Financial Modeling for Franchisee Associations, Why and How

A few months ago I suggested the use of financial modeling by franchisors as a means for rational self governance of several critical aspects of the franchise relationship, including measurement of the investment worthiness of a franchise system and measurement of the extent to which a contemplated program could be shown before the fact to impact upon franchisee profitability.

Financial modeling isn't anywhere near as valuable or available as a last minute rush job slap dab project. It isn’t as credible when done that way. It won’t stand up as well to cross examination. It is something that improves over time through adjustments in the model to make it more efficacious over a broader range of applications. It is not a one time thing.

I recognize that most franchisors inherently fear financial modeling. The reasons are many. If one franchise system’s model shows it to be significantly less than the most profitable franchise system in its business segment, who would want to buy a franchise in that system (once it became known, and there are no secrets in franchising). To the extent that financial modeling reliably depicts the financial performance of the franchises in any given system, how can that information be used in the context of earnings claims in Item 19 of the FDD? Conversely, would a failure to use it in an earnings claim potentially represent a failure to disclose significant pre investment information that any rational franchise investor would want to know about in connection with making his investment decision?

Franchisors also fear the operational implication of financial modeling for the reason that it depicts the gravity of the impact of any franchisor initiated agenda, and could be used as the basis for challenging the agenda as a contract breach – destroying the legitimate economic expectations of the opposite party to a contract without justification other than greed. I will use the allegations by Quiznos franchisees to demonstrate how financial modeling might be useful to their case had they early on established an independent franchisee association that had the resources to perform system wide financial modeling. As a caveat, I do not know the extent to which their claims are true or will be competently provable given that they have not consistently conducted financial modeling over the history of the challenged franchisor behavior.

It is the position of the Quiznos franchisees, however, that Quiznos has used the right to designate vendors for quality control and uniformity purposes to extract an additional revenue stream from the franchisees that is so large as to destroy any possibility of attaining a rational return on any franchisee’s investment. According to the franchisees, they have to pay a much higher price for supplies and ingredients than would be the case in any competitive model that Quiznos franchises are tickets to bankruptcy or at best only marginally survivable. There are other serious complaints and other cases pending in the Quiznos system, but this is the only one relevant to this article.

The first argument of those who don’t want financial modeling to occur in franchising is that it is claimed to be impossible to prepare a competent model because of differences in the treatment of categories of information needed to populate the model.

My answer to that is that it is always the argument of someone who does not want to do something. If financial modeling were deemed desirable by the franchisor community, they would have done it competently long ago and found that information can be harmonized competently through many techniques that are responsible and that are used for financial analysis across many industries.

The real reason why franchisors don’t want to do financial modeling is simply fear – fear that if you aren’t shown to be the most profitable no one will buy your franchises and your stock value will plummet. Even a franchisor whose stock is not publicly traded lives with this fear. In any sale of the franchisor, the reliability of its cash flow is a product of its portfolio of enforceable franchise agreements. Franchisee association financial modeling could represent a threat to its sale value, and financial modeling by franchisees is something that simply cannot be prohibited or prevented by any contract language. It is a legitimate activity of any independent franchisee association and a franchisor cannot by contract limit or constrain franchisees from engaging in legitimate franchisee association activity. Moreover, franchisors must now identify independent franchisee associations established by their franchisees in their FDD documents.

It represents, therefore, an incredible potential weapon in the hands of a competently run franchisee association for use in constraining franchisor opportunism. Properly maintained, it is admissible forensic evidence to show what must be shown to demonstrate that a franchisor has gone too far and is actually violating its own contract by adopting programs that can and probably will destroy the value of owning any of its franchises. This is precisely the model that Quiznos franchisees claim in their litigation. Had they been maintaining a competent continuum of financial modeling throughout the period of the accused franchisor practice, their case might be so good that they might not even have been compelled to sue to prevent the harm.

A valid point often made by my friend Michael Webster is that independent franchisee associations, especially when established early on and widely supported, have enormous economic leverage. The leverage of such an association can often trump the language of franchise agreements for the reason that the franchisor knows he cannot really have a viable organization if he is constantly in conflict with the franchisees, in the mistaken belief that contract language trumps everything.

The value/leverage of a competent financial model of a given franchise system is extreme. If you consider that any franchise investment is an investment in a financial model, the ability and power to define that model is the ability to drive the salability of the franchises. While there is no such thing as an unmixed blessing, the inherent power of the model owner/developer represents great power in the franchise relationship itself.

My argument is that every franchise system’s membership should avail themselves of an early on established, professionally managed independent franchisee association; that the association should be universally supported; that the association not only cannot be stopped but must also be mentioned in the franchisor’s FDD; and that one of the indispensible projects of the association is the establishment of an ongoing financial model for its many beneficial applications.

It is something to which the association can turn when it is decided by the membership that the use of the information in the model in responding to pre investment due diligence inquiries of potential new franchisees is the right thing to do. The association need not actually disclose to potential franchisees what its model shows. It will be sufficient pre investment warning for the association to contradict what the franchisor may be telling prospective franchisees about the earnings potential of an investment in its franchise. “Our franchise financial model disputes what you have been told” should be enough to change any rational investors’ mind about buying a franchise. That is enormous power. Regardless of what the franchisor is telling potential investors, sub cases in the model will reveal whether the statements by the franchisor are responsible or misleading. In the Quiznos model, that power could have prevented great economic loss and possibly even a suicide or two.

It is a competent resource for the measurement of any franchisor initiated program’s impact on the profitability of the franchisees’ businesses. As such it can shift the burden of persuasion to the franchisor to support its claims that the costs associated with any given program are likely to produce incremental cash flow sufficient to justify the project. As things are now, the franchisor says its programs are good for the system; the franchisees have no data on which to challenge the claim; and the absence of data allows the franchisor to show that the franchisees don’t know what they are talking about. When nothing works and resort must be had to dispute resolution, the forensic financial information needed to make the franchisees’ case is already in place only if there has been competent financial modeling as an ongoing association project. That data also permits the formation of responsible decisions about whether there even is a valid case to be made, as it will be the best available indicator of potential resulting harm.

All the franchisee information that is to go into the model must be anonymized. No one will participate who believes his privacy and the confidentiality of his financial information will be lost. Aggregates are reported in the model, not individual franchisee information. The information to be provided by the franchisees will be provided to a third party professional who will provide an acceptable reporting format. The acceptability of the format will be worked out so that as many aberrations as possible may be reconcilable/different treatments of line item information will not produce skewed results. Line items will be treated in a comparable fashion in the reporting protocols, regardless of how a particular franchisee may treat the same information in his tax return. That can be done in several ways, depending upon the nature of the line item in question. No one will be able to trace the individual franchisee’s information back to that individual franchisee. Of that I can be certain and provide for in the agreement between the association and the professional that is retained to build and maintain the model.

Ultimately, the ability to produce reliability in the model will be a function of the franchisee associations’ membership support. It is mission critical to this and to every other association function that it be joined and supported by as close to all the franchisees in the system as possible. To the extent that there are free rider non joiners, their reticence will be accused by the franchisor as a reason why association models should not be considered competent or reliable. Franchisees must be inculcated with the belief that their participation in the association is essential to their success and to their survival. While the approach should be solicitous, there should also be sanctions for non joiners. There is no free lunch, no free ride, and the association membership needs to have and to enforce the discipline to deny assistance of any kind to non joining franchisees. Yes, that is akin to shunning or banning. So what? This is not a tea party. The accomplishment of independent franchisee association goals requires universal participation and support.

People cannot be allowed to think or believe that they will participate in the benefits of an association to which they do not subscribe. Being deleted from association membership must be seen as so damaging to any franchisee’s future prospects that none will dare fail to support it. While no one likes confrontation, there must be reasonably effective discipline amongst the rank and file for the association to succeed. That discipline should begin with every new franchisee’s first coming into the system. Every prospective franchisee considering the investment should, immediately upon his first association contact, receive a very high impact brochure about the value of belonging to the association and the impact upon his prospects for success of his failure to participate. Association membership needs to be part of the culture and the DNA of every franchise system.

There is a lot of negative history in franchising. To be sure, there is a lot of good history in franchising too. For many years people have been looking for ways to counteract the draconian language used in franchise agreements and the opportunistic and destructive behavior of some rogue franchisors. The independent franchisee association is the best and most effective way to accomplish that.

Profile picture for user Richard Solomon

Comments

Excellent question. No franchisee association has ever

addressed this issue to my knowledge. It is opposed by just about every franchisor on the planet. There are other issues that are customarily seen by associations as immediate concerns, and those are usually what is reacted to.

This is a longer term venture for associations. I know that it will yield good results for associations because I know several companies that use this for their own similar goals, with great success.

I started using econoometric modeling in the mid 1960s in antitrust litigation - to show that the assumed entry barriers to business segments were not in fact what the government was claiming them to be; to show that the alleged monopoly profits in concentrated industries were not monopoly profits at all when the entire enterprise in which the accused companies were engaged was measured and the profitability of the whole was measured rather than just the segment that was then enjoying favorable, but transitory, market position; that business life cycle evolution erodes assumed monopoly/quasi monopoly power to the extent that governmenet regulatory intervention is not required to cure tenporary large amplitudes in the swings of concentration ratios; and - as I suggest here - to determine and track cash flows in changing business models and maintain sub case studies relating to the issues those businesses face from year to year.

It is because of those experiences that I am confident that financial modeling by independent franchisee associations has great promise for providing them with leverage opportunities they now lack.

I hope you find that a respectable response to your very reasonable question.

Gorgeous Models

While these discussions and Richard’s original blog focuses to some degree on bad systems I would like to, initially, leave such systems, confrontation, litigation and the influence of franchisee associations alone.

This is a subject that I have spent an awful lot of time on over 20 years.  To me financial modelling is basic to franchising. When I get involved in trouble shooting any individual franchise business, or group of franchised businesses or for that matter, a franchisor operation or a franchise system I first investigate the culture in the business beginning with the quality of communications, training and selection. Secondly I investigate the quality of the ‘product’ be that service and/or actual saleable product.

Then I go straight to the financial model(s).  Financial modelling offers enormous flow on benefits to the businesses and to the franchisor 'product'.  When benchmarking, typically you will find expense categories that restrict the business and when you have the data it is not very difficult at all to convince operators that, in simple terms, if they work to identify reasons for overspending in certain categories they allow themselves the opportunity to rationalize smarter spending in categories that generate greater revenue and presuming the franchise model is basically sound produces greater profit.  When franchisees experience greater profit and growth the franchisor gets the same.  

It is basic to good franchising; what benefits the franchisor must benefit the franchisee and what benefits the franchisee must benefit the franchisor.  Stupid systems involve people that generally don’t ‘get’ that concept and they struggle and fight because of it.  Good systems don’t have to sell franchises; investors climb over each other to get in.

Now as far as bad systems go and refusing to participate; well that is a red flag.  As far as potential damage to the saleability of franchises where the information is not available that is real but we call that competition incentive.  Competition drives franchise systems to review and refine to compete.  Those processes benefit all investors including the franchisor because in the immediate and long term if the franchise product does not measure up the value and return is never as good as it could be or it is a system destined to fail anyway. Benchmarking is the basis of financial modelling and successful franchising.

Remembering that the average franchise investor investigates their ‘industry of choice’ and where the data is available for say one franchise system and not for another it has to be presumed the reason for the non-availability is that the system that hides the data is a less worthy investment than the other.

Hell; franchisors who want to grow their networks and the value of their system should insist on this data.  For franchisees in any system they should recognise that to identify areas of improvement is to allow them the ability to increase their business value and their return. 

Independent franchisee associations are the vehicle to ensure that the data is accurate and the simplest way to ensure participation.  Inaccurate data is always found to be just that because flow on benefits either don’t eventuate or they are at best limited.  And not just for franchisees; the franchisor will not experience the growth and return either.  

Accuracy and ease of data collection happens when participating franchisees are directed to prepare their financials using template formats for financial reporting that meet government and franchise system category needs.  Confidentiality is maintained when I collect this data because I don’t need actual Gross/Operating Expense dollar amounts from franchisees; all I use is percentage of gross figures for the purpose modelling.  I’m not an accountant so this may be argued to be unsophisticated.  All I can tell you is that it works.  You end up with the identifiers you need.

Yes; financial modelling would arm franchisees tied to an abusive system whether that information is used by the franchisees association to negotiate with the franchisor or whether the franchisor forced that information to be used in litigation would depend on the stupidity of the franchisor.

Independent franchisee associations offer many other valuable benefits to franchisees and these have been discussed at length in other blogs and I can appreciate why bad franchisors fear them.  But what I don’t get is why so many franchisors that present as potentially good systems don’t seem to appreciate the benefits that such associations offer the franchisor.  But then again franchising is complex everyday and confused the next.

As an aside; Last night at 8.50pm Sunday I received a call from a franchisor who I had never heard of and had obviously never spoken to; ever.  He wanted to 'chat' about franchising.  He had a problem within his relatively small network of franchisees.  At 8.50 on a Sunday night I'm not at my best and quickly explained that it sounded like the core issue was that he lacked the guts to communicate that he 'really' wanted to produce a healthy system and the smarts to know that in up front communication he might just achieve the collaboration necessary. 8.50 prick .. free chat .. prick

Excellent Idea

For some time, I have been proposing that IndFA's realize that they have important control over the brand.  They can choose to recommend, not recommend or have a neutral view on whether a prospect should purchase a new franchise.  The IndFA can back this opinion up with legitimate and evidentiary proof, if called upon.

As Richard states, there is great opportunity for leverage.  We saw that recently with the AAOHA campaign which forced some franchisors to change their contracts.

Not every IndFA has the power of numbers that AAOHA has, but it really doesn't matter.  If the IndFA targetted new prospects with a buy, don't buy, or we are neutral, ranking then you can bet that the franchisor would have to listen.

Re: Financial modeling

Richard, great article -  WON'T WORK.   As you stated, financial modeling would provide too much insight into the financial viability of franchise systems.  That would affect not only individual franchisors but the financial well being of franchisor associations as well.  Not to mention, provide financial fodder for people in your industry.  Franchises are established to maximize profitability - of the franchisor NOT the franchisee.  More than half of all franchises would close.

Hell, our own government agencies are in on this as well.  The SBA has been shown that the projections on some of their loan applications are off by a standard deviation of 100% (revenues projected to be double what the real average is) and yet their response so far has been "projections are just projections - not set in stone".  This response was given to me even after I showed them a section in their own Standard Operating Procedures manual that states that the projections are one of the most important aspects of the entire application.  The SBA's response also flies in the face of their own OIG's Audit Dept's findings against both borrowers and lenders based on inflated gross revenue numbers on the applications. 

Franchisors, unfortunately, will only laugh at this attempt.  If they can get government guarantees based off of fraudulent numbers and the government will not prosecute then, please Richard, site the incentive to establish a system that will, most assuredly, be the death knell for many in their industry.

That is simply a ridiculous excuse for being lazy and

cheap.

I know from experience how effective this is from my involvement in its applications in the situations I described.

Like I said, those who don't want to be bothered will always find excuses not to be bothered.

Re: That is simply a ridiculous. . .

Richard,  I AGREE WITH YOU THAT THIS IS AN EXCELLENT IDEA!!  I am just saying that franchisors will not accept this lying down.  Yes, it is effective and most important necessary.  However, I believe franchisors will tie up the franchisee associations in legal wranglings (rightly or wrongly) for quite some time and eventually break them financially before they allow this kind of information out in public.

Add on to this that those franchise systems who truly don't want this info out are the very ones whose systems don't really work.  More pointedly, the franchisees are not earning enough money (if any at all) to finance the fight.  Franchisees in a poor system are just trying to keep their homes and businesses- there is no extra "disposable income" from which to finance this option - especially since it mostly helps those who have not yet signed on.  Most who have purchased already signed a waiver absolving the franchisor of any wrongdoings.

One last thing:  since it will be current franchisees who are financing this study what is their benefit?  If the system is failing they already know it and there is no incentive to make it public.  No franchisee wants anyone else to go thru the hell they are currently experiencing - UNTIL, that is, they have the ability to pawn off the albatross to someone else.  A financial model PROVING that the system is not viable shuts the door on this option.  Currently, they can claim either family problems or that, maybe, they just weren't cut out for the business.  This model would essentially close the last "EXIT" door (strategy) left to the franchisee.

Just more excuses - why bother facing down franchisros - let's

just pretend we can't win and do nothing forever so that nothing ever changes.

That is riddiculous and cowardly. If you posit that all franchisees are cowards who deserve what they receive, then I agree with you.

If it is possible that they are not just a lot of low life scum who should continue to be abused and never have the  cojones to do anything about it, then this is one of the most effective ways for them to get going and set up an environment that they will never ever get from the government.

The gutless get crap. The people who will make the comitments to improve their lot get results. This is how life always works.

What do present franchisees get out of it? If changing the way the game works so that they don't always lose isn't adequate compensation, then they should never do anything to free themselves from abuse. And if they choose to continue to suffer, they should stop whining about how rough life is.

It's put up or shut up time for franchisees who are tired of being abused.

Re: Just more excuses? No, Richard, just reality

Your rants are not responding to my statements.  If you want to be a blowhard be my guest.  However, my depiction of the problem still stands with regard to poor franchise systems: 

1.  Most franchisees have already signed their legal rights away with some sort of General Release so they will get nothing from this.

2.  They are in a bad situation which includes finances so they are unable to invest money into developing a financial model that will tell them what they already know -  they are screwed and in a losing situation.

3.  By doing this they cut their own throats.  They will be unable to sell their franchises without full disclosure - and if in a poorly designed system the disclosure would let everyone else now know that the system is designed to fail.

4.  Before ANY of this happens, the current franchisees will not only have to shell out for the financial modeling BUT ALSO for legal representation once the franchisor gets wind of this and tries to stop it - years of legal wrangling - you can thank your compatriots for that. 

5.  For any poorly designed system the results will be the death knell for the entire franchise.  NO ONE will buy into the franchise system - essentially shutting down the franchisor and leaving the franchisee with NO OPTIONS.

THAT, Richard, is only the beginning.  YES, I believe your suggestion should be REQUIRED OF ALL FRANCHISES.  But the franchisees are NOT gutless, just penniless.  For those in an already failing system it will just be the final nail in the coffin.

That is your reality for reasons I have already discussed.

However, if there is a group of franchisees out there who are tired of being abused and interested in doing things to bring abuse to an end, they could now, for the first time, enjoy the services of the team of Richard Solomon and Michael Webster.

Obviously, we would not be useful to the likes of you and your ilk.

RE: My reality

Richard, my "ilk" as you say, are the ones that already signed a General Release form.  You know, the one that YOU told me in a phone conversation that since I signed it there is little to no recourse.  AND, it has been mentioned here fairly often, a similar release form that ALMOST ALL franchisees sign (including the form where it states that we were never told anything by anyone at anytime). 

This modeling will not do anything for THOSE THAT HAVE ALREADY SIGNED ON.  For potential purchasers it will provide an invaluable service.  For those that already signed, it only reinforces what they already know.

However, a Solomon/Webster law firm will be a formidable force.  Best of luck!!

You're right. This is not for ex franchisees. This is for people

who still have to fight for a prosperous future and want to do everything they can to make their odds better.

I don't think it will be called Solomon & Webster. I don't know what it will be called. We are discussing that now. When Mike talks about it, it is called Webster & Solomon. But, jokes aside, it will have a company name and it will have its own Internet presence, and it will be the best resource in the world for every franchisee group that wants to have a rational and normal business existence.

As you know, Mike Webster is about the nicest guy on the planet, and I am on the opposite end of the spectrum. Cooperative franchisors get Mike, and the others may experience a bit of me.

But we believe we will be bringing a formidable resource to the assistance of every actual and potential franchisee association on the planet.

I Sincerely apologize for the restrained understatement.

I know, you can call it.....

A Canuck and a Schmuck. 

Your logo: Maple Leaf with the Lone Star inside. 

Your motto:  "We assist franchisees North or South of the Border, by hitting above and below the belt."

All kidding aside, you can bring a formidable resource to an arena that desperately needs all the help it can get.

You could do what the media does with celebrities

Richwebs, Richmike, or Solomike. Just some silly suggestions. Especially since they are not a couple.