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I once had a case in
which the franchisor had made the customary disclaimers about providing earnings
claims (either none are given or none are given that aren’t specifically stated
in Item 19 of the UFOC), but there were obvious “earnings claims” information in
the franchisee’s business plan submitted to the SBA lender bank as part of the
loan application package to get the requisite financing to enable the franchise
investment. To make a long story short, it was obvious that the information had
come from the franchisor. The franchisor’s lawyer actually claimed that lying to
the bank was different from lying to the franchisee and that the information
provided for business plan use wasn’t intended to be relied upon by the
franchisee. Hard to believe? You bet. But that’s what the fool said.
While it is theoretically
possible for a potential franchisee to have accumulated sufficient information
for a business plan pro forma just through interviewing existing franchisees as
part of his pre investment due diligence, that is never the case. Franchisees
won’t give out such information sufficiently for a business plan pro forma to be
prepared, and it would take too long. The salesman wants the decision ASAP and
the information for the business plan is simply provided. There are numerous
ways by which it is provided, and there are numerous funny stories about how
that isn’t really the providing of earnings claims information by the franchisor
to the franchisee for his reliance. They are all ridiculous when seriously
parsed, and they are all false. Projected financial results of operations
information of any sort constitute earnings claims information, even if it is
claimed to be merely advising the potential franchisee that the numbers in his
business plan pro forma are “achievable” or “reasonable” while claiming not to
have provided the information in the first place. Vouching for reasonableness or
appropriateness is itself the provision of an earnings claim. It is confirmation
that what has been prepared fits within the performance pattern of the existing
franchisees.
The claim not to have provided the information in the first place is false
testimony. If the information came from a third party, that third party got it
from the franchisor or provided the information through some tacit arrangement
with the franchisor. In too many instances, the franchise sales person will have
a particular franchisee to whom the potential franchise investor has been
steered provide the information. Sometimes that provider franchisee actually
gets compensation for a sale when he has been the earnings claims information
provider, also sometimes known as “just one of the franchisees with whom the
prospective investor spoke in his due diligence agenda” – Yeah right! Sometimes
the information is put on a chalk board during the franchise sales presentation
and then erased after the potential investor has copied it by hand. The
shenanigans go on and on. There is no limit to the number of ways. The cocktail
napkin pro forma is perhaps the most famous earnings claim document in franchise
history.
Tracing the source of
business plan pro forma information is always a must in any franchise fraud
case.
The question arises
whether the lending bank has any responsibility regarding the use of that
information. Supposedly the business plan document is relied upon by the lender
in its underwriting due diligence before deciding to make the loan. If that were
so, which it usually isn’t, banks would be more circumspect about how they treat
the information and there would be data bases to disclose the loan success
history of each franchise system’s franchisees for ready reference in rating the
probable success of the loan.
The reason why this is
more charade than serious loan underwriting due diligence is that these loans
are usually SBA guaranteed loans. If the franchisee fails and can’t repay the
loan, which occurs in about 80 % of the instances amongst franchisees of newer
franchisors, the SBA takes the big hit and not the bank. So the bank isn’t
concerned about its money. That’s why franchisee loan application due diligence
is merely an exercise in stuffing the loan file with apparently proper
documentation to give the cosmetic impression that there was serious due
diligence by the bank. No banker would ever admit this, to be sure. But when you
look at what is done and how it is done (or not done) rather than listen to what
the people say, a more rational view of the truth appears.
This is not a lender
liability scenario. The lender is not responsible in the main – in the absence
of some specific evidence of actual and knowledgeable complicity in an
actionable scheme – for the franchisee’s misfortunes attendant upon his reliance
upon the bozo earnings claim information. The lender’s obligation, if there is
any at all, would appear to be to the SBA, and the standard of loan underwriting
quality demanded by the SBA demands no more than stuffing the loan file with the
fictions we have just described.
To be sure, the
appearance of loan quality is buttressed by franchise contract terms that
require franchisee personal guarantees of performance of the contract
obligations, plus fictitious liquidated damages in the event of premature
termination, regardless of cause, and the loan itself is personally guaranteed.
The reason that is pure fiction is that the contract dynamics I have just
depicted are guaranteed to produce a penniless franchisee who is unable to
respond to any financial obligations or even in most instances to find a lawyer
to represent him. This is the contractual construct that every franchisor lawyer
provides to his new franchisor client as insurance against ever having to answer
for disclosure chicanery or franchisee failure due to any other cause. And this
is further enhanced by the fact that franchise law enforcement agencies have no
budget or appetite for policing these practices. There is simply nowhere for the
ruined franchisee to turn for meaningful assistance in almost every instance.
When I speak of the enhanced riskiness of any newly minted franchise offering, I
am being as serious as I could possibly be. The marketing materials of new
franchisors are a treasure trove of falsehoods in every instance I have reviewed
in the last three years. Consider only by way of illustrative example new
franchisors with a small number of franchisees in a small section of the United
States claiming that a prospective franchisee to be located in another
geographic area will benefit from name recognition. Consider by way of further
example a similar franchisor claiming that there is material financial benefit
to be derived from group buying power – utter nonsense. And the list goes on and
on.
Where do franchisees
obtain the information that goes into their business plans? They get it from the
franchisor, one way or another. Where else could information about the history
of the franchisor or its system come from but the franchisor? So much of the
business plan is obviously from the franchisor that it almost defies credulity
to suggest that the pro forma earnings claims information came from any other
source.
Franchisors who claim
they only give out gross sales information raise a big red flag. Who in their
right mind would invest upwards of a half million dollars on just sales
performance information? No one invests to achieve sales. The very definition of
investment is the quest for profit. If you don’t provide information to answer
the question about how much can be made from the investment you can’t sell the
franchise to anyone. Without the prospect of return, no one assumes investment
risk. And since one receives guaranteed return without risk just by putting his
money in a savings account, there has to be information given that the returns
potential from the franchise investment is higher than that. And yet there are
still judges who don’t understand that. You cannot assume that any court has
sufficient investment definition knowledge that you don’t have to put on a case
about the relationship between investment risk and anticipated return. You have
to prove to the jury and the judge that with the enhanced riskiness of the newer
franchise system due to their failure rates, the sale is always induced by
representations that the risk is acceptable because of the opportunity for
higher profitability. “Getting in on the ground floor” is the very definition of
high risk. Lost profits is the measure of damages in any investment fraud case,
not lost gross sales. That’s why the genesis of the business plan pro forma is
so important to establish.
The franchisee cannot
comprehend when making his first franchise investment that anyone would risk the
world crashing down upon him by lying about earnings potential. Why they would
never say that. It’s against the law! Yeah right! You have no idea how naïve new
franchisees are. They accept statements as serious business communication that,
if said by a stand up comedian, would have the audience rolling on the floor
with laughter. The context makes the nonsense sound reliable. Context is an
incredibly important aspect of proving any business investment fraud case.
Context evidence includes such things as professionally prepared and presented
investment brochures and disclosure documents of substantial quantity stating
they are provided in compliance with Federal law; the amount of money being
demanded; the relationship between the money demanded and the investor’s total
worth; the involvement of bank loan applications under penalty of criminal
liability for impropriety; the cosmetics of people all dressed up and having an
office or flying down to see you to discuss the wonderful life enhancing
prospects of affiliating with their franchise system; statistics from government
and universally accepted sources that make everything sound truly rosy; success
stories coupled with names, addresses and phone numbers.
A very large part of why
business plans are little/nothing more than fantasy is the fact that the
franchise investor has no knowledge of how to do due diligence beyond the
documents handed to him by the franchisor. He has never done investment due
diligence before in his entire life. He has almost no where to go to obtain
assistance in that effort. Time and again, after it is too late and the money is
lost, the answer to the question where did he go for help is that he hired a
lawyer for a few hundred dollars to “read the contract”. And the answer to what
he was told by the lawyer who “read the contract” is that he was told that the
contract seemed very one sided, and very little else. People still don’t know
that that is simply incompetent per se. Most lawyers have never been taught even
how to do a decent job of due diligence within the documents provided by the
franchisor. Due diligence beyond those documents never happens in any instance I
have encountered where the franchisee has come to me after losing everything.
Due diligence is the
process by which you acquire a competent understanding of the reliability of
what you are being told by the franchisor. If all your sources are franchisor
directed sources, how can you possibly expect to reality test anything? Just the
questioning of the claim that “We save you money” cannot be answered simply by
questioning the franchisor. “How do you save me money?” is customarily answered
that they have purchasing expertise that you don’t have and that they buy for
more than just one store. All that is meaningless. It is meaningless because it
does not account for what is available to someone who will take the trouble to
search for it. When the franchisor says that’s what they save you from – the
necessity to go out and find out for yourself - they aren’t doing you a favor.
They are probably ripping you off. And the only reason they can do that is that
the investor doesn’t want to take the time or doesn’t know how to look for where
the truth is. For the few investors that actually do ask what the prices are
going to be for things that they have to purchase from the franchisor or from
its designated vendors, to enable some comparison shopping before they part with
their money, they are told that the information is confidential or trade secret
information that they only disclose to people who are actually members of their
“franchise family”. If you are naïve enough to accept that as a responsible
answer, you have no chance at all to make an intelligent investment decision.
The only reason that
franchisors get away with such rubbish is that they know that most of their
prospective investors are too ignorant to be able to understand what is
happening to them. Illustratively, they don’t even know that any time you have
to buy anything only from the franchisor, you will not have access to any
competitive pricing that is usually available in open market purchasing, and
that that overcharge is an additional royalty that is not accounted for as
additional royalty in the disclosure documents. And that is only one example.
The franchise investor doesn’t know that the newer franchisors have no expertise
in location selection either. The marketing brochure tells them that the
franchisor will help them find a good location. But the franchise agreement and
the UFOC say that it is the franchisee’s responsibility to select the store
location for submission to the franchisor for approval, and that the franchisor
is not responsible if the location is a bozo location. Then, when they have
bought the franchise, not having spotted that difference between the marketing
brochure and the contract language, what they get is instructions to find a
local commercial leasing broker or agent and have that person help them select
an appropriate location. And, of course, they don’t know how to vet the leasing
agent selection either, and that means they get shown property that the leasing
agent gets a commission on if the franchisee rents it. They don’t know that they
have to hire their own leasing agent if they want better results. The “free”
leasing agent isn’t “free”. DUH!
How does this relate to
the reliability of the numbers in the business plan pro forma? All these
deception risks produce numbers that have not had any real world reliability
testing whatsoever. The investor has no idea at all about how close to or off
the mark from reality any of those numbers will be, or of the likelihood of
reliability. It is utter fiction and fantasy. It is fiction and fantasy because
it is all based upon the proposition that what has been given you to work with
is real, and it never is. No information in any sales document – and the UFOC is
a sales document these days – is ever going to disclose negative prospects or
inherent risk. They say that profits are not guaranteed and that there is no way
to predict whether you will be able to achieve the described profitability, but
that tells you nothing about the quality of the information itself. They will
say that if you ask, they will provide substantiation about how they came to use
the numbers that are in the earnings claims, but when asked for that
information, it is almost never provided. If anything is provided, it is not of
corroborative quality. It will agree with what you have been told, but you still
don’t know anything about its reliability. Some of the examples of claims
corroboration I have seen are so patently absurd that my concern about the
ability of a potential franchisee to evaluate it is really quite high. Yet
investment decisions are made on that kind of information. The riskiness
compounds upon itself at every turn and in every category of disclosure, and no
one customarily available to the investor knows how to sort it out for him.
What is the germ from
which this disease springs? It is laziness coupled with wishful thinking. The
franchisor offers to hand it to you on a platter. You want it handed to you on a
platter. You want to own your own business now. You may be concerned about the
current circumstances of your job. Wanting it now makes you the patsy for the
people who promise it to you now.
Time and again I have
told people to keep their money in their own bank and investment accounts and go
to work for a company in the business of the franchise system in which you may
be interested. Even if you flip burgers or make pizzas for very little money, in
that low paid interim you are protecting everything you own from risk by
learning on the job. Anyone working in one of those businesses will get all the
trade secrets that the poor business owner was promised, without having to pay
for it or sign agreements or take any investment risk. If you keep your eyes and
ears open for six months or a year, you will know what the risks and dangers of
the business really are. You will hear the gripes. You will witness whether
there is real franchisor support or just baloney level nonsense. You will know
whether the franchisee is overcharged compared to what he could do if he were
free to buy what he needs anywhere he wanted. You will actually see every single
day that you show up to work whether the system works or not, and if so, how it
works. You will then be able to make a really intelligent decision about
investing in that kind of business and about the prospects of investing with
that or any other franchise company. You will probably have saved yourself from
financial ruin. You will probably see the poor owner of the franchise that you
are working for suffer and stress out and collapse into financial disaster. You
will be unbelievably joyous that you saved yourself from that risk by taking the
time to learn the truth the only way in which truth can be learned – the hard
way that is the safe way.
Copyright 1997 - 2008 || Richard A. Solomon
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