Franchisors’ strategy of burying their heads in the sand all too often magnifies the risk to franchisees and the brand.

By Mike Rozman, CFE

Franchise brands face risks around every corner. From the federal government shifting rules about employment to weather patterns impacting commodity prices, franchise executives need to keep a sharp eye to recognize risks and even sharper wits to determine what risks can be mitigated. Like a shepherd protects its flock and fields, franchisors must protect their franchisees and brands. One point becomes all too clear: the ostrich strategy of franchisors burying their heads in the sand is unacceptable and all too often magnifies the original risk factor.

One crystal clear risk facing franchise brands is undercapitalized franchisees. This risk is so well understood by the industry that a review of public-facing franchise websites reveals that a high percentage of brands present the required liquid asset and net worth levels. Visit your brand’s franchise FAQ and you are likely to see clearly articulated liquid asset and net worth levels. This open approach is a fairly new trend among franchise sales executives, who would prefer to reduce unqualified leads from the brand’s sales funnel. This disclosure signals that brands recognize the importance of franchisee capitalization levels. But is that enough?

Unfortunately, recent poll data of franchise executives suggests that this positive trend of brands establishing financial standards and publishing those standards in their marketing materials may just be some old-fashioned window dressing. The poll, conducted by BoeFly, revealed that 74 percent of franchise brands surveyed do not verify the assets of new franchisees. 

Presumably poll respondents who opt not to verify franchisee assets don’t recognize the significant risk an undercapitalized franchisee brings to a brand. Do the 26 percent of respondents who verify assets have it right? Should brands verify a potential franchisee’s assets? Let’s examine that point by exploring common implications of undercapitalized franchisees more closely. To help illustrate, let’s consider a franchise applicant — we’ll call him Undercapitalized Eddie, who seeks to join a fictional brand, Tall Mike’s Ceiling Fan Cleaners (Tall Mike’s for short).

The first consequence we consider when brands don’t verify assets comes not at the hands of Undercapitalized Eddie, but as a result of the lax process itself and the signal it sends to all franchisees: the brand doesn’t enforce its documented standards.  

I’m reminded of the tale of David Lee Roth, famous frontman for Van Halen, and his contractual demand of concert promoters: his dressing room required a large bowl of M&M’s minus the brown ones. Years later Roth revealed that this requirement wasn’t whimsical, but rather an indicator of how carefully the contract had been read. In Roth’s view, if concert promoters ignored the M&M’s term, they may have ignored the band’s technical staging requirements which could result in dangerous conditions. Franchisors who verify assets make it clear that standards are enforced and risk is minimized.  

Tom Spadea, a franchise attorney with Spadea Lignana, a firm specializing in franchise law, sees the process of asset verification as an important step in the franchisee vetting process, in part for the message it sends. “A franchisor should be just as conscientious in their due diligence of franchisee candidates as they ask the candidates to be within the system,” he said. The way a brand behaves during the sales process sets the tone for the future relationship.

Beyond the negative signal it sends, the most basic implication facing brands who fail to keep out undercapitalized franchisees is that the franchisee fails to open, joining the ranks of the brand’s Sold but Not Open (SNO). Unlike the franchise team at Tall Mike’s, bankers and other capital providers will be diligent in assessing Eddie’s ability to service the debt he seeks in order to open his new franchise. Banks will most certainly verify Eddie’s reported assets. If the bank determines that Eddie lacks the liquidity and collateral to meet their standards, he will be declined. Without leverage, Eddie is presumably out of luck in securing the financing he needs. 

But as all too many franchisors know, Undercapitalized Eddie rarely will go quietly into the night (and who would blame Eddie!).  Rather, Eddie will have little other recourse than to turn to Tall Mike’s for help. By Eddie’s thinking, Tall Mike accepted his franchise fee (an all too high portion of his personal balance sheet we now know) — surely the brand is committed to helping him open his franchise? But Tall Mike’s knows the grim truth: every additional moment spent helping Eddie is very likely wasted time. Tall Mike’s needs to spend time with its royalty paying franchisees and properly vetted candidates who will become paying franchisees. Undercapitalized Eddie will inevitably consume an inordinate amount of Tall Mike’s time and energies, relative to well capitalized franchisees.

Throughout the time Eddie is floundering in the SNO category, he is obstructing what should be a valuable royalty stream. We see this risk as the opportunity cost. Consider the case of a prominent West Coast juice brand, with designs to head east. Brand leadership was laser-focused on awarding franchises exclusively to partners who would develop as contracted. The brand’s Chief Development Officer had a clear expansion plan with no room for his greatest threat — sold but unopened units. His plan required density; unopened units were anathema. Brand management created a process to best ensure new partners could open, and asset verification was an important piece of their strategy.

Let’s say Undercapiltalized Eddie manages to scrape together the money needed to open his first unit. He and Tall Mike’s still face considerable challenges. Once Eddie expends all his capital to open his unit, he is ill-prepared to handle unforeseen bumps in the road. Envision a precipitous drop in sales as the result of a short-term road improvement project near Eddie’s showroom (clients love watching the daily ceiling fan cleaning demo!). Without some financial cushion, Eddie’s unit is in jeopardy. Tall Mike’s risks losing a performing location, suffering inordinately from what should be a temporary setback. Should Eddie be forced to close because he can’t financially weather a passing storm, the brand’s reputation is threatened. There is little more ominous for a prospective franchisee than a closed unit. Rest assured, the same goes for bankers too.  

Now that Tall Mike’s grasps the importance of keeping out Undercapitalized Eddie, let’s explore how it’s best done. Diligent brands require franchise applicants to submit financial statements (issued by banks, brokerage firms, etc.) so the brand can substantiate the franchise applicant’s claimed assets. This step should be done early into the candidate’s application to gain the full benefit and avoid time wasted. Brands need to provide a secure path for submitting files to eliminate the privacy concerns of franchisees. 

This process needs to be consistent and well documented. Brands that embrace a verification process often turn to an outsourced service, who will typically bundle asset verification along with a background check and credit report check. By outsourcing this essential, yet technically cumbersome process, brands will gain confidence that they are providing a secure, efficient, accountable, industry standard protocol without having to build one from scratch.  

Franchise executives are shepherds of their brands. Ostriches who bury their heads in the sand, ignoring what’s going on around them, rarely make for good shepherds. 

 

Mike Rozman, CFE, is CEO and co-founder of BoeFly. He serves on the International Franchise Association’s Supplier Board and in 2013 became a Certified Franchise Executive. 

Search