| Licensing, Technology Transfers, |
People of substantial means who may consider active ownership investments in
operating businesses customarily avail themselves of quite expert pre-investment
due diligence. People of ordinary, but comfortable means who consider ownership
investments in franchises customarily do not have recourse to such expertise.
Indeed, they usually are not even aware of what level of assistance may be
required in order to compare the risk from the economic dynamics of the
franchise and the risk inherent in the terms of the franchise agreement. Neither
have they access to the means of determining points of balance between the
riskiness of the economics of the investment and the relative riskiness of
various franchise agreement provisions when viewed in the light of the quality,
or lack of quality of those economics. Lawyers who “read contracts” to people
for a few hundred dollars are almost never equipped to assist at this level of
capability. Accordingly, what typically transpires is that the potential
franchisee is told by his lawyer (1) that the franchise agreement is extremely
one sided; (2) that franchise agreements, much like insurance policies, are
usually not negotiable in connection with the purchase of a single franchise;
(3) that the potential franchisee ought to speak with existing franchisees about
how they are doing as owners of the franchise in question; and (4) if the
representation in the disclosure documents of the franchisor are true, it may be
a good deal. Most of these investments go awry. Most of these terrible
consequences could be avoided if the potential franchisee comes to realize that
general practice lawyers, and even general practice business lawyers are in dire
need of more competent training to evaluate franchise investments and the
assorted contract documents that accompany them.
There is an overarching issue in franchise investment lawyering that focuses
upon evaluating the inherent relationship between one sided business agreements
and the quality of the business proposal to which they relate. This issue, based
upon my experience in dealing with the detritus of franchise investment
failures, is not only under served, but usually not even recognized. If you
invest in a franchise, especially a relatively new franchise, without evaluating
the contracts’ riskiness against the quality of the business opportunity itself,
success or failure is nothing more than a crap shoot with exceptionally long
odds against success. The current literature on franchisee failure rates agrees
with this position. The franchise industry’s claim that franchised small
business start ups have a better success rate than independent small business
start ups was never true and is not now true. The failure rate amongst newer
franchisor companies is also a major issue. When I use the word failure here, I
mean complete failure as a franchising business as well as failure to thrive in
the sense that effective growth programs never occur. Franchisee population
growth stops at a low level, stagnation sets in and support is a myth.
Once we accept the notion that it is just as respectable an investment decision
to decide not to buy a franchise, it becomes easier to consider that no matter
the persuasiveness of the sales pitch, most new or relatively recent franchise
offerings should simply be declined if the franchise agreements cannot be
negotiated. The only reason that an inferior franchise offering can be sold to
anyone on the terms customarily offered in the franchise contract is that the
investor is ignorant and easily mislead. So long as ignorant investors abound
with potentially $ 750,000 in liquidity, new and recently established
franchisors will never accept that they have to match the contract terms to the
risks of the investment. At present they can simply refuse to negotiate because
just around the corner another ignorant franchise investment prospect is
approaching who can be fleeced with relative ease.
When a potential franchisee goes to find a lawyer to assist in evaluating a
franchise, that client is in almost every instance already sold on a particular
franchise. When s/he comes into the office, s/he has all the material for a
franchise and is at the “sign the contract and write the check” stage in the
sales process. The first thing that should be done is determine whether that
franchise offering is from a new or recently established franchisor or from an
old and over the hill franchisor. If it is from either of those kinds of
franchising companies, the client should be told that it is important to reverse
the “sold and ready to pay” mode because it is highly unlikely that after proper
due diligence there will still be any desire to buy that franchise. These are
the two categories of franchise offerings in which the investment risk is
usually too high for the harshness of the contract terms that are being insisted
upon. If the franchisee is already an experienced operator of similar businesses
and therefore a relatively sophisticated buyer, the risk may reasonably be
assumed. But for a novice to the business and to franchising, new/recently
established and old/over the hill franchises are extremely high risk unless the
contract can be changed – which is almost never available. Refusal to buy is the
right call, even though it substantially reduced the population of available
franchise investment opportunities.
Competently drafted franchise agreements tend to be almost the same from
franchise company to franchise company. Franchise lawyers advise their newly
established franchisor clients to adopt contracting practices identical to those
of established, successful franchise companies. The problem presented for the
prospective franchisee is that the unproven franchisor is insisting that
investing in a relationship with that company is the equivalent, from a contract
risk perspective, to investing in an already well established franchise where
the franchisees are doing rather well. The franchisor is trying to sell the
notion that they are as good as the franchise that has already proven itself
when in fact there is really no comparable track record. That is a principal
omission of franchise vetting. When the failure or failure to thrive risk is in
plain sight, no one should sign agreements that assume that failure or failure
to thrive have already been overcome. The value simply isn’t there. Long
established but over the hill franchises have that same high risk. The
likelihood that they may again thrive as they once did is low. The reasons for
that are many, a long list. There are telltale signs in the disclosure offering
circular and in the accompanying financial statements. Not only are the
franchise contracts written as though there is high value worthy of high
contract risk when that is not true, but the price of the relationship is also
the same as the high value franchise. As the financial risk is higher for
franchisees of a start up franchisor, a recently established franchisor or an
over the hill franchisor, it should be viewed as probably not something that is
a suitable investment for a novice franchisee. If the novice is about to commit
everything s/he has, that is usually a set up for disaster and bankruptcy.
The contract provisions that make the newer franchise opportunities
exceptionally high risk are those that make exit from the system financially
devastating in terms of what the departing franchisee can do after leaving the
system – covenants not to compete – personal guarantees by the franchisee and
liquidated damages clauses that allow the franchisor to assert claims requiring
little or no proof. No franchisee should sign a franchise agreement that
provides that in any event of termination for any reason, the franchisee owes
the franchisor royalties to the end of the contract term or the present value of
that discounted royalty stream or any stated large amount of money. These three
provisions make the newer and most older franchise investments unworthy of
investment for a novice franchisee. Inasmuch as practically all franchise
agreements now have that language, there needs to be wholesale refusal to buy on
the part of informed and well advised franchisee prospects unless those
provisions come out of the agreement. They are designed to make impoverishment
and bankruptcy the only prospects for a departing franchisee so that
intimidation holds the system together when on the merits the system would
collapse from its own lack of substance. Even in the instances in which those
provisions might be held to be unenforceable, the expense of the litigation is
usually beyond the means of the struggling franchisee. It might be manageable if
franchisees stood up for each other and by each other and if those with the same
problems teamed up to do something about them. But that is the least likely
scenario. In my experience franchisees will not stand together to deal
effectively with major problems in their relationship with their franchisor, and
reliance on the prospects for group action is usually misplaced. Actually it is
more likely that franchisees of highly successful franchise systems band
together for group action and make the system work even better by being an
important resource for positive policy. Among the less successful franchisee
groups there is usually an unwillingness to commit resources to what could be
afforded only through group action.
There are other franchise agreement terms that operate to make departure
difficult when things go bad because the franchise turns out not to be as good
as it was described. These can remain in the agreement, but the due diligence
has to be of very high quality before the investment is made or disaster will
probably result. Many of these aspects of due diligence are discussed in the
other FRANCHISE FRAUD SYMPOSIUM TUTORIALS on this web site.
When you take into consideration that a potential franchise investor can keep
all his money in his own pocket and go get a job with an existing franchisee of
the system being considered, no matter how low the pay might be for that time
period, any other due diligence is definitely high risk. Working for an existing
franchisee will teach the potential investor far more than could ever be learnt
on discovery day or in franchisee training or during store opening assistance.
At the end of a year, you will know everything there is to know that you need to
know to vet your investment decision. The overwhelming odds are that after that
work experience you will be very happy that you didn’t make that franchise
investment,
and even happier that you didn’t sign a terribly onerous contract for a period
of five or ten years. AND YOU WILL STILL HAVE YOUR $ 500,000 PLUS IN YOUR OWN
BANK ACCOUNT!!! That sure beats having a lawyer “read you the contract”. EVERY
SINGLE FRANCHISEE WHO WAS IN DIRE STRAIGHTS AND CAME TO SEE ME TO FIND OUT HOW
TO GET OUT OF THE FRANCHISE WISHES TO HELL THAT THIS ADVICE HAD BEEN FOLLOWED!!
Copyright 1997 - 2008 || Richard A. Solomon
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 | Licensing, Technology Transfers, |