Franchises: so what's not to like?

Burke, Debra D.

INTRODUCTION

Franchise ownership is a popular and prevalent form of conducting business in the United States. Franchise systems first appeared in the 1860s. Product franchising was the first form to develop in response to an expanding national market for complex and expensive manufactured goods. The concept expanded in the 1920s to include business-format franchising, by which the franchise itself was marketed as a distinct product (Dickie, 1992). Today, franchises can take the form of distributorship, chain-style business operations, or processing-plant arrangements (Clarkson, 1995).

Over one-third of all retail sales consummated in the United States are transacted through franchised outlets, representing $758 billion in revenue (Hearing 103-9, 1993). Projections expect that this figure will jump to one-half by the year 2000 (Cutler, 1991). Franchised operations allow the franchisee access to many of the efficiencies of big business, while permitting the owner a substantial degree of independence as well (Dicke, 1992).

In 1992, the International Franchise Association (IFC) commissioned the Gallup Organization to prepare a national franchise owner study. The results indicated that most franchisees considered their franchise to be successful, and suggested that the franchisees had no regrets concerning their investment (Hearing 103-9, 1993). While commonly cited statistics estimate a ninety-five percent success rate for franchises, that statistic is controversial. Arguably the statistic does not accurately define failures to include enough terminating events, such as discontinuance (Hearings 102-82, 1992). Further, while it is generally accepted that franchises fail at a lower rate than non-franchised businesses, the risk of franchise failure in some industries is higher than for non-franchised establishments (Walker & Cross, 1988).

CASE STUDY: A PUBLICATION FRANCHISE

Diane and Allen had lived in the Houston area for over twenty years. Allen was a professor of history at a university in Houston, while Diane was a civil engineer at a private consulting firm for most of those years. In 1989, she decided to take advantage of her spousal tuition waiver at Allen's institution, resigned her position at the firm, and enrolled in the university's MBA program. The combination of a business and technical degree was quite popular in the 1980s, and Diane thought the business background might help her to secure a management position in another consulting firm. She was tired of the technical drudgery of her previous job and wanted to try something different; more people-oriented.

When Diane completed her studies, however, there were no positions available. The economy had taken a downturn which immediately affected construction starts, and commensurately, the field of civil engineering. Shortly after Diane graduated in 1991, a friend was brutally murdered in her place of business in the middle of the afternoon. This event brought home to Diane and Allen the increase in crime and violence in their community. Since Diane had not located work after graduation, and the prospects looked bleak, Allen agreed to test the market for a teaching job at another university. It was time to get out of Dodge.

When Allen was extended an offer from a small, regional school in the Southeast, Diane had to access her options. Since Diane had wanted to move into management in a more people-oriented position, she decided to explore franchise opportunities which would allow her to run her own business. The couple attended a franchise expo at the convention center in Houston. One in particular caught Diane's eye. It was a publication franchise: Television News & Schedule (TNS). The basic concept involved sales. The weekly television schedule was printed and delivered to business establishments around town free of charge for customers. Revenue was generated for the franchisee based on the sale of advertisements to area merchants. The sales representative for TNS, Rhonda, made it sound so easy! So fun! So profitable!

The cost of the franchise, unlike some, was not astronomical: only $24,500! And, the franchisor was willing to finance $7,500 of that amount at really reasonable terms. The only other fee would be royalties based upon sales after the franchise was up and running. Moreover, the entire operation seemed legitimate. The franchisor had been in business since 1971. While the extent of the exclusive territory granted in many franchises can be a real concern, TNS was willing to grant Diane and Allen a seven county area in their new location for immediate operation and future expansion.

Although Rhonda admitted that she was not supposed to give projected earnings, she ran the numbers for Diane and Allen, giving them lucrative projected earnings through 28 weeks, after a six to eight week start-up period. She further projected earnings after the first year to be $1200 net profit weekly, $1450 net weekly after the first quarter of the second year, $1700 net weekly after the first half of the second year, etc., based on the addition of ads.

As negotiations moved to conclusion, Rhonda provided Diane and Allen with a document containing Information for Prospective Franchisees as required by the Federal Trade Commission. The document listed a schedule of production costs, the names of persons affiliated with the franchisor, the obligations of the franchisor and franchisee respectively, causes for termination of the franchisee's rights under the agreement, and any pending litigation or bankruptcy proceeding involving the franchisor (there was none). The document also contained an audited financial statement for the franchisor. Finally, the document contained a disclaimer with respect to any actual, average, projected or forecasted sales, profits or earnings that may or may not have been furnished by the franchisor's salespersons.

Diane and Allen decided to purchase the franchise. After moving to their new home, they attended a training program in Massachusetts to learn the business. That session was to be followed by on-site visits by the franchisor's sales representatives. Upon returning from Massachusetts, Diane set to work calling on merchants in her assigned territory. His schedule permitting, Allen helped, since he had attended the training program offered by INS for associate publishers. That the results of their efforts were disappointing is an understatement. The three visits by the sales representatives were no more fruitful in obtaining advertisers than their own efforts had been at that point. In reality, the task they faced defied reason. Here Diane was, in a new city, knowing no one, trying to sell advertising in a publication which didn't exist. Right, and how about a plot of fertile land in the Mojave, while I'm here!

Assuming that the whole operation might flow a little smoother if there was a book in existence, Diane decided to go to press with the few brave advertisers who had purchased space at a drastically reduced price. Diane was talented as far as the design of the advertisements and layout of the book was concerned. She pulled together an attractive publication. However, publishing brought with it a new set of problems.

Once an associate went to press, the process had to be continued on a weekly basis. The TNS recommended printer was located in another state. That required correspondence by overnight courier, and hectic deadlines. All that to do, in addition to trying to sell additional advertisers, secure distribution locations, and distribute the books.

Being in print did not ease the burden of securing advertisers. In fact, publishing heralded still another problem: payment. While seeing the book around town made a few more advertisers eager to contract for space, they were certainly less eager to pay. Unlike some businesses which are faced with nonpayment from customers, Diane did not have the option of slapping a lien against the property of delinquent purchasers. Once the ad appeared, they had received the benefit of their bargain, a benefit which could not be retracted. Further, in a recessionary economy, suppliers of tangible goods receive preferred payment; suppliers of commercial advertisements are expendable.

In short, long hours and hard work were to be expected ... but so was payment ... and at the end of the first year, so was that $1200 a week net profit. It wasn't in sight. The total stress of the enterprise began to affect Diane's health. TNS corporate was unresponsive to her post-publication problems. They didn't seem concerned that she was financially unable to pay her royalties, either. Finally, when she was asked by a merchant, "What ever happened to that other 'gal' who used to publish that 'freebie' about four years ago," she decided to cut bait.

After 14 months of operation, Diane ceased publishing, to the dismay of many loyal advertisers who had profited from her efforts. She subsequently secured employment on an engineering project. When that was over, she started an independent consulting firm. Never, but never, had she enjoyed engineering, nor appreciated her talent in that field, so much!

SOME PRACTICAL OBSERVATIONS

Many white collar workers like Diane sought to take advantage of franchising opportunities in the wake of economic downturns (Burke, 1991). Whatever the motivation, all potential franchisors must be financially prepared, committed to good management, committed to working long and hard, committed to salesmanship, and committed to thoroughly investigating the opportunity in which they are interested (Sturgis, 1993). Even so, such preparedness and commitment may not translate into success. In retrospect, Diane and Allen highlight some additional pitfalls as well.

A Franchisee Should Be Familiar With The Business. It would be valuable for a potential purchaser of a fast food franchise to be familiar with restaurant management. However, at a minimum, the franchisee should be familiar with the nature of the business. In Diane's case, the business was, simply put, sales. She had no prior experience in any type of sales. While she rose to the occasion better than many could, she found that she hated sales. While learning that lesson is invaluable, it is a lesson best learned with someone else's money.

A Franchisee Should Be Familiar With The Area. In starting any business, it is advisable to first be a member of the community. Knowing people in the community is an asset in conducting business. If Diane had started her franchise in her north Houston neighborhood, or even in her childhood hometown, her efforts might have been more greatly rewarded, and at a faster pace. Even with substantial backing by a franchisor, which Diane did not enjoy, it is challenging to move to a community and begin successful operations, particularly if that community is small, with its own entrenched network of relationships.

A Franchisee Must Be Cautious And Skeptical. Trust is for friends, not franchisors. Franchisors pursue a profit motive. While TNS provided the disclosure required by law and was hardly a fly-by-night operation, several items of interest to franchisees were not mentioned. Although the financial statement disclosed income generated, it did not break that income down into royalties paid, income from the printer on books printed, or the sale of franchises. Most likely, the bulk of TNS's income came from the latter two sources, while the former source of income, most likely was represented in the accounts receivable entry, or possibly, the uncollectible category, a testimony to the lack of success of the franchisees. Diane certainly could never afford to pay the royalties she owed.

THE LEGAL ENVIRONMENT OF FRANCHISING

Do not be mistaken, if potential franchisees do not look after themselves, the law will not either. Unfortunately, many franchisees have an unrealistic expectation that the law will protect them from franchisors who are less than candid, and that justice eventually prevails (Cutler, 1991; Hammond, 1979). That is simply not the case.

There are three federal laws which do grant rights to franchisees, but these statutes are not sufficient to address all potential abuses which can occur in the franchise industry. The Automobile Dealer's Franchise Act of 1956 protects car dealerships from a bad faith termination of the franchise. The Petroleum Marketing Practices Act protects retailers of petroleum products from bad faith termination, or failure to renew (Clarkson, 1995). On a broader scale, The Federal Trade Commission's Franchise Rule requires disclosure of certain information which is material to making an informed decision concerning the purchase of a franchise prior to the signing of the franchise agreement (Foster, 1988; Foster, 1989). The veracity of the statements contained in the offering circular, or disclosure document, however, are not verified by the FTC (Smith & West, 1986). Although the required disclosure does eliminate some of the evils which occurred prior to its adoption, the FTC Franchise Rule is not sufficiently comprehensive (Hunt & Nevin, 1976).

Further, the Rule, unfortunately, is purely regulatory in nature; it does not grant a private cause of action for aggrieved franchisees. The remedies provided by the rule allow the FTC to investigate, issue cease and desist orders, freeze assets of franchisors who fail to comply, issue redress judgments, and ultimately seek criminal sanctions for violations of its orders. Since the rule took affect in 1979, the Commission has brought 34 cases involving over 30,00 injured investors and has obtained judgments of four million dollars in civil penalties (Cutler, 1991). However, limited resources dictate that only the most egregious offenders will merit the attention of the FTC. Many inducement and relationship problems continue unaddressed. In fact, most abuses occur in the smaller franchise operations which sell at less than $100,000 (Dizak, 1993).

On the state level, fifteen legislatures have passed laws which regulate franchise offerings, require disclosure and registration with the state by the franchisor, and often grant to franchisees a private cause of action for losses occasioned by the franchisor's failure to comply (Burke, 1991; Hammond, 1979). Some of these statutes provide greater protection for the franchisee than what is provided under federal law. For example, under New York's Franchise Sales Act, a franchisor must submit a prospectus to the Attorney General's office for review before it can be used in the public offer and sale of the franchise (McInerey, 1991). Moreover, Iowa recently passed a comprehensive law primarily aimed at relationship problems. The Iowa Franchise Investment Act grants franchisees legal remedies with respect to unfair practices concerning the franchise's transfer, termination, and nonrenewal, and also protects franchisees from potential encroachment by the franchisor's subsequent sales (Oleck, 1992). Nevertheless, the overwhelming majority of states have not passed legislation to complement and augment the Rule of the Federal Trade Commission.

On the other hand, all states have passed Deceptive Trade Practices Acts. These acts, sometimes referred to as little FTC Acts prohibit deceptive acts or practices in the conduct of trade or commerce (Leaffer & Lipson, 1980; Lovett, 1971). They primarily exist to protect consumers from unfair trade practices; as such, they may or may not be applicable to franchisees. That issue will depend on the definition of consumer as provided by the statute or as interpreted by the court. Massachusetts is the only state which specifically provides business plaintiffs with a cause of action under its statute (Pirozzolo, 1977). Bringing suit under these acts is attractive to litigants because most not only allow treble damages, but attorneys' fees as well (Wax, 1985). If applicable, this legislation should embrace inducement problems which encompass deceptive, though possibly not fraudulent, practices in procuring the franchise contract.

Without statutory grounds for relief, a franchisee is left only with common law grounds for recovery. Common law fraud is a potential remedy for inducement problems. However, fraud is difficult to establish because it requires some degree of scienter or proof of an intent to defraud (Garner, 1993). For relationship problems, breach of contract is a possible avenue of redress; however, often the contract is so one-sided, the franchisee can suffer losses without the franchisor breaching the actual terms of the agreement. Unless the agreement rises to the level of being unconscionable, there is no grounds for relief. Further, with respect to bogus potential earning claims, even if there is no disclaimer in the circular provided by the franchisor, as there was in Diane's case, common law contract law will not allow that evidence to be admitted except in limited circumstances. The Parole Evidence Rule prohibits the introduction into evidence of the parties' prior negotiations, agreements, or contemporaneous oral statements that contradicts or varies the terms of the agreement (Clarkson, 1995). Although fraudulent misrepresentations introduced to establish a defense to the contract represent an exception, again, the franchisee must be able to make that presumptive showing.

Even if a franchisee could establish a statutory or common law cause of action, most of the time that course of conduct is not worth its burden. If an unsuccessful franchisee owes the franchisor uncollected royalties or a part of the initial franchise fee, a counterclaim can be expected. Further, most lawyers are reluctant to take such cases on a contingency fee basis because of the uncertainty of recovery and the up-front costs of discovery. Alternatively, if a statute provides for the recovery of attorneys' fees, the attorney, of course, must win the case in order to recover. Thus, only an obviously meritorious case would be considered. If enough similarly situated franchisees are affected, class action suits in which the rewards for counsel increase exponentially, represent an additional opportunity for recovery. Indeed, there has recently been an increase in such suits against franchisors (Hearings 102-82, 1992). Finally the last option available to aggrieved franchisees under the law is the least attractive: write it off. Tax laws allow lost investments to offset income for tax purposes. But that is the rub ... there has to be income to offset. In Diane's case, her subsequent income along with that of Allen could be used. Unfortunately, for franchisees who have sunk their savings into their business and who have nothing substantial to fall back on, this option is unavailable.

SUGGESTIONS FOR REFORM

There are several legislative initiatives which should be considered by congress and state legislatures which would at least address some of the inducement problems associated with the sale of a franchise. Many of these suggested measures have been explored in part in hearings which have been held before the House Committee on Small Business.

Require Historical Data To Be Included In The Disclosure Statement. Franchisees should be provided with information concerning the earnings of past franchise owners over the previous five year period. Currently only fifteen percent of the members of the IFA make such information available (Hearings 102-82, 1992). The substantiated operating history of all units is essential information for an informed purchase decision and should be required by law (Kezios, 1991). The accurate failure rate of franchises should be duly noted as well. While current disclosure requires the financial health of the franchisor to be revealed, that condition may not be probative for speculating on the health of the franchisees.

Prohibit The Use Of Profit Projections By Franchisor. This practice is prevalent in the franchise industry and manifestly abusive (Dizak, 1993). The law should either prohibit the practice, or alternatively, require the information to be included in the disclosure statement so that gross overstatements can be verified and admitted into evidentiary proceedings for administrative or private legal action.

Require The Release Of The Names And Addresses Of All Past And Current Franchise Owners. Presently it is a common practice for franchisors to churn their markets: that is, to sell failed franchise territories over and over again (Hearings 102-82, 1992; Cutler, 1991). Requiring historical operating data should reveal this practice; however, for simplicity, the information should be mandated as a separate requirement as well. Such information would at least give prospective franchisees a staring point for a legitimate investigation of the reasons, presumed or real, for the success or failure of other franchisees.

Simplify The Language of Disclosure Statements And Require A More Detailed Financial Statement. Surveys indicate that most potential franchisees cannot comprehend even the minimal disclosure statement currently required by law (Dizak, 1993). The form should be simplified, while at the same time the financials should be simplified and clarified by providing more detail. While a few accountants and lawyers do purchase franchises, the disclosure document, nonetheless, should be written for the average lay person, and not require that the purchaser be able to read between the lines and interpolate the information.

CONCLUSION

Until such reforms are implemented, skepticism, caution, and vigilance are a franchisee's best weapons against inducement problems. Just because a franchise is listed in a guide to franchising opportunities does not mean that the operation is somehow endorsed. TNS was listed in such a publication (Bond & Bond, 1994). Nevertheless, several key facts were either misrepresented or concealed from Diane and Allen: 1) the failure rate, 2) the profit projections, 3) the existence of a previous associate publisher in the area they purchased, 4) the kickback the franchisor received from the printer, and 5) the lack of continuing support from the franchisor.

Even if reforms are passed it is unlikely that government resources will be sufficient to police all abuses in the industry (Cutler, 1991). Therefore, a potential purchaser should thoroughly investigate the franchisor, and locating as many past and current owners is an excellent place to start. Unless an investor can look at herself in the mirror and say, "It's only money", and MEAN it, it is not safe to rely on the law to make amends.

REFERENCES

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Burke, D. (1991). Statement before the Committee on Small Business, House of Representatives, 102nd Congress, 1st Session, March 20, 1991, Serial N. 102-10, pp.73-86.

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Walker, B.J. & Cross, J. (1988). Franchise Failures: More Questions Than Answers, Paper prepared for Society of Franchising Conference, Jan. 31-Feb. 2, 1988, San Francisco, CA, reprinted in Hearings 102-82, pp.192-211.

Wax, D.E. (1985). Award of Attorneys' Fees In Actions Under State Deceptive Trade Practice and Consumer Protection Acts, American Law Reports 4th Series, Vol. 35, pp. 12-56.

Debra D. Burke, Western Carolina University