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Churning

Although the term “churning” is not generally discussed publicly, most executives within the franchising community are painfully aware of its presence and can most likely name a half dozen companies that are thought to participate in churning.

Churning refers to the practice, fortunately not common, of franchisors who follow a common pattern of selling franchises: 1) Aggressively courting and then selling a franchise system to someone who, from the outset, is generally not qualified as a prospective franchisee; 2) Realizing (maybe praying) that the fledgling franchisee will most likely fail; 3) The franchisee does in fact fail and can’t stay current with the terms of the Franchise Agreement (primarily royalty payments); 4) Buying the failed business back for cents on the dollar; and 5) Reselling that same failed franchise to a “bigger fool;“ 6) Repeat the proven cycle.

Here is a theoretical example on churning. Best Systems is an established franchisor who has been in business for 10 years. It currently has 620 franchisees. To attract new franchisees, it has a booth at the various trade shows across the county and several aggressive sales people manning the booth. The investment to become a new franchisee involves: 1) An average investment of $310,000 (including tenant improvements of $15,000 and an equipment package of $125,000; 2) A franchise fee of $45,000; and 3) An on-going royalty of 6% of monthly revenue. According to the Best Systems Franchise Disclosure Document (FDD), the average franchisee who had been in business for at least 2 years earned $400,000 of net sales. Sounds great and the franchisor’s sales staff assures the prospective franchisee (Jim Everyman) that there are no critical skills required to prosper. Just work hard and you will be one happy camper.

Realizing the importance of due diligence, Jim spends a few hours with a friend who is a successful businessman (he owns a motorcycle shop) to see if there are any obvious flaws in the franchise system. They even call one of the existing franchisees in a nearby town. Although the existing franchisee is hesitant to go into great detail about the underlying economics of his particular location, he nevertheless says that he is doing fine and has had no serious problems with the franchisor. After looking over the FDD and the financial projections, his friend says that it looks pretty straightforward. Elated that Best Systems passes such a rigorous analysis with a clean bill of health, Jim convinces his wife Jazmine that this is the opportunity of a lifetime (borrowing a phrase from the Best Systems salesperson), quits his construction job, hocks over $350,000 in the equity in his house and envisions the great success he will shortly enjoy.

Jim is lucky to locate a high-traffic location (a pervious donut shop that folded) only 10 minutes from his home. He eagerly signs a 7-year rental agreement, spends the $15,000 to improve the space and concurrently installs the recommended $125,000 “equipment package” purchased through a subsidiary of the franchisor. A month later he and Jazmine and a very supportive Regional Vice President (Bobby Unctuous) from Best Systems have a Grand Opening. Attendance exceeded Jim’s expectations and Jim and Jazmine are off to the races.

A year later, after working 70 hours a week and Jazmine helping much of that time, Jim is only generating $280,000 in net sales. Required royalty payments are $280,000 x 6% or $16,800. Jim begrudgingly, but promptly, pays his monthly royalty payments as required by the Franchise Agreement. Jim calls his friend Bobby, the always enthusiastic Regional Vice President at Best Systems, who tells Jim not to be discouraged, those sales levels are not atypical (Jim has not a clue what atypical means) of First Year franchisees. Encouraged, Jim now doubles down and spends 80 hours a week and even gets his nephew to help out on weekends. Because of incessant financial friction, Jazmine spends less and less time helping out.

At the end of 9 months, annualized net sales have only increased to $305,000. Jim is depressed. His now furious wife insists (in no uncertain terms) that he cut their losses, sell the business for what they have invested and return to the construction job. He can no longer justify making the 6% royalty payments on time. He is now in default under the terms of the Franchise Agreement. Despondent, Jim runs some ads in regional papers where he suggests he only wants to get his original investment back. When the potential buyer looks at actual sales numbers for the past 21 months, however, he beats feet. 3 months later, Jim calls Bobby, the generally perky and out-going Regional Vice President, to see if Best Systems would have an interest in taking over the store.

Bobby says sure. After talking with the boss man, however, Bobby says the boss man would only be willing to offer a total of $70,000 and that Jim would still be on the hook for the remaining 5 years of the lease (until a new tenant moves in). Jim pleads that the equipment alone is worth $135,000 and that the tenant improvements still look great. Bobby confides that the boss man is tough to get along with and won’t budge on the $70,000 offer.

After a few weeks of teeth gnashing, Jim calls Bobby with hat in hand and agrees to the $70,000 offer. After signing the necessary paperwork, Jim and Jazmine decide to get a divorce. It is unclear what will become of their house. Fortunately, they didn’t have a kid at Stanford.

Unfortunately, the saga doesn’t end here. At the same local franchise show two years later, Bobby Unctuous is able to corral another optimistic, but equally unqualified, prospective franchisee (Herb Loman) who has a keen interest in Best’s business model. It turns out that Best Systems just happens to have a nearby location available that already has the like-new equipment installed, signage is up and tenant improvements require no additional investment Remarkably, there are even 5 years remaining on the lease. When asked about the previous owner, Bobby confides that sales under Jim’s ownership never materialized because he and Jazmine fought like cats and dogs and they never bought into the Best Systems “system.” Herb, because you are prepared to follow the system, I know you’ll be an exceptional franchisee. Although Herb will still have to pay the $45,000 franchise fee, Best Systems can reduce the total investment from the average investment of $310,000 to $295,000 to reflect the existing tenant improvements. Because there are no impediments to starting immediately, the ecstatic Herb signs the Franchise Agreement, opens the shop 3 weeks later with the Grand Opening assistance of his new best friend Bobby. The cycle begins again.

So what in the world just happened? Best Systems received $90,000 in franchise fees in 2 years for the same location. They also enjoyed a profit on the sale of the equipment package of $125,000 value less $70,000 paid to Jim = $55,000. Grand total = $145,000. For his part, Bobby Unctuous received a well-earned bonus of $30,000, leaving a net tidy profit of $115,000 for the franchisor. If Best Systems were able to replicate this scenario 10 times a year, that would mean a profit of $1,150,000. Wowzers.

Alternatively, had Best Systems provided the proper due diligence in picking a truly qualified franchisee in the first place, they would have received the same $45,000 at the front end and, assuming a best-case scenario of $400,000 annual sales x 6% = $24,000 per year in royalties. Over the same 2-year period, total income to the franchisor would have been the $45,000 franchise fee plus 2 x $24,000 in annual royalties or $93,000.

So, the options are simple: 1) Continue to churn for $115,000 every 2 years or 2) $45,000 at the front end and royalties of $24,000 every year. Man would have to be a chump not to take Option 1. Unfortunately, there are a few franchisors who have no qualms or misgivings about deliberately encouraging and welcoming an unqualified prospective franchisee into their system. Although churners should, at a minimum, be ostracized from the industry, I’m not aware of any legal action that has been taken against franchisors who churn their franchisees.

On the other side of the coin, if a franchisee is failing entirely because of inherent poor management, notwithstanding Herculean supporting efforts on the part of the franchisor, a franchisor has every right to purchase the failing business for its market value. No franchisor wants to have a closed unit in its Item 20.

The distinction here is one of initial intent on the part of the two franchisors. The churner intends to engage unqualified investors who most likely will fail. Once they do so, the churner sweeps in and immediately looks for another equally unqualified investor. The legitimate franchisor, however, makes every effort to recruit qualified franchisees on Day One and is prepared to fully support his or her success. Periodic failures occur in even the best systems and the franchisor has every incentive to purchase the failed unit.

The churning cycle will continue to perpetuate itself until prospective franchisees take personal responsibility for their actions and take the time to thoughtfully evaluate all facets of the Franchise Disclosure Document (FDD), especially Item 20.

How can a franchisor suspected of churning be detected?

The FDD will show:

The are two exceptional and informative industry leaders who don’t hesitate to call out franchisors who take advantage of unsuspecting investors. These are Don Sniegowski at www.BlueMauMau.org and Sean Kelly at www.unhappyfranchisee.com.

We are hopeful that the International Franchise Association (IFA) and leaders within the franchising community will do what at they can to: 1) Highlight franchisors who have a history of churning; and 2) Eliminate egregious Non-Disclosure Agreements (NDAs) that preclude unsuccessful franchisees from speaking candidly about their experiences with their franchisor.

As always, the surest way not to be taken advantage of by an unscrupulous franchisor is to enlist the support of experienced professionals who are well versed on the industry and who have the experience to read and understand any pitfalls that might be spelled out in the FDD. Do your homework and Godspeed.

Postscript:

As noted above, Sean Kelly has more experience in calling out “churners” than anyone else. Noted below are a few of his insightful comments on the above article on churning.

Point #1 above: Aggressively courting and then selling a franchise system to someone who, from the outset, is generally not qualified as a prospective franchisee: “Your point #1, the franchisees are not necessarily "not qualified," though many are not. Many of the churned franchisees have extensive foodservice experience. However, the franchisor charges such high fees and marks-up what they buy that many of the franchises are not sustainable.”

Point #2 above: Realizing (maybe praying) that the fledgling franchisee will most likely fail: “In the case of Dickey's, there are some indications that they planned for a large number of failures, including a 20-year term and liquidation clause that forces them into relinquishing their stores, signing gag orders and going away quietly. Clauses in the leases enabling them to take over the stores also indicates foresight, as does the heavy in-house legal department and a store transition team dedicated to churning. Like I said, they are masters.”

Point #4 above: Buying the failed business back for cents on the dollar: “The franchisor often doesn't buy anything. They threaten the franchisee until he goes away. They have the right - but not the obligation - to take over the lease until they find another owner. They often sell the abandoned equipment as part of the franchise, despite the fact it's technically owned by the bank or leasing company. Sometimes the new owner gets the nasty surprise that there's lien on the equipment. In Dickey's case, they often have an area rep take over and run the store until they sell the franchise to another franchisee or new recruit. They have even fired field reps but given them the opportunity to take over multiple failed stores. In Dickey's case, the fees seem secondary to keeping the store open and maintaining the illusion of success.

Point #5 above: “Sometimes the new buyer is a "bigger fool," but other times they are taking over a store that cost $350,000 to open 2 years ago, and have been convinced the original two owners (here it comes...) didn't follow the system.”

“There are a number of Dickey's locations that have transferred ownership six or more times before a store finally closes.”

Sean’s Penalty for suspected churners: “For this reason, I give the "store transfer" numbers (Item 20) the same weight as "ceased operation" or "terminated" when evaluating an FDD.”

If the subject of churning is of interest to you and you want to know which franchisors have suspect records, I strongly recommend that you visit Sean Kelly’s website at www.UnhappyFranchisee.com.