New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

Recently, in my article "Avoid the Hype when Buying a Franchise: Focus on Specifics and Not Overall Industry Trends"  I discussed what I believe to be the improper and harmful methods for promoting franchise sales, i.e.,  generic statements and promises that may lead to inaccurate and unrealistic expectations by a franchisee.  These statements are bad for both franchisors and franchisees and my advice, basically, was to disregard and avoid this type of promotion.

This afternoon after speaking with a client about a franchise that he was evaluating - a franchise that he explained would provide him with a great "return" -  I took a look at the franchisor's website and, there it was, the pitch:

[_________________] is a proven franchise system with low start-up costs and high returns.

While I readily admit that I am a franchise lawyer and not an accountant, if I were a prospective franchisee or even legal counsel to the franchisor making this pitch, I would have the following questions:

• How High of a Return?  2%,  5%, 10%...?;

• A "Return" Based on What? Start-up costs, overall investment?  

• Is the Return Measured / Based on Gross Sales or Net Income? Before Royalties or after Royalties? Before debt service or after debt service? and;

• What type of return should I expect?

The reality is that this franchisor probably does not (and cannot - without subjecting itself to potential litigation exposure) offer an answer to these questions and even if it did there would (I hope) be an extensive number of disclaimers.  For the prospective franchisee recognize that franchisors cannot guarantee success (that is not their job), so before you make an investment decision based on "vague" statements about "profits" and "returns", start asking questions.

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Driving into the office this morning I listened to a radio commercial that I found to be repulsive . The commercial was not political, did not contain any profane language and, quite possibly, did not contain any false statements.  Nevertheless, the information conveyed in this commercial (really just a bunch of self-serving platitudes) could do harm to the unprepared.  

So what was this commercial about?  The sale of franchises for a national mall based / strip-center consumer video game franchise.  You see, the commercial was not promoting the operations of their retail stores or franchisee operations but rather the sale of "franchise opportunities".  Since I don't have the actual text of the commercial (I am basing this post on my memory of 5 minutes ago) I will not disclose the name of the franchise.

What Do I think is So Wrong about this Commercial? the fact that rather than promoting existing franchisee sales and informing consumers about the advantages of their stores (compared to competitors) they offered a generic pitch about buying their franchise.  Their "franchise sales" pitch followed the following formula:

• Make a generic statement about "becomming your own boss";
• Offer generic information about  "industry growth trends"; and
• Imply, with even more generic information, that you - as a franchisee - can benefit from this opportunity by utilizing their "proven and powerful" systems.

Basically, alot of hype and platitudes - many words but little, if any, information.  

Points for Prospective Franchisees: (1) Just buying a franchise does not make you your own boss; (2) Just because an overall "industry" is growing and profitable does not mean that as a "retail franchisee" your business will also be profitable; (3) Before buying a franchise give serious thought about what makes them "unique" and the "added value" that they bring to the table.  Most importantly, when you hear a franchisor brag about "proven and powerful systems" ask specific questions about those "systems" and what makes them "proven" and "powerful".  Don't wait until after you pay a franchise fee and invest in build-out.

Some of the many internet resources to consider include: The Franchise King, Franchise Essentials, Blue MauMau, Franchise Pick, WSJ Small Business. 

Points for Franchisors:  Advertising franchise sales is no a bad thing and, in fact, may be a key component to overall system development and growth. However, the ads should be based on the unique and fundamental characteristics of your particular system and the advantages that you offer.  If these "unique characteristics" are not readily identifiable then you are doing something wrong and you should be focusing on true "system development" and not unit sales.  Significantly, the witnessed success of existing franchisees is the best source of growth for a franchise system.

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If you are considering the purchase of a franchise it is critical to recognize that your "investment" goes beyond - well beyond - initial franchise fees and startup expenses. While franchise fees and start-up expenses (such as equipment purchases and "build-out") are critical expenses that must be evaluated, they only tell half the story.  That is, when signing a franchise agreement you will be committing yourself to a serious of legal obligations that will involve the commitment of your time, future financial resources and legal obligations for many years to come.  

So when evaluating the "cost" of a franchise, in addition to franchise fees and initial start-up costs, give some serious consideration to:

(a) Reserve Capital. Additional funds that you may be required to invest in your business/franchise during periods of unprofitability and negative cash flow.  As with any business you may very well encounter periods of unprofitability and losses.  When faced with losses and cash flow shortages you will be required to invest additional assets and resources to sustain the operations of your franchise;

(b) Your Time. The extensive time that your will be devoting to operating and managing your new franchise.  Your time is valuable and when operating your franchise you will be foregoing income and opportunities from other sources of employment.  Although obvious, this expense / opportunity cost is commonly overlooked. If your franchised business does not work out remember that your losses include missed opportunity costs and income that you would have otherwise earned. 

(c) Post-Termination Restrictive Covenants and Fees. As a franchisee in most instances you will be committing yourself to long-term obligations and restrictive covenants.  These covenants and obligations have a cost, especially when they restrict what you can and cannot do if you elect to shut down your franchise.   This is of special concern to current business owners with established reputations within a community who - for legitimate reasons - decide to become a franchisee of a national company.  

For Example - If you are a carpenter with a long established reputation within a community and you elect to purchase and become a franchisee of a national "repair" or "handyman" franchise what happens if your franchise relationship does not work out and you cancel your franchise agreement?  Will you be precluded from operating your own repair business - a business that you operated many years before becoming a franchisee?  The answer is that it all depends on the restrictive covenants contained in your franchise agreement - covenants and obligations that you should review and discuss in detail with your franchise lawyer "before" signing a franchise agreement.

So when considering the "cost" of your franchise investment you must go beyond "out of pocket" expenses and fees and evaluate the substantive impact of the long-term legal obligations that you will be committing to.

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In the recent decision of Maintainco, Inc. v. Mitsubishi Caterpillar Forklift America, Inc., the Appellate Division for the Superior Court of the State of New Jersey affirmed the application of the New Jersey Franchise Practices Act ("NJFPA") to the "constructive" termination of franchisee rights.  That is, actual termination is not required for a franchisee to invoke the protections of the NJFPA.

In the Maintainco decision, utilizing fundamental principals contract law, the Appellate Division held that that the franchisor / manufacturer's actions including (a) the threatened termination of the franchisee / dealer's rights, (b) the failure to disclose customary annual business plans to the franchisee, and (c) the grant of competing rights to a third party franchisee within the plaintiff franchisee's territory, constituted "constructive" acts of termination actionable under the NJFPA.  In the court's well reasoned decision, the following points are instructive:

• Franchisee's faced with the "constructive" termination of their franchise rights possess a claim for violation of the NJFPA;

• "Sound and non-discriminatory" business decisions are insufficient to justify the "non-renewal" of a New Jersey franchise. The failure to renew a franchise must be based on the franchisee's failure to "substantially meet the performance requirements of the franchisor";

•  Performance requirements imposed on franchisees must be "reasonable;

• Attorney fees are recoverable by a franchisee who successfully prosecutes a NJFPA claim; and

• Expert fees are not recoverable under the NJFPA.

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