How to Read the Franchise Disclosure Document and Red Flags to Look For
This webinar is designed to help you learn how to choose a franchise wisely. Your selection process should consist of thorough research, analysis, and focused investigation. Understanding how to properly read and analyze the franchisor's required documentation, the Franchise Disclosure Document (FDD), is one of the most important activities you will perform in your franchise selection process.
Mario L. Herman Esq. is a solo practitioner, based in Washington D.C., specializing in matters relating to franchisees. He has represented over 125 foreign and domestic franchisees during his career. Mr. Herman is a graduate of American University and Georgetown University Law Center.
For those of you who would prefer to read the official transcript, enjoy!
Nick: Ladies and gentlemen, thank you for standing by and welcome to the FranchiseHelp, Inc. conference call. During the presentation, all participants will be in the listen only mode. Afterwards we will conduct a question and answer session. If you have a question, please press the one followed by the four on your telephone. We would also like to encourage your questions through your chat feature to the lower left of your screen. If at any time during the conference you need to reach an operator, please press the star followed by the zero. As a reminder, this conference is being recorded Wednesday, June 11th, 2008. It is now my pleasure to turn the conference over to Mr. Mario Herman, Washington D.C. attorney. Please go ahead, sir.
Mary: Nick, I think you skipped me but that's okay. This is Mary Tomzack everybody, and welcome to our webinar, "How To Read the Franchise Disclosure Document and Red Flags To Look For." This webinar is particularly dear to franchise buyers, so I think most of you out there are going to be looking at a franchise to buy. The conference will take about one hour, so please, I'm sure you planned that in your scheduling for the day. If we haven't met someplace or if you don't know me, again my name is Mary Tomzack and I'm the President of FranchiseHelp, FranchiseHelp.com. In 1994 and then in an updated version, I wrote a book called "Tips & Traps When Buying a Franchise." So this is a subject near and dear to my heart, and we as a group at FranchiseHelp have been working with franchise buyers as well as franchisors and other parts of the franchise market for over ten years. Besides being the President of FranchiseHelp and writing the book "Tips & Traps When Buying a Franchise," I actually was a part owner in two franchise businesses, so I know a little bit about some of the challenges and problems that you might encounter. And before that, I was an entrepreneur and owned a fragrance company. Today we have as our very capable presenter, Mario Herman. Mario Herman is a franchise law practitioner, and unlike most of the franchise attorneys, Mario specializes in franchisee matters. So he's the person who can really give you some good ideas about what you should be looking for when you're analyzing the franchise and the franchise system. Mario is based in Washington D.C. and he represents interesting enough, because I think we were slated to have some international potential franchise buyers, and Mario does represent domestic and foreign franchisees. Mario Herman received his law degree from Georgetown University. Now as just a little introduction, which hopefully you all have received and you're following along on the screen. Franchise ownership entails both benefits and responsibilities. I'm not going to go through all of the goods and the bads and the in betweens with you. I think the fact that you're tuning in today shows that you really want to use good judgment and try to select the very best franchise system for your needs. One of the most important things you're going to do is receive a franchise disclosure document, FDD for short, from the franchisor. This is a valuable document for you, but it's very important that you know how to look it over, how to analyze it, and what to look for. Thus the reason for this webinar today. So when Mr. Herman takes over, he'll be taking you through the franchise disclosure document and especially pointing out red flags that should alert you to some things that maybe need a little bit more investigation. So with that I'd like to bring on Mario Herman, and he will be taking you through the presentation. Mario.
Mario: Thank you, Mary, and I appreciate this opportunity to address this very important topic. First thing let's talk about terminology. The document, the FDD, used to be referred to as the UFOC, which was the uniform franchise offering circular. In order to try to streamline and make more uniform all the obligations that franchisors faced in various states, they changed the format now to the FDD. And the FDD is in place as of 2008, and all franchisors need to start abiding by the terms. Some of the terms have changed. For instance under Item 19, there are 23 different items. We're not going to go over all of them, but we'll hit some of the highlights through the presentation. Earnings Claims under Item 19 have now been termed Financial Performance Requirements for instance. The FPRs are important because that is an indication of how well the franchisees in the system are performing. Not all franchisors, indeed most of them do not, provide these performance representations. But if they do, they have to comply with the strict restrictions, the strictures under Item 19. Other terms to look for, the Code of Federal Regulations is what governs the rule, what we call the FTC Rule or the Franchise Rule, and it's essentially a compilation of all the regulations under the Federal Trade Commission that govern franchising. There is no federal statute on franchising, which is important to know. There are various state statutes involving disclosure and what we call baby FTC acts, which are the Federal Trade Commission acts, which essentially prohibit deceptive and unfair trade practices in the sale of these franchises. Another issue that you should be aware of, there was a lot of controversy over what constituted ten day business day under the old UFOC requirements. So it's now gone up to 14 days, but not business days. It's calendar days so that you have to have the FDD in your possession for 14 days prior to actually executing the franchise agreement. You need to sign under Item 23, which is the receipt for it. So these are essentially the terms we need to deal with. We can advance now to the next slide and start talking about the substance. The first issue I want to talk about is the background of the franchisor. This is under Item 1. Essentially, you want to determine under this first item whether the franchisor is what we call a professional franchisor. In other words, is his business the actually marketing and production of a specific franchise you're involved in, or is he just a professional franchisor that looks for a hot business to start franchising and making money off of that? Remember the franchisor's interests are not necessarily consonant with yours. He can make money whether you make money or not, because he tends to or will make money off of the gross, whereas you make money off of the net after all of your expenses. Franchisors invariably will not charge royalties off of your net profits because it's too difficult to determine a net. So it's either a fixed amount or it's a percentage based off of gross sales, what they call subject royalty sales. So you want to determine the background of the franchisor, how many reincarnations has he had over the various years, the amount of businesses, how many have failed? You'll see under item three there the bankruptcy of the franchisor or any of their executives. How successful have these particular executives been in the past, and specific knowledge of some of the executives in this line of business that's being franchised and if they franchised similar types of businesses in the past or completely separate type of businesses over the various years. One area that's not covered on the slides but I want to talk about briefly under Item 3 is litigation. It's important to review this very carefully to determine how many arbitrations or litigations the franchisor has been involved in with his franchisees including some of the previous incarnations of the franchisor, some of the litigations from previous businesses will have to be listed as well. And here you want to make sure that there aren't a lot of cases involving fraud or deceptive trace practices or RICO violations, which is racketeering and conspiracy charges. Or if the franchisor is suing a lot of franchisees for non-disclosure, I think that's an important, excuse me not for non-disclosure but for non-payment of fees because that's important to determine whether the franchisees are making sufficient money to be able to pay the franchisor its royalties and advertising fees. Okay, let's move on to the next slide. The initial and ongoing costs under Items 5 and 6, these are really important because one of the things that small businesses fail at more than just about anything else is due to lack of proper capitalization, what they call undercapitalization. So you've got to make a determination whether you have enough money going in. The franchisor usually states, "Oh, sure you've got plenty of money. Don't worry about it." Or, you know, go leverage yourself here or we'll finance you. There's even a section in the FDD that deals with financing. But you really have to make the determination on your own whether you have the working capital and the capability to take this thing out. The SBA, Small Business Administration, says that if a venture of this sort is going to succeed, it will succeed within three years. So in addition to your fixed costs, your net per month, you've got to make sure that you have enough money to live on to be able to get to the point of profitability. There's a section under Item 6 called Other Fees, and I'll deal with this under termination as well. But I just want to remind you one of the big issues I look for when I review these franchise agreements is what is required in terms of other fees to be paid or what's required upon termination. And one of the things franchisors like to hide in their agreements or they don't even put in at all but they just rely on basic contract law and that's the issue of future royalties, the benefit of the bargain. So you sign up for 20 years and you quit, for whatever reason, because it's not profitable after eight years, and they try to hit you with the present value of the future royalty stream between years 9 through 20. I've seen those cases, I've litigated those cases in the past. It's not a pretty picture. And franchisees invariably said, "Had I know that, I wouldn't have signed." So you want to check under Item 6 for other fees to make sure that that's either disclosed, and if it's not disclosed, to ask the franchisor, "Well, what happens if this thing doesn't work? Can I just close down with impunity?" Make sure when you do a pro forma that you're very conservative in your estimates. You want to estimate the fees very high. There's usually a range in terms of what your costs are going to be and those ranges vary dramatically. There are a lot of hidden costs that you have to be careful about. Under that 4b there, make sure with the EFT, which is the electronic fund transfer payments, that you have enough money when they come in and sweep your accounts once every month. It really takes your ability to manage your own cash flow away from you in terms of when you're paying your bills. So it's a tough call. The EFT is not something that's usually negotiable. That's the way the franchisor reduces the amount of delinquency from his franchisees because you give him the authority to go right in and sweep the accounts. Under item 5 there, restrictions, the issue regarding suppliers, what is the process to approve suppliers? How much rebate is the franchisor getting from approved suppliers? What is the cost to you for the supplies? Is it less expensive for you to go out and buy similar products or services in the open market, and if so, how can you get those particular suppliers approved and then the hurdles that you have to go through under 5b there. The goods or services you may sell, sometimes franchisees need to sell additional goods and services that may not be "approved," but usually the franchisor turns the other cheek because of course he's receiving royalties on those additional services. But sometimes they come in and say, "No, we're going to terminate you if you don't stop selling a particular good or service, because that's not part of the uniform look that we want to present to the public." Customers under 5c, now this is a big issue. Customer lists usually the franchisor reserves for themselves and upon termination they said we own the customers you don't and these are customers that you've developed with your blood, sweat and tears over many years. They have no privity of contract, that means no direct contractual relationship with the franchisor, yet the franchisor is insisting that those customers belong to them at the end. I'm currently in litigation involving a domestic cleaning outfit out of California where the franchisor is insisting that all the customers of this maid franchise belongs to them and not to the franchisee who's the one that developed all the customer base over many years. It's a way for the franchisor to force you to stay in compliance and stay with the franchise and not leave the franchise at the end of the term once it expires, because if your customers are gone, then you really don't have a business that's left. So it's important to try to understand who controls the customers and whether you have an ability to deal directly with them and potentially take them if you leave the business. Under d, where you can sell or advertise, this is actually a very important issue and it relates to Item 12, which is the territory section of the FDD. You've got to be able to determine where you can advertise. Let's say you buy pursuant to the ZIP Codes, which I think is problematic and I'm actually in litigation involving a ZIP Code issue now with a franchisee and what they call encroachment, which is one franchisee encroaching on the territory or the trade area of another. And so you have overlapping with these ZIP Codes and then you have open territories where everybody's competing. And then a new franchisee comes into the open territory and the question is who gets the customers in all this mess? Does it belong to the franchisee who initially obtained those customers or to the new franchisee that comes in that territory because that's physically where the customers are located? Or what? To the extent that the franchisor does not properly enforce or prevent this type of encroachment from occurring, then whatever "exclusive territory" you have will be tenuous at best. You're not able to function properly if the franchisor cannot police the various franchisees competing over open territory or what's in their own territory. For instance, I have situations where a franchisee is very brazen and openly competing with another franchisee in their own exclusive territory. So if a franchisor doesn't come in and start auditing and say you can't do that or we'll terminate you, it makes it very difficult for the franchisee who thought he was purchasing an exclusive territory to move on. In terms of the advertising that's another issue. Do you advertise in your own territory only? What happens if there's overlap and you know some of your radio advertising is going into other ZIP Codes or other jurisdictions or other territories? So this is fraught with problems, and franchisors frankly have a difficult time trying to navigate through these very troubled waters. Under 5e, use of Internet, who controls the web pages? How is it you're going to be able to advertise? Is it the franchisor that controls the Internet, or will you be able to have your own web page? And if so, how is it that you get calls in from an 800 number? Would it come to you necessarily or to sort of a clearinghouse? And then how is it distributed on a random basis or the like? So these are all very important issue and I know I'm going a little bit fast but we have a lot of territory to cover. I'll try to slow down a little bit, and we'll have time for questions at the end. And Mary if you have any issues at all as I'm going through this, please feel free to speak up.
Mary: Sure. And again, I encourage any of you who would like to email in your questions in between feel free to do it right now.
Mario: Thanks, Mary. Next area is terminations. This is under Item 17. If you recall under Item 6, Other Fees, we talked about the issue of future royalties a little while ago. One of the big issues that is present in litigation between franchisor and franchisees is what happens upon termination. And there's been an issue between a termination, which is an actual ending of the relationship mid-term as opposed to a natural lapse, what we call an expiration. So if the franchisor or the franchisee actively seeks to end the relationship during the term, we call it a termination. Otherwise it's called an expiration. Now a lot of the provisions in the agreement apply to either expiration or termination. At one time, there was a lot of litigation as to the distinction between those two, but the FDDs and the franchise agreements have been tightened up considerably since the '90s and there isn't as much litigation in that area right now. So the first area is your right to terminate. If there's a breach, do you have a right? If so, under what conditions, what notice pe riod? The opportunity to cure meaning the franchisor would have to try and fix the problem within a 30, 60, 90-day period and get back to you. Unfortunately, because these agreements are written by franchisors and their attorneys, most franchise agreements don't allow you to terminate, the franchisee. The franchisor can terminate you for all, myriad types of reasons, from underreporting to "moral turpitude," which is a fancy term for saying that your morals or ethics aren't up to snuff. So it's really important that you determine whether you have a right to terminate, and if so, what happens upon termination. For instance under 6e, your obligations upon termination, you'll have to deidentify and make sure you're not using their marks anymore, you have to pay the amounts owed and this is where the future royalties issue comes to play. Does that include future amounts owed as if the agreement has been honored for the full term, or does it just mean the amounts of money owed up to the point of termination? So it's really important that, if that's not specified there, that you ask the franchisor, "Well, what happens if I close?" You can't just assume because it's not in there that they won't try to get it, because under general contract theory you're entitled to what's called benefit of the bargain. And their position is our bargain is 20 years, you left year 8. I'm entitled to 12 years of royalties based on the last 2 years of performance of revenue that you paid me. So these kind of arguments always catch franchisees by surprise. It's probably one of the biggest red flags that you should look for.
Mario: Go ahead.
Mary: Mario it's Mary, excuse me. If I can just stop you for a minute. It occurred to me and probably some of our participants in your many years in litigation for franchisees, what are some of the maybe the typical reasons that a franchisee would have a right to terminate? I have to say in my experience I haven't seen too many. For example, if the support of the franchisor is not there, could that give, would that give the franchisee a good enough reason to ask to terminate the relationship?
Mario: You know it's funny because I was going to address support in the next slide, but I'll go ahead and advance it for that question. The single biggest complaint I've heard from franchisees throughout the years is, "I'm getting no support from the franchisor. Why am I paying them royalties? I want to terminate this agreement and do it on my own." So it's the seeking to go independent and try now that you've learned the business apart from the franchisor to try and do it on your own. Or for those franchisees who say, "Look, I was converted from an independent business and I don't really need a franchisor. I knew how to do this business before. It was a mistake on my part and the like." Franchisees always lament about the lack of support, but these agreements are written in such a way, Mary, that often there's no basis for any contract action or any deceptive unfair trade practice action because there is no breach because there is no requirement for them to do anything in the first place. Some vague reference that we'll help you if we have time or if you call in maybe we'll call you back or I'm being a little bit facetious here and tongue in cheek, but the truth is that often there is nothing specified in terms of what they have to do in terms of sending someone out, for instance, on their nickel to support you and help you with your advertising and help you with your lack of profitability. But to answer the direct question about why people terminate, well, they terminate more often than not due to lack of profitability. You don't want to keep running a business that's not profitable, makes no sense. I liken it to the light at the end of a tunnel being an oncoming train, get off the tracks. If you see this thing headed in the wrong direction, the whole idea of staying in just to pay the landlord, just to pay the franchisor, just to pay all your suppliers while you see your meager cash reserves dwindling rapidly makes no sense at all. So part of what I do is counsel franchisees who are in that type of pickle of when to cut loose and when to make sure that you need to end the relationship so that you affirmatively terminate it, whether you have that right to terminate that we went over or not. But the truth is that support is a big problem. I always tell franchisees make sure you put it in writing even if it's an email, because this whole idea of "well I called them but they never got back to me" doesn't play very far with the court system or with arbitrators.
Mary: So I guess then, Mario, the bottom line is there aren't that many occasions when, where a franchisee is able to terminate except I guess for financial reasons and then other responsibilities kick in on the . . .
Mario: That's correct. And if you end up closing, a lot of times franchisors won't chase you for future royalties. But if you go independent, then they're more likely to come after you as a practical [inaudible 26:04] even though frankly the law doesn't distinguish too much between a closure versus going independent. But I think arbitrators are more sympathetic to people who lose their shirts and franchisors who try to kick them while they're down. On the issue of franchisor's right to terminate, there' are usually two types of provisions. One is automatic termination, which usually involves under-reporting, felonies, moral turpitude, issues such as that. And then notice and opportunity to cure between 30 and 90 days, for instance if you have a health and safety issue in an ice cream parlor that's franchised. You know they'll come back and re inspect. Or a hotel that fails inspection and the like, then they give you an opportunity to cure. But if you have repeated defaults over a certain period of time, then there's automatic termination provisions that usually kick in at that point. The post termination covenants is a really important issue. A non-compete provision that prohibits you for a period of one to three years usually competing with a franchisor in the business after you've been terminated or you expire. So even if you go the full 10 or 20 years depending on the length of the agreement, the franchisor says, okay now you got to be out of the business for 12, 18, 24 months, which then your idea is, "Well, wait a second, I gave you the benefit of the bargain but now I don't want to do this anymore. I don't want to dance to this dance. I really want to go home and do this on my own." And the franchisor says, "Well, the customers belong to me and you can't be in this business, so just turn everything over to me and you'll do some other kind of business." This is unfortunate and one of the most sort of Draconian provisions you'll find in these agreements, which basically enslaves you to the contract and to the franchisor because you really don't have the ability, other than to sell, to transfer to someone else. But for instance, if you want to give it to your kids or you just want to do this thing on your own without the franchisor anymore, it makes it very difficult. Now in states like California, I think South Dakota, and a few other states, non-competes are unenforceable. But most states have some degree of enforceability. I do a lot of litigation in the area of non-competition or post termination non-competes. That and future royalties are probably the biggest areas. Encroachment is also another big area and is rife with litigation. So you really have to be careful and make a determination. Virtually all these agreements contain non-competes but whether this is something you can live with.
Mary: Mario . . .
Mary: . . . before we continue with the next slide, a question came in from Glenn Terrasita [SP] and I think it's probably one that's going through a lot of people's minds. And that is what, if anything, is negotiable on the franchise agreement? And Glenn, like lots of people, like to think that you can negotiate almost anything. Now we'd like to hear what you have to say about that. And I don't know how you want to approach it. But Glenn's question specifically was can you specifically highlight the items that franchisors are unlikely to negotiate and those where they will be a little more flexible? Now I don't know if you want to do that Mario as you're going through it or perhaps save that for the end of the presentation.
Mario: Well, let's just take it now. It's an important issue and franchisees ask me that all the time. More often than not, you're told that it's a take it or leave it, what they call a contract of adhesion, we sometimes call an unconscionable contract because it's just so one sided. But the courts have not uniformly stated that these contracts are unconscionable. Some provisions maybe unconscionable, for instance your right to give up the right to sue may be stricken. There are form provisions that sometimes are stricken for instance. And in California, you have the right to litigate out there any issues that may arise from the agreement under California law. Sometimes the franchisor will allow you to make changes to the forum where you litigate instead of invariably the franchisor's headquarters is what's contained in the agreement, where they're located, they want everybody to come to them, which is additional cost for you instead of you suing them in your own home state. And the choice of law, maybe you're in California and there's better laws for franchisees out there and the franchisor's in let's say a state like Pennsylvania. GNC for instance is located in Pennsylvania. There's no statutes or anything that helps franchisees there. So if you have a shrewd franchisee attorney ahead of time, you'd say well wait a second, we want California law to apply to our agreement and we want to be able to litigate out here. Sometimes franchisors will do little side agreements that enable you to do that, and sometimes they just hold the line depending on how hungry they are, the phase of their maturity. If they have plenty of franchisees like a McDonald's or a UPS store, you know, their attitude is forget it, you sign it as is, no changes. Things like royalties for instance or advertising payments or the use of the brand and how you use the brand, those issues are invariably non-negotiable. So can you sort of work around the edges and try to make some minor tinkering or changes? Yes. Can you change the fundamental terms of the agreement? Invariably no. And that probably applies whether it's a startup franchise or whether it's a highly mature franchisor. But obviously, the hungrier the franchisor is, the more he's inclined to make changes. But usually the franchisor's attitude is there's always someone else willing to buy one of these things, and the more mature franchisors will not provide any leeway in that regard.
Mary: Thank you very much.
Mario: Okay. Next issue is training and support. As I mentioned before, the support issue is one of the biggest complaints and usually not actionable. Training usually refers to the up front type of support that they provide you. In other words, you attend their university and you go on site to their school for a period of a few days to a few weeks. Under 7c there, that varies widely depending on the nature and the type of franchise you're involved in, what you need to learn. The ongoing training, you see that under 7d, the cost associated is very important. If you're cash strapped and you're really not in a position to send your general manager over for expensive training with hotels and meals and the like and then the franchisor said okay, fine we'll send someone over to you to help train you but you've got to pay his costs and that could be very expensive. With some of these food franchises, large restaurant chains for instance, that can run into the tens of thousands of dollars to have people sent, especially if you start sending them abroad. I represent some franchisees internationally, and it gets very costly to send people from the home office. Other issues that aren't covered here but I think are important is the issue of site selection, build- out assistance, and lease negotiations. These are all important issues that are covered in the Item 11 in the FDD. But a lot of times franchisees say, "Well, you know you're the expert, you find the site for me." And a lot of times the franchisors really don't have the ability to determine where an effective site would be or they just use a generalized demographics statistics. They don't have people on site. They don't really hire brokers who have knowledge of the area. And if they do, you have to be careful because they're negotiating leases with the landlords that they know that they can get rebates from, and so you may be involved in a very expensive lease. You have to determine whether the lease term is coterminous with the franchise term. You don't want the lease extending much afterwards, and you certainly don't want it ending before, because what happens if the landlord decides to kick you out and doesn't give you an opportunity to renew? So the lease negotiations is a very important issue. You should get your own independent counsel and not really on the franchisor saying, "Oh, we'll take care of it for you, no worries, no worries." This is part of what we do. I would make sure that on the lease that you know what you're doing and you get the right consultants that working for you and not for the franchisor or the representative's interest. Build-out assistance, larger franchisors will invariably have sort of a cookie cutter approach that this is how we want our place to look and they'll end up sending you diagrams or charts or this is where the counter should be, this is where this and that should be. Sometimes it's good because that way you don't have to hire architects and the like on the build-out. But sometimes it just doesn't work because you can't fit a square peg into a round hole. So you've got to make sure that you have some flexibility in how you build this thing out. And if the landlord is providing you financial assistance in the build-out, then you make sure that you're getting the money and somehow the franchisor's representatives are not squandering it or taking it as their commission or the like. So it's really important that all three areas are investigated thoroughly by you -- the site, the build-out and the lease negotiations. If we can move on to advertising if there are no other questions. Advertising varies widely. Some franchises don't have any advertising requirements at all. It's up to you. If you want to advertise, it's fine, if you don't. Normally the brands that are better known have large advertising pools and funds from their franchisees. The amounts vary widely. It's as low as 1%. It could be 5% or higher. Sometimes, I was in litigation with one franchisor that assisted on an outrageous amount of advertising that would just bankrupt the franchisee. We eventually got the franchisor to back off from it, but they don't understand somehow that the franchisee's net profits are being impinged upon tremendously if they're having to spend 30%, 40%, 50% of their net profits on advertising for brand building. It's great for the franchisor, but the franchisee may not see the return on their investment with that type of excessive advertising and that kind of market saturation.
Mary: Mario, just as an aside, working with a lot of franchisees and speaking to them on the phone, I have to say that the advertising costs are one of the biggest areas of complaint that we hear about what's working with the franchise.
Mario: Yeah, I think the area of complaints, a lot of it is that the franchisor's using the money to get more franchisees in and not using the money for the, to benefit the franchisee so he can get customers, he or she can get customers.
Mary: Well, that is true. There is, you know get customers for all the units or get franchisees. But doesn't that have to be stated implicitly in the FDD document that it will not be used to solicit for franchisees?
Mario: Well, I think what the nature of it is that if a franchisor states that some will be attributed to overhead or administrative costs, you see that under 8d, and then they sort of hide it and use it for whatever purpose they want. If they put in a separate fund, you know every dollar in is a dollar out and it's not, none of it goes for administrative expenses whatsoever, then they become a real fiduciary for that money. And there was actually a case involving a half a billion dollars, $500 million class lawsuit involving the Meineke case back in the '90's on abuse of fiduciary duty to control those funds. Normally there's no fiduciary duty like you have with stock brokers or attorneys between franchisor and franchisee. But if you're controlling somebody's money and it's their money to be used strictly for advertising, then you got to be very careful how you do it and provide a proper accounting and opportunity to audit those funds and the like. But under 8c, the discretion, normally these franchise agreements allow the franchisor huge discretion on the nature of the context and how they advertise. And this is a big issue between local, regional, and national. Sometimes the national won't benefit you at all, because it's geared for other issues or types of products or sources you don't necessarily do. You may want more local advertising, maybe you want flyers or radio instead of a big TV splash campaign that costs millions of dollars during the Super Bowl that you don't think necessarily will help build the brand image for you there locally. So franchisees invariably want more control, and that's why they usually have these regional ad hoc co-ops for advertising. But then there's a lot of fighting among the franchisees there in terms of how they want those funds expended. And then usually there's a fund for a national advertising and then there's a fund for a local advertising and then they expect you to go in the Yellow Pages and do your own advertising on top of that. So if you add up all these costs, one of the issues is the hidden costs that I keep talking about. It becomes, at a point, overwhelming for the franchisee, especially if he's just on the verge of profitability or doesn't really have a lot of extra cash. But it's the old, "Well, you have to invest in order to get the business long term."
Mary: Mario, we're getting . . .
Mario: Go ahead.
Mary: . . . again the negotiation question in again from Sal, which I think I heard you answer before. Something like an advertising percent or a flat amount that has to be spent in advertising, that's not normally negotiable, is it?
Mario: Oh, the amount that is spent, for instance let's say there's a national fund to advertise on the Super Bowl or national TV or something, that invariably is non-negotiable. Now if they, if you say well look I'm advertising in the Yellow Pages but I don't want to do the second White Pages or I don't want to do this particular type of advertising over here, there may be some more flexibility on the local basis of what you can or can't do or get away with. Is that something that's negotiable up front? Hard to say. Does the franchisor look the other way if you're not spending money on that particular thing? Well, unless they're auditing you and figuring out where you're spending all your money on the local advertising area, then they probably are not going to spank you on that one or threaten to terminate you. But the direct answer is, if it comes to advertising that's a percentage of your revenue for purposes of the franchisor to use in a generalized pool for benefit of the brand development or in the case, I said before, of getting more franchisees into the system, they're not going to negotiate on that one. That's a fixed 1%, 2%, 3% amount that will remain fixed just like the royalties do.
Mary: Okay, thank you, Mario.
Mario: Sure. Next issue is really important area, Item 20. These are current and former franchisees attrition rates. Item 20 was changed in part because there was so much confusion and double counting and problems associated, under the old system, with the UFOC. It remains to be seen how clear the new requirements are going to be, but one of the things it appears to have now is sort of the net change from year to year. Under 9a, the attrition rate there, normally I would say in terms of rule of thumb franchisors that vary more than 10%, let's say they lose 10% of their franchisees from one year to the next or have an attrition in terms of franchisees in and out with closures or transfers or just sort of the net effect. If you had 900 units and you're losing 90 through attrition, transfers, or closures, then that figure is something you should watch but I wouldn't be alarmed at. If that goes up to 30%, so instead of 90 you're at 270 out of 900, then it's something to be alarmed at because I believe then that shows that there may be something systemically wrong with the franchise that's causing these kind of changes to occur within the system and people wanting out. I was told by the captains of the franchise industry 15 years ago that all franchise networks cross all lines, food, non-food, business format franchising of all types of product, services break down to a third. A third will end up losing their shirts and go bankrupt. A third will be marginally profitable, and a third will be "successful." Now how do you define success? In my experience, I think of that third maybe only the top 10% of all of them or a third of that third will be making serious money over six figures. The rest of them will be in the $60,000 to $95,000 to $100,000 range in terms of net in your pocket, not gross but actually what you end up paying taxes on. So if you look at it that way, it's a far cry from this guaranteed success that you heard about and was bandied about in the '90s by the Department of Commerce statistics about 95% success rate in franchising. Those statistics have recently been debunked, and the FTC themselves won't allow the use of that kind of statistics in advertising anymore. There was a guy by the name of Timothy Bates, back in the '90s with the Department of Census, a really good statistician that came up with a sampling of 4,000 units, independents versus franchisee, and he determined that the franchisees had a 34% failure rate versus a 28% failure rate for independents, which sort of turns this whole idea of a cookie cutter and success in franchising on it's head. I tell you this because I'm not trying to scare you. I just want you to be aware of it. Knowledge is power and to the extent that you don't buy into this fallacy that, well, I'm buying a franchise so it's got to be successful. I mean remember the franchisor is making money whether you make money or not. And as bad as the failure rate is for franchisees out there, guess what? There's an equally bad rate for franchisors. There's a huge amount of franchisors that come in and out of existence during the course of the years. And if you're a franchisee that happened to buy one of those franchises, well, you know you're obviously not getting the brand recognition, you're not getting the support and the like. So you really have to be very careful when you're buying into one of these things to try and see the big picture, and make sure you contact competent counsel who knows about these FDDs, franchisee not a franchisor attorney. It's really important to do. There aren't too many out there, but search through the Web and you'll be able to find some. On the issue of contacting the current and former franchisees, sometimes it's hard to get at the former franchisees because contact numbers have been disconnected or no longer valid, moved out of state, whatever the case is. Former franchisees, you know there's some sour grapes there. Sometimes you have to take what they say with a grain of salt. But I find by and large you probably get a more truthful answer from them than you would from current franchisees that suspect you might be a plant from the franchisor or not particularly interested in sharing financial information with anybody who just calls in over the phone. So you may not get a true picture, an accurate picture from either one of them. I'd certainly would try to call as many as you can. Be careful of the franchisor that gives you a short list and says call these franchisees, because invariably those are the ones that they want you to deal with because they're going to paint a rosy picture that may or may not be accurate. So I would just call franchisees in your area, in your territory. One of the issues under the financial performance representations we'll get to in the next slide just briefly is the idea of geographic importance. Make sure that this type of product that you're selling for instance ice cream cones in Minnesota versus Arizona. In the summer months sure, it's great. But how about those long winters in Minnesota? Are people buying ice cream? So you want to make sure the geographic relevance of the nature and business that you're getting into. So it's important to call franchisees from your area as well as from other areas as well. The franchisee association, under item 10 there, this is an interesting area. Some statutes, like in California, have a right to free association and the franchisor can't try to restrict your ability to join these independent associations. I think it's important to determine whether it's truly an independent association or it's just merely an advisory counsel, what they call a FAC, a franchisee advisory counsel. I think if you contact places like FranchiseHelp, they can help lead you in the right direction on issues that you may have as a franchisee or as a prospective franchisee. American Association of Franchisees and Dealers out of San Diego also puts together trademark specific associations and helps franchisees try to negotiate better agreements and better deals. So I would contact organizations like that to try and determine whether these franchisees are really speaking with an independent voice. Usually, whoever pays the bills, controls the voice. So if the franchisor is having these wonderful conferences in Hawaii for the top franchisees, all expenses paid, and you're there funning and sunning yourself, well guess what? Whatever the franchisor wants their franchisee association to advocate, you're probably going to do because you feel indebted to them. So make sure that you follow the money and try to determine how truly independent these associations are. Last area, well, next to last area I want to cover is the financial performance representations. I think that at one point the statistics were that 70% were not providing that. I don't know if that's accurate to date or not.
Mary: Our figures are about the same.
Mario: About the same?
Mario: Yeah, I had heard that, but frankly that's dated like five or six years old. But maybe it's, maybe it'll change in the current FDD. I don't know.
Mary: We're thinking the same thing, but we'll find out I guess . . .
Mario: I guess we'll find out over time. The sample size is very important. Or the are we talking about 100 stores, 10 stores? How big is the franchise itself? And I mean they're only in business for two years and only have 10 stores involved in the sampling or they have 200 stores. How many years have they been in existence? The stores under one year, over one year, over three years so you want to look for that, usually those are broken down under Item 19. Whether they're company owned or not. Most franchisors don't have company owned stores. Well, there are some that do, but they don't tend to have a lot and maybe they just have a few. A lot of them are just franchising for other people to buy. They don't want to keep and run these things themselves. And remember the company owned stores don't pay royalties, so you have to take that into consideration if they have it. This gross sales versus net profits issue, it's tough to do a FPR on net profits because are these things properly audited by the franchisor. The franchisee stated this is what my profit is, but there's a lot of stuff that can be hidden in there. For instance, insurance that's covered by the franchisor or cars that are covered that would normally be part of something that you would pay for out of your own net profits. So gross sales is probably a more accurate way to try to determine, and then you have to figure out what your own expenses would be. Back to the point of geographic relevance, you really got to make sure what plays in California, plays in Mississippi or Massachusetts or in Florida. So if it's restricted to certain areas, you got to make sure that you understand what that is. What type of franchisee are we dealing with here? Are we dealing with true entrepreneurs or what they call quasi-prenuers which are not true entrepreneurial spirits but just people who really want to be told what to do and how to go out and market. The reason they're buying a franchise is because they don't feel that they have the ability to start up their own business. That kind of information is not usually disclosed -- the nature and the type of franchisees that are submitting the information. The disclaimers you'll see all over these agreements that you may not do as well as this and you can't really rely on this. You'll see the disclaimers at the end of the agreement saying we didn't give you any financial figures, and if we did, you can't rely on them and you sign here and sign away all your rights to ever sue us on any misrepresentation regarding earnings claims and the like. So the franchisors have buttoned themselves up pretty well. They make it very difficult for you to sue them on any issues relating to providing illegal earnings claims. It's not that earnings claims or these performance requirements are illegal. It's just that they have to be made within the confines of Item 19. If they're not, then they are illegal. A lot of times franchisors, like the 70% out there that don't give them, say, "Oh, we can't give you any earnings claims because it's illegal." Well, that's not true. They can give it to you. They just choose not to because it is problematic for some franchisors, especially if their units aren't profitable, to try to come up with the information to paint the rosy picture they want to paint up front. Last, but not least, is the all-important financial information contained in Item 21. Here is where you'll see the last three years balance sheets, profit and loss statements. How well is the franchisor doing? Does it have steady growth? What kind of growth plans does it have? Is it increasing or decreasing in sales? Is the growth stagnant or reckless? Does it have growing pains? Is it outgrowing its support structure? You need to determine the years in business. If it's a brand new startup franchisor, it doesn't have a track record, doesn't have any brand recognition, then the question is what are they bringing to the table? Is it something you could really do on your own, or are you going to be paying to develop the brand for them? And are they really experts in this thing and can they really train you because you're not trained? And if you do have training in this area, is it something you really need to go to them for? These kinds of issues are really important. Item 13 is not listed here, that's the trademark section. You've got to determine whether the brand is properly registered with the USPTO, that's US Patent and Trademark Office here in Virginia, and make a determination whether they'll follow up and enforce any kind of infringement of their marks. Some franchisors, believe it or not, state that we have no duty to go after anybody who may be infringing on our marks or they don't have marks that are registered. They've applied for registration but haven't been approved yet. Obviously one of the biggest things you're buying when you buy a franchise is you're buying a right to a name. So you've got to make sure they've secured the rights to that name, the name is properly recognized, it has either secondary meaning, which is a buzz word that everyone knows it like a McDonald's trademark name, or is it something that no one has ever heard of because it's one of those fly by night franchisors that are here today gone tomorrow, because just like franchisees, they tend to fail as well. That pretty much sums up what I wanted to go over. It's 2:00 now. We have about 15 minutes for questions if anybody has any questions.
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