Ask the Insiders

Electronic Disclosure, Subfranchising and the Future

Caffey: Let's talk about electronic disclosure. Why don't franchisors provide electronic disclosure of their offering circulars--or do they? If electronic disclosure is not common now, is it coming?

Burzynski: I don't see it that often, and I choose not to use electronic documents. Maybe I'm old-fashioned, but I want to make sure our prospective franchise owners are taking the time to read that document. I'm concerned they will not take the time to print out an electric document and read it carefully. It is surprising, but I still find [people] who come to the table for a serious discussion, and it's clear from their questions that they haven't read the UFOC or the agreement.

Fertman: We still send out that big book to about 600 people every week. A printed version is an expense for the franchisor, but it's easy for people to read. A while back, we made the UFOC available on CD-ROM; we asked prospects if they had a preference for the old-fashioned book or the electronic CD-ROM, and virtually everybody took the book. Electronic disclosure is ultimately a useful tool, but it may take more time for people to get comfortable with it.

Caffey: In the past 20 years, we've seen some strong subfranchising systems arise, and I'm wondering what experience you've had with multi-unit franchising or subfranchising, and whether you think this is a strong direction franchising is taking.

Burzynski: It's definitely growing. Franchising is attracting very sophisticated investors looking to build empires. This is a growth tool that many franchisors will use. I approach multiunit arrangements very cautiously. With Liberty Fitness, we are embarking on a couple of multiunit franchise opportunities, but I'm going to watch it carefully. I want to ensure success for the system and, of course, for the developers.

Fertman: Subway is actually doing more multiunit franchising. We've put together an exclusive area agreement program where we grant a particular territory to a franchisee-or a partnership or consortium of franchisees-and they have an opportunity to develop that area over a period of time. They retain exclusivity as long as they build the business as scheduled. I agree with Andy that multiunit franchising is something we're going to see more of in the future. As our system matures, our franchisees mature and more multiunit operations become available to the owners. They start becoming business-builders as opposed to individual franchisees.

Caffey: What does the state of franchising look like down the road?

Burzynski: The state of franchising is extremely strong. I believe there is a realization not only in our country, but in many countries throughout the world, that franchising is definitely a strong way to expand business. People's desire to own their own businesses and to grow and prosper is growing, not weakening. Baby boomers are consistently disappointed in the corporate culture, so I feel that franchising is going to grow as a strong alternative.

Fertman: I would certainly agree with that. Franchising is indeed a growing proposition. It really is a terrific business model.

Selden: I see a trend-I don't think it's an avalanche, but a trend. Independent economic research and aca-demic literature about franchise systems are telling us that systems following what I'll call a 1950s or 1960s top-down, vertical hierarchy are the ones that never really flourish. Systems that embrace a more holistic, collaborative, internal-governance arrangement are the ones that realize their full potential, and we see more and more of this in big systems and small systems alike. They understand that franchisors and franchisees both have a lot at stake, that they're all rowing the same boat, so to speak, and to the extent they can genuinely work together on system issues, they're all going to come out ahead.

Raise the Red Flag
Does your gut tell you something isn't quite right with that franchise investment? Check out this list of 7 warning signs.

1. No uniform franchise offering circular: Franchisors are required by federal law (and often state laws) to give you a UFOC at least 10 business days before you pay any money or sign a franchise agreement. If you don't receive one, don't even consider investing.

2. The hustle: If the seller tells you the window of opportunity is closing or uses any other hard-sell tactics, be prepared to walk away.

3. Product price squeeze: If you're buying a business that sells the franchisor's product line, make sure its pricing allows you to be competitive in the marketplace. Ask franchisees how the pricing structure works for them. If the product is supplied by third parties, or by the franchisor itself, make sure the supply program runs smoothly. Have the franchisees established a buying co-operative? Do franchisees have input about supply arrangements?

4. High turnover rates: Check Item 20 of the UFOC to confirm how many franchisees have left the system in the past three years. If anything looks suspicious, ask the franchisor about it.

5. Earnings-claim mumbo-jumbo: When you ask how much money you can make with the franchise, listen carefully to the answer. Although a franchisor is legally allowed to provide an answer with either a projection, pro forma or statement about how its franchisees have performed, it must also include the claim in its UFOC (Item 19). If the information isn't in the UFOC, the company must decline to answer the question. If no performance information is given (only about 25 percent of franchisors provide earnings claims), it may be because the true picture isn't pretty. Ask the same question of the franchisees you interview. They are legally free to tell you.

6. Too many lawsuits: Item 3 of the UFOC shows the 10-year history of lawsuits filed against the company. A heavy litigation history may mean franchisees are unhappy, so find out what's going on.

7. Weak financial statements: The UFOC contains three years' worth of the franchisor's audited financial statements. Review them carefully, and take them to a CPA. The poor financial condition of a franchisor magnifies your own risk.

Any of these warning signs should prompt you to ask more questions. If you don't like the answers and your gut (or professional advisor) tells you to be wary, this may not be the right program for you.

Digging for dollars
The biggest challenge most people face when purchasing a franchise is finding the money necessary to build the business. Here are some starting points:

  • SBA-backed loans: The SBA's lending program has launched more franchises than any other in history. Talk to your bankers about whether you qualify for an SBA-backed loan for your franchise.

  • Family equity: Even if you locate financing, you'll have to inject a slug of equity into the business. Check your own resources. What do you need to pay your bills every month? Do you have friends and family willing to invest in the venture?

  • Venture capital: If you approach a venture capitalist, be prepared to provide every last detail of your proposed business and business plan, and be willing to give up as much as 50 percent of your business in return for the investment.

  • Angels: An angel investor is a wealthy individual who is not a professional venture capitalist.

He or she has investment money in hand and is looking for a financial home run, or at least a better return than can be expected from the stock market. Angel investors look for annual returns of at least 25 percent. They're often patient, long-term investors who have witnessed the birth of plenty of entrepreneurial ventures.

Andrew A. Caffey is a practicing franchise attorney in the Washington, DC, area, an internationally recognized specialist in franchise and business opportunity law, and former general counsel of the International Franchise Association.
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This article was originally published in the January 2006 print edition of Entrepreneur with the headline: Ask the Insiders.

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