Encroachment

Point-Zarco

Franchisee Update, 2nd Quarter 1994

 There is a direct correlation between the likelihood of franchise legislation being enacted which addresses the current and sever problem of encroachment/impact facing franchisees and the need for the existence of such legislation to provide protection for the franchisee.

Encroachment is an unfortunate reality for franchisees.  Franchisors have built-in incentives to impact existing units because additional units will increase their profits.  Because most franchisors' revenues are derived from franchisees paying an upfront fee and royalties as a percentage of gross sales, a profit driven incentive exists for franchisors to develop as many stores as possible in a given market.

Every new store or unit represents a new franchise fee plus a net gain in additional royalties for that region.  By way of example, the franchisor would benefit greatly when existing Store A's sales go from $1,000,000/per year to $700,000/per year, if the new Store B, with its newly decorated motif and state of the art equipment generates sales of $900,000.  The franchisor has obtained a net royalty gain on $600,000 of additional sales volume; not to mention the additional service fee and advertising dollars which would need to be paid by the new franchisee.  The original franchisee is now faced with a major problem! Sales have diminished to the point where the existing unit is now marginally profitable if at all, and the franchise agreement commits the franchisee to a 15, 20 or 25 year term.  If franchisee A, who has lost approximately $100,000/per year in gross profits, based on a marginal rate of 33% of sales, is able to sell his/her unit, he/she will be further damaged because the equity has been stripped away from the now decreased value of the store.

Franchisors customarily value their stores for resale based on a percentage of the preceding twelve months gross sales or on an analysis of net cash flow derived from operations.  This "trailing twelve" percentage in the fast food industry for example is approximately 50%-60%.  In the above example, Franchisee A's unit is now worth approximately $150,000-180,000 less (50%-60% x 300,000 yearly in lost sales) virtually wiping out any equity which the franchisee has invested and has earned during his many years of hard work.  Shouldn't the franchisor then offer a qualified existing franchisee, who is closet to the encroaching store, the new store?  After all, it would help offset any decrease in revenues in the existing store with the additional revenues of the new store.  However, as logical as that may sound, historically most franchisors do not use this approach to choose who will get the new store.

Regardless of whether the existing franchisee gets the new store or not, the franchisee should be compensated for loss of profits and diminution of value in the existing store, since the franchisor is the one to gain the most from this debacle.  The slight benefits that the existing franchisee gains from increased market penetration and brand name recognition, as well as addition advertising revenues attributed to a new store in the system, is greatly outweighed by the serious financial impact this "newcomer" has on the existing franchisee's ability to remain financially viable and able to continue as a going concern in the future.

The franchise agreement, currently viewed as the governor (due to the onerous and burdensome terms contained there in which practically take away all of the franchisee's rights to independent control their business) of what in actuality is better described as a master indentured servant relationship usually offers little or no encroachment protection to franchisees who have not been grated an exclusive territory and whose agreements expressly reserve the right for the franchisor to place a competing unit an any location of its choice.  Since most new franchise agreements contain "no exclusive territory" and "specific location" language and now increasingly a "reservation of right to place a competing unit at any place of our choice" statement, franchisees have no place to turn to for protection when their existing agreements (which may or may not grant exclusive territories) are up for renewal. 

What are franchisees, who have been in the system for twenty years, now supposed to do at mid-life after their territories have been taken away and new stores are starting to pop up all around them?  Are they supposed to simply walk away from the business they have grown with and developed for so many years?

Franchisors are quick to argue that if they do not place the unit in a particular location, a competitor will. The reality is that any franchisee can compete with another brand effectively. Brand and taste preferences, together with effective marketing, can preserve a particular customer base.  This is much more difficult, if not impossible to accomplish when your "competitor" provides the same brand, the same taste, the same product, and the same marketing in a newer, cleaner, more up-to-date and technologically advanced package.  No franchisees can compete under these circumstances, unless they expend a significant amount of money necessary to improve their services, remodel, reinvest in the physical place, and market and promote their units so as to recuperate their lost sales!  Shouldn't franchisees expect that any further reinvestment of funds in the business is to improve their sales from where they were before impact, rather than for the purpose of playing "catch-up"?  The need is self evident; but only to those in government and elsewhere who are in fact aware of how prevalent this misfortune is that befalls so many unsuspecting franchisees.

Awareness is created by franchisees advising their public representatives and senators through letters and the media of their plight and the resulting consequences.  It will be very damaging to the local, state and federal economies if the small business/franchisee follows the fate of the dinosaur, where the only remaining franchisees will be the multi unit operators who play golf and are otherwise the "favorite sons" of these large corporations.  Once these government officials become aware of the extent of the problem, it is very likely that new legislation will be enacted which addresses the issue.

Movements led by the Chicago-based American Franchisee Association and various independent franchisee associations from major systems, to educate state and federal legislators at public hearings throughout the country, as well as gross-roots lobbying efforts, have brought this franchisor-franchisee relationship problem to the forefront.  Various states in which the AFA and I have provided expert testimony at their public hearings, have recently taken very positive steps towards passing fair franchising legislation.  Several bills have been introduced and survived committee scrutiny despite tremendous efforts by the franchisors to invest millions of dollars at thwarting any effort to level the playing field between the franchisor and the franchisee.

A frequent problem which arises, and understandably so, is how do you measure encroachment?  Different industries have different standards and geography; demographics, population and other factors make the establishment of a rigid formula unworkable.  Perhaps, requiring the franchisor to share the wealth (the additional royalties and fees) with the franchisee which helps restore the franchisee to a profit level which is close to what it was prior to the encroachment, is a fair and reasonable measure which would be considered good faith and which will not deny the franchisee the right to reap the fruits of the contract and many years of dedication to the system and hard work.

Franchisors argue that government should not intervene in the franchisor franchisee relationship, as the same is governed by a contract.  They argue that it is not the function of legislators to rewrite contracts.

This argument has several major shortcomings. First, contract law assumes that the parties have equal bargaining power and that neither side used such power to create what in reality is an unconscionable contract.  Abusive provisions and unscrupulous language frequently become attached to these "adhesion contracts" because the franchisees are powerless to negotiate them away.  It is usually a "take it or leave it" situation.  When you are promised the pot of gold at the end of the rainbow or a chance of, fulfilling the American dream, most unsuspecting individuals "take it."

Another shortcoming of this contractual relationship is that a franchise agreement is not simply a contract, but a horse of a different color.  Generally, contractual relationships are shore in duration and therefore, allow the parties to anticipate how the relationship will unfold.  Surprises are few in such short-term arrangements.

However, franchise agreement, with durations as long as 15-30 years, create an uncertainty as to what the future will bring.  Changes in the economy, lifestyles, demographics, and even geography, can prevent eve the brightest individuals from anticipating at the moment of contracting, every possible nuance which could arise somewhere down the road.  As such, well thought out legislation which could provide guidelines and standards for how the parties will deal with each other throughout the duration of the relationship will better serve both sides and it will enhance their relationship.  In my opinion, franchise legislation will be enacted in the near future at both the state and federal levels.  It will mutually benefit all parties involved and it will provide more protection than current laws presently do because: it supplements existing statutory law and legal precedents; it provides the framework for case law to develop; the rules of conduct will be more well defined between the parties; it governs the franchisor-franchisee relationship throughout the contractual period and not just during the presale period; it will provide guidelines and limit /prohibit franchisors from engaging in abusive conduct; it will not penalozie any of the franchisers that choose to act properly; it will limit/prohibit the use of certain unfair and unscrupulous, but commonly used, contractual provision; and it will provide greater remedies to franchisees, i.e. injunction, recession, attorneys' fees, costs, punitive damaged, etc.

All of these benefits of new legislation will significantly contribute to a reduction of litigation, as the parties will be forced to play within the rules.

As a result it will protect the franchisee from unscrupulous conduct undertaken by abusive franchisors and it will benefit the franchisee by enhancing the franchisor/franchisee relationship to the point where increased productivity by the franchisee will increase sales, service and advertising fees for the franchisor.

While I recognize that all franchisors are not unfair, and do not undertake abusive and unscrupulous tactics, the new legislation will affect only those that are not acting fairly and in good faith.  After all, while not everyone commits murder, there still are laws against it!

Robert Zarco, Zarco and Associates, is a commercial litigator in Miami, Florida who represents franchisees exclusively in their disputes with franchise systems.