Evidence of the deep impact the “recession from Hell” has had on the franchising community is right there in the Franchise Disclosure Documents (FDDs): a spike in the number of terminations, and, in the lifeless phrase that the FTC insists we use in Item 20: “Ceased Operations – Other Reasons.” This information is certainly enough to give new investors pause. How should a new franchise investor evaluate the meaning if X number of franchisees have been terminated or left the system for “other reasons”?
Any franchise termination means that something, somewhere, has broken down. A franchise relationship is designed to continue for the length of the term and, one hopes, well into renewal terms, without the franchise closing its doors. So what does it mean when there is an increase in the number of breakdowns?
The Termination Story. First, remember that franchise terminations result from individual personal and business circumstances; be careful drawing general conclusions from the numbers you find in Item 20 of the FDD. One termination may be caused by a franchisee retiring after running the business successfully for 20 years, another when a spouse becomes ill and the franchisee agrees to terminate by mutual consent with the franchisor. People move, get divorced, get sick or otherwise have a change in life circumstances, and the franchised business suffers. There is a story behind every termination.
A percentage of those franchisees who were terminated simply failed to make a go of the business, and they probably would have failed regardless of the economic climate. This is a hard fact of franchise life: Some franchisees are just not cut out to run their own businesses and will fail despite all efforts of the franchisor.
Another percentage of those who were terminated probably failed despite their best efforts and full competency in the business, but were simply defeated by the economy and difficulty obtaining capital. So many franchisees stretch financially to get into business, and start off undercapitalized for the ups and downs of business, that we should not be surprised when they fail during tough financial times. If you’re skating on thin ice, sometimes it gives way.
Here’s the ultimate concern of a prospective investor: What if the terminations signal a weakness in the business system being offered by the franchisor? Does it mean that the new investor also runs an unreasonable risk of being terminated and losing his or her investment? I would advise any investor concerned about the termination numbers to talk to both the franchisor and the terminated franchisees about this concern. The franchisor will want to share additional information about the reasons for an increase in the termination numbers, and most terminated franchisees will want to tell their story.
Terminated Franchisee Information. Good news: The FDD lists contact information for terminated franchisees. The disclosure rules require franchisors to list limited contact information only for those franchisees terminated or leaving the system during the franchisor’s prior fiscal year. Do not expect listings in the FDD for every franchisee who was ever terminated from the system. By all means call on the former franchisees listed; you may also want to ask the franchisor to provide you with more recent information about terminations that may have occurred in the current year.
Don’t Forget Item 3. Evaluating terminations should also include a review of the information in Item 3 of the FDD about franchisor-franchisee litigation. The FDD disclosure rules now require franchisors to list legal actions initiated against franchisees in the past fiscal year for enforcement, collection, or any other reason. If you see a large number of these enforcement actions, find out what’s going on, and whether franchisees or former franchisees are resisting compliance with their contracts for some reason.
We should not be surprised that the recession has caused the number of franchise terminations to increase; franchisees are as susceptible to recessionary pressures as any other small business. Just make sure that you take the time and use the available disclosure tools to understand exactly why franchisees are being terminated.
Andrew Caffey is one of the nation’s leading franchise legal specialists and he represents franchisors across the United States. Caffey served as General Counsel of the International Franchise Association, a member of the Governing Committee of the ABA Forum on Franchising, and Chair of the ABA Forum on Franchising. He also is a member of the bar in Maryland and the District of Columbia, and a member of the Panel of Neutrals of the American Arbitration Association. Caffey has appeared on numerous franchise programs and is a frequent speaker and author on subjects of franchise and business opportunity regulation.