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Franchise Pre Investment Due Diligence

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.

A Discussion among Richard A Solomon of www.FranchiseRemedies.com A Division of www.TamerlaneGroup.com and The Michigan Bar Association Antitrust, Franchising and Trade Regulation Section

This exercise is an assignment to find as many as possible of the blemishes in a business proposal someone is making to sell your client a franchise. This is not some rant against franchising, but rather a roadmap to assist you to become more sensitive to the nature and severity of the risks and where to go look to determine if and to what degree the risks are present in the transaction being proposed to your client. This business is bollocks deep in propaganda. Your client may already have drunk the Kool-Aid. You have accepted retention to help him overcome that.

Legal Vetting

All franchise agreements are draconian. Their purpose is to deal with the worst situation in a manner that will provide all the options for the franchisor and as few as possible for the franchisee. Theoretically they spring from the need of a trade or service mark owner to police the borders of its commercial hegemony. These marks are source identifiers. If inroads into their specificity of reference can be made by others, then confusion results. Aspirin used to identify Bayer. Through its conversational usage and the proliferation of sources, aspirin became a generic reference to all sources of that specific medicine and Bayer lost its exclusive rights. Control is the touchstone of ownership. Franchise agreements govern the use by others of the name and other elements of one’s trade identity. If its use by others is not carefully controlled abandonment happens. Since these agreements are that one sided, they require a very tangible prospect for financial success to justify signing one. That is what real due diligence is all about.

You will probably not be able to negotiate any part of the agreement if your client is buying a single franchise. If your client has a positive history as a franchisee elsewhere and will buy a territory with a development schedule, then you can talk. Anyone who will negotiate terms on a one unit franchise is just desperate and is not investment worthy.

Dispute Resolution

If dispute resolution is a two or three step procedure calculated to run you out of money before any possibility of a remedy, turn it down. The choice of law and venue will be the franchisor’s home location and that is enforceable per se in the USA unless a state statute prohibits a franchisor from making a local franchisee go out of state for dispute resolution. (See the State Specific pages of the FDD). In international franchising that is not settled but is the subject of confrontation in the EU. Some member nation courts have ruled against American franchisors on this point.

Arbitration before the AAA under its Commercial Rules is acceptable. Arbitration under any other resource is not. Other private dispute resolution resources have sprung up. Several, to my personal knowledge, have gone to franchisors and told them that if they put that organization into their franchise agreements their prospects for prevailing in any dispute will be much better. The reasons they give for this “promise” are varied, but the corrupt arrangement can’t be missed. In one instance I know of the franchisor’s lawyer owned the arbitration resource selected in the agreement. When you see a non AAA arbitration resource chosen, decline the investment opportunity. Arbitration is now tough enough without that disadvantage. If arbitrators find against franchisors, they go on a “list” to be objected to by franchisors in future arbitrations. This is not unique to franchising. It has long been used in labor arbitrations in addition to other delightful tactics.

Loss of Rights through False Admissions/Acknowledgements

When he signs the agreement your client confesses to no financial performance representations other than those in the FDD. The combined clauses are the merger clause, the acknowledgement clause, the no reliance clause and probably a questionnaire to be filled out at closing saying that there were no financial performance representations other than as stated in the FDD. These do not violate the non-waiver provisions of franchise disclosure laws but are violations of the FTC Rule. Few are bothered by the FTC because the FTC is a very lethargic agency. It usually only moves against small targets that are expected to roll over because of expense. These “victories” it uses to bolster its budget requests before Congress every year. For that reason it is utterly useless for any abused franchisee to go to the FTC in the hope of meaningful assistance.

It is important to recognize that all franchise regulation consists of unfunded mandates. Getting a law passed means very little because there is never an enforcement budget passed with it. Your only remedy is private enforcement under state law. The FTC Franchise Rule has no private right of action because it is promulgated under Section 5 of the FTC Act which has no private right of action. Be aware, however, that violation of the FTC Franchise Rule may be useful in private litigation under state Deceptive Trade Practice/Consumer Protection laws. That may not be so in Michigan if franchises are not considered to be consumer transactions. You can use the FTC Rule in that manner under a state law claim even in Federal Court.

If your client says there were financial performance representations from any source other than in the FDD, then you are dealing with a crook and if your client signs it may destroy all financial performance fraud claims. The courts are not always applying the FTC Rule on that issue. Good sense dictates, according to these courts, that grown ups who sign false statements in order to get a franchise are not allowed to plead ignorance or inexperience vis a vis their business agreements. The policy behind that are that those who claim to be grown ups have to accept the consequences of being treated like a grownup. Some lawyers may think they can coach their clients around this testimonial hurdle, but that is usually naïve. Most importantly, when someone insists you sign on to a falsity, that tells you the person is dishonest and you should not buy a franchise from him.

If your client received financial performance information from a broker, salesperson, lender, a magazine article, that was all from the franchisor. Entrepreneur Magazine is the most infamous hard core recidivist for publishing all sorts of financial performance information sourced from franchisors. Since you get it by reading the magazine, the franchisor disclaims that it is from him, and you will have signed an agreement acknowledging that the franchisor gave you no financial performance information that was not in the FDD. If the Contract or the FDD disclaims his being provided with financial performance information other than what was in the FDD and he got it indirectly, then you know he is being lied to and that if he signs the franchise agreement he is being swindled. There are no exceptions.

Be sure you have your client bring you a set of all the documents and information that were submitted to the franchisor to show qualification to be a franchisee of this franchisor. In that information your client will have overstated/optimistically stated experience quality and how good he was at everything he ever did. He will have portrayed himself as such an experienced business person that no one would ever believe he was naïve when he bought the franchise and didn’t understand what was given to him or what it all meant. In a dispute he will be confronted with all the wonderful things he said about himself.

Changing the Game Unilaterally

The operations manual is often used to change the rules of the relationship without amending the agreement. Case law saying that is not permissible is mainly useless except in the rare instance. The magic of the operations manual is that it is only the franchisor that can make changes. It is the closest thing to autocracy on the planet. When that is combined with provisions that proclaim that the franchisor may make such changes in the franchised business as it may deem in its best interest and that all good will belongs to the franchisor only, the operations manual is the single most dangerous management option of the franchisor. When one computes the net income changes that can be wrought with a simple change in suppliers or in how revenues flow from customers to franchisees – directly or through the fingers of the franchisor – it is evidence of a potential fatal risk. Had I not seen it used in that manner so many times I would not point this out. This is not a theoretical discussion.

Magnitude of the Risk

Walk your client through every provision of the agreement that relates to every item of expense that is a recurring item - rent, utilities, advertising, royalties and so on. He needs to appreciate that his assumption of risk is not just what his initial investment will be. Multiply these monthly totals by the number of months in the whole term of the franchise agreement. The franchise contract will make it sound like the relationship costs – the cost of just being a franchisee (Relationship Costs), in addition to other normal operating expenses for an independent business is reasonably scaled. The arithmetic this exercise calls for will show that the investment being risked is not the $ 500,000 stated, but millions of dollars over the life of the agreement that your client must personally guarantee.

If the agreement confines your client’s purchases to designated suppliers or to the franchisor, he will never get competitive pricing on anything he has to buy. The franchise agreement facially makes it look like the relationship cost is between ten and fifteen percent of gross sales. The real relationship cost will be more like twenty to twenty-five percent. A big selling point is the claim that being a franchisee enables you to take advantage of real buying power. That is utterly untrue in almost every franchise. Where franchisees have to buy from the franchisor or a designated vendor any buying power value goes to the franchisor, not to the franchisees. The vendor compensates the franchisor for getting a monopoly vendor position and the franchisees have no competitive supply. They actually pay more than fair market value due to having no access to competing vendors.

Then go back and reconfigure his business plan pro forma to adjust for this work. It will yield a much lower net and EBITDA. That ought to make a serious difference in his enthusiasm to become a franchisee.

Never ever let your client invest in any franchise where the contract provides that his payment is through the franchisor’s credit/debit card program – or any other system if the franchisor gets his money before he does. Allow no one to come between your client and his revenue stream. Almost every one of these I have ever seen results in the franchisor claiming the franchisee owes more than the franchisee does owe. The resulting net passed through to the franchisee will always be short. “Errors” will never be corrected. Becoming a troublemaker because you are being swindled puts a target on your back. You can expect default notices and termination attempts.

Unless the franchise is for a hotel, never accept a so called liquidated damages clause in any agreement. That is there for intimidation purposes and will usually prevent your client from ever getting due process or fair resolution in any dispute. Hotel franchising is different mainly because there usually is no post term covenant not to compete.

Tell your client that if this doesn’t work out the most likely option will be bankruptcy. He cannot make independent adjustments in the way business is done to try to save his business. He probably will not have enough money to finance legal representation in any dispute resolution proceeding. These are extremely material considerations in buying any franchise that usually do not exist in independent businesses.

Business Vetting & The FDD

The first thing is to look at the effective date of the FDD. If there is or is about to be a new one, get it before any further consideration is given to buying the franchise. It will have one more year of certified financials (including the very important notes to the financial statement) and a new Item 20 – a goldmine of information most of the time (good or bad).

Statements versus Facts

There is a large difference in how you assess the business risks of older franchise systems versus newer ones. One would normally think that the new ones are inherently more risky, but today, depending upon the category of the business (car repair, sandwiches, hamburgers etc), the older ones can be more risky. The reason for this is that many are in the decay stage of their life cycle. At a certain point in any business segment the growth potential is reached and from there on there is a growing saturation problem. Symptoms of this are obvious proliferation of brands and flooding of territories with stores and intense price cutting. Examples of this are pizza, sandwiches and hamburgers. There can still be spurts of short term growth in this stage, but mainly that is not so.

One of the sure danger signs is a company that decides to franchise its theretofore company owned stores. The only reason a company dumps operating assets is that they are money losers or at least low profit operations. The suggestion that individual ownership will raise their profitability is the most common sales pitch. You might draw out the scam by offering a no royalties or initial fee (just monthly site rent) until a stated EDIDTA is achieved for a stated number of months. That would prove out the claim about private ownership of losing assets, but no one will accept it. They are looking for suckers to dump them on.

A regularly used trick is to pump up the store sales with money losing volume promotions. Look at the last nine to twelve months sales figures and you will recognize a “pump and dump”. Run like hell.

Another symptom of a scam is repeated refranchising of closed franchised locations. In a resale/refranchising always get the history of the particular store location. This tactic is known as churning and is rather pervasive in franchising today, especially among older franchise systems that are going past their mature stage of their life cycle into their decay stage. Sometimes the best way to find out about churning to go research the company on www.BlueMauMau.net , www.UnhappyFranchisee.com and using a search string with the word churning and the name of the franchisor.

To me the most egregious franchise program extant is that of www.VetFran.com. VetFran is a program in which returning veterans are getting fleeced under something designed to look like an ultimate patriotic program to support returning vets. If you look at the list of VetFran companies you will see some of the really bad cats and dogs of franchising. A few are so bad that their business model has been attacked as not being a franchise at all, but in reality just paying money to get a very low paying job. There are a few deals in VetFran that might be worth looking into depending upon the market and location, but in the main that is simply not so.

In addition to VetFran a due diligence lawyer should also be sensitive to the targeting of immigrants. For decades the immigration laws have provided for expedited green card and citizenship paths for those making defined business investments in the USA. Franchisors I have known have targeted immigrants even before they leave their home countries. They are sold not so much on the corroborated investment quality of the business, but on the anticipation of immigration and naturalization benefits that can flow from investing in the franchise. Those whose practice focuses upon representing immigrants need to be sensitive to their being targeted in this manner. They are so happy about being able to bring their relatives over on visitors’ visas when they are about to give biirth, so that those children will be natural born American citizens, that they haven’t even thought about risk assumption. Their mental processing tells them that they can sign almost anything and worry about the commercial and legal consequences later. I see them when later has become now and they are confronted with losing everything. Usually it is then too late.

How did your client get involved with this particular franchise? If it was through a “franchise consultant/coach”, your client was probably not paying him. Any resource that is not paid by your client is being paid by the franchisor via sales commission. That means that everything that was so guided was guided by a salesperson, not a consultant or coach. What was told to your client by these folks has to be regarded in light of it being only a sales pitch, not to be given the same weight as anything said to him by someone he paid.

One symptom of older but more investment worthy franchises is that you simply can’t buy one. When that kind of store becomes available for purchase one of the other franchisees will buy it because they already know the system and how to do it very profitably. Franchisors would normally prefer one of their other franchisees to buy available territories because they are more likely to be successful and are a known relationship.

In a more recent offering you really need to be aware of omissions of material adverse information. In the older ones the likelihood is that what is stated in critical sections is knowingly false or misleading. Look at the franchisor’s financial information exhibit, which may be the last item in the whole FDD package, including its footnotes. If the franchisor is new and has no real money to speak of, it is an especially high risk to expose yourself to years of liability to it amounting in total to more than the franchisor itself is worth. A franchisor with $ 200,000 in cash and a $ 50,000 net income last year probably won’t be around for the entire five or ten year term of your franchise agreement. But its creditors may come after you for the remaining fees due till the end of your franchise term, even though it means you are paying for absolutely nothing – and probably were paying for absolutely nothing from the very beginning.

Unfortunately, franchisors are still telling franchisee prospects that the failure rate of independent start up businesses is very high and that 95 % of franchised business succeed. That was never true, and today it is clear to everyone who looks at it that independent start ups are more likely to be successful than franchises, and the SBA concurs. The SBA small business start up loan default rates for franchises used to be available at the SBA website. As they more often showed the truth about underperforming franchises, as the result of lobbying they were discontinued. Many of these VetFran so called high success rate franchisors are among the worst performing start up loan defaulters.

It will be important to counsel both spouses regarding a decision to buy a franchise. Many times one spouse’s enthusiasm is not shared and is seriously resisted by the other. This is a very big danger sign. People need each other’s entire support in doing something like this. You won’t be able to account for that by speaking only with one of them.

One of the easiest and most effective things to do is to give your client homework. When the client does the outside research homework and discovers something the impact is much greater than if you did it and then told him about it.

Illustratively, one of the things I have clients do to check out success stories and financial performance information is to go to the business brokers locally and tell them that you are looking at a business to buy and would like to decide whether it would be better to buy a startup or one that has already been around a while. That is/ought to be true, and should be considered with great seriousness. Ask if there are businesses of that system for sale in your market. If so you can get actual tax returns for several years and learn the truth about financial performance in that system. It costs nothing to get the information other than signing a non disclosure agreement that you are using this information only for investment purposes. If there is resistance to providing that information, you know this is a dog and you should make a negative investment decision on the franchise opportunity. Never agree to pay anything for access to tax returns. That is normal due diligence that only fools pay to obtain.

Talking with current franchisee is OK, but there are good reasons to take what they tell your client with a grain of salt unless you can find extrinsic corroboration. The reasons for this are that franchisees don’t want it to get back to the franchisor that they are bad mouthing the system; they think you might just be a snoop for the franchisor out to find troublemakers.

DISCOVERY DAY is like standing behind a manure spreader on a windy day. Everything is scripted and rehearsed (except maybe the big boss’s remarks) and role played. If they bring in some franchisees to talk about how great it is, these people are simply not to be believed. You can’t possibly believe they are trying to do anything but help sell you a franchise, and in most instances they are compensated for blowing smoke into your face if you actually do buy a franchise. Many franchisors have this franchisee tell the group about wonderful financial performance and claim that does not constitute the franchisor providing it. That this is absolutely absurd only shows how little regard there is for having to deal with consequences.

On DD you may see financial performance information given on a blackboard – and then immediately erased – or given orally. Write it down, Take careful notes throughout DD and show them to nobody. A real crook will ask for your notes. Refuse to show them to him and that also tells you he is afraid of people finding out what happens at DD in a form that may be admissible in court or that may be used to refresh a witness’ recollection in court, or that may go to an enforcement agency. Flee from the paranoid franchisor, no matter what they may say about the joy and enrichment that flows like milk and honey from being their franchisee every day of the year.

An important and often astounding comparison can often be made if the franchisor is a publicly traded company. While the FDD sounds and reads a bit like Alice in Wonderland, what the company says about its franchising operations in its annual report filed with the SEC can be an eye opener. Some companies have a link to their annual report on their home page (not their franchising home page) under Shareholder Relations. Otherwise go to www.SEC.gov and look under Filings to get into the EDGAR filings system. What sounds like the best thing since sliced bread in the franchise materials is sometimes described as a high risk, barely marginal activity when statements are made about it that are subject to securities fraud level exposure.

Some franchisors will say when confronted by these differences that it is the product of the difference between the franchise laws and the securities laws. They are really saying that someone who buys $ 1,000 worth of their stock is entitled to better quality disclosure than someone who is investing upwards in a half million dollars in a franchised business based on their disclosures about it. These ironies should not be lost on you. Your client will certainly lack this level of sophistication and be depending on you to provide real insights.

Item 7 of the FDD is supposed to tell you the total initial investment. It is understated by orders of magnitude. The statements are modified by the notes, expressed in a manner calculated to discourage you from reading them. You do not hit break even in 90 days. Usually your living expenses are not included. In many instances you will not even be open in 90 days from signing the agreement, during which you will be paying for location buildout and other very expensive things. If you hit break even in 9 months you will be extremely fortunate. You will even be lucky to hit breakeven in a year. Many never ever hit breakeven. This is why economic due diligence is so critically important. Legal analysis without more is simply absurd. Lawyers often “read documents” for a few hundred dollars. When the client asks if the lawyer thinks it’s a good deal, the lawyer usually says “it could be if they are telling you the truth”. That is simply not due diligence.

With newer franchisors it is not uncommon that they really don’t know how much it takes to open and establish the business. Your client should be tasked with making his own survey of businesses in the same industry and researching how they were established – usually by taking the time to get to know the owner or manager and being told what that business’ experience was.

Item 19 dealing with financial performance representations is almost always misleading. It usually talks about sales numbers. Sales do not inform you about profitability. It almost never provides disclosure about regional or seasonal fluctuations or about what percentage of franchises in the system achieve the represented sales performance. More and more now do because it is persuasive and useless (even if it is true). Profit/EBIDTA is the only meaningful information. Check out www.FranchiseDisclosures.com and www.Item19s.com.

Item 20 is a gold mine!

Spend a lot of time on Item 20. Go to it several times. From intense scrutiny of Item 20 you can get a picture of attrition/churning and whether that is a high or acceptable risk. If you are fortunate enough to have two or more years of the franchisor’s FDDs (which you can request or get from other sources – like the State of California Government website, as everyone who is worth consideration registers in California - https://docqnet.dbo.ca.gov/search/).

It is not unusual in the instance of a smaller franchisor that over its first five or ten years it sold only about 50 or so franchises. In one recently vetted franchise there were 75 sold in 13 years, of which 11 were terminated or taken back, and resold. So 11 of its sales were resales of failed franchises, bringing actual new deal sales down to 66. Of the 66 originally sold, 14.5 percent failed. That is a large failure rate and a sign that your client should decide not to buy into it. Typically a franchisor with this factor will also be thinly capitalized when you look at its financial statement. In a recent FDD I examined the franchisor had $ 79,000 in earnings the previous year and bought a new BMW and a new Cadillac for its top “executives”. Notes to the financial statement are truly eye opening much of the time.

Sold but unopened information in Item 20 will tell you to run like hell if there are significant deals where sales have not been promptly followed by location actual openings for business. This is most often the decisive indicator of the fantasy franchise – an offering where the really is no business at all. Recently there have been two of them that were rather spectacular scams. One was called Dagwood Sandwiches. Over $65 million was made selling the rights to operate Dagwood Sandwich franchises, said to be the next Subway fortune opportunity and the best thing since sliced bread. When the investors finally came to the realization that it was a total scam no money could be recovered. Those who bought individual store franchises had no money left to hire a lawyer anyway. No contingent fee arrangements can be found in these deals because there is no possibility of collectability.

The other notable craziness was built upon the popularity of a television program called the Soup Nazi. Some imaginative thief started a scam called Soup Man. Of course these almost never got open and everyone lost all their investments. I know about these deals mainly because failed franchisees finally, after they have lost everything, decide to go onto the Internet and find out what happened to them and what they can do about it. They gravitate to my websites mainly because of the various franchise fraud tutorials found there. Then they call me with these stories.

First they want to know how it is that people are allowed to do this to other people. I explain to them that your rights are never self executing and that you have to defend your position before the fact or be wiped out. They lament that America is such a place. Many say that they went to a lawyer before they bought the franchise and the lawyer said it was OK. They tell me that for their $ 300 fee to “read the contract” they expected legal protection. In the instance of Soup Man they say that the soup had a good Zagat rating. Instead of buying a good bowl of soup for $ 3.00, they bought franchise rights for $ 40,000.

These stories are told to you so that you come to a realization of how totally corrupt a bad franchise deal really is. If you really know how to vet these you can do a lot of good in the world for a reasonable fee that reflects the amount and value of what you do. Few lawyers are turning down the $ 300 fee for “reading the contract”. A person has to decide who s/he wants to be. Think on the question of whether the lawyers who do this are any different from the bad franchises they “approve”.

The states where the franchise is registered will also give you information about whether the franchisor is required to escrow initial fees. This is required to be disclosed in the FDD but is sometimes omitted. If the franchisor is thinly capitalized and there is no initial fee impound disclosed, registration states should be contacted to inquire about that. An escrow of initial fees order means that the franchisor is facially undercapitalized. Do not purchase a franchise from a company that has an initial fee escrow. It will more often than not simply fail and the relationship with it prove to be worthless while you are bound by contract to keep on paying for it.

When a franchisor fails and is unable to provide support, theoretically that5 is considered to be an incurable breach unless the franchisor is immediately acquired by a company that is capable of doing that. Some people believe that relieves the franchisee of further franchise agreement obligations. They often stop paying royalties or pay them into some escrow account (which is the same as not paying them at all). That is clearly a breach of contract by the franchisee. Whether what the franchisor has done is a breach of contract has to be proven before the franchisee’s performance is excused.

There are two considerations here. First, read the agreement and you will find that there are few or no specific actions that the franchisor is obligated to take or services to render. The contract says in almost every instance that the franchisee gets what the franchisor decides to provide, and in some areas, like advertising, what is provided is only what the franchisees pay for separately in addition to royalties. Doing nothing may not be a breach at all if the contract is enforced according to its terms. Most franchise agreements are constructed in exactly that manner.

Secondly, if the franchisee is to claim franchisor breach, the franchisee must immediately cease using the franchisor’s name and other indicators of affiliation. Continuing to use those resources constitutes waiver of the breach of contract claims. On the other hand stopping that use is a breach by the franchisee if the franchisor’s antecedent breach is not proven.

That leaves only a suit for a declaratory judgment with ancillary claims for termination and injunctions against enforcement attempts in matters of post termination competition and post termination liquidated damages.

While all this is pretty good theory, the resources to deal with franchisor failure are really substantial. If the litigation is transferred to bankruptcy court it is entangled with bankruptcy policy that the purposes of it all is to give the debtor a fresh start and to protect the creditors. If the creditors see a lot of money coming from future franchisee performance, they will fight for it, and they do have the ability to do so with the court’s permission.

When doing due diligence with a thinly capitalized or declining franchisor, these are real risks.

Buying an existing franchise from a current franchisee.

Buying an existing franchise rather than a start up accomplishes several good things. Among these would be that you avoid start up risk – the target is already established. You will see at least five years tax returns – no one overstates his profitability on his tax return. When you compare that reality to your client’s business plan, reality happens. His business plan represents in reality what he was told by the franchisor in one way or another. Franchisors handle this by “reviewing and approving” the business plan, and then claim that then approval is not tantamount to a representation. I doubt I have to explain this further to this audience.

Buying a resale from the franchisor is more risky. You know the business has failed or it wouldn’t be in the franchisor’s inventory. Rarely is that not true. You will also get push back on extensive disclosure about the particular store. The really crooked franchisor will say that he cannot lawfully give you any information that is not in the FDD. In a resale that is not true and you should run like hell. Even in a start up you can and are told things not in the FDD.

Sequence is important here. Do you qualify as a franchisor’s consent worthy buyer? Why waste a lot of time on this if there is going to be a problem. The franchisor will have a right of first refusal, and you try to get that sorted out in front. By the terms of the extant franchise agreement, the deal will already be subject to the franchisor’s right of first refusal. If there is a problem, it will begin to show itself in this negotiation.

You start with a letter of intent that opens the door for you to go screen all the files you could possibly want to see. That makes your final purchase decision contingent upon your finding no substantial negative issues in your due diligence, for which there is a drop dead date. You need to see the entire file of communications between your seller and the franchisor, with a covenant that it will all be produced for review without modification or deletion. Among the things you are looking for that will seriously affect your investment decision will be communications calling for or discussing remodel or reconstruction upgrades. That in itself could, depending on your evaluation of the business, be a deal breaker and maybe should also be specifically mentioned in the letter of intent. You need to discuss this with the franchisor and the head of the franchisee association also.

You have to square yourself away with the landlord too, if there is one. What changes in those arrangements would be triggered by the proposed sale? Get your own lease terms sorted out here.

You will be required to sign a brand new franchise agreement with different terms. That means you have to see the current FDD and figure that information into your business plan.

If location quality is a significant investment factor in your client’s decision it will be very important for you or your client to investigate competently the extent to which road repair and rerouting construction is going to hurt your traffic. Go to all of state, county and city department websites that deal with highway/street work and account for all the bid lettings and construction plans relevant to your location. Speak to the alderman and county administrators about what is contemplated. Finding that your freeway exit is being changed and eliminated can mean the difference between profit and bankruptcy for your client. Talk to the store owners and managers in the location neighborhood too.

The location itself may have a history that is revealing. What is the business failure history for that location? In a few local places in Houston, six or seven restaurants have failed, and yet some poor fool opens a new one because the old tenant’s equipment is still inside, or other ridiculous reasons of similar significance. In some instances I have dealt with there have been numerous franchisees in the location who have failed. Frequently there is a code somewhere on the lease and/or franchise agreement pages that will tell you what number victim you would be if you took that place. Franchisors disclaim a duty to tell you that a location is really a burial ground. The agreement specifically disclaims all responsibility for operational prospects based upon location quality. You have to hire your own leasing agent. The franchisor only has to bless it. The leasing agent who works for you (important factor here) can give you the history of the location. An agent that does not work for you won’t help you. There is no free lunch anywhere.

Does the new business require special licensing and does/will your client qualify? In particular, alcoholic beverage licenses can be tricky. In some states they are limited to the particular address of the store. They involve background checks. They take time. There are lawyers/expediters in all big cities who specialize in expediting booze licenses. You may also need someone with traction at the county and city level. They know how to do this much more effectively than you. They cost money but are worth it. Think of delays and refusals that take a year to sort out or worse. Alcohol revenue is an extremely important part of most restaurant operations.

Engineering, electrical, plumbing and health department compliance need to be researched in any resale situation or if existing stand alone locations are involved. Check out the inspections records. Figure in the cost of an engineer.

As you can easily see from this material, there is a ton of real work to be done in franchise pre-investment due diligence. Reading contracts alone is nonsensical. It is not due diligence. It is important to have the client do as much of the homework as possible because what he finds on his own will be much more important to him that what you tell him. Document everything. The quality of your file is an important consideration. You can’t possibly do this for hundreds of dollars. If the client tells you that some lawyer down the street has given him a fee of under $ 3,000, it is better to just let him go to that lawyer. The real issue here is value, not cost. When potential clients can see only price and not value in investment due diligence, you need to decline the retention. If you don’t really work your butt off to build competence in doing this you shouldn’t do it at all. Dentists rarely perform successful brain surgery.

One must keep in mind that there is a purpose in organizing the FDD the way it is. Things are said in the beginning – especially with newer franchisors – that are inconsistent with later information. Assumptions are made in the middle sections that are simply not tenable when sorted out in the light of local information, especially in big city markets. Item 1, for example, may state that the franchisor has a related company but that the franchisor does not operate a business similar to the business being offered. There is nothing wrong with that. However, when you get to the franchisor’s financial statements you may see that they are Consolidated statements of more than just the franchisor company. That is done to mislead the investor into believing that there is more substantiality here than there really is. In this profile you will often find that some states have imposed an impound on initial fees. That in itself should make your investment decision be negative. Thinly capitalized franchisors sometimes make it, but not often. The franchise agreement term will probably outlast the franchisor and you will be paying its bankruptcy creditors for support that is totally absent. These are at opposite ends of the FDD.

The Governmental Protection Myth

The notion that there is any protection against fraud and abuse emanating from the government – state or federal – is incredibly naïve. While there are state statutes in place and the FTC Franchise Rule, these are all unfunded mandates. There are no resources for enforcement. They do provide the infrastructure for self help, but one must have the resources when the problem presents in order to obtain help through private enforcement.

Even more demonstrative is the evidence that the government is actually in cahoots with the forces of permissive fraud and abuse in the franchise industry. The IFA is a very effective lobby through FranPac, but the IFA is the franchisors’ trade association, not the franchisees’ . While there are some naïve franchisees who have joined the IFA, they are used as decoys to promote an agenda of appearing to represent balanced interests. This is mere window dressing. The IFA is a wonderfully effective organization, but it is not there either to promote franchise quality or to police quality control in franchising. The worst investment risk franchisors belong to the IFA. You get the Code of Ethics badge for your website by paying dues, not by adhering to any actual quality or ethical standards.

There is an incestuous relationship between the IFA and the Small Business Administration. Moreover, there is also an incestuous relationship – called at the SBA a “special relationship” – between the SBA and FranNet, a franchise selling and consultancy business. Because of that relationship, the SBA is still telling potential franchisees that there is a 95 % success rate for franchised businesses versus a less than 50 % rate for independent start ups. That has been a standing joke even at the IFA for decades.

The SBA, until recently, published SBA guaranteed loan default rates by brand, which was a useful quick access tool for potential investors to see whose franchisees had the highest loan default rates. This became so decisively revealing that it is now no longer available. It was one of the very few government source due diligence tools that were worthwhile.

I view this event in light of the SBA “Liar Loan” fiasco that has been going on for a few years at the very least. Liar loan deals go somewhat like this.

After Discovery Day the prospective franchisee goes to a loan broker – often steered to a particular loan broker by the franchisor. The loan broker knows what the franchisor wants the prospect to put into his business plan and makes the adjustments in the investor’s plan or gives him a canned plan to use. In the plan is a pro forma of what the franchisee will tell the lender he expects the business to do financially for the first few years. The loan broker knows what is required to obtain loan approval and adjusts the pro forma or tells the prospect how to adjust the pro forma to conform to the loan underwriting standards then in effect.

There is absolutely no relationship whatsoever to any even imaginable reality. The loan is approved and guaranteed by the SBA and, in so many instances has a default rate (brand for brand) in excess of 50%. You should talk with your client about his business plan and pro forma and find out just how he put it together and where he got the information from. The financial information came from the franchisor through the loan broker, and your client is being asked to sign an agreement that acknowledges that no financial performance representations were made and that if any were in fact communicated, he did not rely on them, in making his investment decision. In your client interviews you ought to be able to uncover a liar loan deal if you ask the right questions.

Potential franchisees are being told falsely that it is OK to roll over their IRA into the business in order to fund it. This is terrible. The taxpayer has a fiduciary obligation regarding the IRA and if he uses it to finance a business that he controls and directs the business to pay him a salary/commission/whatever the IRS can and will charge him with tax on the whole rollover. It is a bad bet anyway to take what you need for your future funding base and risk it on a business that has at least a 50% chance of failing within three years.

In real terms, there is no such thing as government protection for franchise investors. You are their last line of pre investment defense. Think of that when you accept clients for this assistance.

Summing Up

I have not attempted here to do your due diligence for you. Many issues have not been covered here because they do not regularly arise. You need to do Internet research using the search strings “litigation against (name company)” and “complaints against (name company)”. Go to www.UnhappyFranchisees.com and check the company out there. Ask around about whether there is a franchisee association there – not a franchisee advisory board which is total foolishness – and contact the leadership of the association. If it is just a social group of whiners you may not learn much, but if they have an agenda of adverse issues, that information can often be critical to your client’s investment decision. Go to www.BlueMauMau.net and search for articles and comments about your target franchisor. Many times what you find about your potential franchisor there will by itself determine the investment decision. Go to your Better Business Bureau and check out how the franchisees in your location are handling customer complaints. If that information is somewhat negative, the goodwill of the franchise in that location is greatly reduced and the franchisor is not properly policing quality control within the franchise system.

When asked about adverse findings, the franchisors rather uniformly deny them and attribute them to poor management and bottom level operators. That is so often the response that it per se does not deserve favorable consideration.

If the head of the franchise company has written a book, run like hell, but read the book/have your client read the book first. Those self published books are always just narcissistic fluff and mostly fiction calculated to cause the reader to think he is dealing with really responsible, upstanding people. The presence of the “book” is usually a negative factor in any investment consideration. Years ago some marketing type began telling franchisors that having a self adulation publication is a great marketing tool. You sign a copy and endorse it to the target investor personally, making him feel truly appreciated and important.

What you are trying to accomplish is protecting your client from that trauma called the day after you have signed the franchise agreement and paid the initial fee. That’s when you find that the opening assistance is not what you were told it is, and that the story about their site location approval system is not what you were told, but rather what the contract actually says – that you are responsible for selecting and obtaining your own location subject to the franchisor’s “approval”, and that the real site selection process is that you go hire a commercial leasing agent and have him find you a location. Then you know you paid for something that any independent start up business would receive the same level of help without paying for it.

This could go on and on. There are many war stories that I have accumulated and written about over the last so many years on WWW.FRANCHISEREMEDIES.COM. Unfortunately, they are all true.

Many associated with franchisors accuse me of being anti franchising because of my positions on bad disclosure and relationship abuse. That is simply not so. Rather than being anti franchisors, I am ardently in favor of following the evidence, wherever it may lead. That is supposed to be how people with good sense sort things out.

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