Your own little piece of hell

“Far too many disputes are resolved on the basis that the franchisee can’t afford to fight it,” observes Ned Levitt, a Toronto franchise lawyer. “Period. Goodbye. Hand them a box of Kleenex. You’re out of here.”

MoneySense magazine
June/July 1999

Your own little piece of hell
Every year thousands of franchise deals go sour. If you’ve ever thought of buying your own business, read this first.
Donna Green

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Derek Brown used to dream about running his own business. A paramedic in Peterborough, Ont., the 29-year-old began small, by operating a disc jockey service from his home. When he inherited some money from his mother in 1996, he decided to get more serious about his entrepreneurial ambitions and began shopping for a franchise.

Brown did everything by the book. He took his time, resisted high-pressure salespeople, and looked for a concept that fit the competition, demographics and consumer trends in his home town. He even consulted a lawyer and an accountant before buying a franchise from The Academy for Mathematics & Science, a chain of learning centres that offers tutoring services to high-school students.

None of his diligent preparations stopped Brown’s dream from turning into a nightmare. Today he and four other franchisees are contemplating a court battle with the academy, which they accuse of misleading them about the potential profitability of their businesses. Brown may yet lose his investment, but he considers himself relatively fortunate. Three other franchisees concluded they had no hope of making a profit and simply walked away from their businesses. Brown, who is married and has two young children, says, “I worry how my family is going to get through this. I’m skeptical of everyone’s intentions now.”

Brown’s predicament is painful; sadly, though, it’s not unusual. Every year across Canada, thousands of franchise deals go bad. According to Francon (Canada), a Toronto-based strategic planning and consulting company, Canada is the most heavily franchised country in the world. Yet the franchise industry in this country operates with far fewer constraints than in other major nations. “Compared to the kind of regulation that exists in the United States, Australia, or even in countries like Brazil and Malaysia, Canada’s regulations is non-existent,” says John Sotos, a prominent franchise lawyer in Toronto. “Even where some regulation does exist, it’s not effective.”

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The most glaring problem is the lack of laws or regulations that would force franchisors to divulge a detailed picture of their operations. Many franchisors sell buyers on the prospect of making big profits while hiding the disappointing reality. A franchisor doesn’t have to tell you the actual profits of any of its outlets. A franchisor doesn’t have to tell you if a former franchisee in your area went belly-up. A franchisor doesn’t even have to reveal its own financial health or give you any picture of its own balance sheet. If mutual funds were sold the same way as franchises, no fund would tell you its performance numbers or historical record. Yet in the franchise industry, such a lack of disclosure is regarded as standard practice.

No one is suggesting the entire franchise industry is rotten. Some franchisors, such as McDonald’s or Tim Hortons, have transformed ordinary people into millionaires. Many other franchisors operate quality businesses with prosperous franchisees. And, in some cases where franchises do go bad, it’s not the franchisor that is at fault. “Franchisees are jointly responsible in most circumstances,” says Greg Harney, a B.C. lawyer who specializes in franchising.

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Still, the sheer volume of franchise disputes offers a strong indication that many deserving people get far less than they hoped for when they put down their hard-earned money in exchange for a business of their own. In recent years franchisee revolts have ripped through such well-known chains as Pizza Pizza, Loeb grocery stores, 3 For 1 Pizza & Wings, and other. Those well-publicized battles indicate just some of the dissatisfaction boiling beneath the surface. For every militant franchisee there are many frustrated and defeated franchisees who slink away into the night, afraid to talk because they fear retaliation from the franchisor, or are bound to silence as part of a confidentiality agreement they signed to settle their dispute with their franchisor. David Sterns, a franchise litigation lawyer in Toronto, notes: “The people who suffer the worst of franchising are often held to silence by confidentiality agreements and so the abuses perpetuate themselves.”

Provincial authorities estimate that around 5,000 civil cases are filed every year in Ontario alone relating to disputes between franchisors and franchisees. Many of these disputes could have been avoided with straightforward disclosure and more even-handed franchise contracts, yet Alberta is the only province that has any franchise regulation. Ontario has given first reading to a bill to impose disclosure requirements on franchisors operating in the province, but five successive governments have backed off and it remains to be seen if the Harris government will stick with it. For the time being, most Canadians have more protection from a door-to-door salesperson than they do from a discreditable franchisor.

To understand the plight of many disgruntled franchisees, consider Brown’s situation. The young paramedic carefully shopped around for six months before he came upon The Academy for Mathematics & Science. Intrigued by the potential of the concept, he toured the academy’s Toronto head office and flagship location, as well as an academy operation run by an established franchisee.

Brown probed as many facets of the operation as he could. At his first meeting with Balti Sauer, president of the academy, he brought out a franchise evaluation checklist he had photocopied from a book. He systematically asked Sauer the questions and received common-sense answers: why were royalties and fees 15% when industry standard is closer to 8%? Sauer explained that unlike other chains, the academy does not charge its franchisees for upgraded materials. Then Brown asked Sauer for evidence of Sauer’s financial stability. “I felt I had offended him,” says Brown. “He just flatly told me it was none of my business.” Brown says he was told the system had never had a failed franchise.

Brown took the franchise contract to his lawyer and accountant, who gave the document an emphatic thumbs-down. They disliked parts of the contract that would have required Brown to personally guarantee royalties, given Sauer the ability to withdraw money from Brown’s corporate bank account, and restricted Brown’s other work interests. There were also the bigger issues of hefty minimum royalty payments and a 2% national advertising fund.

Brown’s accountant renegotiated the contract with Sauer and won some significant concessions. The big issues of royalty payments and the ad fund remained unchanged. But Sauer agreed to strike the requirement for personal guarantees and bank account access. Brown says Sauer asked him to keep these concessions private and congratulated him on his thorough research.

It soon became clear to Brown that his research hadn’t shown up the real problems. Simply put, his business wasn’t all that profitable. He paid $29,500 for the franchise, with taxes. After some leasehold improvements, he began marketing for students, but lost $35,000 before owner’s salary. He found that advertising and tutoring costs were higher than projected in the franchisor’s pro forma financials. According to those numbers, an operation taking in $100,000 will generate $35,000 before owner’s salary. (Sauer has since revised this to $31,000.) In Brown’s second year he brought in close to $100,000 in business but made only about $10,000, again before salary. “I was widely regarded as an academy success story,” he says. “I thought I was doing well until you start projecting things and realize that this is never going to pay out what they said it would.”

He joined a fledgling association of academy franchisees and learned that more than a few franchisees were dissatisfied with their earnings. He also discovered that one of the early franchisees had abandoned both her stores after only two years. He found that many of his counterparts felt they hadn’t been given enough information to make a rational decision before buying. No one had seen financial statements for the parent company, and those who had requested such statements were told they had to make do with the pro forma projections for an individual operation.

The association, which at its peak represented 20 out of 40 franchisees, hired a mediator to speak to Sauer about their income concerns. While the mediator wasn’t able to win any concessions on royalty payments, he did obtain financial statements on the corporately run operations. They were not the profit spinners the franchisees had been led to believe, and were generating more modest numbers than the sales information indicated. The franchisees concluded the pro forma sales and profit numbers were not a reflection of a typical operation.

Sauer still stands by his figures in his sales material. “It does reflect very reasonably an average learning centre,” he says, but he concedes that, in response to franchisees’ concerns, the academy, which has become a member of the Canadian Franchise Association, no longer extracts a minimum royalty, and has cut royalties and fees to 12% of gross sales from the former 15%. Sauer’s parent company, Learnco International Inc., now trades on the Alberta Stock Exchange. In 1998, with eight corporate centres (five of them bought from franchisees in that year), it lost money. It also lost money in 1997.

In September 1998, a group of seven academy franchisees returned their teaching materials, changed their signs and went independent. Now they may be duking it out in court. Sauer wanted them to close down and petitioned for injunctions against two of the operations. One petition was denied; the other was withdrawn.

Brown was one of the seven franchisees to go out on their own. He and four of these franchisees are prepared to file suit against the academy, accusing it of misrepresentation. “You read in books all these things to look out for,” says Brown reflectively, “but I never dreamed for a minute I was going to be in one of the situations I read about.”

Brown’s story demonstrates much of what’s wrong with franchising in Canada. Because of the lack of information about the state of franchise systems unless the parent company is publicly traded, or sells its franchises in jurisdictions with disclosure laws, or voluntarily provides disclosure documents. Most franchisors don’t fall into those categories.

While most franchise systems provide pro forma projections of expected revenue and earnings, there are no guarantees that these statements accurately reflect realistic expectations. Franchisors are free to put down any figures they think reasonable, and frequently understate the amount of capital required to fund a start-up business. As a result, many beleaguered franchisees wind up with a failing business but without the money to hire a lawyer. “Far too many disputes are resolved on the basis that the franchisee can’t afford to fight it,” observes Ned Levitt, a Toronto franchise lawyer. “Period. Goodbye. Hand them a box of Kleenex. You’re out of here.”

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Franchisee organizations, like the Canadian Alliance of Franchise Operators run by Les Stewart in Midhurst, Ont., want governments to legislate a mandatory dispute-resolution mechanism for the franchise industry, so financially distressed franchisees will be able to seek some remedy without resorting to the courts. The CFA is also trying to head off disputes before they occur. It requires its members to comply with a code of ethics and to provide all prospective franchisees with a disclosure document. Unfortunately, the CFA represents only 350 of the 1,300 franchisors in Canada.

Alberta is the only province, so far, to take a strong stand on the franchise industry. Its legislation gives franchisees the right to get back their franchise fee and to recoup their losses within two years of purchasing a franchise if they can prove they were given materially inaccurate information. This gives Alberta franchisors a strong incentive to fully disclose all aspects of their operations.

But even Alberta’s legislation doesn’t cover all the abuses encountered in the franchise world. Many franchisees spend years building their businesses under the terms of an initial contract, only to see the franchisor renew the contract on terms that effectively strip the business of much of its value. Encroachment is another contentious issue. Unless the franchisor has given you a guaranteed territory, you have no protection from other units opening too close for comfort. Unscrupulous franchisors have been known to open competing concepts near their own successful franchises. Worse of all, many franchise contracts give franchisors the right to take over or close an operation on very little provocation – in effect stealing the business from a franchisee who may have worked years to build it.

Consider Betty, a former franchisee who will speak only on condition of anonymity. She was a self-employed accountant for 11 years. Then her husband left his job at Ontario Hydro, and she decided to buy electronics franchise from a large national company. Her initial capital investment was $210,000 - and at first she thought the money was well worth the opportunity she had purchased. In the span of eight years, Betty received five national awards from her franchisor. She was the only operator in the system’s history to twice win the Franchise of the Year award, most recently in 1997. At the beginning of her sixth year in operation, she bought a second location. She built her total sales to $2.5 million, yet she was earning only $500 a week before taxes because margins were laser thin. “I worked long hours but I didn’t resent it because I thought I was building something,” she says. “I kept kidding myself that it would get better.”

The kidding stopped when a cheque to her franchisor bounced. It was the first time Betty had ever bounced a royalty cheque and she thought the problem could easily be resolved. Cash crunches weren’t unusual in her business and, besides, she held significant money – at one point as much as $285,000 – in credit notes issued by the franchisor in payment for returned goods. But while those credit notes could be exchanged for new goods, they couldn’t be used to pay royalties or bank loans.

Betty was shocked when, with no warning, head office representatives came into her store and demanded she repay all her loans, including her bank indebtedness – an order the franchisor was entitled to give under terms of her franchise agreement. The demand instantly made her insolvent. The franchisor then insisted she sign over her business to the parent company in exchange for being relieved of her outstanding debts. She was stunned and humiliated: “How was I going to tell my family?” After seven grueling hours in her office, she signed the documents they pressed on her. Only the next day did she call a lawyer. Later she learned the second location was still hers as she – not the franchisor – held the lease. “But I couldn’t buy anything because I didn’t have any money and I didn’t have the relationships with the suppliers,” she says.

The franchisor took over her bank debt but stripped her of her corporation, her business bank accounts and her cash flow. She was left to stagger under the weight of all her other bills, including outstanding GST and PST accounts. The franchisor wanted Betty to sign a settlement of claim, which stipulated that she would be subject to a $10,000 fine if she spoke about the terms of the settlement. She didn’t sign but she is still afraid of being sued for defamation by the franchisor – who is large, powerful and monied. Betty cannot afford to go to court. In her opinion, the franchisor stole her business and the eight years she invested in building that business, but she has no way to fight back.

Betty’s situation is extreme, but it does demonstrate the tremendous power of franchisors in most franchise systems. In many cases, franchisors have the right to change the conditions of the franchise agreement at stated intervals or simply by giving warning of their intent to change. Even such vital factors as prices or profit expectations any shift upon the whim of the franchisor. Franchisees who have spent years developing their business can suddenly find themselves with a sharply devalued property.

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Canada Post is a case in point. With 3,500 franchise locations in drugstores and convenience stores across the country, the postal service is Canada’s largest franchise operation, yet these days Canada Post is speaking to its franchisee association only through lawyers’ correspondence and neither side can agree on much of anything. What is clear is that Canada Post has changed the fundamental nature of the franchisee agreement and many franchisees will take a serious hit to their profits.

Clive Barrett is one of those franchisees. The 52-year-old British-trained engineer has owned convenience stores for 20 years and has worked hard to turn his Esso gas station and convenience store on the western outskirts of Fredericton, into a neighborhood magnet. In a bid to attract more customers to his location, he added a postal franchise in 1991, paying $5,500 for postal equipment and another $12,000 for leasehold improvements, as well as footing the bill for three employees to attend training sessions for five days. His postal outlet succeeded in generating traffic for his store and eventually turned a small profit of about $1,500 a year on sales of $85,000.

But Barrett’s tiny success story evaporated on Dec. 1, 1998, when Canada Post unilaterally cut the commission on stamp sales to 5% from the previous 17.5%. Barrett says his store will now be subsidizing the postal outlet and he’s mad. While he concedes that postal outlet draws people to his store, “there’s only a limited number of loss leaders you can sell without going broke,” Barrett says. He figures his postal outlet is now losing $3,000 a year even after accounting for a new subsidy that Canada Post is offering franchisees to help reduce the impact of the reduced commission. In his view, the postal service has effectively appropriated his profits.

Barrett’s situation is typical of many other postal franchisees, according to Jean Paul Sirois, chairman of the Association of Postal Franchises. His group, which claims to represent 1,300 franchisees, says the 5% commissions well below the break-even point for franchisees. He estimates that almost 200 franchisees have either abandoned or will abandon their outlets as a result of the change.

Canada Post insists those figures are wildly overstated. John Caines, the postal service’s manager of media relations, says only three outlets are closed on average every year. He emphasizes that Canada Post is granting subsidies to outlets to help make up for the money they have lost as a result of the reduced commission structure. Furthermore, Caines is deeply suspicious of Sirois and the association. “We don’t know who these people are. We don’t know who Mr. Sirois represents or how many dealers he represents. He’s a paid lobbyist,” says Caines.

Caines seems equally suspicious of Canada Post’s own franchisees – or dealers as Canada Post insists on calling them. “One of the reasons we had to get out of the exorbitant commission scale at 17.5% was to stop reselling. Many [dealers] were going outside their area, basically opening up a suitcase full of stamps and selling them at discount prices to other businesses… . It was costing Canada Post [millions] and was illegal.”

When a franchisor resists acknowledging a franchisee association and accuses many of its franchisees of criminal activity, you know you have a system close to implosion. And if one of Canada’s biggest and oldest organizations can come to blows with its franchisees, you have to wonder what goes on in many smaller organizations.

What makes these stories of acrimonious franchise disputes especially frustrating is that they scare would-be investors away from the many good franchise opportunities out there. It’s just too hard for a prospective franchisee to tell the good from the bad.

In the long term, consumers should push for a more open, more reliable industry. In an ideal system, each province would require every franchisor, regardless of size, to file a disclosure document every year and to make those documents publicly available. This document should contain financial statements, pro formas based on a typical operation, and a complete list of all past and present franchisees of the system. If the disclosure document is dishonest, franchisors should be liable for any losses a franchisee suffers. Legislation should set out restrictions on terminations, rules for renewal and the resale of franchises, and provisions against encroachment.

Until that day comes, franchisees must protect themselves. You should begin by asking the right questions. (For a short list of most important questions, see “So you wanna buy a franchise?”). But even if the answers look good, approach opportunities with caution. Keep in mind that the best systems are the hardest to get into. They will not accept someone who is investing their last nickel. They will send you to a screening agency for assessment or they will require you to do in-house testing. They will want to make sure you have good marketing skills, and they will give you good training. If they spend more time trying to impress you than assess you, run.

So you Wanna buy a franchise?

Seven simple steps can help you find the business that’s right for you:

1. When you go shopping for a franchise, begin by asking the basics. How many units does the franchisor have? How many company-owned units? How fast has the system grown?

While very fast growth sounds superficially attractive, it can strain management’s ability to live up to its promises. You should look instead for systems that demonstrate moderate, sustained growth. You should also look for franchise chains that include a number of company-owned units. Without them, a corporate parent can easily lose touch with the marketplace.

2. Once you have a picture of current operations, probe the system’s history. How long has the franchisor been in operation in Canada? Elsewhere? The longer the history, the more you can trust a franchisor’s projections.

3. Demand a disclosure document. Canadian Franchise Association (CFA) members are required to disclose specific information to prospective franchisees. (For more on the CFA, check out their Web site at www.cfa.ca) Systems that operate in Alberta and the United States should be able to give you the more detailed disclosure documents required by those jurisdictions. If the franchise you’re looking at doesn’t have a disclosure document, insist the franchisor draw one up in accordance with the CFA guidelines. If the franchisor balks, you should wonder why.

Check carefully for problems that may not be noted in the disclosure document. Ask the franchisor how many units have been closed, terminated, not renewed, or otherwise abandoned. Ask, too, if there has been any litigation between franchisees and the franchisor, past, present, or pending. Check to see whether there are any current problems in the system.

Get the franchisor to state in writing that the answers to all of these questions are full and complete. You are depending on the truthfulness of these answers to make an informed decision.

4. You should request a list of all current franchisees and all former franchisees who have left the system within the past three years. Make sure you get contact phone numbers and addresses. Interview as many of the names on the list as possible, especially people who did not renew their franchise agreement or left the system for some other reason.

5. Once you have winnowed your choice down to seemingly solid operations, ask for the franchisor’s financial statements (not their pro forma projections, but the income statements and balance sheet for the parent company itself). Remember that your investment depends on the financial health of your franchisor. If you can’t verify the state of the parent company’s finances, don’t invest.

When you get the financial statements, look carefully at the breakdown of the franchisor’s sources of income. If the breakdown isn’t given in the financial statements, demand those figures from the franchisor. If the operation derives most of its revenue from selling franchises rather than from collecting royalties on current franchises, watch out. You don’t want to sign on with a franchisor that puts most of its energy into peddling new units instead of serving its existing outlets.

6. Look beneath the surface of even the most solid-sounding franchisor. For $100, you can – and should – obtain a commercial credit report on the creditworthiness of the franchisor.

You should also probe the franchisor’s pro forma projection of expected sales and income. Ask how the franchisor arrived at those numbers. Does the pro forma reflect a typical operation? Where is it? Go see it yourself and interview the operator. Beware of any pro forma that projects sizable profits in the first year.

7. Hire a lawyer and an accountant to review the franchise contract. You may be able to renegotiate to some extent, but if many aspects of the deal strike you as overly restrictive, don’t be afraid to walk away. A draconian contract signals the interests of the franchisor will predominate over the interest of the franchisee in many aspects of the relationship. Pay special attention to the renewal terms in the contract. If there aren’t any, watch out. This means the franchisor can change the terms of the agreement substantially without your consent, and could undermine your ability to sell the business in the future.


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