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.