the present method of organizing FDD disclosures so as to make linking up components of various risks and burying significant items in the arcane and sheer excess language of the document more readable.

The very old statement about securities prospectuses, that they are so complex and verbose that no one reads them, much less understands what they say, applies as well to franchise pre investment disclosures.

The reason that this is so is that the laws and regulations, written to prevent investment confusion and fraud, were lobbied down to such dilution that they provide no meaningful protection to anyone not advised by a real expert with years of experience in sorting these things out.

There are about 12 real questions to be responded to in franchise pre investment due diligence. Some are addressed in the FDD package of documents. Some are addressed in the information the franchisee gave the franchisor about himself. Others require outside inquiry, much more than simply talking with franchisees - something not nearly as useful as most folks think.

An average FDD today is about 200 plus pages in length. Any competent legal draftsman could hide the Presidential War Powers Act in that much verbiage - otherwise designated of course - and almost no one would ever find it.

When a potential franchise investor is interviewing a lawyer about getting help vetting a franchise investment opportunity, it might be worthwhile to ask the lawyer to identify the issues he feels are critical to the vetting; how he intends to deal with the investigation; whether the vetting will include the business risks as well as the legal risks - and how they interact. Most of the lawyers who are advertising themselves as franchise lawyers today have no clue how to answer those questions. If they get two right it would be amazing.

Their fees are relatively low - somewhere around $1,000 - but you get nothing of value from their effort. You are investing blindly. Moreover, you will sign an acknowledgement that you were advised by the franchisor to consult with a lawyer or other advisor prior to making your investment decision and that you in fact did so. When you are cross examined in any dispute resolution proceeding later on, that will be strong evidence to convince a fact finder that you obtained adequate protection against undue investor risk and that fraud was not a cause of your difficulties. Saving some money on the due diligence expense will really shoot you in the ass when disputes arise.

For example, what is a concept? What does "proof of concept really mean"? What is the significance of regionality and seasonality in this particular transaction? How does business segment population impact durability of the business over the life span of the franchise agreement? These are but a few of the sub questions that are included within the dozen or so main areas of inquiry that should be accounted for in any competent due diligence vetting. When you don't vet your lawyer, you can't know whether he is capable of vetting a franchise investment. He may have been doing his work for many years, but longevity in itself is not a measure of insight or competence.

The "art" of selling franchises includes such things as confronting you with questions about your manhood if you do not make important business decisions without nit picking the particulars. Appeal is made to your vision of yourself as a successful business owner when you have never owned or operated any business in your entire life. Operational support is praised to high heaven and extremely effective, but the contract will say that you get whatever support the franchisor happens to be giving out at the time. You are told that the concept is unique even though it is just another store selling sandwiches or pizza or something similar that has been around for years under many names. You are led to believe that you will be the beneficiary of confidential trade secrets that no one else is receiving, when the franchisor's people came from companies doing the same thing and are simply repackaging what they learned elsewhere. You wouldn't know a trade secret from a Siamese cat. Your general business lawyer doesn't know any more about this than you do.

Neither you nor your general business lawyer knows how to project operational financial requirements/risks over the life of the franchise agreement or how to quantify the liability associated with doing that.

Who else should you speak with other than a few franchisees? If you used a loan broker, what was discussed with that person? Did you read published articles about this franchise or a ranking of it by some business magazine? How does one separate out the Kool-Aid from the significant information in the context of this business and this proposal?

Most lawyers miss the significance of the investor being told to sign a non disclosure agreement in order to receive their FDD or to attend their Discovery Day. Discovery Day is just the sales pitch. There is no secret or confidential information given on Discovery Day. A franchisor that insists upon your signing an NDA for any of that is a company to avoid, no matter what they say the deal is. When you are told to sign NDAs regarding material that is in the public domain, do you really think such a company is one with which you can ever have a normal commercial relationship? Just about none of the "read the FDD" lawyers have any insight into this or any similar business insight issues.

These are but a few of the many "insights" issues in play when performing pre investment due diligence of a franchise proposal. You can't get this in law school or by attending seminars about franchising or franchise law. Street smarts come only from experience in the street.

Do yourself a favor. If you are not willing to spend a few thousand dollars to understand what you are looking at that may put you in bankruptcy in just a few years, go to Vegas. The odds are better.

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