Buying a Franchise! Look out for Churning and the Franchisor’s Use of Third Parties -Those Sucking “Straws” who suck up good deals for themselves!
Unfortunately, the legal definition of “churning” on franchise chat and information sites like Blue Mau Mau, and even on sites run by the State Regulatory Agencies eliminates the description of this insidious third-party churning that some franchisors, with low-performing franchise concepts, employ as a management strategy to maintain and grow the gross sales of the franchise system and perpetuate their survival in the marketplace.
Franchisors CAN grow their gross sales of the systems on the backs of failing and failed “founding” franchisees who lose their entire investments in startup businesses – and who are not informed pre-sale of the failure rate of other “founding” franchisees of the system by the franchisor before they borrow money and put their life savings at risk in very risky (not disclosed) long-term commitments to franchised businesses.
Exploitive franchisors CAN perpetuate their systems and their profits as long as they can sell new franchises out of the front door of the system and abet the FIRE sale of failed startup units out the back door to third party agents (straws) who are standing by who then buy these units for pennies on the original investment of the founding franchisees. This is the insidious, but apparently legal, practice of third-party churning, wherein both the third party and the franchisor work closely together to acquire the failing unit, its tangible and intangible assets, as cheaply as possible for the third party, the succeeding franchisee, who will continue to employ the tangible and intangible assets in the service of the franchisor and himself/herself. While the third-party churning may not be illegal, it is my opinion that a failure to disclose third-party churning to new buyers of the franchise should be illegal and treated as fraud.
Churning is defined on these websites referred to above as merely the act of the franchisors, themselves, acquiring the failing units and re-selling the same territories over and over again…Some of the states, like Illinois, have moved to make the franchisors disclose this particular type of direct churning to the new buyer of the franchised location and to disclose this direct franchisor churning in the Franchise Disclosure Document (FDD), however, there is no official description of third-party churning. Obviously, if direct churning is considered material information that should be disclosed in an FDD, third-party churning should also be disclosed presale to new buyers of franchises.
Third party churning, as abetted by the franchisor, is not recognizable or discernible in the Franchise Disclosure Document (FDD)-because prospective franchisees are NOT informed or sophisticated enough to recognize that, maybe, most of the “transfer-sales” listed in “confusing Item 20” of the FDD, the Franchise Disclosure Document, may be fire sales that represent a loss, maybe an entire loss of the investment of the startup franchisee who financed and originally built and operated the physical unit that has failed and now, after failing, appears as merely a “Transfer-Sale” in Item 20 of the FDD.
Just as the actual Termination Column in Item 20 of the FDD requires no reason to be given for the terminations (The original FTC Rule required a reason to be given for terminations) the Transfer-Sales Column in Item 20 of the FDD also discloses no reason for the transfer-sale, and prospective franchisees who don’t understand the franchise business model assume that a “transfer-sale” of a franchise is a positive Item 20 event for the sellers of the franchise. Expansion of the system as indicated in Item 20 of the FDD through obscured churning of failing units in Item 20 transfer-sales columns translates to viability of the franchise in the eyes of naïve and inexperienced first-time franchise investors.
Since the regulators, both state and federal, never check the accuracy of the disclosure documents (FDD’s) unless there is a complaint, prospective franchisees and the regulators themselves can’t even know for certain if all of the transfer-sales and terminations are actually listed, as required by law. Even if they are not listed, and this is discovered by a regulator, upon investigation, it is merely an administrative violation of the FTC Rule, and not actionable fraud because there is no private right of action for violation of the FTC Rule available to franchisees when they have signed the adhesive contract packaged with the inadequate, incomplete, and ineffective Franchise Disclosure Document (FDD) mandated under the FTC Rule and FDD’s that govern the sale of franchises to the public. Interestingly, the regulators, both state and federal, have deniability that they know that third-party churning is taking place when they look at Item 20 of the Franchisor’s Disclosure Document.
Third-party churning, as abetted by the exploitive franchisors, and “founding” franchisee failure, and other generational franchisee failure, is obscured under cover of the FTC Rule and the Franchise Disclosure Document (FDD) because the failing “founding franchisees” of many franchise systems very often do give their businesses away in fire sales of their tangible and intangible assets (their gross sales) to third party straws who are standing by to acquire the failing startup unit in a fire sale. Founding franchisees, and other generations of franchisees give their businesses away in order to get out from under the debt represented by the long-term PERSONAL guarantees on the franchise, the lease, and the equipment, the lease improvements, etc., that can ultimately drive them into insolvency and bankruptcy if they don’t get out from under their failing businesses and cut their great and continuing losses in the operation of the businesses.
Franchisees are between a rock and a hard place when they have exhausted the estimated startup costs (startup costs as advertised, unfortunately, don’t have to be substantiated with existing facts by the franchisors) and franchisees may have used or borrowed even more funds but are still losing money every month and have failed to achieve breakeven status even after many months and years of trying to break even. Franchisees are then willing to give their businesses away in fire sales because closing up and walking away might make bankruptcy certain when the personal guarantees are upheld by the courts and the judgments against their personal assets (their homes or retirement savings) are honored and a “failure fee” is threatened by the franchisor. Failing franchisees then give their businesses away in fire sales in order to cut their losses and save themselves from personal bankruptcy, when possible. However, unfortunately, if they can save themselves from bankruptcy, they must continue to pay on the startup debt for many years.
The founding franchisee thus subsidizes the franchisor and the third-party franchisee who has bought the business assets for almost nothing. The third-party franchisee may be able to attain break even or, perhaps, profits because of zero or low investment costs and lowered overhead. and may be able to sell the business at a wash, or at a profit after a few more years of operation and an increase in gross sales. Or, again, at the least.. in the failure to break even, the franchisee can give the business away in a fire sale to another third party straw if and when the franchisor wants to retain the benefit of the tangible and intangible assets of the business to serve the system, and another franchisee, who gets the business cheap, wants to try again to build the business to break even. Or, the unit might close down for good.
If failing franchisees notify their franchisors that they are losing money every month and can’t afford to stay in business, and will have to terminate as of a certain date, and will cooperate with “termination procedures” the franchisor still treats this as abandonment under the small print of the contract. Exploitive and churning franchisors will investigate to determine whether the franchisee has already defaulted on a startup loan and will then abet the TAKEOVER of the failed business by sending the third party prospective franchisee to the bank that holds the defaulted startup loan to make an offer for the assets and to free up the title to the assets of the failing business. Apparently, the banks are prone to take these small offers for title to the assets of the failing business from third parties because the bank can still continue to try to collect the balance due on the loan if the franchisee has any other assets, in or out of bankruptcy; and/or the loan is guaranteed by the SBA. Additionally, franchisors can delay approval of a fire-sale to the third party through the delay of the normal sales process to the point where the franchisee may be driven into insolvency and default on the loan and the unit can then be acquired for even less money by the third party standing by.
Nobody knows or cares, apparently, how many thousands and thousands of failed startup franchisees have been churned and are still paying on their startup debt and subsidizing the franchisors and the second-generation franchisees (the third parties). They don’t turn up on loan default lists. Nobody cares about the other thousands who are silenced in personal bankruptcies; and the five percent or less who survive to address the courts and who don’t do very well because the courts like the regulators don’t have to recognize the churning and acknowledge that third-party churning is a management practice of some franchisors..
Obviously, direct churning and third-party churning are activities that have contributed to the growth and durability of franchising in our economy. The third party straws have a better opportunity to be successful because they bought a brand new startup unit for almost nothing and have usually reduced their overhead, etc., through direct negotiations with the Landlord, who will negotiate with the third party and reduce the rent in order to retain a tenant, when the Landlord understands that the franchisor, himself, is not going exercise the option (as contained in the lease addendum) to assume the lease and buy the assets to sell to another franchisee.
Churning and exploitive franchisors are in the position to exploit the Landlords as well when they abet third-party churning and direct negotiations by the third party with the Landlord. Landlords sign the lease addendums in the franchise contracts that gives the franchisor the option to assume or not to assume the lease in the event of early co- termination of the franchise and the lease agreement because they know this is the only way the franchisee will be approved to buy and operate the franchise — and they need tenants in their store fronts. Franchisees who are failing and who read their contracts falsely believe that the franchisors will directly assume the lease and acquire the assets (in a fire sale) to sell to a third party standing by if they want to retain the gross sales and good will built up by the failed/failing first-generation franchisee.
Most third-party takeovers are abetted by the franchisors by means of the “penalty clauses” in the small print of the franchise agreements that authorize franchisors to demand a “lost royalty fee” or some kind of penalty for closing down the business before the expiration of the term of the contract. Generally, almost any “early” termination of the contract (except death) is considered an “abandonment” of the business under the small print of the contract even if the “abandonment” by the franchisees is to prevent/avoid insolvency and bankruptcy by cutting the ongoing losses and negative cash flow.
Obviously the clause in the adhesive franchise agreement that authorizes a “lost royalty fee” upon abandonment (early termination) also, necessarily, is intended to hold franchisees to their contracts and keep franchisees working in their businesses to attain breakeven and to stand at breakeven status with no actual profits OR as an inducement to failing franchisee to try to sell their breakeven but unprofitable business to another franchisee, whenever possible. (All franchise agreements require the franchisees to acknowledge by their signature to the contract that they have not been promised “profits” in the operation of the franchise. Franchisees can’t just quit and walk away from their ten-year contracts because there are no actual profits over and above their overhead, operating expenses, and debt service)
In the third-party, abetted (by the franchisor) takeovers, the failed/failing startup franchisee is often threatened with the “lost royalty fee” of several thousand dollars unless they agree to engage in some kind of management agreement (another adhesive contract) in which the third party who is standing by can try out the business while the original startup franchisee remains responsible for the lease and other commitments that have been personally guaranteed, and wherein the third party agrees to sublease from the original startup franchisee whose personal guarantee of the lease will still be in force in the event the third party (the prospective new franchisee) is not approved to be a franchisee by the franchisor or in the event the third party (the prospective new franchisee) decides after the expiration of the management contract that he doesn’t want to buy the assets of the business.
Again, the failed startup franchisees are between a rock and a hard place because if the failing franchisee doesn’t agree to sign a management contract and agree to an immediate takeover of the business by the third party, the failing franchisee is advised that the “lost royalties fee” will not be forgiven by the franchisor and will be immediately due; and the terms of abandonment will come into play and the personal guarantees on the malicious long-term franchise agreements and leases will be due immediately as well. The Courts will enforce the terms of the contracts and the personal guarantees and will issue judgments against any assets still held by the failed franchisees. This situation can throw the failed/failing franchisee into personal bankruptcy. Obviously, the franchisor knows that this is an offer that the franchisee can’t afford to refuse! (I indicate that these franchise contracts are malicious because the franchisors are aware that 50% more or less of their new franchisees won’t make it past five years but insist on ten year agreements and often leases to match that are personally guaranteed with the personal assets of the franchisees because this increases the total debt that is personally guaranteed and increases the pressure on the franchisees to give their businesses away in third-party abetted fire sales when they fail to thrive after exhausting their startup funds and credit, etc..
The third party abetted takeovers provide a great advantage to both the third party prospective franchisee and the franchisors. The franchisors benefit because they don’t have to disclose the failure rate of “startup franchisees” to new buyers as would be necessary if the franchisor directly acquires the failing “startup” units and re-sells them in the marketplace. Additionally, the franchisors who abet third party churning avoid all risk and don’t have to explain the sale-transfer columns in the FDD’s that have hidden the churning (actual risk of the purchase of the franchise) from prospective buyers and from the view of judges in litigations before the courts.
Franchisors also use the third party takeovers when they have encroached on their own franchisees and have produced franchised businesses which are operating too close together to make profits. The franchisees are forced to compete to the point of the death of one and the success of the other, who will get the loser’s business for nothing, if he wants it, and perhaps survive -unless the franchisor again encroaches to saturate the territory to compete with the other franchisors in the same sector.
The “churning” franchisor demands a release of liability for the fire sale, if and when completed, from both the original franchisee, the seller, and the new franchisee (the abetted third party) and requires a confidentiality agreement as to the terms of the sale as a condition of the franchisor’s approval of the sale of the franchised business assets and the franchise rights to the standby prospective franchisee. Of course, the franchisor can make any contractual arrangement he wants to with the straw franchisee as long as there is mutual agreement to the new terms. While confidentiality agreements now have to be disclosed in the FDD’s, the contracts themselves are still upheld in the courts and due diligence with Item 20 references who have signed confidentiality agreements continues to be inefficient and ineffective for prospective buyers of franchises.
The most unfortunate repercussion of all that is described above is that it remains quite invisible to the new buyer of the franchise, the good faith founding franchisees, on whose backs the franchisors churn- based profits are built. It is behind and through the inflow of new start-up capital from new franchises that non-performance of individual units of the founding franchisees is hidden. Compounded churning contributes to dramatically reducing the “ultimate cost” and “sales price” of many/most franchise units in the franchise system– in essence manufacturing pseudo -success for new franchisees who buy “used” franchises “cheap” because the normal startup and breakeven costs associated with any new startup business have been reduced through the practice of churning startup franchisees on the brink of failure.
New franchisees don’t usually come to understand these realities until it is too late. By the time they realize the truth it is impossible to escape so they are forced on to the bitter end of bankruptcy and destitution or to subsidizing the franchisor and the new franchisee for many years to pay off the startup debt.
Those franchisees who succeed in franchise systems because they bought a franchise cheap and avoided startup costs and/or because they were in the 50% of franchisees who are still standing and thriving past five years, or the 29% who actually survive past ten years, are fortunate to have never faced the hard realities of third-party churning..