Do First Generation Franchisees in a Franchise System Get the Shaft from Franchisors?

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On numerous occasion former franchisees of various franchise system have complained that as the franchisor grew the rules changed and eventually forced them out of business – is this a common occurrence? Well, some believe it is and several have emailed me about this problem as I am a co-author of Franchising 101, the premier book for those considering on buying a franchise and wishing to learn the ropes. One of these former franchisees, I replied in an email to recently:

I see you seem to be upset with the first generation of “franchisees” in a new system. I have generally found that the newest franchisees of a new system either get the red carpet or they are forced out later, because the franchisor is able to get more money for territories sold too cheap or too large.

It is unfortunate if indeed a franchisor has forgotten from hence he came. I can remember first starting out in business and running my small business for over a decade, which was nearly identical to the franchised units we later sold. Still, the former franchise who felt slighted by their franchisor stated:

I know, as a former franchisor, that you defend franchise failure as a failure of the franchisee and not a failure of the franchised business plan.

Well the fact is that I am not obligated to defend anyone, actually, I was for a long time the anti-franchisor, franchisor actually. What I am saying here is that it is not so black and white. I have had franchisees from hell, I have had to sell franchises to people I did not want to, because of laws in franchising and then been screwed over by franchisees not paying royalties, changing the name of their business and continuing, when we lost money setting them up and they cheated me. So, that is another thing that happens, over time you are less lose in the deal making and a little harsher to prevent being taken advantage of.

The former franchise then asserted that the franchise failure rates and the information is hidden from view and even the SBA does not come clean on the problem. He stated:

The SBA uses the Loan Default Rate on Franchises on the SBA Registry to prepare Risk Profiles and you can’t dispute that the failure rate of first-generation franchisees, if many, does indicate that there is something wrong with the plan.

I do not dispute anything, I tend to agree, although the franchisors that are very big, rarely, if ever share their economies of scale with their franchisees, they over charge them for supplies and work to squeeze profits out of their signed up captured audience. Yet the larger franchisors get carte blanche with regulators, literally. This can be problematic in my observation and first hand experience, thus I am not amused and fear that someone somewhere named Adam Smith did indeed warn us all of some of the problems with government regulators who cozy up to one business, against another.

I have found that there is something wrong with every business plan, even the ones I have created. You see, planning is about change and adapting so you must change with the flow, but over regulation prevents that, this is why Schlotsky’s Deli got caught with their pants down with the Atkins and South Beach Diets were all the rage, belly up along with Krispy, that got Kremed. Franchising does best when the government stays out of the way and allows free-enterprise to work. Think on this.

Some say that in the UFOC – Uniform Franchise Offering Circular that is required to be given to new franchise buyers that in Item # 20 franchisor are able to hide franchise failures as transfers. These critics state that regulators allow this musical chair game and it impedes the franchise buyers knowledge of the true success rate and hides their failed business plans. Therefore all the original founding franchisees, which may have failed or been sacrificed for growth strategies in some cases are not recorded as having failed, even if they transferred in a “fire sale” type situation.

Of course, once the franchisor is up and running with 100s of franchisees the Business Plan, system and such is completely different and changed. The original founding franchisees generally have lots of other advantages too. Although you are correct about the original franchisees. The franchisor is busy trying to make it work and balance while trying to comply with all the insanity, rules, the changes and modifications needed for regional variation and dealing with new things that they are not use to. Franchising is a lot different than running company owned units, it is unbelievable the transition.

Critics remind folks like me on this side of the debate that under the 1970’s Franchise Rule, the FTC was to protect franchisees by requiring franchisors to disclose information to allow the franchise buyer relevant data to make an informed investment decision and ascertain the risk.

Indeed this is the actual history of franchising law and the FTC perhaps, but those laws have grown and now you see the 250 + pages of disclosure documents that are needed to comply, which in the end serve no real purpose. Imagine the barriers to entry for new franchisees $45,000 to produce documents, $25,000 per year to stay registered in the registration states, $30,000 minimum for audits.

Meaning a new franchisor has to pass those onto the new franchisees. Pretty unfair, especially as a new franchisor has a tough time getting going, after all who would buy a franchise if there are none already? Thus the franchisor has to make deals, cannot be too choosy and this is the basis for most of the original franchisee failures, but remember the over regulation is a factor hurting the franchisor.

One recent knowledgeable franchising critic to these issues and a former franchisee, who felt slighted by his franchisor, stated that the columns in Item # 20 of the UFOC are severely misleading. He pointed out that the transfer columns in Item #20 were a solution to the dilemma of ambiguous information in the disclosure document, but all this has done is allow for manipulation of franchisee failures that are then hidden from the franchisee buyer.

Yes, this does occur, whether by design or necessity or dodging the truth in disclosure and since it is legal, it appears that it is done more often than it ought too. Nevertheless, we are talking a legal technicality, but if we ditch this all together then the franchisee buyer would still not know. The entire UFOC and the new rules are ridiculous, too cumbersome and a slap in the face to the right of citizens and the right to free contract, and to the point of misleading information, well that is yet another result of the over regulation and insanity of the UFOC format.

Some believe that some franchisors like the format charts for Item # 20 that allows them to hide negative information, yet I know of no one who has ever said anything good about it (franchisor, franchising attorney or franchisee) and thus, I often recommend the book “Tips and Traps” for folks who wonder about Item #20. One angry former franchisee stated that Item # 20:

It gives the Government deniability because they don’t really know what the transfer columns are indicating in terms of success or failure of the franchise that is being regulated, and they don’t want to know.

I think most consumers and franchise investors give the regulators too much credit. SPAM went up 3000% since the FTC took over that task, Identity Theft is out of control and what do they do, harass the little guy and make things tougher. Indeed, the biggest purveyor of American’s personal identity is the government and they give away the most information, now they will be giving databases to foreign governments under the auspice of anti-terrorist information.

Thus it appears to at least this Franchise Consultant that if the consumer is looking to government to protect them, and thus believing that they can skip some of their own checking and due diligence that they are in for less than they bargained for. Buyer beware, well that’s my best advice and it comes from a heck of a lot of experience, there is no substitute for due diligence let me tell you.

Next in this ongoing debate and saga is the issues of churning, and how some franchisors who call it re-selling have used this as a franchise system management tool to eliminate first generation franchisees in order to make money selling them again and tightening the controls of the franchise system, as it grows. As a franchise consultant and studier of the industry for years, I admit there is a “Re-selling” or the not so nice term churning strategy going on in Franchising today.

Many attorneys at the ABA forum (which I scan daily and for the past 5-6 years) are concerned about these issues also. Indeed not long ago a few were trying to figure out what that guy in Las Vegas is doing, he seems to be the outsourcing churning king. Sure, this helps franchise systems and it is completely legal, but what about the franchisees who are churned and counted as transfers instead of failures, having lost all their money and nearly gone into bankruptcy and barely got out by the skin on their teeth in order to save their credit or prevent a larger debt as they leave?

As good as this new lady is at the FTC, Deborah, a President Bush appointment, she has no clue as to the blatant incompetence of the FTC in the Franchising Realm (my opinion, I have plenty of documentation, if anyone is interested to back up my comment). Many former franchisees and franchise rights advocates in Online Franchising Forums and Blogs state there are number of large Corporate franchises that do a significant amount of churning.

They name names like MBE – UPS Store, Quiznos, Subway and 100s of others and state they are hiding all the failures and bankruptcies in the “Transfer Column” of the UFOC in Item # 20. I have seen it too, not necessarily with those particular companies, I have not checked, but I have seen this scenario too many times to mention, thus I realize it is an issue.

In fact these comments appear to be spot on with regards to Large Corporate Franchisors and Susan Kezios, President of “Women in Franchising” and “The Franchisee Association” in Chicago told me the same thing. It seems rather than addressing this issue at the FTC, since it is fully legal, the regulators will go after companies they think will not fight back or that are slightly outside the protection of the Industry and much smaller and bury them in court paper work. To me it seems outrageous and disgusting, but I did not make the law.

Once, I sat in on an MBE franchise seminar once to see what they do, I felt bad for those investing in such franchises, indeed, I felt sick to my stomach, many large franchisor put on what appears to be more of a dog and pony show in franchise sales seminars. Some former franchisees say that the SBA helps hide the risks in modern day franchising. In my opinion this is a half correct statement. Other critics say that the Franchising Industry is subsidized by government, again, in observation that is also hard to argue.

You know this goes way back to when all the gas stations were selling to foreigners after the fall of the Shaw of Iran. Folks came to the US and wanted to start a business and many would buy gas stations because the understood that Oil and Fuel = Wealth. Then these immigrants who came with down payment monies, business skills would buy a fuel station franchise. When they were not making money as fuel re-sellers and franchisee gas station owners, then they would sell the non-performing business to another immigrant.

Often this went on and on, churning, sometimes over 5-6 sales. Yes, all SBA loans the price was 60% over its value – hello taxpayer on the last loan that defaulted. I thought that was unfortunate, but when you talk about subsidy, are at least partially correct, probably more than they even realize, as most folks are not very aware of this issue, which is water under the bridge now.

Most of those buying a franchise borrow money in order to attain the American Dream of owning their own business. They are not gambling in the stock market as one critic of franchising stated, nor are they using discretionary funds to buy the business. They are looking for self-employment as an answer.

I concur with these critics actually. In fact, this is what every single franchise buyer told me, and they were serious, most I sent away, as our franchise is hard work and lots physical work and as labor got tight. Apparently, this is why we have franchise laws to protect the investing consumer, but these franchise laws are not serving anyone, not the consumer or the franchisor therefore both are hurt in the end with bureaucracy, over regulation and huge legal fees. Since franchising is a win/win, no one is well served. It is time to de-regulate the franchising industry, and get government out of the way.

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