Franchises Then, Franchises Today: Advice for New Franchisors and the “Guinea Pig” Franchisee

I am a small business attorney, and am helping a local entrepreneur buy into a franchise.    I have reviewed the franchise documents he has been asked to sign, and I admit I’m a bit troubled.  The franchise was formed only weeks ago, and its Franchise Disclosure Document (FDD) was approved by the Federal Trade Commission only last week. Although our state does not require franchises to register locally before they can legally sell franchises, this franchise has not yet registered in any of the 12 states that require registration. Most disturbingly, this franchise has no other franchisees anywhere in the United States.  The founders seem to have experience in the franchise business, but are not currently operating any franchise units themselves.  My client will be the franchise’s very first franchisee – the ‘guinea pig’ on which this franchise will be experimenting to prove their concept. Now, I’m not saying this franchise is doing anything illegal.  The franchise has properly disclosed its lack of a ‘track record’ in its FDD as it is legally required to do, but I’m wondering if I have a duty to this client to tell him not to buy this franchise – to wait a while until the franchise has a few other franchisees on board.  I’m concerned that I may be looking at a malpractice lawsuit if this client buys the franchise and it ‘crashes and burns’ later on.”

To anyone out there thinking of franchising their business, please read this e-mail very, very carefully.

Once upon a time (about 20 years ago), this situation never would have occurred.  The typical franchise would wait until it had at least 10 to 15 units up and running and had perfected its concept before it even considered franchising as a means of growth.
Not anymore.  Today anyone with $10,000 to $20,000 to spend on lawyers and accountants can set up a franchise without any knowledge or experience in the franchise business.  Some new franchises are being set up using business models that have not yet been proven (where nobody has any real experience) in an effort to be “first on the ground” with a franchise concept.  Others see a potential franchise opportunity and figure they can add experienced people to their management team once the franchise is up and running and they have revenue (in the form of franchise fees from the first few franchisees) to pay those folks with.

People buy franchises because they feel they will have a better chance of succeeding than by starting a similar business on their own.  Inexperienced franchises defeat that expectation and, in my opinion, are lawsuits waiting to happen.

It gets worse.  Looking back 20 years ago, the typical franchisee was an experienced business person.  Usually, the franchisee was running a “Mom and Pop” local business of the same type as the franchise, and wanted to buy into the franchise so that he could leapfrog his competition:  by operating under a nationally recognized trademark, by having access to a national “advertising fund” that could buy television and radio time, and by having access to the support and trade secrets that only national franchises can offer.

Not anymore.  Today the typical franchisee is a laid-off – er, I’m sorry, I mean “downsized” – corporate executive with a severance package who can’t find a corporate job because of his age and is looking to do something for 10 to 20 years until he’s ready to retire.  Not only is he inexperienced in the franchise business, he has never before run a business of his own, period.

Combine the inexperienced franchise with the inexperienced franchisee, and what you have is a formula for disaster if things don’t work out. If you are thinking of franchising your business and have fewer than 10 units operating in different places around the country, here are some tips to avoid liability:

*  keep your initial franchise fee as low as possible;
*  state clearly in your FDD that new franchisees are “rolling the dice in Vegas” and could lose their entire investment in the franchise;
*  be flexible in enforcing your franchise rules;
*  give the franchisee the chance to deviate from the franchise model if local conditions dictate;
*  make it easy for franchisees to exit the franchise if things don’t work out;
*  only sign up franchisees who have either substantial experience in running their own business, or a net worth big enough to withstand the total loss of their investment in the franchise (what the securities folks call “accredited investors”); and
*  treat new franchisees as if they were potential plaintiffs in a lawsuit (because they are) by servicing the Dickens out of them.

If you are a lawyer or accountant representing a “guinea pig” franchisee, make sure the client has relevant business experience, knows and appreciates the risks he is undertaking, and acknowledges those risks in writing before he signs his franchise agreement.

ABOUT THE AUTHOR:  CLIFF ENNICO

Cliff Ennico (www.succeedinginyourbusiness.com), a leading expert on small business law and taxes, is the author of “Small Business Survival Guide,” “The eBay Seller’s Tax and Legal Answer Book” and 15 other books.

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