AB Podcast Nick Bibby AND Bruce Shaefer 01162008 Part 2 96kbps (AllBusiness.com’s Chris Bjorklund interviews Nick Bibby and Bruce Shaefer.)

Chris Bjorklund: You’re listening to the AllBusiness podcast. I’m Chris Bjorklund. If you’re getting this through iTunes and RSS feed or an online streaming-media player, you can hear interviews with other experts at AllBusiness.com.

Bjorklund: We’re continuing our discussion with experts Nick Bibby and Bruce Shaefer in part two of this AllBusiness podcast on franchises as a financial investment. I want to talk to Bruce now a little bit or start with Bruce with the disclosure that’s required when you purchase a franchise. Are there minefields in that document?

Bruce Shaefer: Yes, there absolute are. But if I could just jump in for one second and just follow up on something that Nick just said in terms of the importance of the due diligence? He made a really good point. The first aspect of the due-diligence test is really the kind of personality inventory, where the franchisee has to decide whether or not they have the makeup that is necessary to be a franchisee and that makeup is basically based on obedience and the willingness to follow the franchisor’s orders. So if a potential franchisee is the kind of person who considers themselves an innovator and someone who’s going to devise new ideas, they really don’t belong in franchising. The second part of the due diligence that I find is tragically lacking is the sort of homework aspect of it. They really have to be willing, before they make the investment, to go around to other franchisees in that same system and try and find out as much information as they possibly can, because that’s the real-life information that’s absent from either the broker or the salesman or the franchise disclosure document. Now, turning to your question about what is or is not present in a franchise disclosure document, which used to be called the uniform franchise offering circular, there is an enormous amount of information. You have to understand that these documents are prepared sort of as a reaction to a great deal of fraudulent franchising that went on in the 1960s and 1970s resulting in many states and the Federal Trade Commission passing laws requiring the information that is now available on the franchise disclosure document. And that document has lots of financial information and any prospective franchisee should review it very thoroughly, very carefully and unless they have their own financial expertise should do so with an attorney, an accountant, a consultant, somebody who knows something about it and can explain it to them. Why is that so? Well because unlike most businesses that are purchased, a franchisee generally gets no financial information with respect to the specific operation. The only financials that you will find in a franchise disclosure document are the franchisor’s financials. Now that’s interesting in terms of knowing the health and operating skill of the franchisor but it really gives you no idea of what you the franchisee will be able to accomplish at your particular unit. A simple example would be that I believe the poorest McDonald’s generates approximately $600,000 a year and the best more than$8 million. So it gives you an idea of just--within the same very successful system--just how extraordinary the differentiation can be. So a franchisee is going to have to do more than check out the franchisor’s financials. When they do check out the franchisor’s financials, they are going to have to look at the revenue mix because that’s very important. If for example, they see that more than 50 percent of the franchisor’s revenues are coming from up-front franchisee fees and not from royalties, that’s a big warning sign. That may be a disclosure that the franchise system is growing faster than they can accommodate or it may be that they’re looking to just take the money and run. So when a franchisee looks at the franchisor’s financials, they want to check out certain items like something called deferred franchise fees, which shows up on a franchisor’s balance sheet as a liability but is really an artificial one only caused by accounting rules. It is really a sign that a franchisor is growing quite fast. Now that’s a good sign so long as they’re not growing too fast. So a prospective franchisee wants to analyze not only their own potential operation, the costs and expenses of which are usually enumerated in a set of graphs and tables that are present in a franchise agreement, but they also have to look at the franchisor’s financials to determine if they’re getting in bed with someone that can be trusted, that is operating on a prudent sort of basis rather than a hurry-up-and-grab-the-money basis.

Bjorklund: Nick, what is the biggest reason why franchise relationships fail?

Bibby: I’m going to answer that question directly but I’m going to answer it from my perspective because don’t forget, whereas Bruce and I both analyze franchises, we would tend to analyze the investment in slightly different ways. He is a tax attorney and an evaluations expert. I tend to look at franchising from the people side, so the issue of relationships, I think, when you asked me about relationships, I think about the relationship personally, interpersonally between franchisor and franchisee. So when the franchisor is sufficiently interested in the franchisee’s success, they will take as much time performing due diligence in an act of selection process as the franchisee should take in making the decision to purchase or not to purchase. However, as sad as it is to report that most franchisees never conduct adequate due diligence, it’s a misnomer to think that most franchisors conduct any selection process at all beyond the ability to write a check that cashes.

Shaefer: That’s especially true when there’s a broker involved.

Bibby: Yeah. I think you find Chris that Bruce and I ultimately come to the same point. It’s just that we come there from a different path, which I guess is good because I guess you get a more--I guess you get a fuller picture that way.

Bjorklund: Now Bruce, did you have more to say on that issue of some of the failures that go on in this area?

Shaefer: Well, you have to forgive me but having practiced law for 30 years, you find that people don’t come to you in good times. People only go to the lawyers when there’s a problem and there’s a bad time where somebody feels they’ve been taken advantage of or they’ve lost money. So at that level you have to realize that you develop a certain inherent cynicism. What I have found is that when brokers and franchise marketing firms, of which there are many, are involved, it’s just what Nick said: the franchisor basically delegates everything to this sales arm and, in many instances, avoids their proper responsibility. They hire this sales entity and they go out and the only thing they’re really concerned about is making the sale because that’s the beginning and end of their relationship. The franchisor, on the other hand, with the franchisee, they’re sort of married for the next five, 10, or 20 years, so the broker has a lot less sort of invested or a lot less caring about the actual people involved in this relationship or the continuing aspects of it because if the deal is consummated they get paid and they go away and they don’t care about the operations from then on. So frequently, if it’s the broker that simply provides the franchisor with this prospect and the franchisor relies on a broker or some other sales arm to do the discriminating due diligence required of the franchisor as Nick said, you have the real potential for bad stuff because the franchisor will have a document that says we make no earnings claims and the broker may very well write down on a napkin over coffee: this is what you’re going to do in the store. The sales people may not care at all about a problem. For example, I was involved with a franchise operation that had a very long delay between the time they can sell a unit and the time that the unit could open and this was because they required 12-foot ceilings. It involved kids being able to jump up and down on a variety of sort of structures and so, if the ceiling was too low, obviously the kid would smash his head into the ceiling and that would not be the stuff of a good operation. But a broker who’s selling that business is not going to be very specific and careful and tell that franchisee, “Listen, it can take you two years to find a site for this because most places don’t have 12-foot ceilings.” Instead, he’s going to gloss over that fact and try to make his sale as fast as he can and then from then on, the franchisor and the franchisee will have a relationship that’s in some respects poisoned from the very beginning. So in my experience the key element to maintaining good franchisor-franchisee relations is openness, candor and a sort of completeness to the honesty that’s necessary because they’re going to be together almost like husband and wife for a very long period of time. It’s a real interlaced sort of relationship where they both are completely dependent upon each other and the honesty and good will is the key ingredient and if it doesn’t get off on the right foot, it can be jaundiced for a long, long period of time.

Bjorklund: Well that brings us to the franchise agreement itself. I mean, isn’t it written more to protect the seller than the buyer?

Shaefer: Oh absolutely. The one who writes it is the franchisor’s attorney so you may rest assured that they put provisions in there that frequently even they know will not stand up but they just put them in there to make it as one-sided as possible. The dispute-resolution provisions are practically always in favor of the franchisor. The requirements in terms of what services or what obligations the franchisor has are usually minimalized while those of the franchisee are maximized. So you have to realize that as a potential buyer, you really want to have someone critical, someone who’s not an optimist in this context--perhaps overall optimist but not some sort of blind sucker, if you will--you need somebody really cynical to look through the potential for the deal and to point out as many of the possible flaws as possible, because as an investing franchisee you’d rather hear about those problems before they come up than have them surface as a big surprise.

Bjorklund: Nick, have you seen some real doozies in franchise agreements?

Bibby: Yeah, they’ve existed in the past. They especially existed in the era that Bruce referred to, pre-1979, when the first disclosure regulations were put forth by the Federal Trade Commission. We used to call it the land of the blue suede shoes. But, yeah, and it’s not so much, I think, not so much what is written or not written. Not to take away from what Bruce said but more in the sense of what’s written versus what is said and Bruce gave a perfect example of the franchisee who purchased or signed a franchise agreement and may have waited up to two years once they’ve put their money down to open a store or open a location. So I don’t think it’s so much what’s stated because, once it’s stated, the fact is clearly in front of you and you can make a yes-no decision. The big problem is what is said and what is believed as opposed to what is written and that once again goes back to the entire issue of performing adequate franchise due diligence and too few people do that.

Shaefer: Just speaking from my experience, something you run into very frequently with new franchisees is that they look at an available franchise, which may require $200,000 $300,000, $400,000 investment and they try and skimp so much on the due diligence end. They’re not willing to do the hard work that’s required of them without an expert and they’re not willing to pay fees they usually argue a great deal about, you know, “Why do I have to pay that much money for you to look at this?” The reason that you want to pay an adviser is not to get an enhanced asset but to avoid a potential problem. Anybody who reviews and helps with the due diligence necessary is really not there to make the business run better as much as they are there to tell the person to avoid an opportunity that should be avoided.

Bibby: And Chris, let me, allow me to interject just one thing. I told you I don’t know why people refuse or shrink back from due diligence but I told I could guess as to why that is so. So to follow what Bruce has just said, my best guess is this. It’s not so much the money, which pales in comparison--the cost of hiring due diligence expertise pales in comparison to the average investment. So it’s not so much the money. I believe that emotionally and psychologically, the average buyer, once believing that they have found the perfect match for them, never wants to hear the negative side. They do not want that dream tipped over. It’s sad but I believe that’s the truth.

Shaefer: I agree.

Bjorklund: Now before closing, and we’re just about out of time, I’m wondering if we can just finish up by talking about the art and science of financing this type of investment. Nick?

Bibby: Well, two sides to this. My side, Bruce’s side and that’s why I think we tend to work well together. But also let’s talk not only left, right, his side, my side but let’s talk top and bottom. We spent most of this time on the subject of buying a single franchise or a first-time buying. The higher up the ladder you go, in terms of size of investment--and I’ll go back to one word that Bruce used and I elaborated on and that one word is sophistication. The larger the investment, the more sophisticated the analysis. It’s OK to secure disclosure documents on a single-unit franchise but what about that larger investor that we might work with who is looking to buy an entire state to represent a franchise or an entire franchise system? Now we’re getting way beyond the issue of personal fit and more into the realm of how might I grow this company, what is wrong with this company. So it’s not just about the art and science of finance. It’s what you ask, Chris, the art and science of the investment, which goes way beyond money, right? Because it’s all about either a turn-around or a management style or what do you bring to the table. Now we’re talking about mega questions, about personal fit. Should I own this entire company? Should my investment firm help me acquire this entire firm? And that’s when you bring in someone like a Bruce Shaefer who has a capacity that I surely don’t. I can tell you what’s wrong with the franchise company and I might even give you some good tips as to how to improve it and write a best-practice policy and plan to make that company turn around. But you need a person like a Bruce Shaefer who can take the minutiae, take the big numbers and crunch them and tell you from a financial point of view what’s actually been happening with this company and what actually must happen for you to affect change. Bruce?

Shaefer: Yeah, well, the question in terms of the art and science of financing the investment, I think, depends upon the investment. If it’s a first-time franchise buyer, usually the first recourse is to look through your own finances and perhaps your family, your friends to see if you can raise money. In terms of borrowing, there is the SBA, the Small Business Administration, which has an entire roster of preapproved franchise systems that they will finance, and if the franchise you’re interested in isn’t on their preapproved list you can still make an application and perhaps borrow from the SBA, which is one of the easiest places to borrow. In terms of larger developers, then again, they can either self-finance or there are many, many venture firms and now they’re called hedge funds or venture capital funds or a whole lot of different names that have enormous pools of capital that are willing to either finance or actually purchase multiple-unit operations. There are a lot of large operators, for example fast-food chains, that can get financing from places like that. Obviously commercial lenders like banks nowadays, there’s a tremendous pool of foreign capital that is available, for example, for the purchase of franchise systems where there is a larger purchase price and an obviously greater need for capital, so it really depends on the particular investment all the way from a single unit to multiple units to whole franchise systems or even multiple-unit systems. For example, the company Sanden, which just broke up, was a multiple-platform franchise unit. The company Yum, Y-U-M, is now listed on the New York Stock Exchange. That’s the franchisor of Pizza Hut, of KFC, of Taco Bell. So you have companies that range all the way from a single unit up to a multiple-franchisor platform company. And each of those has different alternatives in terms of the capital markets that they can go to to obtain the requisite financing to either acquire or refinance a franchise operation.

Bjorklund: I think that you both have given us a lot of great information and a reality check, I might add. Any last thoughts, Nick?

Bibby: Due diligence, due diligence, due diligence. And I don’t care at what level you’re making the investment. But of course, those words of caution are more aimed at the first-time investor, the more sophisticated higher-level investor has made many a mistake and they’re accustomed to their due diligence.

Bjorklund: And Bruce, how about you?

Shaefer: Well, just in keeping with that theme, the essence of the due diligence--and I don’t want to sound overly cynical but it truly is--don’t be so trusting. Don’t trust anyone. Make sure that you’ve checked out all of the representations and all of the financial supposed projections on your own, because to make a sale, frequently people lie. It’s a sad fact but it is a fact and the only way for potential investors to protect themselves is, as Nick said, to do as much due diligence, due diligence, due diligence as they possibly can.

Bjorklund: Nick Bibby, Bruce Shaefer, thanks for joining us today.

Bibby: Thanks a lot, Chris.

Shaefer: Thank you, Chris.

Bjorklund: I hope you enjoyed learning about franchising as a financial investment from our special guest experts Nick Bibby with the Bibby Group and Bruce Shaefer with Franchise Valuations Ltd. Check out our podcast library for other shows about the different aspects of franchising and send your feedback and suggestions for future guests to podcasts@allbusiness.com. I’m Chris Bjorklund, thank you for joining us.