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

I am a firm believer in the efficiencies and economies of scale that may result from operating multiple franchise units.  Provided that you are a dedicated business person and that you are operating within a solid franchise system, the advantage and benefit of operating multiple franchise locations may be substantial.  Of course, if things are not going well, owning and operating "multiple units" may serve to double or triple your difficulties.  If you are a prospective franchisee considering the potential investment in a multi-unit franchise opportunity (i.e., where you obtain the "right and obligation" to develop more than one franchise unit with a proscribed geographic territory) you must carefully consider and evaluate the advantages, if any, that will result from any potential “mult-unit opportunity”.

When evaluating a multi-unit franchise opportunity your starting point must involve a thorough analysis of the franchisors FDD and a clear analysis as to the substantive rights that you will be acquiring as compared to the additional "legal obligations" and expenses that you will be assuming. Factors that should be evaluated include:

• What is the amount of the development fee that you must pay to acquire the multi-unit development rights?

• Will you be afforded a discount to the franchisor’s fixed ”initial franchise fee”; If a discount exists will the discount allow you to recoup the additional initial development fees that you will be required to pay to the franchisor?

• Will you be afforded a protected territory that possesses sufficient demographics and territory size to permit your "profitable" development of the franchise units that you will be required to develop?

• Will you receive a reduced royalty structure as you develop additional franchise units, or, will you be paying the same royalty rates as single-unit franchisees?

• What are the minimum number of franchise units that you must develop?

• Is the development time-table sufficient for your development of the required number of franchised units;

I am a strong proponent of multi-unit franchising and believe that for the right franchisee, multi-unit franchising presents a significant opportunity. However, much will depend on the franchisor, the franchise opportunity and your ability to develop and manage multiple franchise units. If multi-unit franchising is something that you are considering, you must also recognize that there may be additional opportunities (when compared to the negotiation of a single unit franchise) to negotiate and refine the terms of your franchise agreements.

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There are many reasons why, for many, the purchase of a franchise makes sense. However, buying a franchise may not be right for you. I was, again, reminded of this "obvious and basic fact" during a conference call today with a client considering a substantial investment in a multi-unit franchise. The investment was sizable and, quite frankly, there was plenty of opportunity in the deal.  After a substantial legal review (where everything looked good and substantial negotiating points were achieved) he decided that "becoming a franchisee was not right for him" -  so he walked away from the deal. 

I think the right decision was made.  Not for any particular legal reason, but, because sometimes, becoming a franchisee is just not right.  When your "gut" tells you its not right - then walk away. The reverse, however, should not be applied.  That is,  if, your "gut" tells you that a potential franchise opportunity "is right for you", then your next step is not to just sign a franchise agreement but, rather, to engage in a thorough "due diligence" evaluation to ensure that you are acting on solid information.

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Below are five steps / factors / issues that you should be considering and evaluating before investing in a franchise.  There are many more than five, but the following is a start.

(1) Due Diligence is Critical – If you are considering the purchase of a franchise it is critical that you conduct an in depth evaluation of both the franchisor and the potential franchise opportunity. Far too many franchisees just assume that if a franchise system has multiple franchisees, good looking stores and trade dress, that the franchise opportunity must be profitable. However “profitability” is not guaranteed and all franchises are not created equal. You must research and evaluate the franchisor, the franchise system and whether or not the franchise opportunity is a good fit for you.

(2) Thoroughly Examine the Franchisor’s FDD with a Qualified Professional – If you have already contacted a franchise company to inquire about your potential purchase of a franchise opportunity, chances are that you have been handed, mailed or emailed an extensive document referred to as an “FDD”. FDD stands for “franchise disclosure document” and is the legally mandated disclosure document that a franchisor must provide to you at least 14 days prior to your execution of any agreements or your payment of any money. The FDD is an important document that will serve as a significant resource to enable you to more thoroughly examine the franchise opportunity that you may be considering. The FDD will contain information about the franchisors management team, the franchisors “estimate” of the start-up costs that you should expect to incur and the royalties and on-going fees that you will be required to pay. FDD’s are important and before investing in a franchise you should hire an experienced franchise lawyer to review this document.

(3) Contact Existing Franchisees – One of the biggest resources that a prospective franchisee should consider is the opinion and experiences of existing franchisees. When evaluating a franchise opportunity, take some time to politely contact existing franchisees (choose a franchisee in another state or someone that you will not be in competition with), let the existing franchisee know that you are considering the purchase of a franchise and that you would appreciate it if they would speak with you about their experiences and satisfaction with the franchisor and the franchise system. Don’t just contact franchisees recommended by the franchisor – seek out the advice of as many independent franchisees as possible. Item “20” of the FDD titled “Outlets and Franchisee Information” should include a list of the existing franchisees and their contact information, so use the FDD as your starting point to identify franchisees that you should contact.

(4) Understand that Franchise Agreements are Negotiable – When a franchise opportunity is presented to a prospective franchisee, many times, the prospective franchisee is advised that the franchise agreement is “not negotiable”. Some franchisors and their sales staff may even take this approach a step further and advise that even if they wanted to change the franchise agreement that it would be illegal for them to do so. However, before you simply sign a franchise agreement and pay a franchise fee, you must understand that franchise agreements are indeed negotiable. It is not illegal for a franchisor to negotiate the terms of your franchise agreement. While you must be reasonable with your expectations about the franchise agreement terms that a franchisor may or may not be willing to negotiate, review the franchise agreement with your franchise lawyer and develop an approach to address and negotiate some strategic points that may enhance your rights as a franchisee. Some of the critically important franchise agreement terms that you should be evaluating with your franchise lawyer and potentially negotiating, include:

(a) Scope of your protected territory;
(b) Grace periods regarding the commencement of royalty obligations;
(c) Liquidated damages and liability for early termination;
(d) Renewal rights;
(e) Transfer rights;
(f) Cure periods for alleged defaults; and
(g) Potential "rights of first refusal".

(5) Sometimes the Best Decision may Be to “Walk Away” - It is critical that you remain “honest with yourself” during your due diligence investigation and the consulting with your franchise lawyer. That is, the franchise that you once believed to be a great opportunity (one that you were previously excited about and told your family you were purchasing) may turn out not to be what you expected. Sometimes in the excitement of this entrepreneurial venture you may be inclined to discount or overlook warning signs that should serve as a red flag. Understand that walking away from a franchise transaction, sometimes, may be the best business decision. 

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In the current economic climate there are many news reports discussing franchise failure and the harsh economic realities faced by some well intentioned and hard working franchisees.  These articles typically feature a struggling franchisee and then proceed with a discussion as to the economic difficulties that the franchisee is experiencing.  When reading many of these articles - especially the portion where the franchisees express what he or she believes is causing the failure in the franchised business - I am concerned that many franchisees (including prospective franchisees reading the article) may be missing some critical points.

In Eilene Zimmerman's CNNMoney.com article, "Trench Warfare in the Franchise Field", Rita's franchisee Tish Reisman discusses some of the difficult circumstances that she is currently experiencing.  While it certainly appears that Ms. Reisman is a hard working and well intentioned individual, I am concerned that the points she raises (as to the possible causes for her business losses) may be off the mark.  In the article Ms. Reisman, raises the following points that she attributes to her losses:

(a) Encroachment:  "A competing Rita's opened five miles away";

(b) Time Consuming Promotions:  "A corporate marketing campaign required her to stand in front of Wal-Mart and Kmart stores handing out coupons, sucking up time and resources she couldn't spare";

(c) Product Introductions:  "Rita's requires her to sell every new flavor it introduces for 24 days - even if it tanks"

While the issues raised by Ms. Reisman are certainly issues of concern, are they the actual cause of the "franchise failure" that she seems to be experiencing?  Here are some of my thoughts:

• Encroachment - Encroachment is an extremely serious issue for franchisees and indeed a major contributor to franchisee failure and diminished profits / losses.  However, in Ms. Reisman's case we are advised that the competing Rita's franchisee is located 5 miles away.  When dealing with the "local nature" of ices and similar quick serve products is this really an encroachment issue?  Five miles sounds quite reasonable and could actually serve as a benefit to Ms. Reisman in terms of economies of scale that may be created through possible joint marketing efforts and brand penetration.  While encroachment is a serious issue for all franchisees, I am not certain that this is a significant factor for Ms. Reisman.

• Time Consuming Promotion - I am not sure if I buy this issue at all as a contributing factor.  Having a franchisor interested in market promotion is a good thing and, quite frankly, Ms. Reisman could have paid some teenagers to hand out coupons - as opposed to doing it herself.  

• Product Innovation - many times franchisees complain, and rightfully so, that the franchisor is not actively engaged in product innovation and development.  So, here to, I would not criticize Rita's for its constant product introduction.  However, to the extent that franchisee's are experiencing higher levels of waste (due to poor sales of new products) there should certainly be a royalty adjustment for the franchisee.  This is certainly an issue for Ms. Reisman, but, again is this a substantial contributor to her unprofitability?

While Ms. Reisman may be experiencing other issues not addressed in the article, I can not  help but believe that she needs to be addressing and evaluating some serious additional factors.  For both Ms. Reisman and any individual considering a franchise investment, here are some other factors that I would be considering:

• Debt Service - The issue of debt service is not mentioned in the article but could be playing a substantial factor in the economics experienced by Ms. Reisman.  Did Ms. Reisman borrow money to establish her Rita's franchise and, if so, how much?  Too many times prospective franchisees do not consider the substantial impact that debt service will have on their bottom line.  Is Ms. Reisman over levereged? 

• Expectations - When purchasing her Rita's franchise what were Ms. Reisman's expectations about profitability.  My only point here is that when evaluating something as a success or failure , a lot depends on your expectations.  Did Ms. Reisman have the right expectation when she purchased her franchise?  Did she base her expectations on solid "due diligence" involving discussions with existing franchisees, a thorough evaluation of the FDD and her legal obligations?

There are many other factors that are of extreme relevance to understanding the unfortunate circumstances that Ms. Reisman is facing.  It is not enough to simply blame the franchisor and, quite frankly, Ms. Reisman needs to thoroughly assess her current circumstances and implement some immediate corrective measures.  Unfortunately, if Ms. Reisman's  due diligence or expectations were off, going forward, the Rita's franchise may not be the correct business for herself and her family.  

UPDATE:

In a comment Paul Segreto of Franchise Essentials links to his excellent and "honest" post "Fear and Consequence of Failure: A True Story".  If you are a franchisee definitely read what Paul has to say as I believe that the advice he offices speaks from experience.  If you are a struggling franchisee consider what Paul has to say - especially the part of considering an exit strategy.

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In an effort to expand the information provided at the New York Franchise Law Blog and, hopefully, the timeliness and value of this information for our readers and subscribers, we will now be featuring a continuing series of succinct fact based articles (in addition to our commentary and reports) focused on the "basics of franchising", comprised of "Franchisor Basics" and "Franchisee Basics".

These articles will serve as a valuable reference tool to our readers and, as always,  it is important that you discuss the specifics of your franchise system, disclosure obligations and franchise decisions with your franchise attorney.

As always, we appreciate and welcome the comments and suggestions that we have been fortunate to receive from our readers. Please let us know if there are any specific franchise topics that you like us to address.  Thanks.

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