From the International Franchise Expo: Optimism Overshadows Recession

Franchisors seem unfazed by either the economy or new franchise disclosure requirements. 'Frankly, a downturn in the economy can be good for franchising,' said Chris Moradian, managing member real estate/finance, Nick-N-Willy's Pizza, which has about 70 franchisees. 'We are seeing cheaper leases for restaurants and, in the past two months, lower interest rates on loans. Plus, some people who have lost jobs and have money to invest are looking at franchising.'

Franchise attorneys say that the requirements of the new Franchise Disclosure Document ('FDD') are not discouraging franchisors, either. 'It's more paperwork ' and for some franchisors it's an annoyance. But it is not a problem,' said John E. MacDonald, attorney with Stark & Stark (Princeton, NJ).

Based on attendance at the IFE, coffee bar franchisors might be the most optimistic sub-group in the franchise industry. The half-dozen coffee franchisors in residence each promoted a differentiation point from the dominant Starbucks chain, while seeking to surf the wave that Starbucks created. Coffee drinkers (and franchisees) can select the laid-back atmosphere and U.S.-grown beans of The Bad Ass Coffee Co., the friendly atmosphere and affordability of Saxby's, a caf' menu at The Daily Grind Unwind, the drive-thru convenience of Mountain Mudd Espresso, or the mobile units of Bearclaw Coffee. 'Coffee is still a booming business. There's a lot of room for us to grow,' said The Daily Grind's Carol Haller.

'We have more than a thousand franchises, and we're not finished,' said Harold Hill, president of Bad Ass Coffee.

Whether franchising coffee, pizza, fitness, or children's services, one noticeable trend is that franchisors are seeking multi-unit operators. 'Multi-unit operators are our future,' said a representative of Mountain Mudd, which has fewer than 50 franchise units, all in the Mid-Atlantic and South.

'We are seeking wealthier franchisees who can invest in multiple units,' said Chris Moradian of Nick-N-Willy's. 'They can grow faster, and they are less sensitive to the economy.'

Although franchisors express optimism about their businesses, there's no question that financing is harder to obtain for their franchisees. 'Lenders are changing their criteria,' said Keith Pillow, business development officer for Diamond Financial, a Raleigh, NC, firm that pre-qualifies franchisees for Small Business Administration loans and other forms of financing. 'We are seeing situations where a franchisor has had a long relationship with a lender and has done 25 deals, but then the lending criteria change overnight and it's harder to qualify a prospect. That's the effect of the economy. ' We also have had lenders that did smaller loans of $100,000 or $125,000, but now don't want to do them because of the changes in borrower criteria.'

With these pressures, franchisors and prospective franchisees have to be more creative, said Pillow. 'There are lenders that will do a loan with no collateral, or based on secondary income, or whatever,' he said. 'My job is to give the borrower options about where to borrow.'

Franchise Disclosure Document: Earnings Claims

Earnings claims are one of the areas in the new FDD in which the Federal Trade Commission made the most significant changes. At the IFE, Maurisa Faunce of Plave Koch PLC (Reston, VA) reviewed the new rules and explained to new franchisors why Plave Koch favors making earnings disclosures, which are now formally known as Financial Performance Reports, or FPRs.

'When you speak with a prospect, what's the first question you are asked: How much money can I make?' said Faunce. 'The number one reason to provide earnings information is because financial performance is of primary importance to a prospective franchisee. If you can't give this information, you are at a competitive disadvantage.'

When franchisees are not provided with earning information, they will seek it through other avenues, Faunce said, and that information is likely to be less representative of a system's true performance. Franchisees who have an unrealistic picture of the business they are buying are more likely to become disgruntled, unproductive partners.

David Koch, partner at Plave Koch, said that many franchisors mistakenly perceive that an FPR will leave them vulnerable to litigation about the accuracy of the information they provided. But he said that the opposite is true. 'I tell clients that providing financial performance information reduces risk, it doesn't increase it,' he said.

'Franchisors shy away from providing it due to the cost [of obtaining the information] and the fear that if they lay out information and a franchise doesn't perform that well, the franchisor will be sued,' he said. 'But the opposite is true. Litigation about earnings claims almost always comes about from people giving information outside of the disclosure document, not from information in the document. The fear of financial disclosure is irrational.'

Yet, less than 20% of franchisors provide FPRs, according to research cited by Faunce. For franchisors seeking well-heeled, multi-unit franchisees ' which IFE attendees repeatedly said they were trying to do ' sharing earnings information might be essential. 'Large investors and sophisticated buyers are more to demand financial information,' she said. 'The hotel industry, where the investment can run into the millions of dollars, has 63% of franchisors providing financial performance reports. It's demanded by the franchisees.'

Franchisors who decide to provide the information should be aware that it must be gathered comprehensively throughout the system, and it must be documented and be verifiable. 'We had a client last week who called our firm and said it was now ready to do an Item 19 disclosure,' said Faunce. 'We said that would be great ' do you have the data? They said, 'No, but we are going to call all of our stores today and find out their sales for the last year.' Well, that's not enough. You need written data, and you need to keep it on file for at least three years. You can't just do it overnight.'

Whether providing financial performance reports or not, franchisors also should install a compliance audit program to check that franchisees are not being provided with inaccurate or prohibited information, said Faunce. 'We have found compliance certifications to be very helpful. This can be a short questionnaire given to a franchisee after the sales process. It can ask a few basic questions, such as who the prospect spoke with about the franchise, did they give earnings information, and did they show you outside media coverage of the franchise that had financial information,' said Faunce.

Conflict Resolution Through Mediation

Unfortunately, franchising relationships do sometimes founder on unrealized expectations and poor communications, whether generated during the sales process or during active franchising. Several IFE exhibitors were offering services to alleviate the disputes that arise between franchisor and franchisee. Instant Assist is a new mediation service developed by Mediate.com that provides a third party whom a franchisee can call with a complaint and an ombudsman service that facilitates solving the problem quickly.

'Business networks are becoming ever-more virtual, and franchising is a classic example,' said James C. Melamed, J.D., chief executive officer of Instant Assist. 'Without the face-to-face contact, situations are a breeding ground for conflict. Rapid-growth franchises in particular do not have the infrastructure to avoid conflicts.'

Often, disputes begin because a franchisee has unrealistic expectations for his business, and even a minor question or problem becomes magnified in the context of disappointment, said Melamed. 'We begin with a focus on what expectations the franchise has created. We need to watch out for irrational exuberance ' or unrealistic expectations created by franchisors,' Melamed said. 'Then if you combine it with a system that's grown fast, you have a situation where the problems multiply if the franchisor does not get back quickly to the franchisee to respond to a question. We are the buffer zone when a franchisee is not getting satisfaction.'

International Opportunities Are Bountiful

For more-established brands, international franchising represents an exciting future. In a series of short presentations at the IFE, staff members of the U.S. Department of Commerce U.S. and Foreign Commercial Service highlighted growth prospects for U.S. franchisors throughout the world, and they pledged technical support for franchisors seeking to make the international leap. 'Our goal is to help you expand overseas successfully,' said Kristin L. Houston, senior international trade specialist, estimating that about 20% of franchise brands expand overseas.

Free-trade agreements ('FTAs') have had a significant positive effect for franchising, both in opening markets and providing legal protection. The impact will spread even further in the next several years if pending FTAs are implemented, said the Foreign Commercial Service representatives.

Few pockets of the U.S. economy are growing at 27% per year these days, but that has been the growth rate of franchise investment in the Middle East/North Africa ('MENA') region for the past five years, said Cherine Maher, who facilitates U.S. trade in Egypt for the U.S. Commerce Department. 'The growth rates are almost beyond imagination. And it's dominated by U.S. brands,' she said.

Moreover, governments in the region are encouraging investment in food establishments, retail, and services ' typical franchise business sectors. 'Governments in the MENA are facilitating small- and medium-size entrepreneurs who want to invest. They are making loans more available. They are reducing tariffs and customs,' she said. 'Some countries are now allowing 100% foreign-owned investments. Maybe most important, the governments are offering better intellectual property protection for brands.'

Much the same story can be told about the Americas since the North American Free Trade Agreement ('NAFTA') was enacted in 1994 between the United States, Canada, and Mexico, said April Redmon, Trade Americas Team Leader for the U.S. Commerce Department. 'People are familiar with how NAFTA eliminated tariffs, but they might not realize how important were the legal protections of NAFTA,' she said. 'NAFTA established the principle of 'national treatment' for service trades, so the government must treat foreign services firms the same as locally owned services firms. NAFTA eliminated barriers such as local presence requirements ' and so you don't have to be a resident or citizen to provide a service. And, very important for franchises, NAFTA established the right to effective protection and enforcement of intellectual property rights.'

In the past few years, an FTA with Chile and the U.S.-Central America-Dominican Republic Free Trade Agreement ('CAFTA') have followed the NAFTA model. Franchisors will benefit from the rapid phase-out of duties on products imported to those countries, as well as intellectual property protection, Redmon said. 'CAFTA is unique in that it promotes regional cooperation, so you see situations where a business, like a hypermarket, can go into multiple countries at the same time,' she said. 'Also, the elimination of laws protecting dealers is beneficial for franchisors. Previously, if a U.S. company wanted to terminate a dealer, it would probably have to pay a penalty. Now, if the termination is for good cause, a financial penalty can't be levied.'

However, Redmon acknowledged that U.S. franchisors looking to the Americas should temper their expectations. 'Franchising was recently removed from the 'best prospects' list for Chile because Chileans are unfamiliar with U.S. brands, and it's a small market right now,' she said.

On another negative note, she and other panelists noted that the Columbia free-trade agreement was unlikely to pass Congress in this contentious election year. Yet, they said that the U.S.-Panama and U.S.-Korea FTAs, which are further along, seem very likely to be implemented. Both of those accords have been negotiated, but legislatures in each country must ratify them.

The U.S.-Korea FTA has particularly immense potential for franchisees, said Ronald Babula, international trade specialist, because the country's economy is so large. 'The U.S.-Korea FTA will be the most commercially significant FTA for the U.S. economy and U.S. exporters since NAFTA in 1994,' he said.

In 2006, Korea was the destination for $31 billion worth of merchandise exports out of a U.S. world export total of $930 billion. Food and beverage products ' and franchisors that sell those products ' will be among the most prominent beneficiaries of tariff reductions. Even without the trade agreement, U.S. exports to Korea have been growing at 8% per year.

Kevin Adler is Associate Editor of this newsletter.

Franchisors are an optimistic bunch. As entrepreneurs and sales people, franchisors believe that their destiny is to create national and international brands. Obstacles that might intimidate many people, even other business owners, appear to franchisors as mere nuisances. Given this perspective, it was no surprise to find an increased number of franchisors at the International Franchise Expo ('IFE') in Washington, DC, in April, and to find them determined to prosper even when the U.S. and world economies are struggling.

Franchisors are certainly aware of the U.S. recession, but attendees at the IFE were far from despondent about their businesses or about franchising in general. They see opportunities even in a downturn, and they came to the IFE to generate business as well as to learn from franchise attorneys about the mandates of the new Franchise Disclosure Document ('FDD') and how to build good relationships with their franchisees.

'Attendance is up. We have about 80 new exhibitors from last year, although some of last year's exhibitors didn't return,' said Terry Hill, IFA vice president of publishing. 'When I talk with exhibitors here, they don't say they are retrenching. They tell me that they are increasing their sales efforts to attract new franchisees and upping their advertising to help franchisees attract customers. Their attitude is to work harder.'

Franchisors seem unfazed by either the economy or new franchise disclosure requirements. 'Frankly, a downturn in the economy can be good for franchising,' said Chris Moradian, managing member real estate/finance, Nick-N-Willy's Pizza, which has about 70 franchisees. 'We are seeing cheaper leases for restaurants and, in the past two months, lower interest rates on loans. Plus, some people who have lost jobs and have money to invest are looking at franchising.'

Franchise attorneys say that the requirements of the new Franchise Disclosure Document ('FDD') are not discouraging franchisors, either. 'It's more paperwork ' and for some franchisors it's an annoyance. But it is not a problem,' said John E. MacDonald, attorney with Stark & Stark (Princeton, NJ).

Based on attendance at the IFE, coffee bar franchisors might be the most optimistic sub-group in the franchise industry. The half-dozen coffee franchisors in residence each promoted a differentiation point from the dominant Starbucks chain, while seeking to surf the wave that Starbucks created. Coffee drinkers (and franchisees) can select the laid-back atmosphere and U.S.-grown beans of The Bad Ass Coffee Co., the friendly atmosphere and affordability of Saxby's, a caf' menu at The Daily Grind Unwind, the drive-thru convenience of Mountain Mudd Espresso, or the mobile units of Bearclaw Coffee. 'Coffee is still a booming business. There's a lot of room for us to grow,' said The Daily Grind's Carol Haller.

'We have more than a thousand franchises, and we're not finished,' said Harold Hill, president of Bad Ass Coffee.

Whether franchising coffee, pizza, fitness, or children's services, one noticeable trend is that franchisors are seeking multi-unit operators. 'Multi-unit operators are our future,' said a representative of Mountain Mudd, which has fewer than 50 franchise units, all in the Mid-Atlantic and South.

'We are seeking wealthier franchisees who can invest in multiple units,' said Chris Moradian of Nick-N-Willy's. 'They can grow faster, and they are less sensitive to the economy.'

Although franchisors express optimism about their businesses, there's no question that financing is harder to obtain for their franchisees. 'Lenders are changing their criteria,' said Keith Pillow, business development officer for Diamond Financial, a Raleigh, NC, firm that pre-qualifies franchisees for Small Business Administration loans and other forms of financing. 'We are seeing situations where a franchisor has had a long relationship with a lender and has done 25 deals, but then the lending criteria change overnight and it's harder to qualify a prospect. That's the effect of the economy. ' We also have had lenders that did smaller loans of $100,000 or $125,000, but now don't want to do them because of the changes in borrower criteria.'

With these pressures, franchisors and prospective franchisees have to be more creative, said Pillow. 'There are lenders that will do a loan with no collateral, or based on secondary income, or whatever,' he said. 'My job is to give the borrower options about where to borrow.'

Franchise Disclosure Document: Earnings Claims

Earnings claims are one of the areas in the new FDD in which the Federal Trade Commission made the most significant changes. At the IFE, Maurisa Faunce of Plave Koch PLC (Reston, VA) reviewed the new rules and explained to new franchisors why Plave Koch favors making earnings disclosures, which are now formally known as Financial Performance Reports, or FPRs.

'When you speak with a prospect, what's the first question you are asked: How much money can I make?' said Faunce. 'The number one reason to provide earnings information is because financial performance is of primary importance to a prospective franchisee. If you can't give this information, you are at a competitive disadvantage.'

When franchisees are not provided with earning information, they will seek it through other avenues, Faunce said, and that information is likely to be less representative of a system's true performance. Franchisees who have an unrealistic picture of the business they are buying are more likely to become disgruntled, unproductive partners.

David Koch, partner at Plave Koch, said that many franchisors mistakenly perceive that an FPR will leave them vulnerable to litigation about the accuracy of the information they provided. But he said that the opposite is true. 'I tell clients that providing financial performance information reduces risk, it doesn't increase it,' he said.

'Franchisors shy away from providing it due to the cost [of obtaining the information] and the fear that if they lay out information and a franchise doesn't perform that well, the franchisor will be sued,' he said. 'But the opposite is true. Litigation about earnings claims almost always comes about from people giving information outside of the disclosure document, not from information in the document. The fear of financial disclosure is irrational.'

Yet, less than 20% of franchisors provide FPRs, according to research cited by Faunce. For franchisors seeking well-heeled, multi-unit franchisees ' which IFE attendees repeatedly said they were trying to do ' sharing earnings information might be essential. 'Large investors and sophisticated buyers are more to demand financial information,' she said. 'The hotel industry, where the investment can run into the millions of dollars, has 63% of franchisors providing financial performance reports. It's demanded by the franchisees.'

Franchisors who decide to provide the information should be aware that it must be gathered comprehensively throughout the system, and it must be documented and be verifiable. 'We had a client last week who called our firm and said it was now ready to do an Item 19 disclosure,' said Faunce. 'We said that would be great ' do you have the data? They said, 'No, but we are going to call all of our stores today and find out their sales for the last year.' Well, that's not enough. You need written data, and you need to keep it on file for at least three years. You can't just do it overnight.'

Whether providing financial performance reports or not, franchisors also should install a compliance audit program to check that franchisees are not being provided with inaccurate or prohibited information, said Faunce. 'We have found compliance certifications to be very helpful. This can be a short questionnaire given to a franchisee after the sales process. It can ask a few basic questions, such as who the prospect spoke with about the franchise, did they give earnings information, and did they show you outside media coverage of the franchise that had financial information,' said Faunce.

Conflict Resolution Through Mediation

Unfortunately, franchising relationships do sometimes founder on unrealized expectations and poor communications, whether generated during the sales process or during active franchising. Several IFE exhibitors were offering services to alleviate the disputes that arise between franchisor and franchisee. Instant Assist is a new mediation service developed by Mediate.com that provides a third party whom a franchisee can call with a complaint and an ombudsman service that facilitates solving the problem quickly.

'Business networks are becoming ever-more virtual, and franchising is a classic example,' said James C. Melamed, J.D., chief executive officer of Instant Assist. 'Without the face-to-face contact, situations are a breeding ground for conflict. Rapid-growth franchises in particular do not have the infrastructure to avoid conflicts.'

Often, disputes begin because a franchisee has unrealistic expectations for his business, and even a minor question or problem becomes magnified in the context of disappointment, said Melamed. 'We begin with a focus on what expectations the franchise has created. We need to watch out for irrational exuberance ' or unrealistic expectations created by franchisors,' Melamed said. 'Then if you combine it with a system that's grown fast, you have a situation where the problems multiply if the franchisor does not get back quickly to the franchisee to respond to a question. We are the buffer zone when a franchisee is not getting satisfaction.'

International Opportunities Are Bountiful

For more-established brands, international franchising represents an exciting future. In a series of short presentations at the IFE, staff members of the U.S. Department of Commerce U.S. and Foreign Commercial Service highlighted growth prospects for U.S. franchisors throughout the world, and they pledged technical support for franchisors seeking to make the international leap. 'Our goal is to help you expand overseas successfully,' said Kristin L. Houston, senior international trade specialist, estimating that about 20% of franchise brands expand overseas.

Free-trade agreements ('FTAs') have had a significant positive effect for franchising, both in opening markets and providing legal protection. The impact will spread even further in the next several years if pending FTAs are implemented, said the Foreign Commercial Service representatives.

Few pockets of the U.S. economy are growing at 27% per year these days, but that has been the growth rate of franchise investment in the Middle East/North Africa ('MENA') region for the past five years, said Cherine Maher, who facilitates U.S. trade in Egypt for the U.S. Commerce Department. 'The growth rates are almost beyond imagination. And it's dominated by U.S. brands,' she said.

Moreover, governments in the region are encouraging investment in food establishments, retail, and services ' typical franchise business sectors. 'Governments in the MENA are facilitating small- and medium-size entrepreneurs who want to invest. They are making loans more available. They are reducing tariffs and customs,' she said. 'Some countries are now allowing 100% foreign-owned investments. Maybe most important, the governments are offering better intellectual property protection for brands.'

Much the same story can be told about the Americas since the North American Free Trade Agreement ('NAFTA') was enacted in 1994 between the United States, Canada, and Mexico, said April Redmon, Trade Americas Team Leader for the U.S. Commerce Department. 'People are familiar with how NAFTA eliminated tariffs, but they might not realize how important were the legal protections of NAFTA,' she said. 'NAFTA established the principle of 'national treatment' for service trades, so the government must treat foreign services firms the same as locally owned services firms. NAFTA eliminated barriers such as local presence requirements ' and so you don't have to be a resident or citizen to provide a service. And, very important for franchises, NAFTA established the right to effective protection and enforcement of intellectual property rights.'

In the past few years, an FTA with Chile and the U.S.-Central America-Dominican Republic Free Trade Agreement ('CAFTA') have followed the NAFTA model. Franchisors will benefit from the rapid phase-out of duties on products imported to those countries, as well as intellectual property protection, Redmon said. 'CAFTA is unique in that it promotes regional cooperation, so you see situations where a business, like a hypermarket, can go into multiple countries at the same time,' she said. 'Also, the elimination of laws protecting dealers is beneficial for franchisors. Previously, if a U.S. company wanted to terminate a dealer, it would probably have to pay a penalty. Now, if the termination is for good cause, a financial penalty can't be levied.'

However, Redmon acknowledged that U.S. franchisors looking to the Americas should temper their expectations. 'Franchising was recently removed from the 'best prospects' list for Chile because Chileans are unfamiliar with U.S. brands, and it's a small market right now,' she said.

On another negative note, she and other panelists noted that the Columbia free-trade agreement was unlikely to pass Congress in this contentious election year. Yet, they said that the U.S.-Panama and U.S.-Korea FTAs, which are further along, seem very likely to be implemented. Both of those accords have been negotiated, but legislatures in each country must ratify them.

The U.S.-Korea FTA has particularly immense potential for franchisees, said Ronald Babula, international trade specialist, because the country's economy is so large. 'The U.S.-Korea FTA will be the most commercially significant FTA for the U.S. economy and U.S. exporters since NAFTA in 1994,' he said.

In 2006, Korea was the destination for $31 billion worth of merchandise exports out of a U.S. world export total of $930 billion. Food and beverage products ' and franchisors that sell those products ' will be among the most prominent beneficiaries of tariff reductions. Even without the trade agreement, U.S. exports to Korea have been growing at 8% per year.

Kevin Adler is Associate Editor of this newsletter.