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Churning

Churning is the act of a franchisor taking back a franchise unit in a given location, reselling it, taking it back again, then reselling it again, and so forth. This situation often occurs when the franchisees are not successful at the location. Rather than terminate a poorly producing location, a franchisor can receive multiple franchise fees from the resale of terminated units.

By reselling a failing franchise before it "officially" closes, the franchisor protects itself from having to disclose a franchise failure in the UFOC.

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Churning Scenarios

To get this conversation out of the Isoldit forum, I brought it back to this one.  Do I think that Item 20 is imprecise, yes.  Do I ever think that Item 20 will be precise, no.  There are so many different scenarios out there that could by interpreted one way by the franchisee and could be interpreted another way by the franchisor.  Here's some examples that I can think of:

 1).  Franchisee buys an existing store for an amount that is grossly higher than what the former franchisee was making.   Store fails two years down the road because he can't pay his debt service and the rest of the bills.   He blames the franchisor, the franchisor blames him for buying at an inflated price.  Is this a failure on the franchisor's part? 

2).  A new franchisee buys a franchise.  Finds a location to his liking, and goes against the wishes of the franchisor and signs the lease, because he can make it work.  The store closes in three years, because he doesn't get the foot traffic.  Is this a failure on the franchisor's part?

3).  A franchisee is running the business and hires his family to work the store.  The store is losing money because he is paying them an amount that is higher than he would pay anyone else.  The store looks like it's losing money but if ran properly would be making money.  Is this a failure on the franchisor's part? 

4).  A franchisor accepts an undercapitalized franchisee into the system and the franchisee thinks he can make it work with what he had.  The store closes in two years.  Whose fault is this?  In my opinion both.

Are there scenarios that are the franchisor's fault?  Positively.  Are the scenarios I mentioned reality, yes, because I saw them at the franchisor I worked at. 

 Quantifying the failure rate that you speak of in Item 20 and churning are not all the fault of the franchisor.  To try and quantify this data would take quite the effort for each franchise system and who would be paying for it? 

 That's why I advocate doing as much due diligence as possible on your own with the help of independent advisors, rather than relying on the 500 or AARP.  The information in the UFOC is there to guide you and to inform you.  The government doesn't have the time to 'regulate', that's why they disclaim in the front of the UFOC that it hasn't been checked for accuracy.  Just like stocks in some fashion, because the government is relying on the accounting firms to verify public company books and those reports are made public by the SEC.  The government didn't see Enron coming until after it blew up.  That's why there is one less accounting firm too. 

Churning Presents Visability but not always Viability

I agree! Because franchisors have not had to disclose franchise failures in the UFOC's, they have been allowed to churn an appearance of viability based on the visibility of the network that is built to a great extent (the actual extent is obscured from view) on the backs of failed first generation franchisees.

It is obvious that Item 20 is a compromise that was agreed to between the franchisors and the regulators that works to the disadvantage of prospective franchisees who believe that the VISABILITY of the network is proof of the viability of the business plan.

I think both Quiznos and UPS are suspect and yet they are touted by business magazines and even AARP and "TOP" franchise opportunities. LET THE BUYER BEWARE on Internet Sites like Blue Mau Mazu will not prevent the victimization of future prospects who will buy these franchises because of their VISIBILITY in the communities of our country.

Too bad! So Sad! Been Had! We won't read about this in Entrepreneur or Forbes or Business Week, etc. etc...and AARP won't run a disclaimer.

Quantifying the failure rate ---odds of success and failure

You say "quantifying the failure rate that you speak of in Item 20 and churning are not all the fault of the franchisor. To try and quantify this data would take quite the effort for each franchise system aznd who would be paying for it?"
JD---The franchisors have to count the transfers to disclose in the UFOC's and they are always aware of whether or not these transfers were made at a profit or a loss to the franchisee who has to obtain their permission to transfer-sell their franchised business.
The transferring franchisees have to report to the IRS wehther or not they sold their business at a loss or a profit. and if the government can require franchisees to disclose their personal addresses and phone numbers in the UFOC's for the benefit of the franchisors, then the government can make the franchisees disclose the status of the transfer-sale of their franchised business to the propective franchisees for the benefit of the franchisees.
THE FACT THAT ALL TRANSFEREES WILL HAVE TO FILE INCOME TAX RETURNS ON THEIR BUSINESSES would not make it complicated for the transfer of the unit to be identified as a transfer at a profit or a loss under IRS rules by the franchisee at the time the "asset agreement" and transfer-sale of the franchised business is submitted for approval of the Franchisor.

I don't understand your reasoning! Statistics don't lie as easily as people, and an imprecise statistic that can be interpreted to the advantage of one party and to the disadvantage of another borders on a lie.

The most important and relevant statistic to a franchisee who is taking out a loan and/or who is investing his savings and/or house in a franchise is the odds of his success or his failure in buying/ renting the brand business plan in which he, the franchisee, will make the entire investment.

This is about HIDING the actual risk in statistics that are actually imprecise by design so that the failure rate and the success rate is obscured. It must have been a compromise between the government and the regulators? You didn't answer my question, JD, do you work for government?
Even when the FTC indicated that a reason for "Teminations" had to be indicated, they gave the Franchisors the opportunity to indicate "Lack of Sales" as the reason for termination to provide franchisors with the opportunity to say that it was the "location" and not the business plan that was the problem.
It is obvious that Item 20 permits the regulators not to know the success or failure rate or the amount of churning that goes on in the networks and gives government "deniability"!
Not all of the American people understand that the government of the people regulates on behalf of the franchisors and that most regulation involves the protection of those who are being regulated more than the protection of individual consumers whom the government implies they are protecting.
The government obviously doesn't advertise this fact to the people.
If franchising were retulated at least as well as securities, churning wouldn't be possible.
In the meantime, like Solomon and Purvin tell us, there's lot of bull shit out there about franchising and lots of money too ---some of it that smells really bad.

The Failure Rate is Relevant regardless of the Reasons

The Failure Rate of the franchised businesses in a network is relevant to prospective franchisees regardless of the reasons for the failures.
It is the reasons for the failure that would present difficulty in disclosure but the actual failure rate of the business units under IRS rule wouldn't be a burden to anyone, and those who weren't trained in mathematics wouldn't be misled.

Churning Creates Silence in the Network

Because of the nature of human beings and business, those networks who are composed of both new franchisees who are the original owners and other franchisees who bought discounted stores, the network as a whole cooperates in the silence concerning "churning"!
Additionally, franchisees do not want to "bad mouth" the brand because they don't want to harm their own business in which they bear the entire risk when the business fails.
Item 20 that pretends to give the prospective franchisee references to whom they can talk about the Brand Franchisor is really just an artifice developed as an imprecise and unsatisfactory solution to the failure of Item 20 to reveal the true and actual faiulure rate of the franchised business plan.
The new Item 20 that requires franchisors to reveal which transferees signed confidentiality agreements may help a little but not much because the franchisors will just continue to demand the confidentiality agreements and rely on the message that there are good reasons why parties want to keep their agreements confidential.

Failure Rate

Have you ever seen a company that makes $100k or more a year report a loss on their IRS filed tax return?  I have.  Looking at one tax return doesn't show failure/success.  I think you have to look at the business from the time the person started until the time it ended.  So, in your example, a guy might show a $100 net loss on his 'final' tax return, and that would be considered a failure, even if he made millions during his term as a franchisee.  That's why I'm saying quantifying the success/failure is an imprecise number. 

 Do I work for the government?  No, I'm an accountant at a private company.  I look at numbers all day.  Do I think there are some 'dirty' franchisors that cheat their franchisees?  Yes, I do.  Do I think there are 'dirty' franchisees that hide sales from franchisors?  Yes. 

Do I think there could be more useful information in the UFOC?  Yes, but information such as success/failure rate on an imprecise number is not one of them. 

As I asked above, who's fault is it in each of those scenarios, and if it's the franchisee's fault for their failure, why should it go against the franchisor? 

FranSynergy's picture

Guest: Have you ever heard of NASAA?

GUEST:

You keep saying: "IF FRANCHISING WERE REGULATED AT LEAST AS WELL AS SECURITIES".

I've continued to say: "They are two different animals, You're comparing Apples to Oranges".

So, let me ask you this, "Have you ever heard of NASAA"?  Perhaps the following will be of interest to you!

The guidelines for which information to include in the UFOC (as required by federal law) are not from a federal government source. The North American Securities Administrators Association (NASAA) is the organization that prepared the guidelines, along with instructions for complying with the guidelines, as well as sample forms that comply with the guidelines and instructions.

Believe & Succeed,
Dale
FranSynergy, Inc.
Synergizing Franchising!

You're absolutely right

Franchising is a business type that should not involve any type of risk to the franchisee. It is inherently unreasonable to require the franchisee to conduct any research into the viability of the system they are investing in. We should also restructure the UFOC to enable disclosure by franchisor of anything additional, regardless of whether it is reasonably relevant, that a prospect so requires for whatever reason. Also, franchise agreements should be restructured so that franchisor is responsible for every aspect of the business, excepting success, which shall be attributable solely to the franchisee. Also, the franchise agreement should provide that the franchisee shall be handed the business, preferably on a silver platter and that a chorus of violins should serenade the franchisee during the signing of the franchise agreement.

Casting my cloak of sarcasm aside, at some point you have to realize enough is enough. Just because a government exists and technically serves the interest of the people does not make the people not responsible for their own actions. Sure, there are alot of Quiznos out there, but is that in and of itself sufficient to constitute franchisee due diligence? "Well, they're everywhere so they have to be doing well."

You would have the franchisor disclose everything, and to what end? Just to protect the franchisee in the event that the franchisee is unwilling to protect themselves? If a prospect cannot make a logical inference that "hey, 30% of this franchise's units are in some phase of transition; what does that imply as to the stability of the system..." and then to go from there...regardless of how much is disclosed, disclosure will not solve the ultimate problem. At some point this conversation evolves to, "well yes, they state that 3% of their units failed, but they didn't explain why they failed," or "yes, 14% of the units were transfered from a franchisee to a new prospect because that unit was not doing well, but it doesn't disclose whether the rental amount was inordinately high for the geographic area." When is it enough? At some point it becomes a matter of Sisyphus and his rock; the naive and incompetent will still buy into flawed franchise systems regardless of the amount of disclosure because people want to dream and too often these are emotional impulses to join.

As the UFOC stands, there is sufficient material to "flag" questionable investments. Could there be more? Yes. Is the solution to define every possible risk so that the franchisee does not have to think for themselves? Yes, if your end result is to create a 20,000 page document that no one will bother to read, which I would suggest would defeat the ultimate purpose of disclosing - and then there will be a push to make the UFOC less burdensome for the franchisee.

FranSynergy's picture

Where Can I Sign Up!

GUEST:  (Why are you a "Guest" You write like a Full-Fledged MEMBER!!! Grab a name and register

You make many good points.  But of course, there are those who forget that franchising is about going into business for yourself, without having to develop the entire concept.

Of course, there are those here who would prefer to simply re-invent franchising into something that it is not.  To read some post, like the one by MOM earlier, you quickly begin to realize that some will only be happy if:

The Franchisor places the Franchise Fee on a NOTE only to be paid, in the event that the franchise is WILDLY SUCCESSFUL after 100 years.  And that the Franchisor should foot the entire start-up cost, which they'd then recoup if the franchise were in fact successful.  If the franchise loses money the franchisor would pay for all losses, and if the franchise shows a profit -- then and only then -- would the franchisee pay a percentage of that profit to the Franchisor!  WHERE CAN I SIGN UP???

FORTUNATELY, the vast majority of the franchise community understands a few simple principles like RISK & REWARD; The Harder I Work The Luckier I Get, Success is 10% Inspiration & 90% Persperation!,   If It's to be It's Up to Me!,  LOOK BEFORE YOU LEAP!

Believe & Succeed,
Dale
FranSynergy, Inc.
Synergizing Franchising!

Franchise Unit Averages...

 

Why not at the very least begin the disclosure process by requiring the reporting of Franchise Unit Averages.  Report on a quarterly basis - Unit Average Product costs, Unit Average Labor, Unit Average Utilities versus the Unit Average Volume.  It does not provide the whole picture but over a series of quarterly reports it provides a "viabilty trend" that will tell a compelling story about the franchise.

 -jm

Paul Steinberg's picture

NASAA info

As the organization notes on its website , in some states franchises and securities are regulated by the same regulator, and in other states not.

In practice, the FTC (federal regulator) works closely with NASAA (state regulators). Some regulatory offices (such as California) are quite influential, and there are other individual regulators (such as the person who regulates in Maryland) whose opinions are influential beyond their state. While I do not practice in Maryland or Illinois, I have on occasion spoken to regulators in those states and state regulators are very aware of the multiple constituencies they serve and the need to balance competing interests; the regulators also give presentations at legal symposia and if you want to understand their thought process you should attend or read some of their published writings.

And while FranSynergy may believe that the comparison is "apples to oranges" I would note that the franchise industry itself promotes the comparison (we discussed this at length in our 2004 article). Really, this is a subject in itself, and it is a bit unfair (to both franchisors and the regulators) and misleading to have a discussion of this under the "churning" thread; I understand how the topics are related, but they are really distinct issues.

In addition, many of the regulators work closely with zor-side legal counsel. There is nothing sinister about this, it is a function of the registration and regulatory process coupled with the fact that there are a number of large zor-side law firms but few zee-side. The nature of the interaction does give rise to legitimate concerns about regulatory capture, the same as in other regulated industries.

Those seeking a brief history can see my entry on the topic, where I have tried to present a balanced view.

Loss on your 1040 and Failure Rate ---JD

If a loss provides a gain for Income Tax Purposes, most franchisees, I assume, and especially those small Mom and Dad type operations or smaller retail service franchises don't buy the franchise to lose money that translates to a gain because of the tax structure of their estates! That's for sure!

I think Paul Steinberg indicated that most small franchisee prospects are not looking for tax shelters for their money. I believe I read somewhere that prospects who are looking for a way to get health care and a job are often influenced by the health care/insurance rules that govern small businesses.

Isn't it somwhat specious to compare large corporations with little individual business men who work and operate their own stores under franchised business plans? We understand that large Corporations write the tax laws as well, and when they fail, it is only their corporate persona that fails and goes into bankruptcy and they retire to their mansions or to their yachts that are protected under bankruptcy laws to think about whose piggy banks they can rob the next time!

I know that as an accountant, the government rules and regulations are burdensome and I know many business men who don't want to do business with the government as small business men because of the burdensome regulations.

I do understand where you are coming from but I understand where the government is coming from as well and government can't indulge in shortcuts because of their obligation to govern in the interests of their large and diverse constituency who demand that democratic principles be protected by government even in matters of commerce.

Thanks, JD, for sharing your point of view with me and the other readers of Blue Mau Mau!

Cousin of Fran ---Guest --You are absolutely Wrong

Casting your cloak of sarcasm aside, you say:

"You would have the franchisor disclose everything, and to what end? Just to protect the franchisee in the event that the franchisee is unwilling to protect themselves."

You make me laugh ---are you GlASS, Dale's cousin or something?

In response, I say to you that I would not require the franchisor to disclose everything but I would require the franchisor to disclose the failure and the success rate of the business plan in the UFOC, and I would require them to disclose average sales figures and overhead costs of operating under their business plans. Even those farmers who share-cropped got better disclosure than the franchisee share-croppers of the 20th and 21st Century.

Why should government encourage middle-class citizen franchisee prospects to invest in business plans that are not viable? through creating the impression that there is serious government oversight of franchising while obscuring the rate of failure in the disclosure of imprecise statistics in the UFOC's?

FuwaFuwaUsagi's picture

things that make you go: hmmmmmm...

I have yet to see any presentation of any franchisee concept that has a reward that is appropriate for the risk undertaken; zip, notta, none, not even close.  If you care to change my mind on this pony up the numbers.   Here are the issues you would have to overcome:

1) You need an awfully high probable return to compensate for the chance of a total loss.
2)  Franchising lends itself very handily to a bell normalized curve for a given year in terms of gross sales, cash flow, and profitability.  Therefore one of your first challenges is to find a franchise system where the majority of the franchisees are profitable.   The aforementioned normalized curve is very generous as it would allow for 16% to operate in the red in a given year (68-95-99.77 rule or stated differently 16 not profitable 68% at some level of profitability and 16% making an abnormal profit for the concept)
3) However a given franchise also produces a logarithmic curve over time that is biased against the success of a franchise
4) Franchising as a whole produces a known logarithmic curve which is biased against the survival of any franchise (to understand this point ask yourself how many franchises started 20, 15, 10, 7, and 5 years ago still survive today)

Given the above, the risk assumed by most potential franchisees is simply not compensated for by the reward and it does not even come close.  Examine 1 above carefully.   You need somehow to find a reward where the probable reward of the 68% compensates for the 16% that will eventually represent a  total loss.  One way would be if the upper 16% and the potential of reaching it would produce such a high reward potential it could offset the 16% that represents a total or near total loss. 

FuwaFuwaUsagi

Re: Unit Averages

I would agree that gross profit % should be stated at a minimum in Item 19 of the UFOC.  Once you get into employees, rent, insurance, debt service, etc. that is all based on the personal preferences and the prospective franchisees should be the ones considering that in their due diligence. 

 

FranSynergy's picture

PAUL, can we not surmise that....

So Paul --

As you are aware, AND as it states on their website:

  • Organized in 1919, the North American Securities Administrators Association (NASAA) is the oldest international organization devoted to investor protection.
  • In the United States, NASAA is the voice of state securities agencies responsible for efficient capital formation and grass-roots investor protection. Their fundamental mission is protecting consumers who purchase securities ...
  • The UFOC Guidelines were prepared and adopted by the North American Securities Administrators Association ("NASAA")... .

So, since the UFOC guidelines were prepared by NASSA and NASSA is "the voice of state securities agencies responsible for efficient capital formation and grass-roots investor protection", AND the FTC and the STATES have adopted these standards, is it unfair to surmise that NASSA BELIEVES that the current UFOC provides equally adequate disclosure as that which is provided for SECURITIES based on what is in the best interest of all parties?

Believe & Succeed,
Dale
FranSynergy, Inc.
Synergizing Franchising!

Guest..What about the scenarios?

I'm still awaiting how people would disclose the scenarios that I proposed.  Are they franchisor failure's or franchisee failures and who would decide for purposes of your disclosure? 

 These aren't answers that a tax return can decide. 

I'm Dale's cousin Bubba and we live in shack down by the river

I am glad that I was able to make you laugh, assuming you did not don my cloak of sarcasm during that remark.

Unlike you, I do not think it is primarily the government's responsibility to ensure that franchisee prospects wisely invest their money. Some stocks are entirely speculative and in the end do not work out. It is not illegal or even ethically ambigious to sell them, and regardless of the greater disclosure required by the SEC, in the end, such stock may not be worth the paper they are printed on. Disclosure and regulation does not solve the problem.

People will attempt to jump on "the next big thing," anticipating that they can join the next McDonalds on the ground floor and make it big later. That is called business. Sometimes it doesn't work out the way it is planned.

Should Item 20 be fleshed out better. Yes. But this does not stop the fundamental problem. A fool and his money are soon parted, and as long as there is an endless supply of fools, regulated to hell or not, their money will soon be parted. They will then wail and gnash their teeth that their hard-earned money was wasted. You would argue that this would be solely attributable to the franchisor?

Paul Steinberg's picture

MOM is no fool

... and my Momma didn't raise a fool either.

So I won't wade into internal politics of any regulator's group. But I will observe that there is a broad spectrum of opinion among state regulators with regard to the philosophy of regulation, and one can find NASAA members all along the spectrum.

I'd be careful about reading too much into any regulator's website, particularly when the organization is comprised of such a range of individuals who are in many cases accountable to elected officials: internal dynamics in such a group may be at considerable variance from an organization's PR, and may shift with the political winds that blow their boss in and out of office.

And I don't think the controversy within the franchise industry is so much over disclosure as over the relationship. One can make arguments pro and con, but at least let's draw a distinction between disclosure legislation and relationship legislation.

FranSynergy's picture

JD...R U holding U're breath?

JD,  I hope you're not holding your breath!  It's probably not going to be answered, because as reasonable people know there is no single right answer.  Furthermore the objective of disclosure is not, never has been, and should not be to totally scare people away from an investment.

FURTHERMORE, most small business owners are not really thinking long term.  They are not really thinking about BUILDING EQUITY.  They want equity, like people want to be a MILLIONAIRE RICH, but they're typically not willing to do what it takes to get there.  Thus the reason so many, buy into a philosophy taught by too many accountants and that is "You don't go into to busines for the business to make a profit, you go into business for you to profit".  So with this mindset, it is consistent with Paul's statement that most are  not looking for a 'Tax Shelter' but they are looking to 'Pay as little in Tax' as they can and to 'Personally Profit' as much as they can ---- without thinking about the consequences that philosophy may have on the business entity itself! 

Believe & Succeed,
Dale
FranSynergy, Inc.
Synergizing Franchising!

Hi Bubba! Thanks! UPS Store Fools

Thanks for agreeing that Item 20 should be fleshed out better.

And, remember that when people are downsized or retired early or fired because of an economy where a lot of middle class jobs were sucked right of the American economy into the Global economy, there are a lot of poor souls out there just trying to survive. One of the reasons government supports weak disclosure in franchising is they know that franchising is providing lots of jobs, mostly lousy, but at least they are jobs and they can keep that information, that statistic of "new jobs created" out in front for public consumption.

And I'm not arguing that this is solely attributable to the franchisor if he discloses truthfully and deals in good faith with the franchisee and has a proven business plan. I don't think the almost 2,000 franchisees who transferred or terminated their UPS Stores from 2002 to 2005 were fools but I do believe that most of them lost money, i.e. failed, because of the bad faith of MBE-UPS in disclosure and in operation of their franchises.