Franchising A1 – Loving the Deal Not the Business

While some franchises do offer a good business concept, there are many scams out there and many businesses serve as fronts for organized crime and money laundering. Also many franchises are nothing more than a pyramid scheme the only beneficiaries being those first pioneers of the franchise.
July 8, 2009

Franchising A1 – Loving the Deal Not the Business
Melanie Naidoo & Garsen Subramoney

This is a piece taken from my company blog and written by my business partner Melanie Naidoo.

We (Erasibo) have dedicated this blog to put up a number of thought pieces on the franchised restaurant industry in South Africa. We do this because the franchised restaurant industry has great personal interest for us as a result of our recent experience of having bought, run, cancelled the sales agreement and sued the franchisor. As management consultants we have worked with researching, conceiving, redesigning, managing, marketing and evaluating all ranges of businesses- big and small. So when confronted with the challenge of buying a suitable franchised restaurant- it seemed like a “no brainer”! After all we had evaluated and ran much bigger business investments, and restaurants have been an area we have researched extensively. In addition most franchisors we encountered were not the most sophisticated business people. In fact many were poorly educated but flamboyant characters. Plus we had resources to support our decisions- we had assistance from deal makers who put together billion rand investments and one of the oldest and largest law firms in the country (been around since the days of the gold rush). So we were ready to take on this industry and make it a success. But still we got scammed. Being scammed hurts your pride as hard as it does your pocket. But the experience of it has been priceless. We have interrogated all aspects of the business in detail. We have learn an incredible amount about the contracting, financing and operating a franchised business in South Africa We have also discovered a great interest in the prevention and investigation of fraud in businesses- which has become a new area of consulting for us. We have developed amazing contacts in forensics and with the specialised units of the police and security industry and banks. There are unique aspects to South African businesses, from its closeness to organised crime to its labour issues. We (Garsen and myself – Melanie) shall share with you some of the pointers and tricks to surviving a franchise investment in subsequent articles in the hope that you will benefit from our experience, research and learnings.

Lets fall in Love:
So we made a few mistakes. The first being that we found love. We found it in the business we wanted to buy- it was doing a great trade in a “recession proof” end of Johannesburg. We liked the franchisor they were young, daring and dynamic with a fast growing empire. We also liked the partnership approach they adopted to working with their franchisees and saw much potential for working together with them to build something better. This fit well with our needs. We did not originally come from a background in retail; in fact we have spent the last many years of our working career scoping, designing, marketing and rebuilding businesses of others. Broadly referred to as management consulting. Consulting is fabulous, intellectual, challenging and we had gotten really good at creating something from nothing. But we needed more ownership, more emotional investment. Food has always been my idea of sensuality-passionate love (sad I know!). So finding this fit of restaurant and franchisor felt like the coming together of a puzzle. That should have been the first warning sign. Anything too good to be true- usually is! But this was pure seduction and we were in love with the idea of the business. So this brings us to our first lesson we share with you, of loving the deal and not the business.

Whatever your motivating to get into franchising- whether you are looking for something low risk to start- working off a proven business concept, or have extra cash to put into an investment or been enticed by the advertised success rates or the business itself and the prospects thereof. Whatever the reasons, negotiating for the business has to be the prime focus and not the business itself. How you negotiate for the purchase inevitably determines what happens thereafter in your business not sparing your leverage should you engage in legal battles with the franchisor. Unpleasant as this thought may be. A business doesn’t come with guarantees and no one is going to take care of your interests except you. So diligently cover all the areas of the contract and be more persistent than the franchisor is resistant, make sure you get what you want from a deal or you take your business elsewhere.

About the Contract:
The most important vetting exercise is really to find out how you can be in this business that you think you like without signing a franchise contract. If you can do that effectively, your return on investment over what would have been the franchise period will be at least double. And, no matter what they tell you, franchisees never have a better chance of success than independent, unaffiliated new business start-ups. The likelihood for success is exactly the same either way. Unless you are buying into a big brand concept, like a McDonalds or KFC which has a unique product that customers identify with. Being someone’s franchisee makes absolutely no difference whatsoever. There are usually many ways to obtain equivalent start-up and continuing support assistance without having to sign a franchise agreement. You just have to take the trouble to find out where they are. In most cases what you pay to set up a business or for the acquisition of an existing business is far in excess of the value of the business you are buying. Furthermore you continue to pay royalties for a name which in most cases has limited capital but comes with high restrictions that impact on your ability to survive in a changing economy. Also ensure that you know what comes along with your franchise contract. Franchise rules, license products, standard menus etc are all part of the package. These must enhance your business’s chance of survival and not just create another avenue of income for your franchisor- who is now able to force you to purchase new products which they have licensed that may be a lower quality, higher priced good that impacts on your business’s profitability. The Franchise contract must specify these products and the applicable quality standards. I have fond memories of returning deliveries of burnt coffee beans and putrid meats to the franchisor only to receive in return letters claiming breach of franchise agreement. The representations about the wonderful support that you can expect to receive as a franchisee are always overstatements. ‘You are in business for yourself, but not by yourself’ is the mantra. Don’t believe everything you hear- read the contract to see what you are really being promised. The contract always says — in some form of legalistic sounding language — that you get whatever support the franchisor feels like providing from time to time. That’s it. There is never a contract covenant to provide competent and competitively effective support. But nobody ever figures this out before the franchise investment is made. It is always discovered after the fact, when it is too late and you have bought nothing but the right to sue, if you can afford to sue. Buying the right to sue is always a bad investment! Consult a lawyer who specializes in franchising. Consider the time and money you put into hiring an expert as an investment in your future. A lawyer can tell you what your rights are in a specific situation and help you craft the right business plan to protect your business. As a business owner, you owe yourself nothing less. Consider the old saying” free advice is worth every cent that you have paid for it”. One of the primary reasons that franchise scams still exist today is due to the individuals who do not do their homework and invest in these “opportunities”. They allow the bad opportunities to remain in business. Go on line and research news stories about the company and the industry. Visit their web site and get information about their consumer offering as well as their franchise offering. Learn what you can about their management and thoroughly research their background. When you first contact the company ask them about the process they use in selecting franchisees. If you get the sense that they don’t select franchisees but are in the business of selling franchises, that’s the first indication you should have that the franchise is risky. If the company is willing to “sell” you a franchise before you can perform a thorough evaluation of them and they can perform a thorough evaluation of you, that’s another indication of a poor franchise system. If on top of that the salesman you are talking with is not an employee but an outside sales broker that’s even a stronger indication. Remember, unless you buy, the franchise the brokers don’t earn any money. Never pay any monies or deposits upfront. Any franchisor who asks for money before you are happy to commit to an investment cannot be trusted- they are interested in making a sale and not the success of your business.

Conducting the Due Dilligence (sic):
Start off with the disclosure document. Once you get the disclosure document be prepared to analyse it thoroughly. If this is an opportunity that still interests you after you read the company’s information, you should engage a qualified franchise attorney, consultant or accountant to help you in conducting your due diligence. The franchise salesperson or broker works for the franchisor and should not be a source of advice that you rely upon. Neither is your bank. Your bank’s only interest is whether you can pay back your loan- and it’s all the same to them if it’s from the proceeds of a successful business of the repossession of everything you own. So don’t rely on your banker’s advice with regard to the credibility of the franchisor. They will not take responsibility for this advice when the deal turns sour. Rely only on the qualified resources you hired to help you with the due diligence. What is the financial condition of the company? Your investment is likely to be significant. In some franchises between debt and equity your investment may be more than seven figures. What about the franchisor, will you have more skin in the game then they do? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue or are they relying on the sale of the next franchise to make payroll. Even new franchisors need to have financial resources to meet their commitments.

Whats the Franchisor’s Litigation History?
Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they are able to still maintain a good relationship with their other franchisees than that type of litigation is an indication of a strong and responsible franchisor. However, if there are pages upon pages of lawsuits from franchisees in the disclosure documents, that is not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyse the franchise litigation. These are just a few of the questions you will need to assess in determining whether the franchise is a scam. Your outside advisors will be able to help you put aside your entrepreneurial burn to get into the game and assist you in conducting a proper due diligence on the opportunity. Don’t get into a franchise unless you have the assistance of a qualified expert. The franchise salesman that has befriended has the advantage of having been through the selling process hundreds of times. This is likely to be your first experience.

No Current Franchises:
Treat a franchisor that has few or no current franchises with extreme caution. In the past, it has not been unheard of for companies that have never actually opened a single operating unit to aggressively sell franchises to unsuspecting franchisees. Naturally, the few franchisees that were eventually able to open for business failed because the company’s franchise business plan was ill-conceived and had never been tested. Minimally, the franchisor should be able to document the success of several existing franchises. They should also be willing to put you in touch with current franchisees so that you are able to confirm their success firsthand.

Inferior Selection Process:
Something else that should make you cringe is an inferior selection process. Quality franchisors run potential applicants through a fairly comprehensive selection process. This process screens applicants not only for their financial capacity to purchase a franchise, but also for their industry experience and their ability to manage a small business. If a franchisor doesn’t seem to be interested in any qualifications beyond your ability to buy into the franchise, bells and whistles should be going off. It’s quite likely that the success of the franchise isn’t a real concern for these franchisors. All they’re really looking for is a way to make a quick buck – at your expense.

Lack of Verifiable Financial Data:
Legitimate franchisors should also be able to produce verifiable financial data for the company as well as data for individual franchises. This information is vital in helping you assess the feasibility of owning a franchise should you decide to do so. You not only need to know the earnings of a typical franchise, but also whether or not the company’s financial position is sound enough to ensure its long-term survival. If a franchisor is hesitant or unable to produce financial data it’s usually because the numbers don’t paint a very rosy picture. Make sure that you get raw sales data as well as financial accounts. Financial accounts which are provided are only useful if they are audited statements and not internal management accounts. You must be able to get your auditors to do a verification of these figures from the raw data sources and an audit of equipment that is part of the sale. Remember the registration numbers of equipment on the audit must match that which you receive as part of the sale. Also compare the financials with what the franchisor says it is paying in tax- this gives you a good indication of income and/or the honesty of your franchisor. Avoid investing in a franchisor that is changing banks at the time of your deal. You may not know the reason for this decision, but it does break the “audit trail” and that prevents you from getting essential information.

Inadequate Disclosure Documents
Franchisors are required to provide franchisees with disclosure documents specifying the details of franchise ownership within their company. If the disclosure documents are overly vague and the franchisor is unwilling to fill in the blanks with details, run away from the opportunity as fast as you can. Otherwise, you risk becoming tied into a dead-end business with little (if any) legal protection for your interests. This disclosure must also include breech letters from landlords, financiers, health and other violations and summons and all licenses contained by the business. Finally, make sure that the contract is everything it is supposed to be. If they promise that you will make a certain amount of money or that your expenditure is pitched at a certain level, you need to get it in writing in the contract, otherwise, you have no guarantee that they will follow through on that promise. Also, it is strongly recommended that you get a lawyer to read through the contract before you sign anything, no matter how confident you are in your ability to understand it and the reputability of the company. Experience does count so bring in a specialist- much better to avoid the bitter personal experiences. While some franchises do offer a good business concept, there are many scams out there and many businesses serve as fronts for organized crime and money laundering. Also many franchises are nothing more than a pyramid scheme the only beneficiaries being those first pioneers of the franchise. So beware in your dealings and look out for inconsistencies and hesitations- you could be dealing with a scam. Pay upfront for good advice its way cheaper than the forensic and legal costs that follow later if the business deal was not transparent and turns into a failure or a fraud. At the end of the day- all business is a risk. There are no guarantees against outright and clever fraud, as we had discovered in our own experience. But the above pointers protect you against the likelihood of you being a victim of a scam. Most importanty don’t begin any negotiations until you have worked out what you are looking for in deal. If the deal on the table is not the deal you want- simply walk away. There are many other options available to you. Do not compromise. Look for the deal you will love.

Brought to you by

Risks: Banks are industry cheerleaders, Can't afford to sue, Confidence game, Due diligence, Due diligence cannot predict or prevent post-sale franchisor opportunism losses, Due diligence cannot stop a predatory franchisor in the future, Due diligence is irrelevant, Fell in love with the concept as a consumer, bought the franchise, Fraud, Fraud financed by rigged appraisals used equipment & leaseholds, Fraudster franchisor, Independent businesses much higher profit than franchised ones, Independent businesses survive longer than franchised ones, Money laundering, Must buy only through franchisor (tied buying) , No franchisor support, Organized crime, Overconfidence effect, Ponzi (pyramid) scheme, Pride, Proven business model, Risk much higher for franchisee than independent business, Seduction, Success rate, we don’t know, Professor Timothy M. Bates, Universities are in the business of pursuing objective truth, Universities provide unbiased expert knowledge, South Africa, 20090708 Franchising A1

Unless otherwise stated, the content of this page is licensed under Creative Commons Attribution-ShareAlike 3.0 License