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Either franchise investors will take heed and avoid getting fleeced by franchise
scams and sharp practices, or they will simply be shredded and left by the side
of the road in bankruptcy. It is now, after many years, the consensus of leading
franchise attorneys who focus upon advising potential franchise investors, that
the after signing remedies in any franchise agreement are woefully inadequate,
and that the only real protection against improvident investing is pre
investment killer due diligence.
The essence of pre investment due diligence is that fluff must be separated from
substance; misrepresentation must be identified; there need to be many positive
aspects to the investment proposal to outweigh the very high risk contract
terms; and that those who have not vetted a lot of franchise opportunity
proposals for a very substantial period of time – especially the investors
themselves – lack the competence to do it.
As we see daily on such sites as www.BlueMauMau.org, the leading franchise blog
site in America, franchisees invest in deals of which they know little or
nothing and then believe that some lawyer can extricate them from their dilemma
by threatening to assert this, that or the other claim. It doesn’t work that way
in most instances. Franchisees find out only when they are broke and without
effective remedies that they simply handed themselves over to unscrupulous
people who took advantage of their ignorance.
It doesn’t matter that you may have advanced business degrees and many years
corporate experience. If you have never bought a small business that you intend
to operate yourself, your degrees and experience are useless when it comes to
performing competent due diligence on the deal before you invest in it.
No professional in the business of acquiring businesses would ever think of
making an investment without legal, financial, marketing, industry specific
research on the proposition and on the business issue specific history of the
company making the proposal. Franchise investors omit this indispensible pre
investment exercise every day. Does that make sense? Of course not. Why do they
do it? The reasons are several and they include ignorance, inexperience, excess
frugality and arrogance – they thought that they were smarter than the
professionals who are on the opposite side of every one of these deals.
This article is intended to inform franchise and other small business investors
about how the law is beginning to treat people who invest without competent pre
investment due diligence; the direction In which the law is moving; and the fact
that pre investment killer due diligence is now their only – yes, their only –
protection against losing everything they have in this world in bad deals they
simply cannot spot.
Consumer Protection Does Not Help Franchise Investment Victims
Beginning in the 1960s, franchise investment fraud was recognized to be of
epidemic proportions. Several states enacted franchise investment laws. Most of
these were laws mandating disclosure protocols. Some also included relationship
abuse prohibitions (California, Wisconsin, Illinois, Michigan). The Federal
Trade Commission promulgated a Franchise Rule under authority of Section 5 of
the FTC Act that prohibits unfair and deceptive acts and practices in interstate
commerce – no private right to sue under this act – government enforcement only.
Most people thought of Franchise laws as consumer protection statutes. In the
beginning they were treated that way. There were some notable cases in which the
belief that these were consumer protection laws seemed to be confirmed.
Lawyers representing franchisors – yes including me – drafted franchise
agreement provisions to avoid liability for actionable misinformation used to
induce people to buy franchises. These include clauses that provide that the
contract itself includes all the terms and the only terms of the franchise
investment deal (merger clauses); clauses in which franchisees acknowledge that
no one acting for the franchisor made any statement to them regarding financial
performance or any other matter except for what was stated in writing in the FDD
(acknowledgement clauses); and a provision in the franchise agreement that if
anyone did make statements to the investor other than what is stated in the FDD,
the franchise investor did not rely on the statements made when he made his
decision to invest in the franchise (non reliance clauses). You will find these
in any competently drafted franchise agreement you look at. Early on I had my
franchisor clients get an executed questionnaire from each prospective
franchisee when he came to sign the agreement. The questionnaire asked whether
anyone had given him ay information that was not specifically provided to him in
writing as part of the disclosure materials provided by the franchisor. If he
answered “Yes”, we went back and corrected the sales procedure. If he answered
“No”, we knew we had a sale that could not later be cancelled on any claim of
fraudulent misrepresentation. Many franchisors have since adopted that procedure
in addition to the use of the acknowledgement and other escape clauses I just
mentioned.
Over the years, courts have made significant changes in the direction of
franchise law based upon changing attitudes about those who make major financial
investments in small business opportunities; the franchise contract provisions I
just mentioned; and the fact that anyone who can raise upwards of a million
dollars to invest should not be treated as some bumpkin who is easily deceived,
but should be treated as a more sophisticated party who has some duty to take
affirmative action to defend his own interests. He should, so the courts are
saying more and more today, be held to a duty of competent pre investment due
diligence before he made his investment decision.
Part of this attitude is based upon the current availability of competent legal
and business issue due diligence resources, another recent arrival on the scene
– something that I offer at a very high level of quality, but that costs more
than just paying some general business lawyer a few hundred dollars to “read”
the FDD and explain the legal issues, leaving the business issues unaddressed.
As this notion goes, why should an investor be allowed to refuse to buy
competent legal and business due diligence and then blame the franchisor for his
failure to see the risks he assumed before he signed the franchise agreement?
This is the direction in which franchise investment law is moving today at a
fairly rapid pace. Franchisor counsel, also including me, are now preparing
defenses to franchise fraud litigation and arbitration that develops a defense
almost like contributory negligence. This is usable where the investing
franchisee failed to avail himself of competent business and legal due diligence
easily findable on any Internet search engine. Consider as one inviting basis
for this that any franchise investor can go on any search engine and search
using the words Franchise Lawyer. He can then call the lawyers that appear on
the first two pages of the search results and ask two questions that will get
him to the right resource – Do you focus on franchise pre investment due
diligence in your practice? Do you vet the business risks as well as the legal
risks in franchise investment opportunities? The lawyer who answers Yes to both
those questions is the lawyer you should hire.
Since self protection is that available, there is little excuse for any
franchise investor not using that resource to reduce critical investment risks
associated with buying a franchise.
Accordingly, franchise fraud law is moving more and more away from consumer
protection principles to a mode of traditional tort law in which a victim is
held to a reasonable standard of having to use good judgment in the protection
of his own interests.
This killer due diligence is not a guaranty of success. You can still fail for
any number of reasons. However, it does reduce a lot of critical risk. If you
have used this resource and still have been swindled, you will have a better
chance to survive the defenses based upon your failure to do what a reasonably
prudent investor should have done to protect his interests.
In the movement away from a consumer protection mode in franchise investment
law, courts are more and more seeing franchise agreements to be unlike insurance
policies. Courts are finding that even though franchise agreements may not be
negotiable, they are not contracts of adhesion like insurance policies are
considered to be. Therefore, the rules of contract construction that favor
claimants in insurance policy claims litigation are less and less available to
franchisee claimants. Among the other reasons for this are that one does not
have to buy a franchise as one does have to have insurance in most instances of
normal business; and that franchise agreements are coupled with disclosure
requirements that are subject to competent due diligence challenge to a higher
degree than is true of insurance policies.
Understanding the Risk Level of Failing to Do Competent Franchise Pre Investment
Due Diligence
Most franchise investors think of risk quantification in terms of Item 7 in any
FDD – Total Initial Investment. This is incompetent for the following reasons.
First, the stated requisite working capital is always much too low. It assumes
breakeven being achievable much earlier than any competent analysis would ever
assume. It also does not include living expenses during the period before the
franchised business becomes cash flow positive. In good times an investor should
never assume in any business plan that he will become cash flow positive in less
than two years. Moreover, positive cash flow in early years is often consumed by
debt service and is not available to live on. You will find that working capital
actually required in that assumption to be multiples of the working capital
number in any FDD Item 7. In the current economic circumstances, any break even
assumption less than three years is simply ridiculous. If you beat the
assumption your surprises are pleasant surprises. There is no joy in
underestimating working capital needed, and failure because you didn’t have
enough working capital is a well known economic principle called “gambler’s
ruin”.
Secondly, franchise investors do not recognize that most clauses in every
franchise agreement are statements of quantifiable financial risk. Here is how
that works.
Posit a franchise term of ten years; an anticipated gross sales volume of $
800,000 per year; a royalty rate of 7 % and an advertising requirement of an
additional 2 %. The royalty clause in this scenario is a stated financial risk
of $ 800,000 X 9% (royalty and advert combined) X 10 years= $ 720,000. At least
$ 100,000 of this is the real risk because in your franchise agreement you will
now find a “liquidated damages” clause that states that if the franchise is
terminated for any reason whatsoever, you owe the franchisor liquidated damages
in the lesser amount of royalties to the end of the unexpired term of the
franchise or $ 100,000. Add that $ 100,000 to the risk you think you are
incurring before you read this paragraph. Is the liquidated damages clause
enforceable? Sometimes yes and sometimes no - Your risk.
You will be required to lease premises for your store in almost every franchise
agreement. Your lease and other occupancy costs will aggregate roughly 8 % of
gross sales. You will be required to personally guarantee the lease as well as
the performance of the franchise agreement itself. Your real risk under this
clause is therefore 8 % of $800,000 X ten years =
$ 640,000.
There are other ongoing risks should you sell your franchise, including the fact
that your lease guaranty will continue even if someone else is now running the
business and that your franchise agreement personal guaranty may also not be
released just because you sold the franchise to someone else. Many franchise
agreements now require you to guarantee the performance of your successor
franchisee.
This is by no means a complete itemization of your total financial risk that
arises the moment you sign a franchise agreement. You don’t get this information
by reading Item 7 of your FDD.
Add to the above the probability that if you do not succeed, the documents are
calculated to leave you in a position of such financial privation that you will
not be able to finance any dispute resolution (lawsuit or arbitration) to get
yourself made whole again, even if one were to assume that you had a valid claim
against the franchisor In the first place. Contingent fee lawyer arrangements
are now almost totally unavailable with any law firm that knows what it is
doing. The only viable contingent fee deals available now involve situations in
which the evidence of fraud is really great; the franchisor is collectible if
you win; and there are so many franchisee victims in the plaintiff group that
the potential reward to plaintiffs’ counsel is extremely high. That scenario is
rare. It does not include any case in which you failed and you have your claim
against your franchisor that you cannot afford to pay the freight to
litigate/arbitrate.
Now perhaps you understand the real risks associated with franchise investment,
and that all your significant self protection opportunities exist only at the
front end. Once you sign a franchise agreement, there is no Mulligan
opportunity. If you put yourself on that hook without having purchased competent
killer due diligence before you made the investment, you cannot realistically
expect to have an effective remedy to make you whole on the other end. Only
someone who has long experience in franchising and who vets the business risks
as well as the legal risks can provide you this service. Have long discussions
with the due diligence resources you decide to contact. This will be the highest
risk assumption in your entire life, and you stand to lose everything you have
in this world if you don’t get it right.
You Also Have to Vet the Prospects in Reality Mode That Concern What Can and
Will Happen to You During the Life of Your Franchise Relationship.
No general business lawyer who lacks many years experience in the franchising
business can possibly explain to you the realities of your life after you sign
the franchise agreement. The FDD does not clue you in about that either.
Consider, for example, some of the following real prospects for impact upon your
expectations of a return on your investment.
Every competently drafted franchise agreement has as its purpose the protection
of franchisor options, no matter what those options might be. Obviously your
franchisor can’t take your money and close you down just because he doesn’t like
the cut of your jib, but short of that it is open season on you.
You are required to comply with the franchise operating manual in every aspect
of your business. The franchisor can change the operations manual at any time
and for any reason, inflicting practices and policies upon you that you didn’t
contemplate when you were being mesmerized on discovery day. By changing the
manual, your franchisor can unilaterally change your days and hours of
operation; change the equipment you are required to use in the operation of your
business, regardless of the cost to you; change the levels of insurance
coverage; change the products and services you must offer; change the list of
authorized vendors from whom you must buy what you need; change the way you
report the results of operations of your business and the manner/speed of
collecting royalties, advertising funds and other fees; change the manner in
which national accounts are handled, including how they pay and when you get
whatever your share may be from the revenue stream associated with serving
national accounts; and dozens of other financial impact functions of your
business. The operations manual can change your cash flow all by itself from
good to marginal or worse. You can’t do a thing about it in almost every
situation.
Your franchise agreement suggests that you have renewal rights if you wish to
continue in the business relationship after your first franchise term expires.
Look at it again. It says that, upon approval by the franchisor, if you have
never been in default of any terms of your franchise agreement, and if you pay
renewal fees, you can renew your franchise by signing the franchise agreement
being offered to new franchisees at that time, with different terms. The
different terms include different royalty rate; different or no territory
protection whatsoever; different advertising and other fee requirements; among
many other things.
What you have is not functionally a right to renew your franchise. You have an
opportunity – not a right – to buy the franchise anew on whatever terms your
franchisor may then choose to impose.
Your franchise agreement requires that you conform to the franchisor’s changing
equipment and fixture package and that you remodel your store from time to time,
at your expense. This can aggregate $ 500,000 or more. Many franchises insist
upon changing the “look” of the stores to the point of total remodel. They also
change the management information system from time to time, requiring new
equipment, and new software. For this you will pay the cost of the new
equipment, either by purchasing it or leasing it and pay for a software license.
Each of these can and probably will be a profit center for the franchisor, a
revenue stream that was not spelled out in Item 7 of your FDD or in any specific
clause of your franchise contract. In one instance of which I have personal
knowledge, the franchisor’s son went into the “ambient sounds” business, and all
the franchisees were required to install that system on pain of termination, and
no consent was given to anything requested by any franchisee until the
requesting franchisee bought the new system. Sounds like something right out of
“The Sopranos” doesn’t it?
Even worse, your franchisor can, and many actually do, decide to change the look
of your store at a cost of over $ 100,000 to a new look that has been decided
upon by some committee and that has not been adopted and tested in the
franchisor’s company owned stores and shown to have any positive impact on sales
or profits. A year later many such franchisors decide the changed “look” isn’t
working and start ordering retrofit back to the old “look”. Nothing in your
franchise agreement prohibits this kind of abuse. Time limitations on remodel
frequency are easily circumvented by withholding of approval for important
things you want to do until you “elect” to comply with the current policy
changes.
Sales and Marketing Brochures Provided To You by the Franchisor To Get You to
Buy the Franchise Are Contradicted By the Terms of the Franchise Agreement
You have been provided sales and marketing materials by your franchisor to
induce you to buy the deal. It “promises” you benefits that are claimed not to
be available to you if you choose to start your business from scratch as an
independent business from scratch instead of buying a franchise. None of these
statements are “promises” in legal terms. They are statements of what the
franchise relationship includes, not promises. The statements are in almost
every instance contradicted in the franchise agreement.
Consider the following. A statement that you will get buying power if you buy
the franchise is almost always false. It is false if the franchisor is a
recently established company with less than hundreds of franchisee because that
scale is simply insufficient to generate buying power where the vendors have to
deliver goods to franchisee stores one store at a time. You get no more
consideration than any other reseller who buys for one store at a time, one
delivery at a time. Vendors have quantity price breaks, but they are for single
delivery to one location only. Additionally, if your vendors have to pay money
to your franchisor for the right to sell to his franchisees, that cost goes on
top of the price you pay for the goods and services – hardly an element of any
buying power for the franchisees. There may indeed be buying power, but the
benefits of the buying power go to the franchisor, not to the franchisees. Your
franchise agreement does not contain a provision that requires your franchisor
to pass on to you any benefits of buying power.
If there is a claim of savings in your start up costs, you will find that your
franchisor gets a commission on every piece of fixtures and equipment you buy
and that if you actually buy it from the franchisor, there is a substantial mark
up. The franchisor will not give you those prices before you sign the franchise
agreement so that you can comparison shop. You find out later that you could
have done much better buying initial fixtures and equipment from local vendors
in your community – but too late for you to anything but whine about it, because
the franchise agreement does not prohibit the franchisor from doing that.
A very few franchise systems do have aggressive, pro active independent
franchisee associations that have corrected many of these imbalances, but you
are not likely to be buying a franchise in one of those fortunate systems. A
franchisee advisory council is not anything like an independent franchisee
association. See www.FranchiseeAssociationManagement.com for the realities of
almost all franchise situations in this context.
The list of killer due diligence issues is much longer than this already too
long article, and it is not the purpose of this article to cause you to think
you know how to do what you have never done before – vet small business
investment risks.
Conclusion
There is competent investment risk management assistance available to franchise
investors. If you fail to use it, you can expect little or no sympathy later on
when you are asking for relief from contracts that you signed that you could
have avoided for comparatively little money. The choice is yours and the
consequences are yours.
Copyright 1997 - 2010 || Richard A. Solomon
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