The down side of franchising is the unpleasant way franchise relationships can end.   When buying a franchise, typically neither the franchisor’s representative nor the prospective franchisee look at how the relationship might terminate—voluntarily or not.  It is all about the positives and the prospect of independence as a business owner.

Depending on the particular franchise system, the philosophy of management and the goals of the franchisee, it is possible to avoid some of the worst consequences by planning an exit strategy and negotiating critical terms.  Then it’s all about the boilerplate. That boring part of the contract near the end where all the bad things that can happen to a franchisee are listed. [After all, it is inevitably one sided since the franchisor writes and so controls the contractual consequences.] Often there are unpleasant surprises for the franchisee lurking as the franchise relationship unravels.

Even when a franchise business is profitable, things can go wrong.  So finding the “best franchise” is no guarantee of success.  When things go wrong, everyone starts pointing fingers.  The big challenge is to keep communications open if possible.  When franchisors and franchisees stop communicating, both are left to find a solution in the franchise agreement.   Promises and good intentions won’t matter.  When the ship is sinking, that one big happy family becomes “sauve qui peut” [every one for him or her self].

How are your problem solving skills? There will be no easy answers, so think ahead.

Following was originally posted on the Dallas Bar Association site.

by Kat Tidd

A franchise is not a magic word, it is a legal definition:

1. license a trademark or permit substantial association with the trademark or trade name;
2. accept payment of consideration; and
3. provide significant assistance, control or other forms of ongoing support or a continuing relationship.

If that definition is met, then the franchisor has certain obligations concerning the timing and manner of offering and selling a franchise, and the use of a Franchise Disclosure Document.

Keep in mind that a franchise is essentially a specialized form of business opportunity, with the additional element of a trademark or trade name license. And, generally, a franchisee has no special rights except those that the franchisor grants by contract or those accruing through reasonable reliance on franchisor promises. In some states, there are specific statutes that regulate relationships and/or termination, like Arkansas, New Jersey (Franchise Practices Act) and Wisconsin (Fair Dealership Law).

Pricing

While many antitrustissues have fallen into disfavor, pricing controls traditionally unquestioned as per se unlawful price-fixing practices were rehabilitated by the Supreme Court in Leegin Creative Leather Products Inc. v. PSKS, Inc., 127 S. Ct. 2705 (2007).

Since Leegin’s holding that vertical price restraints are to be evaluated under the rule of reason, Pandora’s Box has opened. Leegin offers franchisors some comfort in their ability to dictate at least the parameters of a franchisee’s pricing as a reasonable resale price maintenance program. Any challenge will now be scrutinized under a rule of reason analysis that calls for establishing several ambiguous and difficult-to-define factors (e.g., such as what is the relevant product market). This may make plaintiff’s counsel more reluctant to challenge such practices.

Several states, however–Illinois, Michigan and California among them–have reacted negatively to Leegin and maintain that minimum resale price maintenance is still per se illegal. And with less certainty, friction seems inevitable.

Encroachment

Disputes over the proximity of competing franchisees, solicitation and diversion of customers, and sales of product within a franchisee’s trade area or exclusive territory are being litigated with more frequency. Some states like Iowa have passed protective legislation.

Franchisors have reacted by broadening the reservations of the rights to encompass everything not specifically granted to the franchisee.

With such clauses in place, more franchisors are exercising their contractual right to place franchises closer together and to sell products and services directly by “alternative distribution channels,” e.g. Internet sales and discount membership chains like Costco. Where the franchisor diverts–real or perceived–business and customers that would otherwise go to a franchisee, disputes and litigation ensue.

Duty or Implied Covenant of Good Faith and Fair Dealing

In franchising, this is typically asserted by a franchisee. Numerous states recognize this duty or implied covenant–sometimes by statute and sometimes by common law–including Oklahoma, Tennessee and Georgia. However, Texas courts have yet to find that a franchise creates a special relationship beyond that of a normal commercial contract and, so far, have not found that a franchisor owes its franchisees such a duty.

Breakaway Franchisees

Franchisors often assume they can keep franchisees from going into the same business or from competing with their franchisees. They often fail to grasp that there is a patchwork quilt of state laws affecting restrictions against competition. They must balance the scope of protection they want in the franchise agreement against what is most likely to be enforced in the greatest number of jurisdictions in which they will franchise.

In some states, like California, a post-termination restriction may not be enforceable at all. In Georgia covenants against competition in franchise agreements have long been disfavored and subjected to the difficult standard of strict scrutiny.

In Texas and several other states, the scope must be reasonable in duration and geography. What constitutes “reasonable” remains unpredictable and intensely fact-driven. Amerispec, Inc. v. Metro Inspection Services, Inc., 2001 US. Dist. LEXIS 9259 (N.D. Tex. 2001) had the odd result of finding the franchisee in the wrong, but refusing to apply the contractual provision prohibiting the franchisee from competing in the territories of other Amerispec franchisees in Texas.

Whose law?

Franchising reaches across state borders. It is an industry regulated at both the federal and state level in a way much like securities are. Whether representing franchisees or franchisors, Texas counsel needs to be sensitive to the laws of other jurisdictions that may apply, such as state franchise registration laws, franchise relationship and protection laws, “little FTC” acts and, of course, the overriding umbrella of the Federal Trade Commission’s Franchise Rule, 16 CFR § 436.1 et seq. Much useful information and a copy of the Franchise Rule and the proposed new business opportunity regulations can be found at business.ftc.gov/legal-resources/13/33.

Kat Tidd, Law Offices of Kat Tidd, P.C., advises franchisors, franchisees, dealers, and entrepreneurs and advises other attorneys on franchise and business opportunity transactional and dispute resolution matters. Ms. Tidd may be reached at kat@tiddlaw.comor (972) 247-6934.

             Last week an online article was published about McDonald’s aggressive actions to stay ahead of  consumer trends by being willing to continually implement both change and innovation.  These are attributes that can certainly benefit small businesses and franchised businesses as well, and I applaud the general idea.

However, if you read further into the article (See,  McDonald’s Sales Growth Comes at a Price to Franchisee Profit Margins you will learn that McDonald’s profits and increases its bottom line while franchisees on the front lines see a decrease in theirs.)

            Unfortunately, I see this as part of an ugly industry trend. Many franchisors are sacrificing their franchisees’ financial well being to their own profit margin, frequently without regarding to the ability of many franchisees to survive the hit to their own bottom line..or just plain staying at or above breakeven. Market encroachment that cannibalizes their franchisees on the ground and in cyberspace are other ways that some franchisors may generate more revenue to the detriment of individual franchisees.

            Such actions by franchisors cannot be concealed.  Prospective franchisees who go the extra mile on their due diligence (some prodded by yours truly) will learn where their prospective franchisor’s priorities lie.  When the chips are down, they discover they will be thrown under the bus.  To add insult to injury, these are often the same franchisors whose franchise agreements claim the right to go after the franchisee for liquidated damages or lost royalties when the franchise business fails!  Yes that is another ugly trend.

            Franchisors–and those planning to franchise–should take heed.  People do not want an “invest-to-rent a business” solely for the fun of it.  They want and should have a fair return on the business, or alternatively a franchisor who will share or at least attempt to ease the burden of hard times.  Certainly they should not have to worry about their franchisor creating the problem. 

            How about this for a franchise mission statement:   “all for one and one for all”?

Or, why not just save a little money?

            The Internet is a tremendous source of information.  A lot is written about franchises and franchising unfortunately, I am still waiting for the next gen to produce infallible Truth or Lies software.

            In the meantime it is all about Truth or Dare.  You can find a franchise agreement for any type of business somewhere in Cyberspace.  Anyone with a good grasp of the English language (sadly less common with our weakened education system) can change the wording a bit to fit a different business.  Sometimes they can get lucky and write a new paragraph that really says what they think it does and IT is enforceable–at least in most states.

            So often I get to read junk agreements all the time.  Some from prospective clients who used them to franchisor need them fixed, and–the most fun, from prospective franchisees who want to know what I think.  Would I think of the contract?  Of the franchise?  Of the deal?

            Here is what I often think:   this contract puts the foot of the franchisor on the throat of the franchisee. It is indentured servitude… pre-paid.

            Ironically, at least half the time the franchisor is a well-meaning entrepreneur who is determined that “his or her” franchisees will succeed.

            One of the many problems with cut rate or plagiarized franchise agreements is that the franchisors using them often don’t understand what the cloned agreement really means, nor the consequences of using it. I tell them, sometimes directly and sometimes through the client: “this is what your contract says you can do which makes your franchise a really bad deal.  Is this really what you would do to your franchisee?”

            Usually the answer from the franchisor is “of course not, but I was told by my lawyer that I need this language.” But if you don’t mean it, why say it?!  I take the tone of the franchise agreement as the tone of the franchise system.  Mean contracts make for an unpleasant, ultimately and trusting relationship.  Sticks and stones won’t hurt, but lousy your heartless contracts will do yourself a favor. If you care about your life savings, if you care about the success of your company, see an experienced franchise attorney.  This applies to both sides of the deal.

            By the way, there is a reason for the saying: you get what you pay for.

Lately some franchise and business opportunities seem to be more like a lot of the mystery business web sites on the Internet. Can you tell who you are dealing with? Let’s start with the company. Where is it located? State and city? Can you even tell what country? Is it a corporation or an LLC?

Even more importantly who are the people? Running the business? Who are the decision makers? Is this a real biz or are they operating on smoke and a pretty web site? Is there a president of the company? A name and a face of the founder. Is the staff real? Is support and assistance really available? how long has the business been operating? How many names of real people?

Sad to say but there are also a number of mystery franchise services firms and websites out there that raise these questions as well. Who are the experts they claim? Any names? Bios? Where are they actually performing their services?

Bottom line: Give no one money and sign nothing without knowing who is taking it and ensuring that their part of the bargain is kept.

             I counsel prospective buyers frequently about how to evaluate franchise opportunities.  One of the traps they fall into when buying a franchise is just falling in love with the business and wanting one badly.  If it is a newer and/or smaller franchise system, or one of the ever increasing numbers of start up franchises, it can be really difficult to get an accurate picture of the franchised business’s true probable profitability.

            My Jedi Knight Ninja Social Mediaist Guru (whom I constantly frustrate by being too busy to participate in social networking the way he says I should) emphasizes that social media is about the connection to a real person. He also says that effective social media activities generate trust between the connections made through participation in social media.   In my sporadic forays onto Twitter, I have seen that there are many franchise developers and franchise sellers active on Twitter.

            Here’s the number 1 pitfall in the effects of social media used by those who pitch buying a franchise is the: 

Franchise sellers – and really anyone in sales and marketing.  They attempt to build a relationship with the prospect that has an implicit “trust me” element to it. 

“Trust me”, I won’t steer you wrong;

“Trust me”, this is the business opportunity you have been looking for;

“Trust me”, this franchise is in the top 100 list of Know All Business and Franchise Opportunities Magazine;

“Trust me,” this is a proven concept;

“Trust me”, this fits your personal passion for [saving the planet, offering healthy meals, making a million dollars......]

            There are many franchise sellers who are honest, accurate and play by the rules set by state and federal franchise law who don’t need to imply you can trust them.  However, there are many who sell franchises who really don’t care and make their living by selling and that is where “trust me” can tip your decision making in the wrong direction.

            Following your passion may lead to personal fulfillment, but it may not lead to profitability.  To paraphrase what the Dormouse said to Alice:  

“Use your head!”

What Is “The Best Franchise” to Buy?

Everyone wants to know the best franchise to buy, but it is really a meaningless question.  There is no such thing as best franchise or even worst franchise. The “question” covers a lot of ground.  The purpose of owning a franchise is to own a profitable business.  So what franchises are profitable? Some of them, sometimes.  As in certain to make money? None are a certainty.

What does the “top 10 hottest franchises” or the “10 best new franchises” get you?  The current winners in a popularity contest where the rules change and no one knows who makes the rules–or picks the best franchises or the hottest franchises.  Just because the sheep follow the leaders over a cliff, doesn’t mean you have to. 

Even the most solid of business concepts, the most thoughtful and most comprehensive in training, systems and support can result in a failed investment. 

Here are five reasons a franchise fails:

*life cycle of the business model is nearing its end (used records, video rentals,

*wrong location/wrong demographics

*underestimating the various ways the business can be affected by competition

*overestimating the market for the service or product (especially true in this economy)

*bad operator (you need to have confidence in your abilities, but few are good at everything they try)

  No franchise is certain to succeed – even the largest franchise systems in the country have far from a perfect track record– there are some that seem virtually certain to fail. 

Here are some red flags:

1.  the business being franchised has not been operated long enough to do much more than make a profit but it is promoted as a proven concept.

2.  the founder of the business has either: started the business for the sole purpose of franchising it and has no real passion for the business or decided to franchise without understanding how to be a franchisor and has focused on selling franchises and–more or less–getting them started rather than a small core of truly successful franchises

3. franchisor has no money, no ongoing business advisors

4. franchisor uses a franchise “packager” to put together its franchise documents who profits primarily from the start up package and/or sale of franchises, but not from on-going counseling of being franchisor, or….   

5. franchisor copies the franchise documents of a similar business concept to cut costs which means they are basically clueless about the whole business

6. when franchise fees/royalties/mandatory purchases are added to operating costs, the probability of the business being much better than a low paying job  

7. the franchisor cuts corners on legal compliance because it’s too expensive           

The best franchise is the franchise that will be profitable for you, achieves breakeven at a point in line with your expectations  and is supported by a franchisor that meets or exceeds the expectations they create.

When you think about buying a franchise, you need to investigate the franchise carefully.  One of the most important things you should do is talk to other franchisees.  Listed below is a list of questions to get your evaluation of the franchise or business opportunity started:

1.         How long have you been operating this business?

2.         Did the cost of your start-up fit within the initial investment numbers set out in the Offering Circular you received?  

            — if not, what was different?

3.         Did the training program prepare you adequately to open and operate your business?

            — if not, why not?

4.         How would you describe the quality of the training program? the instructors?

5.         Did the training meet your expectations and the description given in the Offering Circular? given by the franchisor’s representatives?

6.         How long from the time you signed the franchise agreement and paid the franchise fee until your business opened?

7.         How long did it take you to reach breakeven (or enough positive cashflow to pay your operating expenses for a period of  consecutive months)?

            –including a salary for yourself?  – how profitable do you believe this business can be in one year?

8.         What kind of help did the franchisor give you in actually setting up and opening your business?  and how many days was a representative present at your opening or start-up?

9.         When you opened, do you feel you were prepared?

10.       How did you choose your location or territory, what help did you receive and are you satisfied with it?

11.       If an advertising fee is required and/or advertising support promised, is it what you expected?

12.       What do you think of the management of the franchising company?

            –are they good leaders for the franchise system?  –do they do what they say?

13.       How would you rate the financial stability of the franchisor?

14.       How responsive is the franchisor to your requests for help? 

15.       If you purchase supplies or inventory from the franchisor or required suppliers, do you feel the prices are fair and the quality competitive?

16.       If you have an exclusive territory or other exclusive marketing or customer rights, are you truly protected from other franchisees?       Are your exclusive rights adequate to protect you?

And the closer, when you have nothing left to ask:

17.       If you had the choice, would you buy this franchise again?  Do you recommend it?

A successful franchise usually (but not always) means there is a successful relationship with the franchisor as well.  As an attorney, I consider it successful when, once signed, the franchise agreement is filed away and never looked at again, except to replace it with the renewal agreement.

When business is good and the franchisor-franchisee relationship is positive, the contract doesn’t matter.  If things goes south, it’s all you have.  Too often franchisees are so caught up in the struggle to make their business profitable and keep it going, that they put off addressing core problems involving the franchise.  They just cannot seem to find enough time to deal with difficult underlying issues.

Procrastination does not solve problems. Or turn a business around. Too often the clock is ticking on the remedies available to franchisees in trouble.  While not perfect or always applicable, there are laws and contract provisions that can sometimes help.   But sooner rather than later.   Problems in a franchise relationship take action, not procrastination to solve positively, before the situation becomes irreconcilable.

The dynamics of each franchise relationship are unique:  Franchisor leadership, fundamental viability of the business concept, situational viability of an individual franchise unit, new versus established franchise system.  All these factors and more will affect how any given situation should be addressed.

Not everyone is suited to be a franchisee.  Some are not naturally followers and will chafe at the restrictions of uniformity and control imposed by a franchise system.  Where that is the case, then inevitably constant problems and disagreements will develop,  if not outright disputes.  In those situations, usually the best hope for a positive result is either find a way to negotiate a mutually agreeable parting of the ways, or sell the franchise to a suitable buyer.  The franchisor should be highly motivated to help.

For the typical franchisee, however, who looks to the franchisor for guidance and support,  problems that develop where a franchisee will–at some point–seek legal advice generally fall into the following categories:

1.          The franchisor does something that either affects the franchisee’s bottom line or is perceived to narrow or otherwise eliminate rights the franchisee has.

Example: reducing or in some way infringing on territorial or customer rights

2.         The franchisor refuses to take action that the franchisee believes it should take.

Example: other franchisee sells inside another’s exclusive territory and only franchisor entitled to enforce exclusivity

3.         The franchised business stops being profitable after some period of time, and the franchisee wants the franchisor to help or let it out.

Example: Core product or service either goes out of style or is superceded by new technology and cannot generate revenue necessary to support royalties;

4.         The franchised business never makes money, perhaps has not achieved breakeven and doesn’t appear likely to do so.

Example: Start-up franchise with insufficent time in the marketplace to identify how to drive business in other regions of the country, poor location

Let’s take the worse case scenario, and the franchisee finally decides to seek legal advice.

A close review of the franchise agreement and read all the exhibits and any other agreements and forms that have been signed with the franchisor may present a few surprises.

What is the franchise agreement likely to say?  Typical provisions are:

1.         Waiver: franchise agreements usually provide that just because a franchisor hasn’t enforced a requirement previously, doesn’t mean it can’t start.

2.         Venue: Generally means what it says.  Litigation or arbitration will be where dictated in the in the agreement.  (There are some exceptions, but usually involving unique facts.)

3.         Dispute Resolution: Before you get to a binding forum for litigation or arbitration, most require you to mediate and split the costs.  (Not necessarily a bad thing.)

Arbitration: Afterwards, binding arbitration is required and the initial complainant pays a large filing fee, determined by the amount claimed as damages.

Litigation: Jury trial has usually been waived.

4.         Statute of Limitations: Claims do not last forever, whatever they might be.  The cut-off is  created under various types of statutes of limitations that fall into two categories:

By law:             4-6 years for breach of contract, 2 years for typical tort claims (e.g. interference with business relations, fraud, misrepresentation,  2  years for the typical deceptive trade practices violations; 2 or 3 years for violations of any applicable state franchise or business opportunity law.

By contract:      Many franchise agreements, especially those in recent years, create their own statute of limitations, typically two years, sometimes even one year for any claims “arising out of or in any way connected to” the franchise or the franchise agreement.

5.         Default and Termination. If a dispute reaches crisis point, these are the provisions that count.  On a closing reading of the wording, franchisees are often unpleasantly surprised to learn how broadly the franchisor may interpret certain terms.  These terms give the franchisor the power to terminate the franchise, resulting in the franchisee’s loss of its investment.

Obviously “boilerplate” matters, when things go wrong.   When a franchisee delays understanding and addressing problems fundamental to the success of their business, or their relationship with the franchisor, they will invariably be left with fewer options and less likelihood of a favorable result.

If you have signed a franchise agreement, do yourself a favor, sit down with a strong cup of coffee and read it.  Unclear?  Talk it over with your lawyer, your franchisor, your business advisor.  Know where you stand and you will learn which directions you can or should go.