Finding Total vs Immediate Risk in the FDD
Even the IFA has asked its membership to stop saying that franchises have a better success rate than independent start ups. That old so called Department of Commerce survey that was never a competent survey in the first place, that every franchisor has happily quoted for so many years, that says you have a better success chance if you buy a franchise – was never true. You have the same success chances in an independent start up that you have in buying a franchise. And if the franchise you are looking at isn’t the newest and best thing since sliced bread, you are simply DOA.
You can’t tell what you are looking at just by reading the documents you have been given. Neither can any normal business lawyer. You either hire an expert in franchising investment analysis or you are flying blind with everything you have in the world at risk.
People say that if you consider the average total initial investment at around $ 300,000 to $ 500,000, a $ 3,000 due diligence fee is about 1 %. Actually it is far less than 1 %, because the total initial investment is not a competent statement of the risk. What is a competent statement of the risk you assume when you sign a franchise agreement? Consider the following scenario that is the standard features profile for every franchise investment today. You can follow this analysis in any FDD that you are holding in your hand right now. This tutorial will teach you how to do it. On the other hand, this tutorial is only about a very small part of franchise pre investment due diligence. Its purpose is to show you how little ability you or any business lawyer advising you will have trying to do the due diligence on the cheap.
Go to Item 7 of your FDD, entitled Total Initial Investment. You will see a list of itemized costs adding up to an incorrect total of the initial investment, even at best – and we are only talking about initial expenses here, not the risk profile associated with signing the franchise agreement.
You see the initial fee; the estimated store build out cost; fixtures and equipment; leasehold initial expenses; insurance premiums; training expenses; grand opening; initial advertising layout; and several other items that will bring the total up to anywhere from $ 350,000 to $ 1,000,000, depending on the franchise you are considering. This is at today’s costs.
Even though it is only a statement of supposedly initial expenses, what is always left out is what you need to finance your way to break even, including your living expenses until you start making money you can live on. The cash flow from depreciation and amortization will be consumed by debt service, so that isn’t available for living expenses – assuming there even is positive cash flow. In all likelihood there won’t be positive cash flow for at least a year and a half to two years. What? They didn’t tell you that? Awww. Po baby! They may have put some nonsense lowball working capital number in Item 7, but that is chump change compared to real working capital requirements including living expenses for at least two years. If you get sales up to the rate of $ 300,000 per year in 18 months, you may just be approaching positive cash flow – but maybe not. How much did you lose in those 18 months that you had to reach into your pocket for extra cash to cover? That is nowhere in the FDD you are looking at. And we are still talking about what you have to be able to account for having available the moment you sign the franchise agreement. If you don’t have it available at the moment you sign the franchise agreement, you face gambler’s ruin – a fair chance to succeed but inadequate funds to get you to that point.
What is a more realistic statement of the financial risk profile can be estimated by reference to the liabilities you are assuming in signing the franchise agreement. These liabilities are continuing, regardless of whether you succeed or fail – at least according to what the agreements you will sign provide for, and these agreements are enforceable unless you can prove you were fraudulently induced to sign the agreements. You will find that if this does not work out well, you won’t have the requisite funds to prove fraud and obtain protection from the risks of what you will have signed, even if by then your franchisor is still collectible, which as we are seeing more and more, is not assured. Insurance does not cover fraud liability, so you can’t go against insurance coverage on a fraud claim. A lawyer who tells you there are ways to get around that is a fool.
Let’s take a look at that real risk profile. In addition to everything in Item 7 of that FDD in your hands there are the following. You will be getting a bank loan. Repayment of that amount plus interest is not contingent upon your success in this business. It is an absolute obligation that you can escape only in bankruptcy if you can’t repay it. It will amount to anywhere from $ 100,000 to over $ 500,000, depending upon what kind of franchise you are buying. Put $ 250,000 in the first line of this itemization of total risk profile elements just for the sake of this discussion. You will sign a store lease for the period of your franchise agreement, though it may include renewal rights to get you all the way to the end of the agreement. Your monthly rent will be roughly from $ 4,000 to $ 7,000 per month base rent. In the ten year period of your franchise agreement that is 122 months or $ 671,000, using $ 5,500 a month as the probable rent number. You will be paying royalties for the assumed ten year term of this franchise agreement in the average amount of 6 % of gross sales. Assuming gross sales for the period are roughly
$ 500,000 a year, that aggregates $ 5,000,000. You will be required to spend about 2 % of sales on local advertising and maybe more in contributions to a national advert fund “managed” by your franchisor. The number for that item is roughly
$ 100,000 for the ten year term of the franchise based on this sales volume assumption. If your franchise agreement follows standard drafting methods for franchise agreements in 2008, there will be a liquidated damages provision that states that if the franchise terminates, for any reason at all, regardless of fault, you owe the franchisor the lesser of $ 100,000 or the average monthly royalties for the remaining months of the franchise term that you will not be performing. Figure
$ 100,000 as a minimum. If you fail, you will probably fail within three years, leaving many months of liquidated damages royalties – probably far more than
$ 100,000, so we use the minimum number.
There are other items that can be put into this exercise, but just what we have accounted for here represents a total investment risk, if you sign the franchise agreement, of at least $ 16,210,000. Only bankruptcy can save you from this risk if you do not succeed.
If you have been given any version of an earnings claim and you are thinking of your risk profile as the total number at the end of Item 7 of your FDD, and deciding the likelihood that you can achieve a positive return on the risked capital using that risk profile number, you are missing important risk analysis points.
Every aspect of the riskiness of the business proposal being presented to you needs to be thought of in terms of the $ 16 million, not the less than $ 1 million number at the end of Item 7 of the FDD. Now how good does the totality of prospects for this investment being a positive event in your life look?
This is only one franchise investment due diligence exercise among many. The level of acuity required in doing competent franchise pre investment due diligence cannot be learned in any law school or in any MBA program offered in any university. You almost certainly did not learn how to do this kind of pre investment due diligence in whatever jobs you may have held as an employee of any company or companies. Even if you were an acquisition specialist in your career, you certainly didn’t do acquisition due diligence on any franchised small business investment.
Want another frightening little tidbit as a closer for this tutorial? If your average pre tax operating profit before royalties and required advertising contribution to the franchisor’s fund is 17 % of gross sales, the combined 8 - 10 % of gross sales royalty and advert contribution reduced your pre tax net to less than 10 % and makes your franchisor a roughly 50 % partner in your bottom line, without the franchisor having any measurable risk associated with the operation of your business. They will say they risk their reputations on your success, but that is just sales talk, not anything responsible.
If the failure rate is the same – as we now know it is – for franchised and independent start ups, think of how much better you would be doing to spend some time – and far less money and risk assumption - trying to figure how to enter the business you are interested in without becoming someone’s franchisee. In most small businesses there are other ways to do it. You are not really buying better odds for yourself when you buy a franchise.