Owning a Franchise
A lot of corporate executives who have been “downsized,” especially those in their 40s and 50s, are looking to buy franchises. All well and good, but what happens if the franchise doesn’t work out?
Most franchise agreements do not allow franchisees to terminate the relationship before the franchise term has expired. The idea is that if things don’t work out for whatever reason, it was your fault (you weren’t a sufficient “fit” for the franchise, or didn’t give it the old college try); and you should sell your franchise to someone who can do a better job with the franchise territory than you did.
That’s OK if we’re talking about an established franchise like McDonald’s or Burger King. But the franchises most people are looking at nowadays are “early stage” franchises — with fewer than 100 franchisees and sometimes less than 50 — that are still testing their business models. If a franchise like that doesn’t work out, there’s just as good a chance it’s the franchise’s fault as it is yours and the franchise should let you out of the deal.
That’s easier said than done, though. Not only do most early stage franchises not give you an opportunity to get out of the franchise if things don’t work out, they actually impose penalties — sometimes large penalties — if you ask to be released early. For example, if the franchise imposes a “minimum monthly royalty” requirement on their franchisees, the franchise will require you to prepay all monthly minimum royalties for the balance of the franchise term, sometimes in a single lump sum installment. The franchise will discount this amount to “present value,” of course, but the reduction won’t be more than a couple thousand dollars.
I recently reviewed a very early stage franchise program with fewer than 30 franchisees nationwide where the franchise got this right. When a franchisee signs up, she commits to a monthly royalty of 8 percent of her gross sales, and signs a “promissory note” agreeing to pay the franchisor a total of $200,000 in royalties (without interest) during the 10-year franchise term. As the franchisee pays royalties each month, the amount paid is applied to reduce the note so that once her total royalty payments reach $200,000, the “promissory note” ceases to exist.
If the franchisee wants to quit the franchise before the $200,000 “promissory note” is fully paid, she can either agree not to compete with the franchise for a three-year period, or refuse to sign the “noncompete” agreement. If she chooses to sign the “noncompete,” the $200,000 “promissory note” is forgiven. If she elects to compete with the franchise, however, the balance due on the $200,000 “promissory note” becomes payable in monthly installments at 6 percent interest per annum over a five-year period. If the franchisee elects to quit the franchise after the $200,000 “promissory note” is paid in full, the “noncompete” period is reduced to one year and the franchisee doesn’t owe anything to the franchise.
An approach like this one not only gives franchisees a choice of “exit strategies,” but it also demonstrates a little humility on the franchise’s part — an acknowledgment that nobody really knows whether the franchise model will work in all locations, in all economic climates and under all circumstances. Sadly, most franchises are not as enlightened as this one.
If you are planning to buy a franchise anytime soon, be sure you understand clearly what your “exit strategy” will be if things don’t work out. And don’t buy a franchise if there’s even the slightest doubt you can last out the full franchise term.