THERE ARE PITFALLS FOR THE TRUSTING FRANCHISEE
Franchising Realities & Remedies: Page 2
There Are Pitfalls for the Trusting Franchisee
By Harold Brown ©1999
Reprinted with Permission
Important problems may exist for any franchise, including those sold by some of the very well known franchisors. This list is not complete, but it does address some of the difficult areas:
A. The Franchise
Hundreds of people create franchise systems. Studies show that a large percentage of them may not last for even five to ten years. You should try to avoid franchises that do not have a well established track record, since you can suffer serious losses if the franchisor goes out of business.
B. Substantive Problems – Copying
The franchise may have been poorly created. Some franchisors simply copy the documents and system of an existing franchise. The documents are easily available and can be imitated. For example, franchise agreements and FDD’s can be obtained from almost every franchisor at the first substantial meeting with a prospective franchisee. In the fourteen states where franchisors have to register or file their documents with a public agency, anyone can obtain copies at reasonable cost. In addition, thousands of FDD’s can be obtained over the internet or from private vendors.
If a new franchisor simply copies another franchise system, it may not possess enough expertise to support the system and to fulfill its promises to new franchisees. It is less likely to succeed against competitors in the marketplace.
C. Local Representation
Even if a franchise is well-known and successful, it may not have enough or any franchises located in the region that is offered to you. It is very hard and expensive to develop local goodwill without cooperation from a substantial number of franchisees in your “advertising” area. They can share the high costs of local development of goodwill.
Every franchisor promises to provide initial training and subsequent guidance. Such service is almost impossible to regulate, so franchisors are free to handle this in any way they wish. There is no assurance that the teachers will be qualified to teach, that the material will be of good quality, that the brief two or three week training will be sufficient to produce successful operations or that up-dating the data will regularly occur in an efficient manner.
If your franchise is successful, your franchisor may decide to sell competing franchises in your marketing area. If such encroachment is too close to you, it can cause severe losses in your gross sales and net profit.
F. Site Location
There is no assurance of a good location. Some franchisors reserve the best sites for company stores, for multiple franchisees, and for employees and friends seeking to enter the business. As a result, the offered location may have been previously rejected by knowledgeable insiders. The remaining sites may be remote or located in sparsely populated areas or even in degenerating neighborhoods.
Some highly successful franchisors have built up their businesses in distinct areas of the country. They may want to expand into new territory, but history has shown that they sometimes fail in that effort, leaving the existing franchisees stranded and to fend for themselves.
In some franchise systems, the franchisor may decide to try to recapture for itself a successful marketing area. The goal may be a concentrated area where economies of scale are more productive. When such a decision is made, there can be many kinds of inducements to pressure franchisees out of that market.
Sometimes encroachment is motivated by a plan to increase the franchisor’s profits by its serving the ultimate consumers through alternate means of distribution including Internet sales. That may also be done either by “direct sales” from the franchisor to consumers or by other alternate means of distribution, such as through supermarkets that directly compete in a franchisee’s area.
G. Franchisor’s Royalties Versus Franchisee’s Net Profit
Virtually every franchisor charges a direct or indirect royalty for use of the trademark and the licensed business system. This is often done as a percentage of gross sales. Alternatively, there is some form of basic charge blended into the prices charged by the franchisor for products or services. The risk from such arrangements is that the royalty must be paid regardless of whether the franchisee is successful.
H. Sources of Supply
Franchisors generally control the sources of products and services needed by the franchisee to operate the business. The franchisor may make a profit on each of these or it may illegally obtain direct or indirect “kickbacks” or commissions from each approved supplier.
The franchisor has the right and a duty to maintain quality standards and specifications. Provision is usually made for a reasonable procedure to obtain approval of other third party vendors. A minority of franchisors may, however, unfairly prevent the approval system from working by using unreasonable inspection procedures and time delays.
I. Resale Prices
Franchisors often seek to control resale prices directly or indirectly. This is being done directly and with more frequency for maximum prices. Also, it can be done in a subtle manner by requiring the franchisee to provide free services to each customer. The latter may include excessive guarantees, a very large inventory selection of new merchandise, plus repair and replacement parts; strong advertising; all forms of discounts and special sales; liberal delivery and return policies; and new products at very narrow margins of profit.
While all of these free services will increase gross sales and produce increased royalties for the franchisor, the franchisee may confront cost hurdles that wipe out net profits. This is because the franchisor’s royalties will increase due to the increase in the franchisee’s gross sales, but the franchisee’s profit may decline or disappear because of his increased expenses.
J. Alternate Credit Sources
A franchisor may restrict the pledge of the franchised business as security for capital loans. The result may prevent a franchisee from obtaining access to cash needed to keep the business healthy and able to expand.
K. Dispute Resolution
Many franchisors require the franchisee to agree to specific ways to restrict the resolution of disputes. This often demands that all such matters have to be handled in the location of the franchisor’s home office and exclusively under its local state laws. There may be express limitations on due process because of the contractual use of releases, short time bars, and exclusion of compensatory and punitive damages. Some franchisors require the waiver of a right to jury trial.
L. Non-Competition Covenants
Except where prohibited by local law, such as in California, many franchise agreements provide that upon termination or non-renewal, regardless of the reason, the franchisee cannot compete for a prescribed time period and distance. This may mean that he cannot engage in the only business that suits his training and experience. Franchisors often try to accomplish the same restriction through their control of the site, the franchisee’s confidential customer lists, the telephone numbers, and similar methods. Another way is to make an excessive charge as the price for separation. There are some legal limits.
M. Trade Secrets
A great many franchise agreements provide that everything connected with the business is a confidential trade secret. They prohibit the franchisee from ever using those trade secrets outside the franchise, without time or distance limitations. Genuine trade secrets will be protected, but such claims may be exaggerated, non-existent, ineffective in the marketplace, or lost through public disclosure.
N. Renewal, Transfer, Relocation or Sale of the Franchised Business
Most franchise agreements reserve (unless certain conditions are met)to the franchisor the right to prohibit the above capital events. Sometimes they provide that such permission shall not be unreasonably withheld as to one or more of those capital occurrences. In case permission is granted, they usually require that the franchisee must cover all unsatisfied conditions and give a general release of all claims. A minority of states now prohibit such restrictions on capital matters except for good cause addressed solely to franchisee factors.
O. Keep Good Records
Each franchisee owes himself a duty to preserve his knowledge of the facts at the time of their happening. This starts from the first moment that the person heard of the franchise. It covers all communications, both written and in oral conversations. This record will play a crucial role in helping you to resolve disputes, regardless of when they arise either soon or many years later.