What's New In Franchise Purchase Due Diligence?

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Within the next 15 years we will see dramatic changes in the franchising business.

Today the business is saturated with "me too" so-called concepts that lack adequate business model legs to survive even at marginal profitability through the lifespan of their franchise agreements.

Their FDDs are fiction and fantasy, and those who buy them lack relevant sophistication for small business investment (to put it mildly). In plain English, they are sold to fools who sign ridiculous draconian franchise agreements critically lacking in merit level consideration.

Soon they are whining to be let out of the deals as realities they could have discovered pre-investment descend upon them and they recognize the terminality of what they did. This will begin to change.

The franchise business cannot grow on toxic deals that are just myths designed to fleece morons.

The world does not need any more pizza, hamburger, sandwich, Mexican, Asian, ice cream, cake and fruit stores, print shop, single product, all other kinds of retail stores franchises.

When what is sold through a franchise system becomes available through alternative distribution channels that do not pay franchise relationship expenses, or over the Internet, franchisees are detrimented and lose investment value.

Anytime a franchise is configured so that the franchisor gets paid your revenue stream and then deducts what you owe from that and remits the rest to you, you will be robbed into bankruptcy.

Moreover, every time it is suggested that some new government program is afoot, someone designs a fantasy concept to fit it. Someone is now, for instance, selling franchises in which the mythical profit opportunity is based entirely upon Obama care being upheld by the Supreme Court. Even if it is there will not be sufficient funding to cover the care services that will be provided, a return on that investment plus revenue sufficient to cover to costs of being someone's franchisee.

The Old Model franchise business provided a living for legions of franchise lawyers who were essentially clerks grinding out template franchise agreements and FDDs, many hundreds of whom are now walking the streets looking for law jobs, presenting resumes that show they spent the last ten years being overpaid clerks.

The economic meltdown we are now enduring has impacted franchising as well.

So what should we expect the next phase of franchising to become. Here is my take on it.

1. Investor quality will change. Fewer investors will charge into buying a franchise without competent pre investment deal due diligence assistance. The horror stories are now so pervasive that greater care will be taken before betting the farm on someone's optimistic descriptions of so called "concepts".

To be sure, there will always be suckers, which means there will always be bozo franchise deals to be sold to them. As long as there are sheep there will be wolves.

But more intelligent franchise investing will mean that only revenue credible franchise opportunities will attract financially responsible operators.

Revenue credibility will have to be demonstrated in the sense that there is a provable track record of financial success after the costs of being a franchise are accounted for - all the costs of being a franchise, not just those specified in what is laughingly called today a Franchise Disclosure Document (FDD).

Franchises today that describe themselves as having a franchising expense of 10 % to 13 % of gross sales are in reality at 20 % to 25 % of gross sales. Such franchises have no legs and will only bankrupt investors.

2. Smarter buyers will force changes to the draconian terms of today's franchise agreements. Among the clauses that will be modified or eliminated will be those that tie in purchases, that run revenue through the franchisor's hands before the franchisee gets his share, that provide for so called liquidated damages upon termination, that prohibit group dispute resolution proceedings, that force acknowledgment that representations made were really not made at all, and no reliance provisions.

Intelligent investors will refuse to accept terms that put them in a serious bind should things not be as represented.

Courts will refuse to allow enforcement of contract provisions that exonerate fraud through the artful use of language. Bad facts will cause a re-examination of just how sacrosanct contract language has to be.

It may be that this carve out is limited to franchise investment cases of certain profiles, but some way will be found to curb the "license to steal" provisions that are today in every franchise agreement.

3. Life cycle characteristics will become a more aggressive segment of due diligence. No one will any longer rely on the fairy tales told in franchisee interviews, as it is now sufficiently obvious that franchisees rarely tell the truth to prospective investors for many very valid reasons, including fear of franchisor retaliation.

Expectations that franchisee associations will provide a reservoir of truthfulness for investors may not come to fruition in the next 15 years.

The problem with that is that truthfulness is not attractive if it would result in making it more difficult for franchisees to sell their franchised businesses. Franchisees should not be expected to act contrary to their perceived interests in order to protect third parties. Will that aid and abet franchise fraud?

Of course. The solution to that issue will again come only from competent deal due diligence in addition to legal due diligence. Those who offer only legal due diligence will find it harder and harder to attract franchise investor clients.

People will more maturely recognize that so called government regulation of franchising is a myth and that they conduct competent pre investment due diligence or face failure. Were it otherwise we would not just now be exposing the massive "liar loan" schemes in which franchisors insert fraudulently inflated financial performance information into the SBA loan application process to enable SBA backed bank loans for franchise offerings that haven't the slightest possibility of providing return on investment.

4. Similarly, realists will no longer expect real government assistance in improving the quality of franchise pre investment disclosure or of franchise relationship abuse restraints. Investors will know that if the franchise provides the franchisor the right to be a predator that is precisely what will happen. The vehicle for most of these changes will be the more substantial investors who can afford multi unit and area development deals. Single unit investors will continue not to have the bargaining power to get the best terms or the best deals.

The single unit investor will continue to be the victims of franchise charlatans more often than not, as single unit investors tend to fail to purchase competent deal due diligence help.

Established multi unit operators often buy area deals from new or recent franchisors, believing that they know how to make the business model work and won't suffer if the newbie franchisor isn't up to speed on support.

With all the bottom feeding going on, it should be expected that good operators may take advantage of the difficulty of a brand and buy it for nickels and dimes.

Any new owner with franchise knowledge knows that you can always find ways in today's franchise agreements to squeeze more money out of the franchisees, and that if you squeeze them to death that really isn't much of a loss.

The acquiring good operator company can take those locations and convert them to their brand. Those locations can be had with a mere swap of releases in most instances, as the starveling franchisees would see a walk away as a positive event compared to having to pursue bankruptcy as the way out of the franchise agreement with its liquidated damages and personal guaranty clauses.

When the new crop of toxic guaranteed failure franchise concepts dries up over the next ten years this will become less of a factor.

Some of these going broke franchise systems are also conducive to money laundering by narco traffickers as well as a front system for drugs distribution itself. One day someone will do an expose on the use of decay stage franchise systems by narco traffickers.

By 2030 I expect to see franchising have a different and better look.

It will be harder to bring a franchise to market, so only better franchises will make it. Charlatan franchise consultants who tout that anything can be franchised in order to get people to hire them to help franchise their businesses, usually drop outs from past over the hill franchise companies, will be less and less credible as they are exposed for over selling the ability of any franchise company to extract large extraneous revenue streams out of any franchise system, regardless of its success in attaining any significant measure of growth.

More of these guys would already be defendants except that they usually are judgment proof and not worth suing.

There will be very few viable new franchises. The good ones will be extremely rare. Indeed, the good ones are already extremely rare, as certain popular categories are already too overcrowded and price sensitive to be investment worthy. That includes the all time favorites in the fast food business. None of them is worth having. The few good ones are not being franchised, like Chipotle Grill for instance.

Toxic new franchises will tend more to lean toward technological themes and be sold to nerds with no business savvy.

You have to be really stupid to buy a food franchise today, or to buy any franchise that is already 20 years old. The few good old ones are bought by existing operators when they become available, and new buyers never get a chance to buy them. Why allow a resale to a newbie when someone who already has a positive operating history in that same franchise is willing to buy it?

Vulture capitalists are securitizing old franchise agreements in moribund companies and categories.

Bain Capital is scamming the public into buying stock in over the hill Dunkin Donuts, saying that this regional geriatric has new life in expanding westward.

That ought to be a great lesson in what not to invest in. Bain reaped millions in fees; risked nothing; and loses nothing if price of the stock crumbles. It is the franchise version of the mortgage backed securities scam that created so much damage in 2008.

One could posit that, having learned nothing from the mortgage backed securities fiasco, franchising is headed for its own royalties backed securities disaster, and that is certainly not unlikely. If so, the ball should drop within the next few years. It is unfortunate that evil begets evil until the roof falls in, but so it seems goes life these days. This is the kind of abuse that I expect to assist in turning the market in franchising from a thieves market into a more rational market over the next 15 years.

In an intelligent investor's world, no one would go near any franchise related investment without extremely competent deal due diligence in addition to the legal due diligence. When asked what in franchising today is worth investing in, my usual response is NOTHING for the moment. There may be isolated niche opportunities, but only extremely competent deal due diligence could possibly perform the tests necessary to identify a real opportunity from a false opportunity masquerading as a real opportunity.

Franchise law practice now is centered more upon people wanting to find ways to escape from the franchises they invested in. I look forward to the positive changes I anticipate in the next 20 years or so.

As always, you can call me, RIchard Solomon, at 281-584-0519.

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18 Comments

Franchisors who want to grow durable franchise systems with sophisticated and qualified franchisees are going to have become more competitive and deliver franchise programs that have real marketplace value.

If you have, or plan to launch a "me too" franchise with a borrowed & copied FDD and Franchise Agreement you should re-think your plan.

I'd consider changing the title as almost all of the article deals with changes that will supposedly happen sometime in the future. Where does the article address what's new today?

Having represented franchisees for 34-years now, my take is little has changed and little will, given the powerful lobbying influence of the IFA and large franchisor law firms.

A minority of people, probably less than 10% consult an attorney pre-investment.

Those that do are pretty much sold already and are just looking for validation from a "professional."

Most "franchise attorney" focus strictly on the legal aspects, which is less than 50% of the franchise equation. Don't know of any, with one exception, that have actually owned and operated a successful franchise.

Critical business and financial analysis is not done, with the client simply advised told they should consult an accountant.

Fortunately, I've been able to dissuade most prospective franchisees from making foolish investment decisions that are a train wreck waiting to happen. The bad news is a small minority have ignored my advice and detailed evaluation.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Kevin writes: "Don't know of any, with one exception, that have actually owned and operated a successful franchise."

I don't think being an owner is a necessary condition of being able to review the business model of a franchise & what the FDD discloses or hides.

It's not a necessary condition, but walking the walk, instead of just talking the talk, provides a unique skill set and perspective for evaluating business model metrics, FDD disclosures, franchise agreement provisions, etc.

If you had the choice of using a franchise attorney or a franchise attorney who actually owned and operated a successful franchise, who would you choose?

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Kevin;

Because I would be wary of survivor bias, I would pick the person who had a demonstrated record of making sense when it came to examining the FDD & comparing it to business reality.

I would want to read what they had said, to see if it made sense to me.

If you had a choice of using a franchise attorney or a franchise attorney who actually owned and operated a successful franchise, and was a court-accepted, testifying franchise expert, who would you choose?

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

The author writes:

"Franchises today that describe themselves as having a franchising expense of 10 % to 13 % of gross sales are in reality at 20 % to 25 % of gross sales."

If the royalty is 10% to 13% of gross, how "in reality" does that jump to 20% to 25% of gross?

Doesn't compute; is there any explanation?

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

My guess is that once you add in the imputed costs of vendor programs, improperly disclosed in item 8, then you could easily get to 20-25% effective royalty rate.

That's my point. Franchise attorneys, let alone lay persons, should not have to "guess" what an author means by unsubstantiated allegations.

And I don't understand your statement about "improperly disclosed in Item 8." It's either disclosed or not. There's nothing "improper" about disclosures in Item 8. Unless there's some statutory authority that's been recently promulgated to the contrary that no one is aware of.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Kevin hopefully writes: "There's nothing "improper" about disclosures in Item 8. "

This is an unrealistic picture of the Item 8 for many systems. You can simply cannot calculate from the disclosure what the effective & imputed royalty rate will be.

Again, that's my point exactly. If you can't calculate the "effective and imputed royalty rate" then you can't make unsubstantiated statements, like the author did, that a 10 % to 13 % of gross sales royalty are, in reality, 20 % to 25 % of gross sales. That's just pulling numbers out of a hat, throwing them against a wall and hoping they stick.

Also, it's mixing apples and oranges. A royalty fee is one thing; purchases through the franchisor for goods received are quite another.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Kevin,

You have misunderstood this thread.

When Quiznos required, for example, that their franchise owners had to buy Coke at $30/case instead of $10/case, that was equivalent to an increase in the royalty rate.

And no, the exact increase was not disclosed in item 8.

Actually, you are not understanding the accounting difference between a royalty and purchases through a franchisor.

If Quiznos increased its price to buy Coke, this is not "equivalent to an increase in the royalty rate." If you said this in any accounting course, you'd get an "F." It's an increase in the cost of Coke, and has nothing to do with an entirely different accounting expense - the royalty.

And what about in my franchise, where we were "required" to buy our doors from a specific source designated by the franchisor. The franchisor received nothing, but we saved about a third of what it would cost to buy from any other source. Using your imputed royalty logic (not), my royalty payment would have been a very significant nothing. Again, you're mixing apples with oranges. It has no basis in accounting, franchise disclosure law or logic.

Which all goes to show, what's really new in franchise purchase due diligence is a number of "franchise attorneys" really need to take some continuing education courses in franchising.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Ok, let's try another angle.

Consider two franchise systems, A and B.

Franchise System A has royalty payments of 6% , but the cost of participating in the vendor programs added 3% to 90% of the purchase a franchise owner had to make.

Franchise System B had a lower royalty requirement, 4%, but their vendor programs added 7% to 85% of the purchases a franchise owner had to make.

On the rest of the material terms, Franchise A and B are the same.

1. How would you advise a person to choose between A and B?

2. What is the justification for your answer in 1?

3. What might be alternative answers to 1?

First of all, I would never advise a person based on just royalty and required purchase information, even assuming the rest of the material terms of the contract are the same.

Second, you have not furnished the information required by Item 8 so an analysis of just this aspect is even remotely possible; namely:

1. required purchases as a percentage of total initial investment; and

2. required purchases as a percentage of ongoing expenses; and

3. franchisor's revenues from all required purchases; and

4. percentage of the franchisor's total revenues that are from required purchases or leases.

I understand you are not a U.S. attorney, and it shows, so I'm providing some free MCLE to you as a courtesy at this time. I may have to charge you for further MCLE, Michael, if you want the benefit of my 34-years of franchise expertise.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

"Courts will refuse to allow enforcement of contract provisions that exonerate fraud through the artful use of language."

"[R]ealists will no longer expect real government assistance in improving the quality of franchise pre investment disclosure or of franchise relationship abuse restraints."

How do you reconcile these two competing prognostications? Without the aid of government intervention to level the playing field, how do you expect courts to not enforce onerous and unconscionable contract provisions? Isn't the sanctity of contract the governing theme absent some type of government intervention to temper "abuse"?

Either the "realists" with no government intervention will win out, or they won't, and either the playing field will be leveled over time, or it won't. But, it can't be both.

Mario L. Herman
The Franchisee's Lawyer
[email protected]
http://www.franchise-law.com

Excellent point Mr. Herman.

The author apparently thinks courts will "forget" the common law (which had it's origins in the 1150's) and established precedent since then, and somehow decide, willy-nilly, to ignore sanctity of contract and not enforce contractual, agreed-upon provisions.

Maybe in an alternate universe, but even the odds on that are about the same as getting struck by a lightening bolt in mid-summer.

Kevin B. Murphy, B.S., M.B.A., J.D.
Attorney at Law & Franchise Expert
Director of Operations - Mr. Franchise
FRANCHISE FOUNDATIONS APC
http://www.franchisefoundations.com

Kevin; I agree that your analysis is not even remotely interesting.

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This page contains a single entry by Richard Solomon published on October 12, 2014 10:09 AM.

The Art of Solving Franchise Disputes was the previous entry in this blog.

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