Why Do New Franchisors Really Fail?


A very long time ago (about 15 years) I wrote about why new franchisors fail.

During that 15 year period we lawyers have "improved" upon the legal infrastructure of the franchisor quite substantially.

As you may know, the franchise legal infrastructure, a/k/a franchise agreements and FDDs, have moved significantly along the road to elimination of all legal risks for franchisors, except maybe for the more hard core thugs.

If you are not and do not intend to become a hard core thug, you might just want to read all of this.

There is still a lot of room for sound concepts to be developed into investment worthy business replication models. And the fact that in doing that your legal infrastructure has morphed into much better protection should be a positive influence for you.

After all, isn't risk reduction what this is all about after you demonstrate to yourself that you have a profitable model and that you can translate that into a profitable business for others even after loading onto it the costs of being in a franchise relationship?

The Current Franchise Landscape

Even in the old days there were dodgy franchisors:

  • They sold tons of franchises and opened very few.
  • They made profit representations that were total fiction and impossible to achieve.
  • They said things about where the business was positioned and about the quality of the support they provided that were outright falsehoods.

In the 1960s some states began enacting franchise disclosure and relationship laws modeled somewhat upon the laws regulating securities selling.

But there were also a lot of really good, serious opportunity franchisors, and a reasonably careful person with some professional help could buy into such things as KFC, McDonalds, Little Caesars Pizza, Pizza Hut, Wendy's and Burger King, among others.

Today there are many more dodgy deals being put out for investment to less able investors.

The techniques for getting around the law one way or another have become more sophisticated. Analysis of potential franchise investments is more complicated. Most lawyers shrink from giving any business advice or analysis for fear of professional liability lawsuits. Asked about an opinion whether a particular franchise is a good investment, the lawyers say that it might be if they are telling you the truth, and stop there - utterly useless.

Franchise blog sites abound on the Internet, chock a block with broke and whining franchisees on their way to bankruptcy and unable to afford legal representation. Class action lawsuits against tough franchisors take years and are rarely certified by the courts. When they are, they drone on for a few years and settle out for paying the lawyers, with the franchisee class members getting little or nothing.

Where Does That Leave You?

If you really have long term intentions regarding the health and survivability of your franchisees, it helps to build a dynamic financial model of what the business is that your franchisees have to live in.

(None of the bozos do this. They don't really care anyway. All they want is as much fast revenue as they can squeeze out of the system)

For the serious long term franchisor, departure from the IFA norm can really help you measure the health of your system.

But you have to make the franchisees send in the tax returns their agreements require anyway, and from those, you can build the dynamic financial model, making the adjustments to derive an approximate EBITDA. It is not the impossible project that the IFA says it is. 

The reason it isn't thought to be a smart move is that then you would eventually find out which franchise system in any business segment is the most profitable, and once that got out no one would ever buy any of the others in that segment. Nobody wants to be known as tail end Charlie on producing positive cash flow.

The IFA also fears that such activity will one day lead to compulsory financial performance disclosure, which is a distinct possibility only if the IFA lobbying arm, Franpac, runs out of money.

So it is a bit of a dilemma. You really cannot count on the information not getting out. On the other hand, since the franchisees will soon be doing this for themselves, there is little justification for you to deprive yourself of the information. Dynamic financial modeling will enable you to see what the traffic can bear and continue to have positive, meaningful yield potential for your franchisees.

If your franchisees start a lawsuit or arbitration proceeding using dynamic financial modeling to show that you are tearing the financial heart out of the business they invested in, you would have to build your own model to dispute theirs, and yours might have to be rather contrived and convoluted in its attempt to show that theirs is not reliable.

Econometric modeling of markets has been used for decades in antitrust litigation, to positive effect. The government lost its first merger case under Section 7 of the Clayton Act because the target defendant used competent econometric modeling. The same thing soon after that happened when the FTC lost the breakfast cereal oligopoly case. I know because I brought econometric modeling into both those cases.

Financial Models for Franchise Systems

Financial modelling of franchise systems is not more complicated than that.

The universal solvent would be a cooperative project that produces a really high value dynamic financial model. That, as we say in Texas, ain't gonna happen.

Franchisors that operate numerous company stores, if they are going to consider this, should have a separate financial model for the company stores. While it may lack positive sales information potential, the ability to compare company owned versus franchisee owned financial results probably would yield marketing information. It would show what we have always believed to be true, that absent artificially imposed barriers to positive cash flow, franchisees really do better than the company does in producing cash flow.

But the really important value of dynamic financial modeling would be that it would tell you when you are approaching marginalization of the franchisees through add on extraneous periodic charges. If you went just one step further, you would also know your franchisees' debt structure profile and would be able to determine what they can afford in terms of remodeling the stores and even to prearrange the financing of large projects before you impose them.

Lenders pay commissions to those who bring them large deals like that.

In this interim before everyone is doing it, you can designate all information regarding financial modeling to be a highly secret body of information and treat it as such. If you designate it secret but everyone in the company has access to it, you are just kidding yourself. If more than five people have access to it you can forget confidentiality. The grunts who churn the basic data can be controlled if you don't fire them every now and again.

Attitude Issues

No franchisor is ever going to be loved by her franchisees. That is axiomatic. Within a year or two of becoming anyone's franchisee, the attitude becomes one of disbelief that there is anything special or unusual in being your franchisee.

They believe your support sucks and that they are getting little or no value from being affiliated with you. How virulent this attitude is will be the only variable. If you don't have a competent information management protocol in place your franchisees will rob you blind. There are just as many cheating franchisees as there ever were dodgy franchisors.

Back in the days when franchisees filled out monthly paper sales reports, the audit of their actual performance was their biggest fear. Of the literally hundreds of depositions I took in cases having to do with under reporting terminations, not one franchisee was ever under reporting unintentionally.

Some of the stories of whining franchisees and what they were charging to the business would make your eyes roll back. One franchisee in Florida was writing off a twin engine airplane against the revenue of a print shop with a three mile territory. His lawyer went ape when that part of the examination happened. Lawyers rarely make the effort to understand the finances of their clients before the horse leaves the barn, and clients never tell you where the bad stuff is hidden. If you don't find it yourself, you can usually bet that your opponent will.

Since you will never be loved in franchising, your contentment will come in providing a working positive cash flow franchise model from which you will become wealthy. If you need more than that, well, be prepared for large legal bills.

The Ultimate Franchise Solution

The ultimate franchise solution for anyone wanting to begin or expand a franchise system is to provide a concept that you have field tested and proven to be revenue credible in a franchise mode, and then to continue to measure its financial performance through dynamic modeling. To be sure, you will also have to improve its appeal to its customer base, but that is what you tell your franchisee prospects that you do best. It helps is that is true.

(I am publishing another article about the risks of becoming a franchisee. If you read that you might be offended. Franchisees who see that I drive both sides of the franchise road often criticize me for that, and some franchisors wouldn't touch me with a stick because I represent franchisees too from time to time. I never worry about that, but be aware that I see this business from both sides all the time, every year, year after year. My feelings about franchising are really love - hate, but that is because I wish I could make it better and that people could more safely invest in franchise opportunities.)

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

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Richard is right about the need for system wide reporting tools. The IAFD is looking at a couple of vendors right now, both of their tools are extremely interesting.

The point about lenders paying a lot of money for information is well worth understanding also.

Franchisors new and old can learn a lot from Richard's article.

I am fascinated when I hear a franchisor state what a wonderful franchise they have and that it's a system worthy of investment

And they can't produce an Item 19 Financial Performance Representation - FPR with the excuse that they don't get good monthly and annual franchisee P&L reporting.

Richard is marching ahead of the band, encouraging all new franchisors to plan to have a comprehensive Item 19.

This is the direction all new franchisors should head in & get a jump on the older franchise systems.

A few years back in law school, I was a research assistant to Wake Forest IP Law Journal article that makes the case for mandating Item 19. I found that litigation occurred nearly exclusively against those franchisors who did not make formal Item 19 b/c of misrepresentation outside of the four corners of that FDD. Also, in comparing SBA loan data from 2000-2008, a franshisee was 55% more likely to default from a franchise concept that did not make Item 19 than one that did provide Item 19. The article can be found on my firm's website at http://thetechlawfirm.com/articles/kanouse/Mandate_FPRs_Article.pdf

When I started in franchising with a major burger category QSR we had a very detailed full P&L Item 19 Financial Performance Representation - FPR (Earnings Claim).

We had an advantage over franchise brands that didn't have a provable & reliable financial performance representation in the competitive world of franchise sales.

And we had an advantage in litigation related to pre-sale disclosure. Having an FPR was something we could affirmatively say we gave to the prospective franchisee. Not having an FPR wasn't a great answer.

GREAT advice "Franchisors that operate numerous company stores, if they are going to consider this, should have a separate financial model for the company stores". I wish I had done that. I have/had 5 company locations and was selling them off to the employees who ran each area. Three employees opted to buy. When I put the other 2 franchises on the open market I lost one sale because I did not separate each area, and it was not good enough for this person for my accountant to break everything out for them...Lesson learned!

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