Franchise Follies

“There’s a balance,” he explains, holding his hands palms up like a set of scales. “I’ll put up with this much bullshit if I’m making that much money.”

Report on Business magazine
August 1993

Franchise Follies
Far from being a quick and easy route to entrepreneurial riches, a franchise can be a nightmare of double-dealing and betrayal. Think twice before you buy in
Bruce McDougall


What's worse than owning a Pizza Pizza franchise? Owning two, according to Dave Michael.

Dave Michael, a former advertising salesman and manager of a consumers Distributing store in Toronto, bought his first Pizza Pizza Ltd. franchise in 1983 for $90,000. “I was a customer,” says Michael, a husky, straightforward 35-year-old who grew up in the city’s west end, a few blocks from his store. “I was impressed with their service. Having done a bit of selling myself, I knew that if you had confidence in your product, it should be an easy sell.”

With his wife’s help, working 12 hours a day, seven days a week, Michael paid real estate fees, telephone fees, advertising fees and cartage fees to Pizza Pizza, plus royalties (6% of sales, withdrawn twice a week from a specially arranged bank account) and occasional fines to the company for infractions, such as an employee not wearing a name tag. His hard work paid off. Over eight years, Michael nudged his first store’s average sales up to more than $13,000 from $3,000 a week. His reward? Pizza Pizza opened another store in the area, immediately cutting his delivery sales by 50%.

Still, Michael liked the system enough to try his luck with another Pizza Pizza outlet in 1991, for $165,000, in Orillia, Ont. “There’s a balance,” he explains, holding his hands palms up like a set of scales. “I’ll put up with this much bullshit if I’m making that much money.” Wiser by now, however, he tried to limit his vulnerability to the franchisor in his second contract. “I now pay my rent directly, not into a rental pool,” says Michael on a Sunday afternoon at his Etobicoke, Ont. Bungalow. “I answer my own phones. My advertising fee is 4%, not 6% of sales. They couldn’t open another store in my area unless I approved it first. The only thing I couldn’t include in my contract was the cartage fee, which is 1.5% of sales at the time. They said it was being revised. Six months after I bought my second store, they raised my cartage fee by 100%. I was paying more for cartage than I was for rent.”

Many of the 500-odd franchise systems operating in Canada, such as Midas and McDonald’s, live up to their sales pitches. But not all of them.

Pizza Pizza says it is now adjusting the way in which it levies fees for such things as cartage, advertising and rent. “We have a 25-year track record and 245 outlets,” says Stan White, vice-president of marketing for Pizza Pizza in Toronto. “We encourage potential franchisees to seek legal, accounting and banking counsel and to visit some of our franchisees before they get involved. Unfortunately, underperformers seem to emerge in bad times.”

Michael, however, is now one of 51 Pizza Pizza franchise operators who are suing the company for dealing in bad faith with its franchisees. “There’d be lots more of us,” he says, “but some people are scared.”

To a hard-working, ambitious Canadian like Michael, it’s a rude shock to find yourself battling a franchise system that you had patronized yourself as a customer and then paid thousands of dollars to join. After all, a franchise is supposed to be an idiot-proof alternative to starting a business from scratch, allowing you to enjoy the independence of working for yourself without the risk of losing your shirt if the business falters. In fact, the franchisor will even supply the shirt, along with the pants, the shoes and the funny hat, for a fee. If you’re lucky, the franchisor will also provide the support you’ll need to keep your operation afloat, from accounting services to marketing programs. All you have to do is turn the key in the door, switch on the lights and start making money.

Many of the 500-odd franchise systems operating in Canada do live up to their promoters’ sales pitches. Companies such as Midas and McDonald’s have been around long enough to establish a track record and refine their systems. They provide franchisees with a comfortable income in return for their efforts. But others don’t, despite their well-known names and high profiles. In both the United States and Canada, an increasing number of franchisees are complaining – sometimes in court – of inflated promises, soaring franchise fees and even outright fraud. And in most of Canada, there is little legislation to protect the unlucky ones.

But there’s no shortage of Canadians buying the franchising pitch as an alternative to self-employment or a salaried job. Franchises now account for 40% of the retail businesses in Canada, with annual revenues of more than $80 billion. In 1992, the 200 members of the Canadian Franchise Association (CFA) sold almost 300 franchises to buyers willing to lay down $40,000 or more for the dubious pleasure of spending long hours running a business that doesn’t really belong to them. Another 300 franchise operations that haven’t joined the CFA are also aggressively seeking franchisees to peddle everything from shampoo to accounting software.

The franchising boom blossomed in the economically buoyant mid-1980s, when it seemed that you couldn’t go wrong. Franchisors made money almost in spite of themselves. And even if they didn’t, the franchisor could sell another franchise around the corner, for as much as $40,000, the franchisor would enjoy immediate rewards and collect royalties from two outlets instead of one, even if both proprietors were going bust.

But this way of operating doesn’t work when the economy is tottering through a prolonged recession. “A lot of franchisors have gone into survival mode over the past 18 months and realized that they could have made far more money if they’d managed themselves better,” says John Douglas, a retail consultant with Ernst & Young in Toronto. Fast-food outlets like Druxy’s in Toronto have laid off more than half of their head-office staff. Others have closed outlets and reduced their spending on advertising.

Even when the economy turned sour, potential franchisees were still lining up at the door – especially ex-middle managers armed with hefty severance packages. After all, who else had ready access to the $170,000, including $70,000 in cash, required to open a Speedy Printing Center ($82,000 for equipment, $19,500 franchise fee, $24,000 start-up fee, $15,000 leaseholds, $30,000 working capital); or the $300,000 needed to sell paint through a Color Your World outlet ($75,000 in cash, $65,000 for fixtures, franchise fee of 7.5% of previous year’s sales, royalty of as much as 18% of gross profits or as much as 8% of average sales, advertising and rental charges of 28% of gross profits or 13.5% of sales, handling fee of 14% to 17% of gross profits or 8.5% of sales)?

Laid off or nudged out of their comfortable mid-level management positions, these refugees from the corporate world wanted to put their business experience to good use without gambling against the enormous odds involved in starting a business from scratch. The odds sound good: Only about one in five franchise fails outright in its first few years, compared with four our of five independent business start-ups. But what they don’t tell you is how hard you may have to work just to keep your head above water.

Lynn Choromanskis was one of those who bet with her severance package. Now in her early 40s, Choromanskis was laid off from her job as a management-information specialist at Canada Packers Inc. in Toronto with a $37,000 severance package and a desire to do something different. In 1991, she paid $140,000, most of it borrowed, to Moneysworth & Best Quality Shoe Repair for a franchised shoe-repair in downtown Toronto. The money covered store fixtures, equipment, site selection and training, as well as a franchise fee. “I wanted something small, where I wouldn’t have a lot of employees,” she said at the time, “where I’d meet the public, and provide a service they’d need. Even in a recession people always get their shoes repaired.

Fuelling the boom are hordes of ex-middle managers who want to put their business experience to good use without the risk of starting a business from scratch.

Unfortunately, Choromanskis relied on the assurances of the franchisor rather than her own investigations when she signed up. Opening her shop in a downtown skyscraper, she soon discovered that the building’s tenants were less optimistic than she was about their prospects in the recession. They began moving out in droves. Meanwhile, in nearby underground malls, Choromanskis counted at least 10 shoe repair shops competing with hers, some of them independently owned. Since 1991, she has managed to pay her store’s bills and meet her royalty and loan payments, but she has not paid herself a penny.

In June, 1992, Choromanskis hired a manager to run the store while she returned to the world of the employed, working 12-hour shifts as a computer operator at a Toronto hospital. “I needed a job,” she says. “But the job market’s the pits, even worse than my business. So I took what I could get.”

Last March, when her manager said the store had not generated enough money to pay its bills, Choromanskis closed the door. “I had two choices,” she says. “I could have stuck it out and asked [the franchisor] to let me get behind ion my payments, which I would have been responsible for paying, or I could get out while I didn’t owe any more money.” Chorosmanskis chose the second option, breaking her 10-year agreement with her franchisor.

Choromanskis now is all too well acquainted with the substantial differences between buying a franchise and running your own business. A franchise offers little of the flexibility and none of the independence of her self-employed competitors. As a franchisee, she had to buy her supplies from the franchisor, for example, even if she could get them more cheaply elsewhere. She could not negotiate another lease. She could not independently cut prices nor pursue any of the other options available to cash-strapped entrepreneurs. And she had to continue paying the franchisor 12% of her sales in royalties and advertising fees, whether she could afford it or not.

Choromanskis does not blame Moneysworth & Best for her predicament, even though the company did suggest verbally at the outset that her sales would be satisfactory. But even if she did complain, she would find no legal remedy for her predicament other than an expensive and time-consuming lawsuit. “Except in Alberta, there’s little protection for a franchisee,” observes Toronto franchise lawyer John Sotos. “Franchisees don’t benefit from consumer legislation, because they’re considered to be sophisticated investors and businesspeople.”

Alberta requires franchisors to prepare extensive documentation similar to a prospectus issued by a company selling shares to the public. It describes in detail the financial history of the company, the background of the owners and principals and the exact fee structure. Franchisors also have to describe any restrictive covenants in the franchise agreement and the conditions under which a franchise can be transferred or terminated. Compliance with Alberta’s regulations can cost the franchisor from $5,000 to $20,000, a factor that discourages some franchisors from operating in the province. Other provinces rely on the franchise industry to regulate itself, leaving disgruntled franchisees with no alternative to a court battle to seek a remedy for a franchisor’s negligence or fraud.

By the time franchisees recognize their predicament, they usually have neither the energy nor the money to sue a franchisor. But a few determined individuals have taken franchisors to court under common law and won their cases. Last year, the Ontario courts released a decision in a suit by Joseph Shai, who sought damages from Gulf Canada Ltd. after sales at his franchised gas bar and car wash fell far below the level predicted verbally by Gulf’s sales representative, Howard Hicks. Hicks had told Shai that the gas station would pump 4.5 million litres of gasoline a year. Shai used a more conservative estimate of four million litres to obtain bank financing for the facility. No one at Gulf told Shai that there were at least two similar operations within a few kilometers of the location or that 11 brand-name gas outlets had failed in the area in the previous eight years. Nor did Shai fully investigate the area and talk to other gas-station operators. Shai’s facility pumped less than two-thirds the amount estimated by Gulf and, when he sold the station less than a year later, he lost $125,000 on the sale. In compensation, the court awarded Shai almost $200,000.

Shai broke the No. 1 rule in buying a franchise: You must do your homework. Like any expensive product or service, a franchise isn’t always what it appears to be. “The process of finding a suitable system isn’t easy,” says Sotos. “Six months is not a long time to spend looking at different systems. And if anybody says you should sign up today or you’ll miss your chance, you should pass. Good franchisors don’t push people. If it’s an opportunity, it’ll still be around. Even if it costs you an extra $10,000, it’s better than losing $200,000.”

Pat and Berna Bradley thought they were reasonably well versed in the franchise they bought, but that did not save them from some unpleasant surprises. In 1991, the Bradleys won a lawsuit against Print Three Franchising Corp. and Print Three Ltd. for reneging on a variety of promises in their franchise agreement to operate a print shop in British Columbia. Among other things, Print Three told them that their cost of sales would be an average of 22%, but it turned out to be 37%. And Print Three’s support services were inadequate.

The Bradley’s, both 43, first encountered Print Three at a local franchise show. At the time, Pat, a former sales and marketing executive, was operating his own company from home. Berna, a former teacher, operated a sewing company, also from home. “We wanted to combine our talents, and continue working together,” Pat recalls.

In the Bradley’s opinion, Print Three gave them the best story of the few franchise systems they looked at. They even called some of the company’s franchisees in Ontario, who said they were making piles of money, Pat recalls. “But most of them were in their first year. In your first year, you think everything’s terrific. Your sales are going up month over month, and none of the bills have come in yet. So the feedback was relatively positive.”

After paying $150,000 in fees and equipment costs to set up Print Three’s first franchised outlet in British Columbia, the Bradleys soon found that franchising didn’t live up to their expectations. They were compelled by their agreement to buy equipment from the franchisor. But they discovered that they could buy the same equipment more cheaply from other sources. They also relied on the expertise of Print Three to obtain a lease on the best terms. But they ended up paying 6% of their gross sales in rent. “I looked at that and said it was nuts,” says Pat. “I renegotiated the lease at 4% of retail sales, which account for only 25% to 40% of our business.”

The Bradleys spent $80,000 in legal fees and 18 days in court, eventually winning less than $10,000 from Print Three. The company spent $200,000 on the case. “But that’s a lot more than we’d have spent in royalties,” says Bradley, “so we’re ahead of the game.”

In 1989, three brothers who operated McKinlay Motors in St. John’s Nfld., won a judgment of more than $130,000 from Honda Canada Inc. The McKinlays had spent $160,000 to upgrade their dealership, only to have their allocation of cars arbitrarily cut in half. The McKinlays sued Honda for breaching their franchise agreement and for dealing in bad faith.

For every successful lawsuit against a franchisor, however, there are others who hang on until the money runs out, then merely walk away from their businesses, whether or not the franchisor was negligent or misrepresented the franchisee’s potential sales. “The numbers aren’t huge,” says Sotos. “Most franchisors are reputable. They try to do the right thing. But there’s a subclass of franchisor that causes problems, based on franchisor greed, mismanagement, opportunism, exploitation and corruption in the system.”

Like the careless driver who causes all of us to pay higher insurance premiums, a relatively few bad franchisors have brought discredit to the entire industry. Other provincial governments, such as British Columbia, are considering regulations similar to Alberta’s, a prospect that concerns the CFA and many franchisors, who do not relish the thought of the additional costs involved in compliance. “If franchisors aren’t more prudent in their selection of franchisees, if they don’t reduce the number of failures, we could see legislation,” says Mike Claener, vice-president of Midas Canada Inc. and a director of the CFA. Like many other reputable franchisors, Midas operates in Alberta and is fully prepared to comply with similar legislation in other provinces. “But if legislation were passed in Ontario, a lot of franchisors [operating in the province] wouldn’t make the grade,” Claener adds.

In business for more than 30 years, Midas has kept its turnover of franchisees to a minimum. Some franchisees have operated their shops for 20 years. With more than 100 franchisees now operating 206 outlets, the company goes to great lengths to govern its own operations efficiently. Franchise candidates spend a full day in interviews with Midas executives. They also complete a personality profile that identifies their strengths and weaknesses as businesspeople and franchise operators.

“We also make sure they know financially what they’re getting into,” Claener adds. “While they may have positive cash flow, we tell them they won’t make any money in the first three years. In the third year, they may break even. So we don’t get people saying we told them they’d make $400,000 in their first year. We keep our franchisees up to date in new technologies, and we make sure they understand who we are.”

Midas applies no pressure on applicants to buy a franchise. “We want to open new shops,” says Claener, “but we don’t want our franchisees failing across the country. If you have to expand to make money, your franchise system is in trouble.”

Midas franchisees, who include a former accountant, a department-store manager, a fireman and an oil-rig worker, need at least $125,000 in unencumbered assets. They should be prepared to make a total investment of $250,000, “and in this climate, even more,” says Claener, “because the takeoff is slower.” In return they receive exactly what Midas promises – “a focused program with strong advertising and marketing support.”

Other franchise systems have equally good track records. Dairy Queen, McDonald’s and Tim Horton, for example, apply similarly thorough procedures to screening and selecting franchisees. “I bought my first Dairy Queen 27 years ago,” says Regina’s Jack Nicolle, who has bought and sold several franchises since then, including an interest in the Regina Pats junior hockey team. “I was selling cars at the time. I suppose I’ve felt ticked off at them from time to time over the years, but they’ve never misrepresented themselves. The things I’ve wanted to do with my franchise, I’ve done.”

For Nicolle and hundreds of others, franchising has lived up to its potential. But the process of finding a good one is not easy, cautions Sotos. “In addition to checking our the franchisor, you have to do a self-evaluation, identify your own strengths and weaknesses, decide if you can follow the dictates of other people about the way the system should operate. If you’re buying a franchise, you should never take anything for granted.”

Dave Michael, still embroiled in an ugly legal battle with Pizza Pizza, agrees. “If you’re thinking of buying a franchise, get advice from an experienced franchise lawyer before you sign anything. And listen to what he tells you.”

Franchising 101: A Primer
Make darn sure you do your homework before signing a franchise agreement

To protect yourself against making a costly mistake, you must do your homework before you invest in a franchise system. No matter how reputable the company or how enticing its image appears, a little investigation goes a long way.

“A franchisee should never take anything for granted.” Says Toronto’s John Sotos, a franchise lawyer for 13 years. “Salespeople will tell you anything.”

Once you’ve identified the system that you want to join, spend several months investigating its finances and learning how the system operates, Sotos advises. “If they have franchisees in Alberta or some U.S. states [that require franchisors to file documents], ask for a prospectus,” he suggests. “It’ll give you the company’s litigation history and financial details. And ask who the principals of the company are. I know of one system run by a guy who’s been bankrupt three times, and he knows nothing about the business he’s franchising.”

Also make sure the franchisor isn’t your sole source of information. Talk to other franchisees. Any franchisor worth his salt will give you a complete list. Check with a franchise lawyer who can tap into his or her own network for information about the company. And if you don’t feel confident in your own investigative skills, a franchise consultant can help. “I’ll go with a franchisee and just hammer the franchisor with 50 questions,” says John Douglas, a retail consultant at Ernst & Young.

For a start, here are 15 questions that you should ask before you buy a franchise:

  • How long has the company been operating its franchise network?
  • How many franchises have failed in the past five years?
  • How many new franchises have been sold in the past five years?
  • What’s the company’s total investment in the franchise system?
  • Will I have market protection – written assurance that the company can’t open another franchise within my territory?
  • Can I expand by buying another outlet if I’m successful?
  • What training will I receive?
  • How many people work at head office?
  • What support will I get from head office?
  • What advertising support will I receive?
  • Has the company made changes in its system to expand or contract the product line?
  • How are such changes carried out?
  • If I die tomorrow, does my family inherit the business?
  • How long is the term of my franchise agreement?
  • Who signs the lease for the real estate?

Chain Letter: The Franchising Epidemic
From bungee-jumping to weight-loss clinics, it it’s legal, you can franchise it

Bungee-jumping, hamburgers, handguns, accounting software, you name it; if it’s legal to sell it, it can be franchised. Gravel Doctor markets a franchised concept for maintaining gravel driveways and parking lots. In the United States, Air Boingo sells franchised bungee-jumping systems. Strictly Shooting is a network of franchised gun dealerships.

The money required to open a franchise has little to do with the cost of the product or service involved. Burger King advises potential franchisees to have access to $650,000. To sell a 99-cent hamburger for McDonald’s, you need up to $950,000 to cover equipment, fees and other costs. A Harvey’s outlet can cost as much as a $1.3 million, depending on location and the extent of ownership. Of course, if you had happened to have $50 million and a Goofy hat on hand last winter, you could have bought the franchise now called the Anaheim Mighty Ducks in the National Hockey League.

For the economy-minded, you can become a franchised leasing consultant with Lease Mart for as little as $25,000 or run a Physicians Weight Loss Centre for a minimum of $40,000. You can sell personal alarms, whistles, distress signals and safety training courses for a company called Out of Harm’s Way for an investment of just $55,000, or open a Servicemaster carpet cleaning outlet for $18,600. If even that’s beyond your budget, how about setting up a commercial cleaning operation with Jani-King International for as little as $6,500?

If flipping hamburgers and scrubbing carpets seems too tame, consider Spytech in Toronto, a franchised system that markets intelligence-gathering equipment and services, and trains its franchisees to become “counterespionage detectives.” From cheating husbands to pilfering employees, no job is beyond the scope of Spytech. Whether Spytech is the franchising jackpot of the ‘90s is still unknown at this point. But if you really have what it takes to become a counterespionage detective, you’ll find out.

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Risks: Encroachment (too many outlets in area), Canadian Franchise Association, CFA, Survivability (franchisee and franchisor), Must buy only through franchisor (tied buying), Fraud, Misrepresentations, Public perception of sleaze and greed, Low investor confidence, National press coverage, Canada, 19930801 Franchise Follies

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