Get Out Your Eleven Foot Pole

Last month, I talked about distribution agreements. Now, I want to talk frankly about one of the most misunderstood forms of small business: franchises. I have advised numerous potential and acting franchisees, franchisors, and banks which grant and enforce franchise loans. I have also explored franchising personally, as a possible investment. You won’t see this kind of analysis anywhere else.

I cringe when I see the typical newspaper articles or a financial institution promotional pieces on franchising. You expect the franchisor to enthusiastically tout their business, but the banks and the newspapers bring their stalwart reputations and ostensible independence to the process of recruiting new franchisees.

My legal-weasel colleagues deliver platitudinous advice to prospective franchisees, like “Read the franchise agreement carefully, and ensure that you are protected…” Yeah, right. See if you are able to negotiate the addition of one semi-colon in the franchise agreement.

Let me offer you my personal opinions about franchising, utilizing some of the most commonly encountered recruiting clich�s as starting points:

Be your own boss! Turnkey operation!

Acquire a proven brand and system!

Full training and support! No previous business experience necessary!

Join a rapidly expanding team!

Protected territories available!

Good financing available! No franchise fees!

First of all, you might keep in mind that franchisors are major advertisers in newspapers, so the fourth estate is delighted to contribute some fluff to fill in around the big display ads in the business section of their paper. Second, banks do a lot of franchise financing for franchisors, hence their unbridled enthusiasm for the sport of franchising. Always consider the source.

Many, many Canadian franchisees have made a lot of money, lived comfortably and retired in style to Florida. Like a chain letter, they got in early, while the getting was good. The first tier franchises are generally more lucrative, and offer more support for franchisees. Everything is relative.

The rules have changed. Now, if a franchisee is doing too well, the franchisor tries to figure out how to saturate its market, or it takes over the location as a company store when the franchise comes up for renewal. It happens.

Believe it or not, I have no axe to grind against franchises, per se. My perspective derives from my economic and legal training, and my experiences with broken franchisees. I could name names, but I don’t want to get sued, even if truth is a defense. They have bigger and tougher lawyers!

Let’s get on with it then:

1. Be Your Own Boss! Turnkey Operation! This is a beauty. A whopper. Franchisors actually want managers, not entrepreneurs. They want “owners” who follow the system, don’t question it, don’t innovate, don’t think too much. Attention to detail and adherence to the program are required and rewarded; creativity and criticism is punished.

Of course it’s a turnkey operation. The last thing a franchisor wants is some know-nothing franchisee to diddle with the system! My personal observation is that some franchisees and their employees seem to regard the franchisor/system as their boss, and not the customer.

Conformity and consistency are intrinsic to the successful franchise system: it’s not a bad thing necessarily, but it’s good to know before you plunk down $100 K to buy a store. Visionaries need not apply.

And, there’s a dark side to this: don’t piss off a franchisor. A franchisee is totally and utterly dependent on the franchisor. You must buy all your supplies through head office. Your accounting and business software is supplied by them. They are the tenant on your lease, you are their subtenant.

There are a million and three ways a franchisor can hamper, hurt or kill your store. A late shipment of crucial supplies or products. Non-renewal at the end of the initial term. Lots of ways short of, and including thermonuclear contractual war. You are at their mercy. You have virtually no contractual rights under your franchise agreement. Surrender peacefully. You can be the boss of your golden retriever.

2. Acquire A Proven Brand And System! This goes to the core value of a franchise, as contrasted to thrashing around on your own. However, sometimes the franchise brand and system is tired, obsolete or declining in the market, so the franchisor decides to go into the business of franchising, shifting the business risks to the franchisees.

Put another way, the franchisor decides that the rate of return is greater in the sale/licensing of thesystem than it is in conducting the underlying business. There are all kinds of examples out there now.

I’ve seen aggressive entrepreneurs actually start franchising long before they perfect their own business system I’ve seen franchises planned while their first store teeters on the brink of bankruptcy. It takes awesome chutzpah, but it happens.

3. Full Training and Support! No Previous Business Experience Necessary! Full, that is, to the point the franchisor can afford to do so, or is competent enough to adequately train. Or is willing, after it receives the upfront franchise fee, to expend more effort and money. Training is often done at the head office of the franchisor, not at your store, for a few or several days, at the very start of your franchise relationship. Before you know what the problems are.

After that, you’re mostly on your own, unless you can get some attention from head office staff who are busy training the next wave of live ones, I mean franshisees.

Forgive me if I seem too vicious, but you must understand that many franchisors really don’t care if franchisees fail, so long as it isn’t too quick or messy. Economic Darwinism at its very best. There are 10 more eager beavers behind you, all keen to donate their net worth to a sure thing. More on that later.

4. Join a Rapidly Expanding Team! No doubt, rapid growth in the number of franchisees is a boon to the franchisor: more stores, more fees, more supplies sold, more co-op advertising charges, more fees…

Being part of a rapidly growing franchise system might create economies of scale in the purchase of supplies or services, assuming the franchisor passes on volume rebates to the franchisees. Can I sell you some stock in the biggest gold mine in the world? It’s in Indonesia.

On the other hand, exponential franchise growth has its drawbacks for the new franchisees. It reduces the care, attention, and training available. Growth pains are inevitable (especially if the franchisor is in the process of blowing its brains out down south, a favourite Canadian business preoccupation to be covered in a subsequent article).

Franshisors appear to have become more cynical in the process of signing up new franchisees. It’s like the first class at law school when the professor says, “Look to the person on your left, and now, look to the person on your left. By Christmas, one of you won’t he here anymore.”

Let me be blunt: franchisors sign up 10 or 25 or 100 new ones, knowing full well the market, their system, the training program or whatever, will only support two-thirds or half of them, or even less.

5. Protected Territories Available! The essence of a franchise is the grant of the exclusive right to use the system in a defined territory in exchange for the franchise fee and ongoing royalties. You pay a price for a monopoly for a time in a geographic area.

In theory, this sounds pretty good. You must read the fine print in your franchise agreement, as it is rarely so simple. Sometimes, the franchisor gives the franchisee a right of first refusal to buy another store in your protected territory! If you have enough cash and the other resources, you can protect your territory by buying another store!

Or, your territory can be reduced or ‘liberated’ if you fail to meet targets. In either case, the ‘protected territory’ is threatened when you most need it: when you are struggling. The franchisor is not concerned with saturating the market: see my comments above about rapidly growing chains.

6. Good Financing Available! No Franchise Fees! Only $25,000 Required!! This is the way it works: the rapidly expanding franchisor lures a bank with the prospect of 75 business loans, new accounts, payrolls, personal loans and RRSP’s with the franchisees.

Instead of charging hefty franchise fees, some franchisors arrange a complete financing package for the new franchisee, the key aspect being an equipment purchase loan. After all, the franchisor knows exactly what you need to succeed, and can no doubt secure the best price for the equipment, right?

Well, I have personally seen deals where the mark, I mean the franchisee, pays two or three times the fair market value for food handling equipment or tenant improvements! I kid you not, as Jack Paar used to say. Obviously, the hefty franchise fee is built into the equipment purchase or improvements.

The bank facilitates this exercise through the generous granting of a Small Business Loan of up to $250,000 to the franchisee, most of which is guaranteed by the Government of Canada. No, the franchisor doesn’t guarantee the loan as a commitment to the success of the franchisee: I guess you haven’t caught on yet.

See, it is really good financing – really good for the franchisor who books a tremendous profit on the equipment sale, and good for the bank, even on a default, when the Government of Canada reimburses the bank in exchange for the filing of some annoyingly detailed reports. And hey, who says the banks in Canada don’t support small business?

There can be a further plot twist in these highly leveraged franchise financings. The franchisee pays the franchisor, through the nose, for tenant improvements for the new store. Sometimes, the burden of debt service is so great that the new franchise fails before the tenant improvements make their way to the actual store! Guess what? The franchisor arranged a Small Business Loan for the improvements through its bank.

If the franchisee fails, remember that the franchisor is the head tenant under the lease of the premises. So, the franchisor kicks out the franchisee, re-takes possession of the store, and then proceeds to re-sell the same store, with the paid-for improvements to a new franchisee, at the regular price (unless the new franchisee happens to be a relative or a close personal friend of the franchisor).

Meanwhile, the old, failed franchisee has lost the store, lost deposits/fees paid to date (at least $25,000), lost the equipment and improvements, and is personally liable, with a spouse, for many thousands of dollars in loans and guarantees (Small Business Loans do limit recourse against the borrower and guarantor to 25% of the loan, but franchisees typically have other loans, being chronically undercapitalized).

The hapless franchisee goes personally bankrupt, or goes out and buys another franchise! Around and around.

My humble suggestion is to avoid franchises in general. If you have a nest egg or severance package, and want to get into business for yourself, then take advantage of the myriad of small business assistance and education programs. Only pursue a business where you have an advantage of some kind: knowledge, access to cheap capital, unique skills or technology. If you really, really want to run a business in a field occupied by a franchisor (e.g., hamburger, coffee), go and work for that franchisor for a couple years.

There you have it.