The lease that many franchisees have to sign is often just as complicated as the franchise agreement.
Depending on the brand, it might be more complicated. Here are some ideas about what to watch out for.
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Bad Earnings Claims in Item 19
Liar Number Two does provide earnings claims information in Item 19 which is not reliable for the following reasons, among others:
Especially if the franchisor is a relatively new franchisor, numbers are inherently less reliable if there are none of the franchised stores in the market you intend for your location. That stores seem to be doing well in one part of the country means nothing if you aren't going to be in those markets, for many reasons.
If your intended location is 'out of the loop' geographically, your support and advert economies won't be the same either. The advert economies associated with several stores all in one market are important expense issues. If you need a penetration level for your advert message that can be effectively afforded only by a group of stores sharing the budget, the numbers in Item 19 will be significantly out of whack for you.
If the stores are only a few years old, the system has not had time to 'prove' itself. Many things change in a franchise system as the franchisor decides to mandate changes without first proving them out in test market in company owned stores. Without that prove-out test market, every change is just a crap shoot.
If the franchise is one in which a major segment of your cash flow is not paid directly to the franchisee, but is paid first to the franchisor who then makes deductions and, supposedly, passed the net of those deductions on to the franchisee, you are dealing with a thief. Anyone who can come between you and your cash flow will always find ways to nick you. Channeling the money in that manner is the hallmark of the crooked franchise.
If company owned stores' financial information is part of the mix that went into the earnings claim data, that is being done only because those company owned stores are performing better than franchisee owned stores. That skews the earnings claims and makes them false as applied to what you would be doing if you were to buy the franchise. One way the liar reassures you is to say that the stores are identical to the kind of stores that you would be operating as a franchisee. The may be identical in the sense that the sell the same products or services, but they are not identical in any sense relating to financial performance prospects for any franchised store.
If the working capital requirements do not include money for you to live on until you reach break even, then the working capital number in the total investment required disclosure is inadequate. If it doesn't say that living expenses are included in working capital, then living expenses are not included. If it does say that living expenses are included in working capital, you need to have that broken out. The odds are that you are being short changed.
If the earnings claims say that the information was compiled in accordance with generally accepted accounting principles, that is probably not true, and it is a hallmark of misrepresentation. The purpose of making that statement is to make the numbers seem more reliable than they are. There is no other purpose to make that statement. Ask to see substantiation of the Item 19 information. If they won't show it to you before you sign a franchise agreement, it's a scam. If they tell you stories like they can't show it to you before you sign the contract because it's a trade secret, you know you are dealing with hard core crooks.
If after you make adjustments for royalties, advertising fund requirements, lease and other occupancy expenses for the area where you intend to locate, insurance expenses for your area, labor expenses for your area, state and local taxes for your area, and every other expense you can think of, you end up with less than 15% of gross sales as your pre tax net income, you are just buying a job, not a real business, and there will be no room for any adverse change in any significant expense item.
One thing that is never covered in the earnings claims data is the cost of borrowed money -- the interest and the principal payments that you will have to make every month. You need to add that information to the equation. You will be told that that money comes out of the non cash deductions on your tax return -- the depreciation and amortization expenses that are not actual cash payments.
You need to figure out whether that is correct arithmetic or not. If the total of all payments to the franchisor, other than for goods you have to buy from them, approaches 10% of gross sales, then the franchisor has an effective 40% share of your total potential pretax net profit (if you do as well as the earnings claims data suggests) with no investment risk in your business.
Moreover, the franchisor's income expectation from your business is a function of gross sales and does not require that you make any profit at all before those payments are owed. If you can't find a better way to get into that business, you might be better off keeping your day job. There are some exceptions to this statement, but they are very rare.
Conclusion
If Item 19 of the UFOC states that no one is authorized to provide any information regarding sales or profits other than what is stated right there in Item 19, and the sales person does provide other or additional information regarding prospective profitability, then you ought to be able to recognize that you have just been lied to in Item 19.
And it is important to recognize that the same techniques of arranging for third parties to provide the earnings claims information, or approving or praising the pro forma information in your business plan, also make the disclaimer in Item 19 a falsehood, just as in the instance of the franchisor who claimed not to provide any earnings claim information at all.
Franchisors who provide sales information in Item 19, but who do not provide additional profitability information there, and whose employee or sales representative provides the additional information to enable a profitability estimate to be prepared, or who arrange for a third party to provide it, or who do it by approving or praising your business plan pro forma, are also lying to you when they deny that such information is provided as part of their franchise sales procedure.
They know that you are not buying any business opportunity in order to achieve sales numbers, and that it is only profit potential that you are seeking. They also know that by using only gross sales numbers in the 'official' statement made in Item 19, they don't have to tell you how many of their franchisees are achieving that level of profit performance. Gross income isn't net income. DUH!
These are just a few of the many issues that you will encounter in trying to figure out where the ball is being hidden in the Item 19 disclosures. The inventiveness of the crooked mind is limitless. Regulations can't protect you. You have to protect yourself.
You cannot allow yourself to sign contracts in which you agree that something that happened, and that you ought to know happened if you were paying attention, did not happen.
You have to go through what was said to you and see whether the contract is requiring you to agree that something that was an important consideration to you in making your investment decision did not in fact ever happen. If things important to you are excluded, either by not being provided for in the contract or by your having to pretend that they never happened, you are dealing with a thief.
That's another reason always to take careful notes on everything that is said to you, orally or in some brochure or written on a cocktail napkin. Being alert and diligent throughout the sales process can save you hundreds of thousands of dollars in lost investment, lost profits and attorney fees and expenses.
If you really want to know how the system is performing, you should include as part of your due diligence contacting business brokers in cities where this franchisor has franchised stores located, and finding out whether any of them are for sale.
If you agree to sign a confidentiality agreement that says you are using access to the financial information only in connection with your effort to find a business to buy, you will be able to find out which of this franchisor's franchisees is trying to sell the franchised business and get access to the federal tax returns and the profit and loss/operating statements and balance sheets for the past five years. Compare that to what the franchisor is telling you in Item 19.
Do the same thing with businesses in the same business that are for sale and that are not affiliated with this franchisor. No one ever overstates profitability on their tax return.
When someone tells you things that you could figure out are untrue if you just pay attention, and you then sign a contract in which you agree that they didn't tell you that, and you later find out that there are many things that are not as they were described to be, after you have parted with your investment funds and taken on a lot of debt and other liabilities, is it realistic for you to expect to find an effective remedy in a lawsuit or in arbitration?
As always, you can call me, RIchard Solomon, at 281-584-0519.
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The choice of an entity is often the first important legal decision that an entrepreneur must make. In the last few years, there have been more choices making it important to review the pros and cons of choices.
On what basis does a firm make this important decision? Certain key factors help to form a guide in answering this question.
An organization with several owners can be formed as a Limited Liability Company ("LLC"), General Partnership, or a Corporation. Limited partnerships and Limited Liability Partnerships will not be discussed in this article.
1. Limited Liability Company
The LLC is a relatively new entity. It was created to combine some of the advantages of a general partnership and a corporation while eliminating some of the disadvantages of both. Owners of an LLC, called "members", have limited liability similar to shareholders of a corporation.
However, in structure, the LLC is more like a partnership.
The LLC can be managed by the members or by a manager. Usually there isn't a board of directors or officers. Corporate formalities such as meetings and minutes are not required. Profits and losses are passed through to the owners on their personal tax returns and are not separately taxed to the entity.
LLC members do not have to be individuals and voting power and share of profits and losses do not have to be identical; for example, an owner can receive X% of the profits and own Y% of the LLC and have Z% of the voting rights.
It's obvious to see why LLC's are so popular.
2. General Partnership
Similar to the sole proprietorship in the ease of formation, the only requirement to form a general partnership is that two or more people engage in a business activity for profit (Uniform Partnership Act). Expenses and profits do not need to be shared equally. Although there are no formal requirements, it is highly recommended that a written partnership agreement be executed among the partners. Like a sole proprietorship, the general partnership is not taxable as an "entity".
There are disadvantages to a general partnership. The partners of a general partnership have unlimited personal liability for not only their own torts and contracts, but for those of the other partners too. The death or withdrawal of one of the partners causes a dissolution of the general partnership. Caution should be exercised to avoid having the partnership be viewed by IRS as a corporation and then taxed as such.
3. Corporation
A corporation that is owned by a limited number of people is known as a "closely held corporation". Like a partnership, most, if not all, of the shareholders are involved in the management of the business. However, unlike a partnership, all the shareholders, or owners of the corporation, have limited liability for the acts and omissions of the other owners.
Additionally, avoiding personal liability for business debts and court judgments is another advantage of a corporation. Without personal guarantees a creditor can only collect from the assets of the business, not against the personal assets of the owners.
Because a corporation is a separate legal entity from its specific shareholders, the business continues regardless of who owns the shares. Corporations offer the opportunity to bring in investors who can own shares in the company without having to worry about personal liability. Tax deductions may be taken for benefits provided to its employees and to the owners.
Corporations often have a more favorable tax rate structure to allow the owners to save earnings at a lower rate.
There are two types of for profit corporations, the "C" corporation and the "S" corporation. These refer to IRS statutes that dictate different tax treatment for the two types of entities.
A "C" corporation is required to pay corporate taxes on profits and the shareholders pay taxes on their compensation and/or dividends.
For this reason many small organizations elect to be "S" corporations.
An "S" corporation does not pay taxes on the profits; profits and losses are passed through to the owners. However, the owners of an "S" corporation cannot be corporations, partnerships or LLC's.
Some of the disadvantages of forming a corporation are the costs and formalities involved. The costs to incorporate vary by location, but typically run several hundred dollars. Corporations are required to hold annual board and shareholder meetings and minutes of director and shareholder actions must be maintained.
Finally, a single individual business owner can have a sole proprietorship, corporation (C or S) or limited liability company.
4. Sole Proprietorship
This is the easiest, least costly and least regulated form of organization for the individual owner. The only legal necessity for forming this business is to commence operations. It is recommended to file a fictitious name registration in all states in which the business will operate and check zoning and licensing laws for the location of the business. Additionally, all marketing materials should be trademarked and/or copyrighted.
As a result of the simplicity and low costs involved in a sole proprietorship, many individually owned businesses choose this option. However, there are some negative aspects to consider. The most important reason to choose one of the other options is that the individual is fully liable for any and all claims by customers, employees, vendors or others.
Conclusion:
In conclusion, there are many factors to consider when choosing the form of entity for your business. The joint advice of your accountant or tax advisor and attorney should be considered before making a selection.
So, what business entity do you want to form?
THIS ARTICLE IS NOT INTENDED TO PROVIDE LEGAL ADVICE. IF YOU WOULD LIKE TO DISCUSS HOW THIS INFORMATION RELATES TO YOUR SPECIFIC SITUATION, PLEASE Contact Spadea, Lanard & Lignana
