September 2015 Archives

KFC pioneered conversion franchising. Pete Harman was the first KFC franchisee. He converted his independent restaurant to a KFC.

But, think before you convert your existing business to a franchise. If you have an existing business, you may discover opportunities to convert your business to a franchise--to get the benefits of a "well known brand", to gain "purchasing power", or to gain advertising and support. You may even be tempted because of the attractiveness of the package.

Such conversions probably occasionally work out well for the franchisee--but often they do not. As part of such conversion agreements, you probably are transferring (giving) all of your current customers and their information to the franchisor. In most cases, if the franchise ends for any reason, you have no right to even contact any of those customers--and you will probably be prohibited from being in the business you have been operating for years without their help--we call it a non-compete.

It is rare that franchisors pay for such benefits--except the somewhat illusory "right" they give you to sign their franchise agreement. Meanwhile, by signing the franchise agreement, you give up a great deal of the flexibility you now enjoy to control the products and services you offer to your customers and the direction of your business.

They want your money. If they want it bad enough, they will agree to some simple changes that might protect you in case things do not work out. For example, they might waive the post-term non-compete under certain circumstances or pay for your customer list or make other concessions. They might even agree to exclude your existing customers from royalty calculations.

If you do not think very carefully and listen to some good advice, you could lose not only your franchise, but the business you worked to build before you learned about the franchise "opportunity".

You could discover, after it is too late, that you now have to pay royalties on all of your existing customers--but that new brand and all the promised advertising and support has not delivered new customers.

In this situation, we cannot give a bright line rule. You should discuss your decision with an experienced franchisee lawyer. He or she should be able to advise you as to the risks specific to your situation. The longer you have been in business, the greater the risk in most cases. An experienced franchisee lawyer might also be able to help you negotiate some of the terms of the franchise agreement. (Yes, franchise sales people say they are non-negotiable, but that is not true.)

Take your time and think before you convert.

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When I am contacted by a franchisee or a group of franchisees that believe that their franchisor is engaging in conduct that is hurting the financial performance and value of their business, it is practically always the case that they have already done something that is not in their best interests.

When someone is perceived to be hurting your economic interests, any normal person becomes enraged and wants to go immediately on the counterattack. They do this in a number of ways.

Mistake 1: Write and Send an Angry Letter

One of the first very bad things that they do is write an angry letter in which they vent their frustration, often accusing their franchisor of unlawful conduct or conduct that violates the franchise agreement, or both.

Frequently there is much in the letter that is aggressively accusatory and threatening, to put it mildly.

The threats customarily include reports to government enforcement authorities, lawsuits, group action by many franchisees, political action and publicity about the negative attributes that the franchisee(s) believe deserve exposure to the public eye.

Mistake 2: Call up the other Franchise owners and Complain.

Another of the bad things that franchisees do is that they call each other without thinking it through and try to stimulate some group cohesion for the purpose of sharing expenses and jointly addressing the grievances.

Mistake 3: Hire a Trial Lawyer who doesn't know anything about Franchising

Another very bad thing that they do is to get involved with a lawyer who does not know much about how franchising works -- frequently a relative or some other lawyer who may have represented them in some matter totally different. Having no sensitivity about how franchise relationships work, the advice is usually awful.

The bad letter to the franchisor usually contains strong statements accusing the franchisor of violating duties that the franchisor really does not have. As such, it is insulting and not conducive to the achievement of positive results.

There are some very fundamental truths about franchise disputes that hardly any franchisees know about.

For example, a franchisor may lawfully do just about anything that there is no contract or statutory prohibition against. The fact that whatever the action is may negatively impact upon the franchisee's business does not mean that the franchisee has any right to prevent it or to recover damages because of it. Some injuries are simply the product of other companies behaving rationally in a changing market (merging with competitors, for example).

In addition, there is no 'moral' duty in any commercial agreement. The parties are obligated to do what their contract says they will do, and to refrain from doing what the contract says they cannot do.

Even those apparent absolutes are sometimes not as absolute as they sound. If the contract does not impose a specific duty to act or to refrain from acting, the duty probably does not exist.

No implied doctrines of good faith or fair dealing will supply provisions in a franchise agreement that the parties did not put there in writing in the first place.

Several courts have sought to insert good faith and fair dealing doctrines into franchising cases, mostly having to do with encroachment. These courts have either been reversed, or their rationales have not been followed in other cases. Congress has been holding hearings on changing the franchise legal relationship to include concepts like good faith and fair dealing. This has gone nowhere, and it will not go anywhere in the future.

Mistake 4: Threatening to Bring a Lawsuit against the Franchisor Immediately

Threatening the franchisor is always the worst first step in addressing any serious problem. The threat may be empty, either because the franchisor has the right to do whatever it is he is doing, or because there are not adequate resources to fund litigation/arbitration to redress the grievance.

Empty threats put everything on the worst possible footing. Everyone digs in his heels, and getting anything resolved peaceably is made doubly difficult or impossible.

Getting legal advice from some lawyer, who does not know what he is doing, either because he is a relative or because he is inexpensive, is always bad. If the gravity of the problem is not sufficient to justify spending a few thousand dollars to get really good professional help, it isn't worth starting a fight over anyway.

Today you can get on the Internet and find many experienced franchise lawyers who will evaluate competently whatever your situation may be and suggest alternative approaches in an order of priority calculated to make the worst and most expensive response a last resort.

No competent lawyer will recommend litigation without first having analyzed the problem and done research to bring his knowledge of what the courts are doing with similar problems up to date.

No group action should ever be attempted without capable guidance from legal counsel about how to go about it. Rabble rousing always gets reported to the franchisor and makes people targets. Other franchisees will always think they can get an inside deal for themselves by ratting you out. How one goes about making group action happen is very important.

Often the angry franchisee(s) may have some dirt in their back yard also, and that may come back and bite you if you don't handle this activity very professionally.

• Get a lawyer who knows how to do this to show you how.
• Ask lawyers whether they have ever done this before and how they would go about it.
• Don't think that every franchise lawyer knows how to organize a revolt.

The goal of this approach is to preserve as many franchisee options as possible -- to burn bridges only when absolutely necessary. Angry confrontation often ruins the chance to resolve matters with a positive business solution. It may very well come down to angry confrontation. That should be done when other approaches are unrewarding and when there is a proper legal basis to wage war and the chances of winning are good.

Remember: Most franchisors can afford to defend bozo lawsuits.

Only a real, valid claim, competently presented to the court or arbitration panel, has a likelihood of changing anyone's mind or getting redress for injuries suffered. A seasoned franchise litigator can provide that kind of help.

There is a moment (and it may last for days or weeks) when nothing could make you angrier, when what is happening to your business is seriously injurious and is being done by your franchisor.

It is in this moment that you must, for your own benefit, find competent counsel -- that you must, for your own benefit, keep a lid on your feelings while the right thing to do and the right way to do it is accounted for.

Author Richard Solomon is a Franchise Lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.

Give him a call at 281-584-0519 to is discuss your specific franchisor problem. He probably already knows about it.

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If you're thinking about purchasing a franchise, pay close attention to the franchise disclosure document (FDD)--the large document that contains disclosures about the franchisor and franchise system.

Item 20 of the document can seem daunting, but be sure to dig in and examine the information it contains. This section is made up of five tables that show the status of outlets within the system over the past three years.

Table 1: History of system outlets

Table 1 summarizes the history of system outlets over the past three years. It shows the number of franchised outlets, the number of company-owned outlets, and the number of total outlets. This chart is important because you can see if the franchise is growing or declining.

Table 2: Transfers

Table 2 shows the number of transfers by state from existing franchisees to new owners. A high number of transfers, particularly within one state, could indicate franchisee difficulties in that locale.

Table 3: Status of franchised outlets

Table 3 shows the status of franchised outlets by state for the last three years. It also provides details on the number of terminations, non-renewals, and units reacquired by the franchisor.

Terminations and non-renewals occur less frequently these days, so it's important to look at the number reacquired by the franchisor because franchisors often use this method to take care of stores that are in trouble.

A high number of terminated, non-renewed, or reacquired franchisee stores--particularly within a state--may be cause for concern.

Also, look for stores that have ceased operation for other reasons.

Table 4: Status of company-owned outlets

Table 4 shows the status of company-owned outlets over the last three years, including the number of outlets closed or sold to franchisees. In large systems, this table shows how the franchisor is fairing with its own stores. A decline in the total number of outlets may indicate trouble or that the franchisor is simply selling its stores to franchisees.

Table 5: Projected openings

Table 5 shows projected openings and provides the number of outlets the franchisor expects to open over a period of time. This gives you an idea of whether the franchisor anticipates growth in the near future and in what locations.

If you want more great tips on how to be a savvy franchise buyer, then click here.

The term Conversion Franchise refers to the situation in which someone with a successful small business is offered the opportunity to convert his independent business into a franchised business by affiliating with a franchise organization. And so, thereafter, if the proposal is accepted, the business would no longer be known by its former name, but rather by the name of the franchise chain.

Many of these conversions have been successful. The realty brokerage business is one of the more notable instances in which belonging to a large organization with national coverage has facilitated synergies that would never be available to a small or even a regional group of realtors. However, many, maybe even most, conversions are a disaster for the unfortunate person who converted an independent business to a franchise and didn't know how to do the "due diligence" before making the decision to convert. So many have come to me with this problem, usually no longer having sufficient funds even to hire a lawyer, that I have decided to put the due diligence protocol on this web site in the hope that some fine small businesses may be saved from a franchise conversion disaster.

What is needed to mitigate the conversion decision risk is never offered. What is offered is a franchise agreement with an initial franchise fee, subsumes an initial investment in changing the business identification to that of the franchise organization, a required regular payment to an advertising fund, a required periodic royalty payment which starts with the first dollar of income every month. The franchise contract purports to obligate the converting franchisee to a term of affiliation of at least five years, with a non-competition agreement to prevent departure from the franchise chain - you lose your business if you leave. While these are much less enforceable in the context of a conversion franchise, they are not entirely free of enforcement risk, and even if you win you have spent a great deal of money to fund the litigation. Then, too, there is the cost of re-identifying your business to its old name and advertising blitz expenses to get that name back out there where people are educated and conditioned to accept and patronize it.

Every conversion franchise agreement I have ever seen has these provisions. If this is the deal being offered, and it always is, there are certain obvious exercises that must be done to analyze its investment worthiness. Obvious, yes, but almost never done. I guess it is obvious if you know about it and how to do it. Well, now that you are reading this article, you will know.

The formula is quite simple. You will, by converting to a franchised business, add to your expense profile the monthly royalties (anywhere from 4% to 8% of sales), plus the advertising fund payments (usually around 2% to 4% of sales) plus other expenses. Frequently use of e-commerce facilities and other "support" elements are not included in the fee and royalty structure, but are separately and additionally charged for. These monthly expenses must be added up and subtracted from your profit and loss statement. What is the impact upon your profit as a percentage of gross sales? That reduced profitability will be your future profit-as-a-percent-of-sales profile if you decide to convert. What do you get for that? You are told that you will get greater name recognition, the impact of being in a national organization that can generate more sales, "support" (whatever that is), and the privilege to participate in that franchisor's "unique" system of doing business. There is an objective way to determine how much of what you are being told is true and how much of it is blatantly untrue.

The test is that you aggregate the monthly incremental cost of being a franchisee, and mathematically determine how much in incremental sales at the now-reduced profit percentage you will need to reach break even on your having assumed this additional financial burden. Your accountant can do this for you. And that is merely a break even sales number. To make the conversion decision a profitable investment you have to exceed that sales number by a substantial margin.

Once you have derived that sales number, go to Item 19 of the Uniform Franchise Offering Circular (UFOC) that the franchisor is required to have provided to you before you signed any contract, and see if sales ranges achieved by their franchisees is provided. If not, you are about to make a big mistake if you decide to convert your business to their franchise. Immediately and absolutely refuse to convert to any franchise that does not provide their franchisee sales ranges broken down into the categories of: (1) the number of franchisees in the top 25%, the second 25%, the third 25% and the bottom 25%; (2) the number of franchisees in each geographic region that are in each sales percent category (frequently there is great variance in sales performance by region, and knowing which region you would be in can be critical - not all regions perform with equal success profiles for any franchisor); and (3) the length of time the franchisees have been affiliated with the franchisor in each percentage of sales grouping (if it takes ten years to get near the top tier, you don't want to convert your business).

Now that you know how your sales would have to increase just to cover your expenses of conversion, without any incremental profit to you from having converted, ask the question, "How many of this franchisor's franchisees have achieved this sales level? The reason so many conversion franchisees have ended up in my office wanting to know how to get out of the franchise contract and how to get their money back is that their franchisor had few or no franchisees generating sufficient sales to justify the conversion investment. It is a loss situation for the converted franchisees. In many instances, the answer to this exercise is that the franchisor has never had even one franchisee with sales at the level you would need to justify converting your business.

This analytical exercise tells you whether the sales pitch about how wonderful the franchisor's stuff really is is true or false. While there may well be franchisees in that system that are satisfied with their relationship with this franchisor, that is not the question. The question for you is whether the affiliation with this franchisor will provide sales results for you to make you happy at the reduced profit percentage caused by the costs of affiliation.

If the results of this exercise are not positive, but for some reason you still wish to consider converting your business and joining this organization, you can mitigate the risk by insisting upon the following terms being put into your franchise agreement:

1. Current sales are exempt from all payments based upon percentage of sales. Percentage of sales payment obligations apply only to sales above current levels.

2. If sales growth does not exceed 20% by the second year, you may terminate the franchise agreement with no non-competition or other constraint upon your right to do whatever you want to do with your business.

3. If you are still in the system when the time comes to renew your franchise agreement, you have the right to renew upon the same terms as your current agreement, with no adverse changes. Many franchisors want you to renew on their new agreement that frequently has higher fees and less protection for you.

4. If you sell your business, your buyer gets your contract, not some new contract with different rights, including renewal rights.

If the franchisor if unwilling to agree to these terms, reject the conversion offer. So endeth the lesson.

Author Richard Solomon is a Franchise Lawyer with 50 years of experience in business development, antitrust and franchise law, management counseling and dispute resolution including trials and crisis management.  Give him a call at 281-584-0519.

For the 5 Most Fascinating Stories in Franchising, a weekly report, click here & sign up.