Spotting What You Need In Financials-Sold But Unopened Store Revenue

This is an example of only one of the many things you need to be able to spot when you are thinking of buying a franchise and are handed an FDD document with the franchisor’s financial statements attached as an exhibit.

What the franchisor wants you to focus upon is whatever the positive signs may be, especially year to year stability and growth in its financial condition. But is it real?
For one thing, it is presented on an accrual accounting basis. What does that mean? What are the implications of that fact, standing alone, upon the reliability of the financial statements? What do you have to look for to find out? Where should that information be located? If you don’t know what it is and where it should be, how will you know to ask about it, or what to ask for?

Are there special accounting rules for franchisors? What are they? Are they being complied with in the financial statements you are holding in your hands? How can you tell? Where do you look for it? If it isn’t there, do you know what to ask for?

The list of whistle stops as you travel through the FDD is a long list. This is just a peek at one of them.

There is a long tenured problem in franchising that identifies franchisors that are not investment worthy. Actually there are many such problems, but we are only talking about one of them right now. That is the SOLD BUT UNOPENED stores problem. Some franchisors sell more franchises than they are capable of bringing along through training and store opening support. If you knew to ask about that and you did ask – Please tell me how many franchises are sold but not yet open? How long has the longest been waiting for opening after signing the franchise agreement? – the response would probably be a “how dare you ask me such a question” answer or a statement showing that sold but unopened is not a problem for that franchisor – assuming the answer is truthful. You can’t usually test the FDD for the truthfulness of the statement if the franchisor you are looking at is violating the accounting rules.

The AICPA accounting rules for franchisors call for segregation of revenue from initial franchise fees until the store is up and running. Only franchise sales revenue from stores open and operating should be included in the general statement of gross sales. In franchise registration states where there is some review of the registered materials, a thinly capitalized franchisor will be required to place initial fees revenue into an escrow account until the franchisee is up and running and signs a release of funds statement acknowledging that he has received the promised initial support needed to get up and running. This phenomenon is that important. This isn’t nit picking here. If it is included in gross sales – as it almost always is – there should be a footnote by the gross sales entry in the financial statement that takes you to a note to the financial statement showing the amount of initial fees income that is attributable to sold but unopened franchises. Expect that you will not see compliance with that protocol in any company that is having the problem. They don’t want you to know that when you sign the franchise agreement you only get to stand in a long line of suckers who are waiting many months – or longer – to receive training, site location assistance (an unreliable promise and representation in almost every instance), store build out and grand opening assistance.

I have seen this phenomenon dozens of times in my practice over the years. In one instance, the most outrageous I have ever heard of – if the accusations are true – Quiznos in being sued for having over 3,000 sold but unopened franchises. I don’t know the truth of the matter as a matter of my own knowledge, but if it isn’t a responsible allegation the lawyer who brought the suit can expect a lot of trouble from the judge – maybe even an attack on his license to practice law. And yet Quiznos continues to advertise for new franchisees, despite that problem and the many other Quiznos problems that are catalogued by those claiming to be aggrieved on www.BlueMauMau.org. People attend Quiznos franchise “fairs” hoping to become a “lucky” Quiznos franchisee making the enormous profits and investment returns that the ignorant think Quiznos franchisees earn.

Evidence that some of my most FranWhack, unworthy of investment, companies, are doing this may be seen in this week’s Nations Restaurant News (Vol 42 No 46), that reports on the front page that Cold Stone Creamery and others “sought profits as usual by signing up new franchisees”. What does that tell you? It tells you that a company that has to keep selling franchisees to keep its earnings on line isn’t generating earnings from operations sufficient to keep earnings on line.

The message from such really stupid revelations (the people from those companies who said such things will probably get slapped hard for their big mouths) is that they are engaging in accounting slight of hand in their financial statements and that they are certainly not saying to franchise investment prospects what the truth is about profits from operations. The truth may be buried somewhere in their financial statements, and maybe not. But the important thing is that such companies are not investment worthy. Intelligent, well informed franchise investors will not buy their franchises. Only suckers will buy their franchises, and they will appear on www.BlueMauMau.org lamenting how they got ripped off, joining the other franchisees of these companies in their weekly dirge about their lousy franchisors.

There are many articles on www.FranchiseRemedies.com about franchise fraud. They are all available without charge. Read them. Send them to your lawyer or whoever else is advising you about investing in a franchise opportunity. Don’t do this with everything you have accumulated in this world without becoming well informed.

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Comments

Accounting Rules

Richard, most franchise agreements specify that the franchise fee is earned upon the signing of the franchise contract and not when the franchisor's obligations to open the store have been performed.

This is technically how they skirt the accounting issue.  

Since the fee is "earned" upon the signing of the contract, franchisors argue that they don't have to treat it as deferred revenue.

Personally, I think that this is crock. 

Michael Webster, a franchisee attorney in Toronto, Ontario, who publishes a website on business opportunities and franchises, called "The BizOp News" 

Michael: I can't remember

Michael:

I can't remember the exact lame me too concept we kicked around in Ryan's forum the other year, all I remember was it had something to do with "skanks with scissors and furry peanut butter sandwiches", but as I recall the State of CA did not feel the were adequately capitalized and referenced the potential that they might not be able to fulfill their franchisor obligations and were holding their application until they corrected the deficiency. So I think that the State was trying to say we don't care what your FA says, if you want to offer in our state you will be held to a higher standard.

Anyways that was my interpretation.

FuwaFuwaUsagi

"Never underestimate the power of stupid people in large numbers." 

CA Regulator

But you forget Fuwa, the regulator gave us a choice either post a bond or change the language in our franchise agreement so that the fees would not be earned until the build out was complete.  We changed the language, but treated the fees as revenue anyways.  Oh, I forgot that we weren't supposed to talk about this in public. 

Michael Webster, a franchisee attorney in Toronto, Ontario, who publishes a website on business opportunities and franchises, called "The BizOp News" 

It is a crock - that language changes nothing

One day the right case will preent that allows that issue to be explored. So far, it must not have had any significant impact on anything.

--

Richard Solomon, FranchiseRemedies.com,  has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School

The primary goal of bad zors-

selling franchises. After they get you to sign it is all over. They have you trapped. Even if you don't open they have made alot of money. I know a zee that after she signed and found a place for her business and signed the lease the area director said you can leave anytime. She never opened but has lost alot of money.
Solomon you are dead on about the right questions to ask. That is the problem many future unsavvy zee wannabees do not know the right guestions to ask. It may be too late for our family but people who read your blogs are plain stupid if they do not call you and use your due diligence services.
Another blog full of meat. If only EVERYONE had your mind there would be no suckers. I can only imagine the bad zors and their reps laughing their heads off after you sign. What a sad reality to face.

Sold but not open

What an insightful comment and article. I expect nothing less, Riichard, having followed much of what you write.

Do you think the Sold but not open(SNO) phenonmenon is a function of a great sales effort by Zors or a creation of over-anxious Zees frothing at the mouth to get a piece of the American Dream? Could it be the commission/bonus driven sales people at Corporate selling to just about anyone. anywhere? is it worth asking how many SNO's there are in your market area(notas a whole in the nation), even though they can parachute anyone in from another area? will they ever answer truthfully? is there another way to find out, apart from the FDD?

Interesting that Quizno's has a SNO problem , and Subway is begging for loctions from landlords and sqeezing their franchisees in tighter than sardines in a can, with 2000 sardines on the SNO side line.

mrfranchiseman answers many franchise questions in a free teleseminar accessible at www.mrfranchiseman.com with much in insight in the Subway/Quizno's franchises

Sold not Opened

Richard makes a really good point here. These accounting policies are usually part of Financial Statement Note 2, and under the recogintion of revenue section of that footnote.

Financial statements will give you some necessary information, but you just have to know where to look for it. It also gives you the ability to question those franchisors about inconsistencies in the financials and the FDD. For example, the 2007 Cuppy's FDD stated that they had 110+ stores signed not yet opened, yet if you looked at their financial statements, the auditor said it was between 30-40. Big discrepancy. How many times do you think that question was asked as to the discepancy? My guess, zero.

people need to review the financials for the stability of the company. Are they operating with cash flow or are the leveraged out and having to take on more financing? Financial statements can tell you so much more, but my guess is people don't pay attention to them. Hell, I think I maybe had one person ask me about a footnote that should've been a red-flag to anyone reading the financial statements in UFOC.

As for Michael and Fuwa talking about the states, they sometimes need to understand what they are reading as well. I remember having to write a letter to MN, because our 'cash' balance was down from the prior year, but the difference was that we hadn't used up our line of credit as in the previous years, yet they thought we were worse off financially, because 'cash' was down. It was the exact opposite. States need to wise up to if they want to effectively regulate.