July 2013 Archives

Connie Gentry of FSR has written a short blurb on the popular Maryland franchise The Green Turtle Sports Bar & Grille.

It is not clear whether this is an advertorial, a press release, or simply a small news piece.  It matters because if this was an advertorial, it would have to comply with the FTC's Rules on Testimonials and Endorsements.

It is further unclear as to what the * is supposed to refer to - I expect the author thought that this was sufficient notice that some disclaimer was being made about these numbers.  But no such disclaimer was in the article.

Since, it was not clear what reliance one could reasonably place on these AUV's, I decided to get the Green Turtle's 2012 FDD and look at the Item 19, directly.

This is the middle of 2013, and the 2012 Item 19 was calculated for the end of 2011, we do need to get some up to date data if we were going to make a buying decision.

But, instead I want to highlight something I have seen a number of times.

First, this is a gross sales only Item 19.  There is not enough data here to make a reliable cash on cash return estimate - important basic costs line rent, cost of goods solds, and labor are not disclosed.

Second, and I have seen this a number of times, is the insertion of a median annual gross sales.  In this case, 11 locations  had gross sales above the median and 11 had gross sales below the median.

The natural question is:  what was the average gross sales for the 11 locations under the median?  Could be $500k, $1million, or even up to $2.24million. Makes a big difference.

But, we don't get any more useful data - just some disclaimers.

So, what you should you do?  After all, it is important to know what the gross sales of those units below the median.

It is a flip of the coin whether your location will be above or below the median.

The answer is to ask: ask for the back-up, look at those 11 units and calculate yourself their average gross sales.  Because if you don't ask, nobody is going to tell you.

Another interesting decision has come down regarding the use of exculpatory clauses in franchise agreements -- and this time, the decision went in favor of the franchisee. 

Exculpatory clauses are provisions that parties use to disclaim the making of any promises, representations, or statements outside of the contract.

Such provisions are commonly used by franchisors in franchise agreements to give the franchisor the assurance that their franchisees are not relying on any promise, statement, or representation that was made before signing -- many of which the franchisors may not even be aware (for example, those that were made by salespeople speaking beyond the limits of their authority).

The most common form of exculpatory clause is an integration clause, which in most contracts goes by the title "Entire Agreement." An example of an integration clause (taken from the franchise agreement in this case) is below. Often, a franchisor will be able to rely on an integration clause and other exculpatory provisions to avoid liability in court for promises that were allegedly made to a franchisee that are not reflected in the terms of the franchise agreement. 

But other times, a badly-written or otherwise non-comprehensive exclupatory clause will not provide a sufficient shield to a franchisor to avoid liability.  The C&M v. True Value case, from the Wisconsin Court of Appeals, provides a good example of how courts can sometimes find that a franchisor's exculpatory clause is insufficient to protect it from liability for an alleged misrepresentation.

In this case, C&M was a True Value hardware store franchisee for a short time, having only operated the store for less than a year before closing it due to financial reasons.  Shortly after closing the doors, C&M sued True Value, claiming that (among other things) that True Value misrepresented the possible performance of the franchise business. 

The franchise agreement in question, called a "Retail Member Agreement" (the "Agreement") was signed by C&M and contained two different exculpatory clauses that said:

[True Value] has not represented to [C&M] that a "minimum," "guaranteed," or "certain" income can be expected or realized. Success depends, in part, on [C&M] devoting dedicated personal efforts to the business and exercising good business judgment in dealings with customers, suppliers, and employees. [C&M] also acknowledges that neither [True Value] nor any of its employees or agents has represented that [C&M] can expect to attain any specific sales, profits, or earnings. If [True Value] has provided estimates to [C&M], such estimates are for informational purposes only and do not represent any guarantee of performance by [True Value] to [C&M]. [TRUE VALUE] MAKES NO REPRESENTATIONS OR WARRANTIES EITHER EXPRESS OR IMPLIED REGARDING THE PERFORMANCE OF [C&M'S] BUSINESS.

 And

This Agreement, and any other agreement which [C&M] signs with [True Value], is the entire and complete Agreement between [C&M] and [True Value] and there are no prior agreements, representations, promises, or commitments, oral or written, which are not specifically contained in this Agreement or any other agreement which [C&M] signs with [True Value]. The current form of the Company Member Agreement shall govern all past and present relations, actions or claims arising between [True Value] and [C&M].

Based on these two exculpatory clauses, the trial Court determined that C&M was placed on notice that anything True Value said could and did not constitute representations or warranties about the possible performance of the business.  Based on this holding, the trial Court dismissed C&M's misrepresentation claims.

C&M appealed.  The Court of Appeals of Wisconsin first stated the general rule that exculpatory contracts are disfavored in the law.  Because of this general rule, the Court said that exculpatory contracts should be carefully reviewed by a trial court to determine whether they violate public policy.

Moreover, the Court advised that any such provisions should be strictly construed against the party seeking to rely on them.

The Wisconsin Court of Appeals stated that, to enforce an exculpatory provision in Wisconsin, the contract must specifically inform the signer of the types of risks being waived. 

The Court found that the Agreement failed to notify C&M that it was intended to operate as a "waiver of True Value's liability for misrepresentation" and that it did not make any "mention of disclaiming liability let alone specifying any specific tort." Because the two exculpatory provisions in question failed to "clearly, unmistakably, and unambiguously" inform C&M of these types of liability being waived, the Court held that the provisions failed to protect True Value.

The Wisconsin Court of Appeals also determined that the exculpatory provisions were not sufficiently conspicuous in the Agreement because they "did not stand out from the rest of the form in any manner and did not require a separate signature." 

The Court particularly noted that the exculpatory provisions were not placed together, did not have to be specifically initialed or signed by C&M, were not in a conspicuous location, were not surrounded by an attention-grabbing box, and were not emphasized by a heading. 

The provisions were in the same typeface as the rest of the contract, and, "although the last sentence in the first provision is in capital letters, it is neither a title nor a warning to C&M." 

Because the provisions were not remarkable or notable on the face of the Agreement, the Court held that they could not be enforced against C&M.

In light of the above findings, the Court of Appeals reversed the trial Court's dismissal of C&M's misrepresentation claims, holding the exculpatory provisions void because: "(1) [they] failed to clearly, unambiguously, and unmistakably explain to C&M that they were accepting the risk of True Value's negligence; and (2) the form, looked at in its entirety, failed to alert the signer to the nature and significance of the document being signed."

The lesson for franchisors (at least under Wisconsin law) in C&M is twofold: first, make sure that your exculpatory clauses are reasonably specific, addressing the types of statements that you do not authorize your salespeople to make and upon which your prospective franchisees should not rely.  

Second, your exculpatory clauses should in some way stand out from the rest of your franchise agreement -- by separating them from the agreement itself, or by using capital letters, bold, or a text box to call the reader's attention to them. Many franchisors have successfully relied on a separate "disclosure questionnaire" containing exculpatory clauses for this purpose.

For franchisees, the lesson is to carefully read your franchise disclosure document, franchise agreement and other related contracts before you sign them!

If a promise, statement, or representation was made to you by the franchisor or its salespeople and you're relying on it, make sure it's in the franchise agreement or in an addendum before you sign. 

What are a franchisee's rights and duties upon the termination of the franchise agreement? Upon termination of the franchise agreement for any reason, the rights and duties of the former franchisee are specified in the franchise agreement he or she signed.

Typically these obligations include several key steps that are essential to the franchisor and to other continuing franchisees.

1. The first step is that a former franchisee should immediately cease using the logos and trademarks of the franchise system. This means that if you were a franchisee of ABC Doggie Daycare franchise, for example, you would need to remove everything showing that name and any logo, including on any signs, Yellow Pages listings, any advertisements, all stationery and brochures, etc.  
2. You would also have to change the decor that makes your location look like an ABC location and change any clothing that identifies your employees as part of the ABC system.  If ABC was a food service franchise then any recipes and food products that were proprietary to the franchisor would also have to be removed.
3. Typically a terminated franchisee will also have to pay all monies that are owed by the franchisee to the franchisor, its affiliates and to any suppliers.
4. Additionally, the former franchisee would have to return all manuals and other documents which the former franchisee received during its time as a franchisee.
5. Most franchise agreements today also have a non-compete clause in the franchise agreement or require franchisees to sign a separate non-compete agreement.
6. Typically a former franchisee would not be allowed to remain in the same business after the franchise has been terminated or expires because the term ends.

This means that you may have a lease for your business that continues, but cannot operate the business. Often franchisors require their franchisees have Collateral Assignment of Lease provisions included in their lease so that the franchisor has the option to take over the location and run the business there until a new franchisee comes along for that territory.

This is another example of the importance of retaining experienced franchise counsel to advise a prospective franchisee prior to that prospective franchisee signing the franchise agreement.

Similarly, experienced franchise counsel should be retained to assist with any franchisee who is terminating his or her franchise agreement for whatever reason.

On October 16, the FTC issued FAQ #37 which disallows franchisors from claiming to award an "exclusive territory" if it reserves the right to open franchised or company outlets in so-called "non-traditional venues" like airports, arenas, hospitals, hotels, malls, military installations, national parks, schools, stadiums and theme parks.

Many franchisors have long excluded these closed markets from territory protection due to the unique and specialized nature of operating in such venues and the need to secure franchisees that understand, and have the knowledge to navigate, the nuances of those venues.

This is why you will frequently see the same few companies operating multiple brands in the same type of venue in multiple states. For example, have you ever wondered why you see the same neon-yellow-shirt-clad workers walking the isles at baseball parks across the country?

It's because those companies have spent precious time and resources figuring out how to successfully operate in a non-traditional setting--an endeavor which the vast majority of franchisees have no desire to undertake.

Importantly, and fortunately, the new FTC proclamation is not one which will prevent franchisors from continuing to making a reservation of rights for these closed markets.

It does, however, require that such franchisors include the "no exclusive territory" disclosure in ITEM 12 of their franchise disclosure document (i.e., "You will not receive an exclusive territory.

You may face competition from other franchisees, from outlets that we own, or from other channels of distribution or competitive brands that we control.").

With several weeks remaining in this calendar year, now may be the time to evaluate whether an FDD update is in order.

The crisis management debacle du jour is Asiana Airlines' decision to announce they will sue a television station for broadcasting a bad cultural slur/joke about their pilots who were unable to land the plane successfully at San Francisco airport.

You would think they would prefer the story go away as fast as possible, but they are keeping it alive through lack of debacle management insights.

Paula Dean did the same thing by testifying in a PC charged environment that she had used the N word and then going on one television event after another with a hillbilly headed campaign that destroyed her total franchise value.

These glaring examples of the consequences of winging it with inexperienced situation insight resources should be business school case studies in why professional crisis management should be called at the very first moment when a major problem can be spotted looming on the horizon.

You can't stuff this material back into the horse once the big initial mistakes have been so publicly made. Why make them?

Is the senior management of Asiana Airlines simply so arrogant that they believe the world owes them a duty to pretend they are thoroughly training their pilots? Can anyone be that out of touch?

Did the crash in Buffalo New York two years ago not teach everyone in the airline industry some lessons about arrogance and hysterical PR blindness?

The Internet has cured everyone of the disease of respecting the inept. While your employees (or rather some of them) may not go on the Internet with exposure information and tasteless jokes about your situation, the public at large can now do so with anonymity.

Reacting with indignant rage is the worst thing anyone can do. There is no difference between Asiana suing the television station and Paula Dean saying "I is what I is".

Who will be the next to fail to finesse an extremely bad situation?

It doesn't have to be that way.

Tamerlane group's purpose is to prevent you from shooting yourself in the foot when you see a bad event threaten to develop. Our focused expertise in crisis management can prevent these situations from developing if we are called before someone makes self-humiliating public statements/files absurd lawsuits.

Guanxi is in the news again.  Last year, three high-profile businessmen - Neil Heywood , Sheldon Adelson and the former railways minister Liu Zhijun were considered Masters of the Guanxi Universe at one point, but are now grabbing headlines for all the wrong reasons. Heywood is the unfortunate expat fixer who died at the hands of Gu Kailai (wife of Bo Xilai) after close relations with the ruling family of Chongqing went horribly wrong.  

Adelson, CEO of the Sands Casino, is the can-do American mogul who helped build Macau into the Vegas of Asia, but is now under investigation in Beijing for massive bribery.  The year-long trial of former Ministry of Railways boss Liu Zhijun has just concluded with 6 guilty charges against him and some close associates involved in a complex, long-running network of kickbacks and corruption.

Now, "Chinese investigators said Thursday that executives from GlaxoSmithKline, the British drug giant, had admitted to using bribes, kickbacks and other fraudulent means to bolster drug sales in China."

Western negotiators in China should take note of one very important similarity in each of these three cases: at their peak, these men were held up as prime examples of the benefit - some have said the necessity - of relying on guanxi when doing business in China.

If you are arranging business deals in China, it's just a matter of time before someone tells you that A) everyone does it, and B) it's the only way to get things done in China.  

How can negotiators in China draw the line between cordial relationships and graft?

Guanxi and negotiation - build relationships, but state your goals and your limits early.

When the baijiu is flowing and the conversation is still light-hearted, do like the Chinese do.  Know your goals, steer the conversation where you want it to go, and establish a framework for the negotiation.  In China small talk isn't empty talk. A good Chinese negotiator starts staking out positions, assessing your assets and maneuvering for advantage from the very first meeting.

You have to do the same. Use your guanxi-building time to declare your goals, inventory their resources and capabilities, and establish limits.

Conversation in China is never as light or casual as it seems. When they ask about your family, reciprocate - and find out where their child is going to school. When they talk about travel, find out where they spend time.  If someone is a civil servants but his child goes to school in California and summers in France with Mom, then you have to do the math and draw conclusions about his source of income.  Make judgments about potential partners and associates early - and stick to your decision.  

No one gets more honest when the amount of money on the table goes up.   Westerners frequently let promises of  quick riches in China cloud their judgement and put them into bed with wrong counter-parties  (both literally and figuratively).

It's only guanxi until you get caught.

If you don't know what the FCPA (Foreign Corrupt Practices Act) is, get up to speed right away. When you get caught paying bribes, either in the PRC or the US, saying, "but the Chinese middleman I just met in Beijing told me it was OK" is an admission of guilt - not a legal justification. You may not get caught, but if you do the results can be devastating to your company and to you personally. If your company has a policy on gift-giving and bribery it is your responsibility to know it and abide by it.

If your company doesn't have a policy, then you need to clarify your position with the relevant people at HQ BEFORE you get into trouble. This is a conversation to have with your own people early.

Good guanxi and bad guanxi.

Guanxi translates as relationships or networks - not corruption. It is possible to build strong connections without bribes. The key is to select the right partners early, and communicate honestly and thoroughly. The wrong Chinese partner is going to get you into trouble by soliciting or facilitating bribes and graft. The right partner will steer you away from individuals and transactions that will cause problems.

China is much more relationship-oriented negotiating culture than the West, and it's difficult to do normal business without getting to know your counterparty on a personal level.

But there's a big difference between paying for dinner and paying a bribe. All corruption in China starts as a guanxi relationship - but not all guanxi ends up as corruption. You have to know what you are getting into and establish boundaries.

Guanxi may not help, but getting it wrong definitely hurts.

Should honest businessmen avoid guanxi and personal relationships completely? Some experienced expats have recently started suggesting that Westerners in China are better off dispensing with guanxi and relationship-building efforts since foreigners don't get the same benefits as Chinese do, but can run into more problems.

While this may be true, it is still a bad idea to ignore the importance of establishing cordial business relations. Good guanxi may not help you - but failing to establish a solid guanxi foundation will definitely hurt you.

For a discussion of Guanxi for Western professionals, take a look at the ChinaSolved ebook: Guanxi for the Busy American.

How's this for irony? 20th Century Fox (a subsidiary of 21st Century Fox) recently released the movie "The Internship," starring Vince Vaughan and Owen Wilson who, as desperate 40-somethings looking for work in a bad job market, land a coveted internship with Google.  This coming at a time when another subsidiary of Fox has had high-profile court trouble with regard to its practices of using unpaid interns.

First, about the movie -- it may not have struck box office gold, but I liked it.  I thought it was a fun buddy comedy with heart that speaks to a generation of people who have been left behind by rapid advances in technology. While it wasn't "laugh-a-minute," it did have some good laughs including a truly inspired scene (it's the one featuring NTSF:SD:SUV's Rob Riggle). I also liked that franchising played a small role in the movie, but hopefully I'll get to writing a separate post on that later.  

Now for the irony: another Fox subsidiary, Fox Searchlight Pictures, just last month lost a high-profile lawsuit by real-life interns. 

On June 11, 2013, the U.S. District Court for the Southern District of New York ruled that two unpaid interns on the Fox Searchlight movie, "Black Swan," should have been paid because they were essentially regular employees, not "interns" under the Fair Labor Standards Act (FLSA). 

The "Black Swan" ruling and other recent decisions are a wake-up call for companies to re-evaluate unpaid internship programs to ensure compliance with the law.

Indeed, for-profit companies that are currently using unpaid interns should be acutely aware that the FLSA's exception that allows this practice is extremely narrow, and that any "intern" who does not fit the narrow exception must actually be paid as any employee.   

Every "employee" under the FLSA must be paid at least minimum wage and, when applicable, overtime. 

Courts interpret "employee" very broadly.  In fact, courts sometimes presumptively view internships at for-profit companies as employment. However, interns who receive training for their own educational benefit, rather than the benefit of the employer, may nevertheless meet the unpaid intern exception and not be paid.

The U.S. Department of Labor (DOL) has identified six criteria that must be met for determining whether an internship program meets this narrow exclusion:

1. The internship, even though it includes actual operation of the facilities of the employer, is similar to training that would be given in an educational environment;
2. The internship experience is for the benefit of the intern;
3. The intern does not displace regular employees, but works under close supervision of existing staff;
4. The employer that provides the training derives no immediate advantage from the activities of the intern, and on occasion its operations may actually be impeded;
5. The intern is not necessarily entitled to a job at the conclusion of the internship; and
6. The employer and the intern understand that the intern is not entitled to wages for the time spent in the internship.

While some Courts do not require that all six factors be met, the Court in the recent Fox Searchlight decision agreed with the DOL that all six factors must be satisfied. 

In whatever Court a company finds itself, the ultimate determination as to whether an unpaid intern is an "employee" entitled to compensation will be made on a case-by-case basis and depends upon all the facts and circumstances of the internship program.  

In short, employers should undertake a proper evaluation of their unpaid internship programs now, and hopefully avoid facing those interns in Court later. (And, if you do see "The Internship," let me know what you think). 

For more of Matthew's Kreutzer articles, Please Click Here.

A word of caution about franchise businesses is indeed good advice; and our readers are wise to heed the warning. Unfortunately not all franchise opportunities are created equal.

As the vice president of Sparkle Wash International - a pressure washing franchise that has been in business since 1965 - I have had thirteen years of experience.

What has become abundantly clear during this time is there is one sure-fire way to get a handle on the legitimacy of a franchise organization... and that is through what is known as VALIDATION CALLS.

A validation call is the act of the franchise candidate conducting telephone interviews with several existing franchisees already up and operating in the franchise system.

During this process everything comes out in the wash - good, bad and ugly. To be fair to the franchisor the candidate must understand that not all franchisees within a system are going to be in love with the franchisor - and this is to be expected.

However, after several calls the candidate will start to see a pattern emerging, and THIS will be the truth behind the franchise opportunity.

Here is how to make a validation call.

a) Introduce yourself to the franchisee

b) Tell him you're interested in opening a _____________ franchise in (your location)

Here are three important questions you will want to ask the franchisee:

1) What were you concerned about before you bought into the franchise?
2) What have you learned since?
3) Knowing what you know now, would you do it again?

Be fair to the franchisor, not all franchisees will be in love with the system - that is only to be expected.

However, are the majority of the franchisees you speak with giving you a favorable report?

Chinese negotiators have a different definition of selfishness, and you have to know it. Finding a balance is harder than you think it should be

A recent post on ChinaSolved asked Western managers in China to answer a simple question - What is your Chinese Partner's Plan B?  What are his alternatives to doing business without you? This is a key question for Western negotiators doing business in China, because there's a good chance you are operating under a dangerous misconception.

Mutually Assured Business Destruction?
Many Westerners negotiating business deals in China erroneously believe that self-interest and that most blessed of all instincts - greed - will keep their Chinese partners engaged and relatively honest. After all, without me and my technology, assets, designs, marketing, brand.... (fill in unique competitive advantage here) the Chinese side would earn much less. "They need me at least as much as I need them..." are the famous last words in many US-China failures. The Chinese side may be working under a completely different set of assumptions, and what you consider to be universal values may in fact be quite variable. Case in point: They may consider getting rid of you to be an extremely important and valuable business objective - one that they are willing to pay a high price to realize.

Understand Chinese Negotiators' Differences:
Forget the myth of common ground  . Smart negotiators in China focus on differences, and accept that their local counterparty's values, orientations and priorities have very little in common with their own. Don't assume that they will be satisfied with the same deal terms that would make you happy. Westerners sometimes think that they can secure cooperation and loyalty with carrot & stick tactics - enforcing contract terms with the promise of big rewards later. Back ended payouts don't always work in China. The Chinese side has a different definition of self- interest and different priorities. They don't necessarily care about cash - they may want something different, like technology, branding, product, or customer lists.

Different Destinations
You are all about the cash. They may not be. What are Chinese partners after?

• Technology & IP
• Product designs
• Production process
• Marketing techniques.
• Overseas markets & clients

The problem is that you would be happy to share much of that in the normal course of business, and if they just cooperate as good, honest partners, they will meet their goals. But they see it differently. Why wait around and put up with you for 2 years (and bear the cost of lost opportunity) when it is much easier to drive you out of the market and still have 70% of your IP right away. Never estimate a Chinese partners' self-confidence to backwards engineer and patch together work-arounds.

Different Routes
As far as they are concerned, the China market belongs to them. You think you are hiring them to manufacture, and you're splitting profits on a distribution deal in the mainland market. They don't see it that way. They helped you develop the product, and now you should go away and leave the local market to them. Government bureaucracy, corruption, convoluted distribution, regulations, insider advertising deals and distribution bottlenecks all support their efforts to get rid of you. You see these diseconomies as wasteful, unnecessary taxes on your resources. They see them as viable and sustainable competitive advantages.

Different Values
Getting rid of you may be a top priority and they may be willing to pay a high cost. There may be many complex cultural and sociological reasons for this - but you don't care about any of them. The only thing that matters to you is the extent to which YOUR China business may be jeopardized by partners, staff, suppliers and distributors, and what you can do to safeguard your interests.

Financial modeling is not new to business planning. It is attempted in one form or another, crude and sophisticated.

The pro forma in every franchise investor's business plan is an example of crude, incompetent financial modeling.

Many Item 19 FDD presentations are incompetent or deliberately misleading attempts at financial modeling. In decisions to franchise businesses, pie in the sky financial modeling is the delusional mind expansion medium that caused many doomed franchise attempts to be initiated. In this article we will discuss them all.

Anyone who has ever contemplated turning their established successful business into a franchise operation has gone from the anecdotal "This would make a great franchise" suggestion from friends and customers, to contact with a franchise consultant whose sales pitch enthuses the mark with suggestions of revenue streams capable of slaking the greatest thirsts.

A hundred sold franchises at $ 25,000 initial fees provides $ 2.5 million - never mentioning that most new franchises never attain that number ever.

A hundred franchised stores generating $ 500,000 a year in gross sales represents at 6% of sales $ 3 million a year in royalty revenue and, at 2% of sales, another $ 1 million a year in advertising revenue that can be used for all sorts of yummy venture functions.

Four and a half million a year plus initial fee income makes many otherwise rational people delusional.

But, reality may be seen in my article Why New Franchisors Fail The new franchisor field is strewn with the wreckage of misled business owners who were successful at what they did and lost everything in the world to unscrupulous franchise consultants.

In my opinion, in addition to all the failure causes dealt with in that article, there is the matter of failing to model with financial competence the business that the franchisee will be operating.

If there is no competent success financial model for the franchisee's business, you cannot arrive at a decision that your business is franchisable.

More importantly, franchise investors have no ability without focused specialist assistance to sort out the incompetent and misleading information presented. Consequently, the field is also strewn with the financial corpses of duped franchisees who thought they understood what was set before them. 

Constructing a competent franchisee's business model is an exercise in multivariate regression analysis. That isn't as complex as that fancy name suggests, but it must be honestly done if a reasonable financial model is to result.

(Using wishful thinking financial modeling causes incompetent financial planning in the franchisor model and in the information that will end up in your Item 19 Earnings Claim calculated to enthuse franchisee investors to buy into your system.

Then only litigators will make money on your franchise and you will spend years in misery funding nightmare dispute resolution instead of sipping good single malt on the fan deck of your yacht.  Examples of this are Cuppy's and Java Joe coffee; 1-2-3 Fit; Curves; Dagwood Sandwiches; and many others that are on the brink of collapse but not quite yet in the tank.)

Boiled down to a very simple statement, financial modeling is an exercise in which you establish a chart of accounts that your franchisee's business will use and then populate the chart with the numbers/ranges of numbers that you can identify as reliable.

That will leave a number of line items that you have no current reliable data to corroborate, where you have to provide an estimate for each category.

How you do that is to repeatedly, ad nauseam, ask "What if..." questions until you believe you have probably exhausted the range of expectable events that could influence the number than goes into each line.

Actually, you also do "What if..." analysis on the lines where you are fairly certain you already know the appropriate number, discounting for learning curve impact and discounting further to arrive at an imputed value for unidentifiable risk. What's that, you ask.

Unidentified risk includes such things as the extent to which others may not be as adept as you are in the operation of your kind of business; or that it may take quite a while for them to get the hang of it while you fine tune your franchisee training program; or the vicissitudes of any geographic market (or the market as a whole) for your products or services; or "gambler's ruin" - poor estimating of the time required to achieve break even/positive cash flow (which may not result in "free" cash); and several more such categories.

Asked simply, the question you would be trying to answer is "Can a franchisee, using my business format, have a reasonable potential to achieve a good return on his investment if he operates my type of business competently in another geographic area and had to carry, in addition to all other expenses, the costs required in order for him to be a franchisee?" These costs include more than simply the initial fee, the royalties and the advertising fund contributions.

For example, if you believe you will confine your franchisees' purchase of supplies/inventory to vendors designated by you, and that those vendors will be paying you for your approval to be vendors to your franchisees, the franchisees will incur an opportunity cost of not having access to competitively priced vendors and the cost of their having to pay you for the privilege of being designated vendors.

Inasmuch as there will be opportunities for you to impose other expense categories from which you will intend to derive extraneous revenue, these will also be franchise relationship carrying costs.

The "What if..." analysis is a lengthy exercise if you intend to come up with a reasonable financial model of what your franchisee will encounter.

For more of Richard Solomon's articles, please click here.

One of the important findings in behavioral economics is the discovery of "anchoring".  Anchoring is responsible many poor financial decisions and this is how it works in franchise sales.

Science has discovered that when we are presented with an estimate or percentage measure from a population that we know nothing about, we tend to anchor on the estimate and act as if it was true -even though we understand that we have no real knowledge.

Here is an example, from a QSR interview and Teriyaki Madness, which states how much you can make with Teriyaki Madness.

"He says that not only are potential franchisees attracted to the impressive numbers operators are pulling off--including an average 23 percent same-store sales increase; AUVs of $855,000; and profitability of 16-21 percent--but also to the uniqueness of the concept, which combines Asian flavors with healthy items."

Now you and I have no idea whether the AUV is correct, what the average is based upon, or how "profitability" was calculated.  However, the science says that you will anchor on these numbers and act is if they were true - despite not knowing what the Item 19 actually stated.

You will also notice that this claim made in an interview could not be compliant if it were an ad - the required disclaimer about how many units achieved that AUV is not present.  QSR can make this claim on behalf of Teriyaki Madness only if the interview is not a paid advertorial.

So for fun, let's take a look at the numbers behind the claim.

This is from Terriyaki Madnesses' 2012 FDD - and things could have changed by then.  Even so, the real numbers are revealing.

Teriyaki Madness Item 19 (2012)

We have provided the following information: the high and low annual gross revenue information for each year that the franchised locations were open; the average same store sales percentage increases for each year; the average unit volume of the group for each year; and the  number and percentages of franchisees that met or exceeded the average unit volume for each year.

For 2011, four (4) Teriyaki Madness restaurants were in operation for the entire year and for the years 2008 to 2010 only three (3) Teriyaki Madness restaurants were open for the entire year.

The financial picture disclosed in the Item 19 looks very different from the rosy picture described in the QSR article.  We find out that we have reporting only from 4 units, and two of those units had an AUV between $380,000  and $615,000 for the three years 2008-2010.

A new store would likely face a similar ramp up period.

Even the reported high is less than the AUV reported in the QSR story, compare $796,000 to an AUV of $855,000.

Further, the profitability story is taken not from a franchisee store but a company or affiliate store.

All of the reporting is designed in the writers minds to paint the glossiest story that he or she can tell - but, a smart reader like you knows to go beyond the anchoring effect, read for youself the Item 19, request the back-up for the Item 19,  and then come to a more realistic conclusion.

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