A Cautionary Tale For New Franchisees

All had similar complaints: The Coffee Beanery, they say, never disclosed that the café stores were historically unprofitable; the equipment they bought was defective (and overpriced); and the basic business model of the café store was flawed. All said they ended up spending 30% to 40% more than they had expected to build their stores, and all are flirting with bankruptcy.

Forbes magazine
February 16, 2007

A Cautionary Tale For New Franchisees
Mary Crane

On its face, franchising promises the best of both worlds. You get to be your own boss while avoiding the bloody learning curve that comes with honing a new business model. Instead, you pay a (relatively) small fee for the chance to profit from someone else's proven concept.

That's the way things are supposed to work. Reality, of course, is another cup of java.

At least five franchisees of Flushing, Mich.-based Coffee Beanery found that out the hard way. One couple, Deborah Williams and Richard Welshans, sunk $1.6 million into an Annapolis, Md., café they opened back in January 2004. They allege that Coffee Beanery-now with 131 locations in the U.S. and 25 overseas-duped them into buying into a failed business concept. The couple says their store has never turned a profit, and they are now fighting to recoup their losses in arbitration. (The Coffee Beanery declined repeated Forbes.com requests for comment.)

Williams' and Welshans' struggle serves as a cautionary tale for all wannabe franchisees. And their ranks are growing: The number of retail food franchises in the U.S. jumped 28%, to 561, between 2003 and 2005, according to FRANdata, which tracks franchises. Surging, too, are the number of lawsuits brought against franchisers: Susan Kezios, of the American Franchisee Association, estimates that franchisees bring at least a dozen such lawsuits every month. (It's impossible to track the exact number because many cases are settled out of court.) On the flip slide, franchisers argue that franchisees simply bite off more than they can chew as business owners.

These skirmishes can sting on both sides. Quiznos is still doing damage control after Bhupinder Baber, one of its California franchisees, committed suicide (in a Quiznos bathroom) last November during a legal battle with the sub-sandwich maker over alleged false representations. In the same month, 28 other Quiznos franchisees filed a class-action lawsuit against the company for allegedly forcing them to buy food and supplies at unfair prices and for misrepresenting or omitting facts about the company's operations.

In recent years, franchisees with Pizza Hut, KFC (owned by Yum! Brands (nyse: YUM - news - people)), Denny's (nasdaq: DENN - news - people), Burger King (nyse: BKC - news - people) and Sonic (nasdaq: SONC - news - people), among others, have formed associations to keep franchisers in check. The 28 plaintiffs in the Quiznos class-action suit are also members of the Toasted Subs Franchisee Association.

A common problem in all of this: Too few franchisees thoroughly digest their disclosure documents, sometimes called a Uniform Franchise Offering Circular (UFOC). This document-required by the Federal Trade Commission's Franchise Rule-stipulates that franchisers must disclose information about themselves, their business model and the franchise relationship before any agreements are signed.

"Generally speaking, when a franchisee has a complaint, it's irrelevant to a judge or arbitrator because the contract says 'This is it,' " says Peter Singler, a franchise lawyer at Singler, Napell & Dillon. (He suggests that fledgling franchisees hire a lawyer and an accountant right at the beginning to avoid any snags.)

Getting a solid handle on that document is even more critical considering that, under the Franchise Rule, the Federal Trade Commission (FTC) isn't required to review franchiser disclosure documents, often hundreds of pages long, for completeness or accuracy. Scarier still: Only 15 states have franchisee-protection laws on the books.

Big Promises
Deborah and Rick's story began back in the spring of 2003 when Rick lost his job as a sales representative at chemical maker Rohm and Haas. Neither had worked in restaurants before. "We wanted to get away from a big [company] atmosphere and do something smaller," says Rick. "We were looking for a small company franchiser that has already gone through all the problems you would go through [as an independent entrepreneur]-someone with a proven system and a program of success." They surfed the Internet for coffee shop franchises and ended up at the Coffee Beanery.

At headquarters the couple met with Rick Greenbaum, head of franchise development. Greenbaum told them Coffee Beanery was moving away from its smaller coffee bar, coffee cart and kiosk-style models and was focusing more on a new franchise concept called the "café store." These were bigger, more expensive and required franchisees to sell sandwiches, wraps and pastries in addition to coffee-related products.

When the couple balked at the price tag, Vice President of Development Kevin Shaw, they say, reassured them they could expect to clear $125,000 per year as café store franchisees. Impressed, the couple left Michigan with a signed agreement in hand; seven months later, they were open for business.

But trouble wasn't far behind. "We realized something wasn't right even before we opened," admits Deborah.

For starters, Rick says, the mandated store design wasn't conducive to crowds—everyone bunched up near the front so the store looked extra busy, deterring passersby. The two cash registers were a pain, too: They couldn't be used at the same time, couldn't ring up customized food orders and would repeatedly freeze and shut down, he says. On top of all that, he claims, the refrigerated display cases were defective; water would pool at the bottom, damaging the food.

Coffee Beanery's financial condition is in similar soggy shape lately. For every franchise sold, the company receives an upfront $27,500 fee. (It also collects ongoing royalty payments.) But Coffee Beanery pulls in most of its revenues-roughly 63%-selling its equipment and products to franchisees, according to its latest UFOC for the fiscal year ended June 30, 2006. In that year, Coffee Beanery squeaked out just $24,295 on nearly $14 million in revenue. Meanwhile, cash flow from operations-arguably the most honest measure of a company's health-had plummeted 78% since 2004. Starbucks, this isn't.

Confounding Contracts
Rick and Deborah maintain that the Coffee Beanery played fast and loose with the FTC's disclosure rules. Had the company been more upfront about the costs involved in opening a café store, the couple never would have invested in a Coffee Beanery franchise, they say.

A cornerstone of their complaint filed with the Maryland Attorney General's Office: In its 253-page offering circular, the Coffee Beanery didn't distinguish between its traditional stores and its café stores, making it difficult to analyze just how profitable the café stores really were.

While the Coffee Beanery is required by the FTC to list the number of stores that were opened, in operation and closed during the previous fiscal year, the company didn't separate the data on its café stores from those of its other franchises. Harry Rifkin, an attorney with Cohan, West, Rifkin and Cohen who represents the couple, claims that 60 to 90 café stores have opened in the last 10 years, and only one ever saw a profit.

Another problem: Though Coffee Beanery was required to list contact information for owners of current and terminated franchises, the company didn't break out the information specifically for café store owners. So, "the odds of finding and calling a café to talk to someone working a store you'd be buying were small," says Deborah.

About that $125,000 in annual profits? Because the UFOC says Coffee Beanery cannot make any sales projections, Rifkin argued that Shaw's alleged oral pronouncement violated franchise law.

Last September, the Maryland Attorney General's Office found the Coffee Beanery in violation of Maryland franchise law for "making material misrepresentations" regarding its franchise offering. In accordance with the attorney general's order, the company agreed to release all Maryland franchisees, including Rick and Deborah, from their obligations under their franchise agreement. This meant returning the initial franchise fee and payments for all products bought from the Coffee Beanery, but not lost wages, operating loses, lease obligations or store build-outs. Rick and Deborah refused—choosing instead to fight to recoup all their losses in arbitration.

In Sad Company
Rick and Deborah aren't the only ones whining about Coffee Beanery. Four other current and former franchisees were willing to go on the record with Forbes.com about their experiences. All had similar complaints: The Coffee Beanery, they say, never disclosed that the café stores were historically unprofitable; the equipment they bought was defective (and overpriced); and the basic business model of the café store was flawed. All said they ended up spending 30% to 40% more than they had expected to build their stores, and all are flirting with bankruptcy.

Robert Griffith, who opened a franchise in Maryland in February 2004, accepted his rescission letter and is now refinancing his house to "dig out of a very, very big hole." In spring 2005, Oliver Garner spent $300,000 to open a café store in Chicago and sold it a year later for just $85,000; he is now $400,000 in debt. Marysue Shagena-Leven in 2004 opened a café store in Ferndale, Mich., with her son, Scott; the two are now $1 million in debt and are trying to sell their store.

Kay Hur, of Ann Arbor, Mich., sunk $600,000 into her café store and is facing bankruptcy; she promised not to sue the Coffee Beanery if they would help her sell her café store. Says Hur about the business model: "It defies economics 101."

Lessons Learned
For its part, the Coffee Beanery has updated its offering circular. It now separates out café stores from the rest, listing turnover rates as well as current and former franchise contact information. By the end of 2006, there were 37 café stores; 10 locations had closed since 2005.

As for Rick and Deborah, they await the results of arbitration in Michigan. The fate of other disgruntled franchisees may well hang in the balance. Next month Oliver Garner, the Chicago franchisee, hopes to begin his own arbitration hearing in Michigan.

Says Rick: "Maybe we were naive. We thought everything was on the up and up, and they seemed like a reputable company." Adds Deborah: "You'd think it was a nice family-run business. Boy, were we fooled."

Risks: Liar Loans, Multi-tradename franchisors are often the most ruthless, Susan Kezios, American Franchisee Association, AFA, Raining litigation, Lawsuits, class action, Bob “Bhupinder” Baber, Franchisee leader, Violence, Suicide, Health consequences, Suicide committed in franchised store, Gouging on supplies, Independent franchisee association, U.S. Federal Trade Commission, FTC, Uniform Franchise Offering Circular, UFOC, Misrepresentations, Bankruptcy, Rescission United States, 20070216 A Cautionary

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