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Licensing, Technology Transfers,
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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!!
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