All franchisors are required to provide prospective franchisees
with a substantial disclosure document, called the Uniform
Franchise Offering Circular (UFOC), which contains a wealth of
information concerning many aspects of the franchise company. One
of the document's items is a history of any material lawsuits
or other litigation that either the company or its executives have
been involved in.
Prospective franchisees often have a number of questions about
these disclosures. Are they relevant and material? Should you be
worried about these disclosures? What can you discern about the
franchise company by reviewing these disclosures? To answer these
questions, you need to understand the reality behind most legal
conflicts in the franchise industry.
The franchise agreement contract is carefully drawn up by the
franchise company attorneys and governs the relationship between
the parties. Franchisees often do not use the same care to make
sure they completely understand the requirements of the contract as
the franchisor did during the drafting process. This can lead to
confusion and future conflict.
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When litigation is instigated by the franchisor, it is almost
always because of the failure of the franchisee to meet the
obligations contained in the contract. These obligations are
usually spelled out pretty clearly. The most common areas of
"default" on the part of a franchisee are not paying fees
when due or not meeting the terms of a development schedule.
When litigation is instigated by franchisees, it is almost
always because the franchisees are not happy with their franchise
business anymore. This could mean they don't like the
franchisor, they don't like the business or they are
financially failing in the business. In fact, it is often all of
the above.
The challenge franchisees have in litigation is that most
franchisors are very careful to make sure they meet all their
obligations under the terms of the contract and there is typically
no contractual obligation to make sure the franchisee is happy or
financially successful. Therefore, most franchisee litigation
alleges that the franchisor violated the rules pertaining to the
initial sales process, since prevailing on this point is one of the
few strategies that would allow the franchisee to obtain a right of
rescission to undo the contract they signed with the
franchisor.
When evaluating litigation disclosed in the UFOC, there are some
clear deductions you can make about the franchisor. This is
typically the case regardless of the allegations contained in the
specific disclosures. The most important of these are:
- If you take the total number of franchisees in the system and
divide by the number of litigations listed for the past year (or
for each of the past two years), you'll have an idea of the
percentage of franchisees who end up in litigation with the
franchisor each year. As a general rule, you want this percentage
to be very small, regardless of who instigated the litigation or
what was alleged to have taken place. Remember, these are your
future odds we're talking about.
- If the total percentage is significantly less than 1 percent
(for example, if they have about one litigation event per year with
500 franchisees), you probably don't have much to worry about.
These things happen in business occasionally, but if you're a
reasonable person, these odds suggest it probably won't happen
to you.
- If the percentage is greater than 4 to 5 percent, my advice is
to run away from this franchise as fast as you can. You don't
even need to know what the specific problem is, since this
percentage tells you there is a significant problem somewhere in
this system.
- If there is a percentage of system litigation in the past two
years is in the 1 to 3 percent range, look at the cases to see
who's instigating it. Don't worry about what is being
alleged at this point; just see who started it for clues about
where to do more research.
If the litigation is predominately instigated by franchisees,
you need to research the financial performance of this franchisee
business very carefully, since this is a red flag that something is
wrong in terms of the moneymaking potential of the business.
Franchisees who are making good money don't usually file lots
of lawsuits against the franchisor-if they're unhappy, they can
probably just sell their profitable business and move on to
something else.
If it is predominately instigated by the franchisor, this is an
indication that they may be litigious and prone to solving problems
by calling in the lawyers. Though some would argue there's
nothing wrong with this approach, I would personally just send them
a copy of How to Win Friends and Influence People
and go find another opportunity with people whose values were
closer to mine.
It is not uncommon for franchise companies that have been around
for a while to have some litigation disclosures, but anything
greater than a small amount should raise questions in your mind
about either the financial performance of the opportunity or the
values of the people behind it. The best advice is to steer clear
of any franchise with excessive litigation if it's important to
you personally to avoid such events in the future.
Though the above analysis ignores the substance of the
allegations contained in the disclosure, if a company passes the
tests mentioned above, you still need to look at the specifics of
the litigation history. Ask the franchisor for their explanation of
whatever happened and try to contact the franchisees to get their
side of the story. Even if it is a fairly rare event, this research
may give you information that is relevant to your decision about
whether this franchise is the right one for you.
Jeff Elgin is the "Buying a Franchise" coach at
Entrepreneur.com and has almost 20 years of
experience in franchising, both as a franchisee and a senior
franchise company executive. He is currently the CEO of FranChoice Inc., a company that provides free
consulting to consumers looking for a franchise that best
matches their needs.