in reference to: Doctor’s Assoc., Inc. v. Stuart

This above case from 1996 illustrates many of the horror stories you read on this blog, particularly site selection and mandatory arbitration clauses.

Site Selection:
Several Subway franchisees sued Subway corporate for basically screwing them on site selection.

First a little insight into Subway’s site selection process described in the court’s opinion.

After a Subway franchise is purchased, Subway helps the franchisee to find a site for the Subway shop. If Subway approves the site, it requires each franchisee to sublease the premises from one of several real-estate leasing companies that are affiliated with Subway (red flag!).

In 1990, Defendants opened their first Subway sandwich shop in Granite City, Illinois. Later they bought a second Subway franchise. Subway corporate allegedly promised to approve any appropriate site Defendants found for the second franchise in Bethalto, Illinois. After locating two potential spots in Bethalto, Defendants asked Subway corporate for approval, but were told that both sites were too close to another Subway sandwich shop located in Wood River, Illinois.

Subway corporate then allegedly permitted another franchisee to open a Subway shop in Bethalto, at or near the spots picked by Defendants. Despite Defendants’ objections, Subway corporate made Defendants locate their second Subway store in Granite City, less than two miles from Defendants’ first store. The opening of this second shop cut into the sales of Defendants’ first Granite City shop.

Subway corporate is your landlord. They can dangle an eviction notice in the face of franchisee to compel desired behavior. If Subway had the franchisee’s best interests in mind, that franchisor-landlord relationship could work in theory. Intuitively, you would think that maximizing the franchisee’s profits would maximize Subway’s profit, right? Wrong. (see The hidden ways franchisors make money off franchisees)

Arbitration Clause:

So you think, "If they try to screw me, I"ll sue them!", right? Well, you can’t because like most franchise agreements, the Subway franchisees agreed to settle disputes using an arbtration service instead of the government courts:

Any controversy or claim arising out of or relating to this contract or the breach thereof shall be settled by arbitration

Convincing a judge the arbitration clause is unconsciounable is a very high hurdle, but can be done as Rob Boulter has done recently in California representing Mail Box Etc. franchisees.. That means you have to argue your case in front a “unbiased” private arbitration company. Ironically, arbitration companies compete verociously for Subway’s business. If Subway thinks the arbitration company is unfair, it can contract with another arbitration company. In arbitration, there is no jury, few evidenciary and discovery rules, and the outcome is binding. You can sue them if you find a technicality in the contract (which the case above found in the Sublease Agreement which did not contain an arbitration clause like the Franchise Agreement).

It looks like the Quiznos franchisees are not standing by in the face of apparent fraud:

The primary allegations of the complaint are that the franchisees were harmed by the company’s "deceptive recruitment practices" and "failure to deal in good faith" when it took franchise fees from the plaintiffs, but refused to approve locations to open Quizno’s stores. In addition, the complaint charged, Quizno’s has refused to return any portion of the franchise fees, even though the plaintiffs paid more than 18 months ago and are now being threatened with termination.

and more general comments…

Commenting on the lawsuit, Susan P. Kezios, President of the American Franchisee Association, said, "This lawsuit is a classic example of a popular franchise chain using its brand name recognition to deceive hard-working Americans into investing their dollars to grow a franchise. Bob-the talking baby in Quizno’s current media campaign-is definitely talking out of both sides of his mouth in this case."

Added Klein: "It is unfortunate that not enough people are aware of the abuse that franchisees often endure at the hand of their franchisors. Too many entrepreneurs automatically assume that buying a franchise is a safe investment. We are confident that we will prevail in our lawsuit, and are eager to finally bring justice to the franchisees who were victimized while also alerting people who are interested in purchasing a Quizno’s franchise to make an educated decision.

I don’t have a comment from Quiznos, but I’d assume they deny the allegations. Still, Quiznos claims to open a new franchise every 16 hours. Have those franchisees all done enough due diligence to uncover these allegations of fraud? I fear they are too eager to hand over the $25,000 franchise fee.

Even if this lawsuit turns out to represents a relatively small percentage of franchisees, I would never buy a franchise from a company who would keep an entire franchise fee after refusing to timely approve site selection. Perhaps Quiznos has a logical explanation, but I find it hard to believe so many franchisees in the same city would have the identical claims of fraud. Our legal system allows freedom to contract even if the terms are unfair, but those contracts are not enforceable if one can prove fraud or unconscionable terms.

So what is the problem?

• management’s ego and greed
• salesmen training and guidelines
• commission/bonus structure

The salemen’s compensation is composed of mostly commission and bonuses on total franchise fees. There is virtually no regard for franchisee’s site selection wished or oversaturating the geographic market. Management is certainly aware of the complications, but do nothing so long as the franchise fees keep rolling in. These circumstances seem obvious to me. What do you think?

If you want to be a franchisee, understanding the motivations and decisions made by franchisors is important. I came across this article that walks through the general considerations a franchisor must deal with when deciding whether to franchise their business. Reading the article will help franchisees evaluate whether the franchise fees and royalty are a fair exchange for the training and franchise system. The article lays out 13 steps, all of which should be included and considered during a franchisee’s due diligence.

First, the article helps evaluate whether a particular business can be franchised effectively. Franchisees need to understand what makes a good franchise business before evaluating the thousands of franchise oppotunities out there.

The article also describes the intellectual property consideration (mainly trademarks) which will somewhat strengthen the exclusionary power of franchises. It discusses the importance of the business, strategic and execuation plans of the business.

The article further describes how important pro-active operations and training support are to a franchisee’s success and for establishing a consistent brand image.

All of the above are important research points for franchisees, even when the franchisors has hundreds or thousands of units already sold. If a franchisee has weak training, poorly thought out business plan or poor site selection rules, you will find yourself one unhappy franchisee.

update 6-9-2005: Thanks for the link, Dane.

As a follow up my previous post, this article contains a relevant list.

10 MAJOR TASKS WHEN STARTING A NEW BUSINESS

1. Determine startup costs and find the money (e.g. savings, home-equity loan, business loan, etc.).

2. Find location (many startups begin in owner’s home).

3. Choose legal structure (sole proprietorship, partnership, corporation, limited liability corporation).

4. Apply for business license if city requires it and/or other required permits and licenses, depending on type of business.

5. Register a fictitious business name and/or apply for trademark (a franchiser will handle this issue).

6. Obtain seller’s permit if business will sell products subject to sales tax.

7. Apply for tax-identification number for IRS if business will have employees.

8. Set up business bank account to keep company revenue and spending separate from personal account.

9. Set up record-keeping system to track finances, deductible business spending, etc.

10. Write a business and marketing plan.

Of course, these are the most basic prerequisites and there are MANY more major tasks and gut checks, but this is a good start.

I found this story interesting. It tells the story of a working family ditching their jobs for the life of a franchisee.

Are they making more money? No. Are they working less hours? No. Are they happier? Yes.

They’re living on less, spending more hours at work and couldn’t be happier.

They are saving money on business clothes, gas and travel costs, food, and other work related expenses.

How do they market and advertise the business?

With no advertising budget, the couple do their own marketing. Don and Kasey tour the nearby residential neighborhoods dropping off menus sporting their Z Pizza address. Don delivers small pizza boxes to nearby businesses with an invitation to bring it to the restaurant in exchange for a free pizza.

I find many franchisees are making less money but are more happy in the end.

Law suits between franchisors and franchisees happen regularly. The outcome of the litigation, however, is rarely known if a settlement occurs. As a condition of settlement, franchisors usually require the franchisee to sign a statement admitting liability. In exchange, the franchisor will pay a premium settlement. With the signed admission of liability, the franchisors can claim victory in the matter and possibly scare away other law suits.

Franchisors are required to accurately and clearly disclose litigation events with past and present franchisees. 16 C.F.R. §436.1(a)(4)(ii). Of course, disclosures will usually be technically accurate but, whenever possible, will put a positive spin for the franchisor. One way this is accomplished is with the liability admission mentioned above as a requirement of settlement. Even when the franchisor was clearly at fault, the “admission” of liability by the franchisee can shade the actual events. More info here.

You may have seen the garage organization and shelving ads in the mailers, I know I have. I think the idea is novel and can make someone a nice living. I didn’t realize it was a franchise business, but I suppose it can be profitable enough. One franchisee of the Garagetek system with a territory in Jacksonville, Florida, has sold the franchise business and area expansion rights for about $300,000 (he initially paid $25,000).

Often, if you can afford it, signing a franchise agreement to develop a geographic or metro area is the safest and most financially protectable position. The restrictions on where in your terriroty you can set up shop, how many locations you plan to saturate the area with, and many other competitive factors are much more within your control.

Have you been putting off the decisions that are important? Are you spending your short time on earth the way you want? What if you knew you were gong to die in 2 years, what would you do different? Attorney Carolyn Elefant from MyShingle.com legal blog wrote a touching reminder that life is sometimes unexpectedly short no matter how healthy our lifestyle, and the decisions you make TODAY are important and long lasting.

How you lead your life is your decision, and maybe the risk of buying a franchise is a risk worth taking.

If the Franchise Pundit hasn’t given you enough reasons to research your franchisor before buying into the company, here is another one. As a franchisee, you are required to purchase inventory, supplies and other items through the franchisor or one of its listed suppliers. What if the franchisor is slow in delivering the product you need to sell? Well, you are out of luck. You’ll be in legal trouble for breaching the franchise agreement if you buy supplies or products elsewhere.

Moral of the story? Research the franchisor’s management, talk to other franchisees, ask to see the financial results of the franchisor and their credit ratings based on audited financial statements. Demand (or better, ask your lawyer to demand) the franchise agreement include a clause that you can buy necessities from alternative equivalent sources if the franchisor fails to deliver in a certain amount of time. If they refuse, I’d walk.

I’ve been thinking about the soup franchise idea more after the Soup Nazi article I posted. While I don’t think the Soup Nazi franchise is the one to buy (store size and look is bad, management is poor), I think the soup franchise concept does have real potential. The only soup franchise I know of that almost entirely focused on soup is ZOUP! Fresh Soup Company with a $25K franchise fee. The carryout business seems extra compelling too. Soup franchises can serve fast (how fast can you laddle soup?) and the changing menu of soups recipes can be infinite. Zoup, for example, has 12 soups daily. I think a soup focused franchise with a Panera Bread look and feel will be the next QSR boom.

Al Yeganeh, the Soup Nazi character from the Seinfeld T.V show is franchising his soup restuarant. They’ve signed 123 deals so far, and they’re aiming for over 1,000 units.  The franchise fee is reported to be $30,000 with royalty and advertising fees totalling 6%.

Special kiosks sold by the company and storefront locations will bear Yeganeh’s “The Original Soup Man” logo with his photo. For $10, customers will get eight ounces of soup _ from seafood bisque and chili to cold and exotic soups _ plus bread, a beverage, fresh fruit and a small chocolate.

Can this work? I’ve seen a few soup focused franchises coming online lately (Zoup,San Francisco Soup Co.), but I’m skeptical of this small-scale soup franchise. They are making the soup in New Jersey where it will be frozen and shipping to franchisees. I’d feel much more comfortable franchising a nice soup and sandwich cafe, or sandwich cafe known for their soups like Panera Bread, Pickerman’s Soup & Sandwich Shop, Obee’s Soup Salad Subs, or Schlotzky’s.

Strangely, as Professor Bainbridge points out, franchisees are prohibited to use the words “Soup Nazi” or “Seinfeld”.

I wouldn’t buy it!