Risky Business: Pursuing The American Dream With A Franchise

What To Look For Before You Invest In A Franchise System
by Robert Zarco, Esq.

For many, franchising is a way of fulfilling "the American dream." For others, it is the beginning of a long, hard-fought road toward financial success. Although the investment in a franchised system may ultimately yield significant monetary rewards, there are numerous traps and pitfalls potentially threatening the unwary. Franchise investors, even in the best of systems, must tread cautiously.

Since founding my firm in 1992, I have represented and counseled franchisees in nearly 150 different franchise systems around the globe in disputes with franchise giants such as Burger King, McDonald's, KFC, Schlotzsky's, TGI Fridays, Dunkin' Donuts, Bonanza Steakhouses, Ramada, Days Inn, Best Western Hotels, Denny's, Quality Inn, as well as smaller, less well-established systems. Even since 1992, franchising has expanded beyond fast food and hotel/motels to numerous other industries, such as healthcare, temporary staffing services, child care, senior services, internet franchises, tanning salons, etc. In addition to encroachment claims, my clients' disputes have encompassed breach of contract, fraud, violation of franchise statutes and the Federal Trade Commission rule, misrepresentation, unfair trade practices, improper termination, in addition to many others.

Franchising has been, and continues to be the boom-industry of the 1990's -- there are over 850,000 franchised outlets nationwide, and undoubtedly franchising will continue to grow as we approach the new millennium. Franchising is the most popular method of growing businesses today. Franchises account for more than one-third of all retail sales in the United States, according to Francorp, a Chicago consulting firm. Indeed, a brand-new franchisee opens for business approximately every eight (8) minutes. By the year 2000, franchised businesses will likely generate fifty (50) percent of all retail sales.

Nevertheless, there is a downside to these rosy projections. Franchises are a low-cost method for companies to expand their businesses, and may tempt companies to enter the fray, unprepared to support a franchise system properly. For every investor seeking an opportunity, there is a company attempting to lure eager, but uninformed, buyers into purchasing a pipedream. Nor is it inexpensive: Some franchises cost upwards of $ 500,000 in capital investment, franchise fees, start-up fees, and almost 20 percent of gross sales for rent, marketing royalties and advertising.

In considering franchising as an investment, it is important to keep in mind the following:

• Invest in what you know. People who pursue their heart's desire often perform better than those who enter a "hot" industry just because it is in vogue. Remember: purchasing a franchise is likely to be a 15-20 year commitment. I tell my clients that it is like everything else -- if you like what you do, you will give it 110%, and thus, achieve greater financial and personal success than if your true passion lies somewhere else.

• Study the marketplace. Interview existing franchisees about the company's track record of living up to its promises of providing service and support to franchisees. Visit potential franchise sites and monitor the customer traffic and the unit's operation. In assimilating the input of existing franchisees, also be skeptical. Current franchisees may see you as potential competition and skew their answers so as to divert potential "inside" competition.

• Review the Company's Financial Statements. Do not place blind trust in any company's performance statistics or financial statement summaries. Frequently, the selected numbers are extremely confusing or misleading. Analyze financial statements and market performance, and be particularly wary in dealing with smaller and newer franchisors. Consult with your accountant or attorney to evaluate the franchisor's financial strength and resources available to provide its franchises with the support and services it has promised. No matter how sincere the franchisor's present intentions, if it lacks the proper infrastructure and financial resources, it will not be able to provide the promised services down the road.

• Review the UFOC and Franchise Agreement Carefully. Franchise Agreements are not your typical business contract. Hire an experienced franchise attorney to prepare and review the transaction documents carefully. Experienced franchise lawyers have been trained to spot potential trouble-spots in franchise agreements and disclosure documents. They will likely recognize a potential problem before it is too late to repair it. Attempt to verify with independent sources the franchisor's assertions in the Federal Trade Commission disclosure documents -- prior to signing anything, to determine whether the company's representations are accurate. Most importantly, compare the two essential documents -- the Franchise Agreement and the Uniform Franchise Offering Circular (UFOC) -- make sure that their terms do not conflict. Generally, the Franchise Agreement's terms will trump the more positive assurances in the UFOC documents.

• Look Ahead. Does the contract permit you, the franchisee, to renew the franchise license automatically after the initial contract term? Certain franchisors retain almost complete control over who can renew the franchise agreement, and under what circumstances. Some state franchise statutes require automatic renewal for qualified franchisees, but these protections are not uniform across state lines. Assuming that your business performs well financially and operationally, you should be the one to decide whether you wish to continue in the business for a second term.

• Get More From Each Advertising Dollar. You will be paying a significant amount of fees for local, regional or national advertising. To optimize the resulting benefit, try to negotiate a requirement that any national or regional advertising campaign also be extended to your market area. Follow up to make certain that the advertising dollars are being applied to advertising expenses, (i.e., to benefit franchisees), and not for any other function. It is not uncommon for franchisors to spend advertising dollars to finance corporate operations or other ventures unrelated to marketing or advertising.

• Ask to See the Franchisor's Business and Market Development Plan. This document should reveal where the franchisor's resources and market development and growth intentions are now, and what the franchisor's plans are for the next few years. You should be able to determine whether the franchisor's vision for the future is consistent with what the franchisor is telling prospective franchisees, and if it is reasonable, based upon the concrete facts contained in the plan.

• Promises, Promises. If the franchisor makes a promise, get it in writing. Consider verbal promises and agreements -- especially without witnesses -- worthless. Verbal promises can rarely be considered in legal disputes concerning what happened prior to your signing the franchise agreement. Furthermore, with the rapid rate of corporate executive and management turnover, it is unlikely that the individual who made the promise will be the one in charge several years from now. Follow-up every conversation encompassing promises with a confirmation letter to the Franchise Department. The franchisor's lack of response or failure to dispute your recollection may determine your legal right to enforce that promise later on, should the situation necessitate a lawsuit. Do not rely on any promises, representations, statements or agreements, even if in writing, if made prior to signing the franchise agreement. There usually will exist an integration or merger clause in the franchise agreement that will make such prior agreements invalid and unenforceable.

• Don't get eaten alive. To decrease the potential for intrabrand competition, try to have your franchisor commit -- as much as possible -- to a definition of your "market," or territory. Include in your franchise agreement your right of first refusal to purchase stores planned in close proximity to your own, or include a provision for the franchisor to compensate you for the decline in revenue and/or market share your store will suffer as a result of the encroachment. Be sure to request, in writing, the company's encroachment polices and future development plans for new stores in your market area and neighboring trade areas. The franchisor's failure to disclose a known, material fact at the time of your purchase, which might affect the value or viability of your franchise, may be evidence of franchisor fraud and/or misrepresentation.

• Thanks for the memories .... If you decide to sell your franchise, who chooses the buyer? The franchisor should be willing to approve any reasonably-qualified buyer with the financial wherewithal and operational acumen. The franchisor should not retain sole discretion over the decision, so as to be able to withhold its approval of a buyer unreasonably. Franchisors can, and do, use this unbounded contractual discretion to extract concessions from its franchisees later on, or to control who the purchaser is, or the price at which you are permitted to sell.

• Beware of restrictive covenants. Depending upon the state law applicable to your franchise agreement, you may be negotiating away your ability to earn a livelihood, should you decide to terminate, (or should the franchisor decide not to renew) the franchise. Restrictive covenants hidden within the franchise agreement may preclude you from operating a similar type of business within a prescribed area well after your relationship with the franchisor is over -- for a number of years. Be attentive to these provisions, so as to keep your all of your options open, should this venture turn out to be less than ideal.

• Keep it Close to Home. Sometimes venue and jurisdictional provisions require that any dispute which arises out of the agreement must be resolved in the courts of another state, even if that forum is on the other side of the continent. Read the franchise agreement carefully for provisions requiring lawsuits or arbitration proceedings to be filed in a certain state, or court. You must also consider which state law governs the relationship or any disputes which arise subsequently. Such provisions can prove to be quite costly in the future and create an unequal bargaining position in the franchisor's favor.

• Negotiate. Frequently, a franchisor will not allow many changes to be made to its standard franchise contract. Remember, a franchisor will never bargain away its right to self-protection, but you will maximize your negotiating strength in a partnership with experienced franchise counsel. You will also be armed with an increased understanding of those terms which the franchisor considers to be the critical aspects of the franchise agreement, should the character of the relationship change over time.

• Avoid the slippery pen. Do not sign any documents, regardless of apparent time pressures, without first consulting a franchise attorney. Oftentimes, the contracts contain hidden releases or other clauses, which may prejudice, or even preclude entirely, past, current or future claims which you may have against the franchisor. If, in the future, a court reviews the circumstances of the transaction, it will presume that you have read the agreement carefully, with the advice or opportunity to obtain the advice of an experienced attorney, whether or not that is actually the case. Read everything carefully, and ask your franchise attorney about anything that is unclear to you -- even seemingly-ordinary English phrases take on a special significance when they appear in a franchise contract. Be sure to take advantage of all the available resources to protect your very substantial investment -- this is not the time to take shortcuts.

Franchise law is a rapidly evolving area; participants need both an in-depth knowledge of the legal points, coupled with an understanding of the business issues involved in the franchised industries.

The courts and the legislature attempt, with varying rates of success, to keep pace with the frequent changes, but also rely heavily upon the private sector, including franchise attorneys, for guidance. As a an internationally-recognized law firm which specializes in franchise litigation, Zarco & Pardo has been, and continues to be involved in franchising as an emerging industry by representing franchisees, advising franchisee associations and organizations, and promoting educational and legislative efforts on franchise issues and concerns.

Robert Zarco has, and will be contributing to the AAHOA's monthly publication as a featured columnist and as a speaker on franchise issues in several of the AAHOA regional conventions. He will also be making a presentation at the AAHOA annual convention in Las Vegas in January, 2000. The author welcomes comments and suggestions pertaining to that column or to his presentations. You may contact Robert Zarco, Esq. at the law firm of Zarco Einhorn Salkowski & Brito, P.A., Bank of America Tower, 100 Southeast Second Street, Suite 2700, Miami, Florida 33131; by Telephone at (305) 374-5418; by Facsimile at (305) 374-3428; or by e-mail at zarco@zarcolaw.com.