wadeandalexia.com

Posts Tagged ‘Franchise’

Imagine opening 20 new business locations without having to foot the bill for real estate, equipment and development costs or taking on any of the risk. Even more, imagine finding managers to run all those locations, who are just as committed to growing the company as you, and you don’t have to pay them a dime. Finally, imagine that these managers will hire, fire and manage all employees as well as foot the bill for all operating costs and expenses. Sound far-fetched?

Not if you’re planning to enter the franchise industry, one of the fastest ways to grow a small business without breaking the bank. For many companies, franchising a business (or licensing) is a sensible way to achieve rapid, profitable growth without giving up any control or ownership. Going from a single location to a dozen in a couple years, or a hundred in ten years is possible and well-documented because franchise owner-investors put up all investment capital, shoulder all risk and assume all day-to-day operating responsibilities.

It’s expansion, using OPM – Other People’s Money. Also, the franchise company gets paid handsomely for teaching others the secrets of how to operate its business. First, there’s the up-front “membership” or franchise fee of $20,000 to $50,000 paid for using the brand name and operating methods. In addition, there are continuing royalties of 5% to 10% of gross sales for ongoing advice and consultation. In essence, a franchise development program allows a company to get out of the trenches and become a highly-paid general overseeing its soldiers. Long-term options are also attractive. Build an empire and relax, or let the franchise company be acquired by an increasing number of large companies that look for small, but growing franchise companies. According to the International Franchise Association, 900 new companies have franchised in the last three years.

ENTERING A NEW BUSINESS
A company planning to franchise must realize it is entering a new business, offering an entirely different service (training & support) to entirely new customers (business owner-operators). This new business requires different skills, abilities and expertise. In the new business of franchising, it is critical to develop effective evaluation, documentation, mentoring, training and consulting skills. Since these new skills are rarely present within existing personnel, an outside franchise expert is needed to train existing personnel and plan the transition. The first step involves determining whether or not a business can franchise, and if so, what needs to be developed. Next, strategic franchise planning is necessary to create a “blueprint” for successful expansion efforts. Experience shows that, just like a building, the foundation developed at the beginning will create lasting consequences affecting the relative success (or failure) of the entire venture. Legal (franchise disclosure document, franchise agreements) and operational documents (franchise operations manual, franchise training program) are prepared and drafted and finally a franchise registration process is required in some 14 states, depending on which state(s) the company sells franchises. These phases are discussed below.

THE FRANCHISE FEASIBILITY PHASE
An indispensable step before any franchise development program gets underway is an analysis of the concept and business model. Has the concept been sufficiently proven in the marketplace? How profitable are existing prototypes or company-owned outlets? Franchising will not solve existing problems, it will only intensify them – and usually at a serious cost to franchise investors. Franchising should not be viewed as a method to raise capital, expand a business that has existing problems, or a way to get rich quickly. There must be sufficient profitability in the business model so that royalty and other payments can be made and leave the franchise investor with a sufficient profit. With a franchise feasibility analysis, a determination can be made about:

(a) whether franchising or licensing expansion ideas should be pursued, postponed or abandoned; and
(b) assuming a positive result in (a), what needs to be fine-tuned or developed from scratch for the franchise program.

Besides determining if and when the business can franchise, the analysis should also include providing guidance and direction so as much of the groundwork as possible can be done by existing personnel. This has proven to be a very effective approach and significantly reduces franchise development costs. If the feasibility analysis is positive, the other phases discussed below follow. My twenty-eight years of experience in the franchise industry lets me share a valuable insight about franchise feasibility studies. Too many companies leap into franchising without doing a feasibility study, or if one is done it is performed by a franchise consultant or group that tells everyone good news – they’re all “franchise-able.” The vast majority of franchise feasibility studies I’ve done either identify areas that need attention before franchising makes any sense or tell the client to forget about it and pursue other options.

THE FRANCHISE STRATEGIC PLANNING PHASE
A successful franchise development program begins with a solid plan – a foundation for franchising. The long-term goal is to establish balanced, integrated, successful business relationships with qualified individuals who support the company’s goals and image. Creating an enduring relationship requires a comprehensive strategy that addresses all aspects of the franchise endeavor.

The starting point is a detailed analysis that covers:

(1) identifying profile characteristics of who will be the best franchise owners for the particular business;

(2) competitive positioning to make the franchise stand out from the other 3,000+ franchise companies;

(3) geographic scope – where and when will franchises be sold;

(4) analysis of the company’s organizational strengths and weaknesses relative to franchising;

(5) identifying the appropriate franchise organizational structure as well as staffing requirements and responsibilities; and

(6) structuring the franchise relationship for a balanced, win-win scenario.

What should emerge from this detailed analysis is a specific strategic plan and framework for guiding virtually all franchise efforts. Despite the long-term importance of the franchise planning step, too many emerging franchise companies enter franchising with no plan or planning – other than “let’s try and sell a lot of franchises.” They rush through (or neglect entirely) the strategic planning process, thereby creating future franchise litigation land mines that are ticking franchise lawsuits waiting to happen.

Often, this is because they only utilize the services of a franchise consulting firm or franchise attorney, where little or no attention is paid to critical strategic planning, operational and organizational issues. Normally, these firms draft “boilerplate” franchise disclosure documents, franchise agreements and franchise operations manuals based on a questionnaire completed by their client, who is presumed to have made all strategic decisions. The franchise documents are presented, along with an invoice and a handshake – hardly the ingredients for success in the new business of franchising.

THE FRANCHISE DOCUMENTATION PHASE
If the company has made doing a good job at the planning stage the number one priority, franchise documentation goals will be apparent. Proprietary and intellectual property assets (like operating techniques, customer information, recipes, formulas and methods) need to be identified and protected. A trade secret protection program is developed and implemented. The name, logo and tag lines should have been previously registered as trademarks or service marks.

franchise operations manuals
Franchise operations manuals and training programs are developed, often from scratch, to impart business operating skills to the franchise owner as well as ensure uniformity of products and services. The franchise operations manual and training program curriculum must be drafted with a particular focus. Certain topics, chapters and policies found in manuals for a company-owned chain, for example, are entirely inappropriate in a franchise environment, creating significant liability (lawsuit) issues for the franchise division.

I routinely find franchise operations manuals drafted by franchise consultants or do-it-yourself manual kitscontaining inappropriate chapters or topics. Not knowing where the bullets come from in franchise litigation, they proceed blindly ahead using “boilerplate” manuals where most (but not all)

Franchise Disclosure Documents (FDD) under the FTC’s new Franchise Rule continue to be a good concept in theory. Unfortunately, reality plays a more important role and reveals an entirely different picture.

Here are some of my observations, based on twenty-eight plus years of experience in the franchise industry as a franchise attorney, franchise expert and former franchise owner. During this time, I’ve drafted, reviewed and negotiated over 500 Franchise Disclosure Documents.

Franchise Disclosure Goals

Franchise Disclosure Documents or FDD (formerly known as Uniform Franchise Offering Circulars) are a document containing twenty-three chapters of information. These disclosures are intended to give prospective franchise buyers enough pre-sale information so an intelligent franchise investment decision can be made before long-term contracts are signed, money changes hands and sizeable financial commitments are made. In most cases, a franchise investment has long-term financial consequences. It means putting everything on the line – savings, retirement accounts, home equity, etc. With all this at stake, it’s easy to see why the disclosures in the FDD are so important.

Aura Of Credibility

Attached as exhibits to the FDD are the franchise company’s audited financial statements, franchise agreement, and a list of operating (and departed) franchise owners. If the company elects to make a franchise “Earnings Claim,” that information will be set forth either in Item 19 or attached as another exhibit. The entire document is quite lengthy and can exceed several hundred pages. In certain states (known as franchise registration states like California, New York, Illinois, etc.) the FDD makes reference to being registered with the state. All these formalities creates an aura of credibility. Many franchise buyers assume a regulatory agency has reviewed and approved the franchise offering. Unscrupulous franchise companies engage in blatant misrepresentation, referring to their franchise registration with a state as that state’s “stamp of approval.” Nothing could be further from the truth.

Franchise Registration Realities

First of all, registration of a company’s Franchise Disclosure Document only means they’ve paid a registration fee to a governmental agency and submitted their document. There are no standards a franchise company must meet before it can sell franchises, such as business experience, financial stability, operating a successful prototype for a certain period of time before franchising, etc.

Business Experience And Financial Stability?

You and I could have no experience in a business concept, and never operated a prototype. All we have is an idea to franchise, letting other people (franchise buyers) risk their savings, homes, etc. to see if our idea pans out in the marketplace. All we need to do to franchise is put together a Franchise Disclosure Document, and capitalize our new franchise corporation or LLC. Let’s say we don’t want to risk anything ourselves, so we decide to capitalize our new franchise corporation with only $1. After producing an audited financial statement (showing $1 cash and stock issued for $1), and including this financial in our Franchise Disclosure Document, we’d be able to sell franchises with impunity and collect our $50,000 franchise fee every time we sell a franchise.

Franchise Registration States

Of course, in the U.S. there are about 14 franchise registration states where we’d have to pay a registration fee and file the document with the appropriate state agency. But that’s just a rubber stamp and no registration state will refuse to register our franchise offering. Because we’re “thinly capitalized” these states may require an escrow condition where we don’t receive the franchise fee until the franchisee opens for business. Or these registration states may just say we can’t accept payment of the franchise fee until the franchisee opens, and require a simple amendment to our franchise agreement to reflect this condition. That’s the trend here in California and the bottom line is we’d get “registered.”

Even franchise examiners (who are usually attorneys) in registration states issue registration renewal orders to franchise companies who have been operating a couple years and whose audited financial statements say (in an brief footnote): “Since its inception, the franchise company has incurred a net loss of $X million. These and other factors indicate substantial doubt the Company will be able to continue as a going concern.” Translation: the auditors are saying the company’s ready to go broke. Result: Not to worry, the franchise examiners issue renewal orders allowing them to sell franchises to unsuspecting buyers. It’s not right, in fact it’s outrageous, yet it happens.

Franchise Non-Registration States; FTC To The Rescue?

In the balance of the non-registration states (36) we’d be able to sell franchises with impunity and no regulatory oversight. Of course, there’s the Federal Trade Commission’s FTC Franchise Rule that applies in all states. But this only requires producing a franchise disclosure document – FDD. There’s no registration process with the FTC and they rarely get involved in franchise complaints. A 1993 government report found the FTC acted on less than 6% of all franchise complaints. The U.S. General Accounting Office reports that franchise complaints to the FTC from franchise owners increased ten-fold from 1997-1999. This dramatic rise is profound considering complaint data was only available through June 30, 1999. Since 1998, according to the FTC’s website, only one franchise enforcement action was taken against a franchise company. There’s just not enough money or resources available to the FTC, a situation that will only grow worse in the current economy.

My point here is registration of a Franchise Disclosure Document with a governmental agency only means the franchise company paid a filing fee and forwarded its document. There is no due diligence undertaken by examiners in a registration state. So the real guardian of the franchise investment must be you – the franchise investor. Because of the complexities of franchise agreement provisions and offering circular disclosures the need for competent, professional advice is critical. Many of the critical disclosures are required only in a table, where the relevant contract sections of “boilerplate that bites” are listed, without going into any “details.” If you’re not a franchise attorney looking for red flags, it easy to get duped.

Breakeven Point

Returning to the Franchise Disclosure Document, critical business information is NOT disclosed in the document, principally due to lobbying by the franchise industry. For example, the time it takes to reach the break even point – where revenues cover expenses – is not required disclosure in any franchise disclosure document. A bank would never loan money without this critical financial milestone, yet franchise companies let franchise buyers invest hundreds of thousands of dollars, often mortgaging their homes and tapping into savings and retirement accounts. What type of financial milestone must franchise companies disclose before franchise buyers risk what is often everything they have? The relevant disclosure, Item 7, only requires an estimate of what is called “Additional Funds,” a 90-day estimate of working capital needs. Because many new franchises can take a year, two years or more to reach the break even point, knowing only what it’s going to take to get you through the first 90 days is not helpful – in fact it may set you up for financial suicide. If you don’t have enough working capital to reach the break even point, which can be a year or more down the road, your entire franchise investment will go down the drain.

Financial Performance Of Other Franchise Owners

Another major shortcoming of disclosures in the Franchise Disclosure Document is not telling you how much money the franchises in the network are making. Instead of answering what is the most important question in a franchise investment decision, the franchise disclosure laws make this “optional” for the franchise company – they can tell you if they want to. If they decide to answer this critical question, it will be found in Item 19. But don’t hold your breath – more than 90% of franchise companies opt not to answer this question. It’s another bizarre reality in the world of franchising. Because they require complete monthly (and in many cases, weekly) financial profit and loss statements from their franchise owners, the franchise companies know exactly how much their franchises are making (or losing). But more than 90% decide not to say anything before you buy one of their franchises.

Asking Current Franchise Owners

Of course, current franchise owners are a potential source of information and a list of these are found in an exhibit to the Franchise Disclosure Document. My experience is most franchise owners exaggerate their financial performance or decline to share their finances with a stranger. Many of them I’ve spoken with over 28-plus years claimed they were making good money, when a studied examination of their financial statements revealed they were either losing money or operating at or below minimum wage performance. One couple invested $200,000 in a pizza franchise and were desperate to sell it eighteen months later. Their financial statements showed they were making about $0.50 (fifty cents) per hour. Fortunately, my client promptly lost interest in buying the franchise after listening to my analysis. The incredible thing is I discovered the franchise was subsequently sold to another person who operated the business for a year then filed for bankruptcy. There are many more examples of these franchise nightmares. Franchise “resales” where unprofitable franchises are sold over and over are another bizarre reality in the world of franchising.

Copyright 2007-2009 Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved

For more informatiion, visit the Franchise Foundations website.