By D.R.J. Prevost
The Franchise Relationship
In theory, the franchise relationship is a symbiotic relationship, such as a marriage, or a partnership. However, as often happens, there is a significant gap between theory and practice. What should be well understood is that the goal of the franchisor is the same as any other business entity: maximize profits. Moreover, we live in an era of immediate gratification; therefore, in many business entities long-term planning is limited to managing earnings per share (EPS) for the current reporting period. Thus, many franchisors will maximize profits in the short-term whether of not this has a deleterious effect on the franchisee. I owned and operated a family restaurant franchise; therefore, this discussion will tend to focus on this type of franchise.
Clearly, the franchise relationship mimics a marriage in that there is a strong tendency for disputes to become more frequent and bitter as the business relationship evolves from the honeymoon stage to an actual business relationship, a partnership where one partner controls the other. Often, the franchisor is soon viewed as a greedy control freak by the franchisee as the realization dawns that the franchisor is not be the savior that he made himself out to be during the courting period. In fact, it soon becomes evident that the franchisor may have been somewhat less than candid during the sale of the franchise.
Pro Forma Statements
Pro forma financial statements is the term applied to financial statements that would result if certain projections for costs and revenues had occurred during the financial year of the pro forma statements. Clearly, they are what if statements based upon assumptions made by those generating the statements. The validity of the pro forma statements is directly related to the validity of the underlying assumptions. To be sure, pro forma statements are a valid accounting tool; they are used frequently for planning purposes. For example, they are part of the annual budgeting process for most organizations. What the pro forma financial statements depict for management is what the financial statements will look like if the planned activities for the budgeted year actually come to pass as forecasted during the budgeting process. In summary, the key for anyone working with pro forma statements is to determine precisely what the underlying assumptions are, and the validity of those assumptions. Hence, it is not surprising that most theorists and advisors believe that the client should to seek professional accounting help when considering the purchase of a franchise.
The Role of the Accountant
Invariably, theorists and advisors suggest that the franchisee s accounting advisor should, amongst other things, assist in:
Assessing capital requirements; Reviewing pro forma financial statements; Examining the accounting information and reporting system; Determining the reserves necessary to finance the losses associated with a start-up due to promotion, staff training, and possible economic downturns; Investigating the financial strength of the franchisor through credit checks or the review financial data, if the franchisor is a public company or has filed information in a jurisdiction where such disclosures are required by law; Planning personal and corporate taxes; and Evaluating the real value, if any, of the franchise itself.
Normally the franchisor provides pro forma statements and the accountant merely performs a typical financial analysis on the statements. Recall that the pro forma statements can be useful if, and only if, the assumptions underlying the statements are valid. Sadly, without a great deal of industry expertise, most accountants have difficulty in determining whether or not some of the underlying assumptions are valid, especially some of the more detail oriented assumptions such as what percentage of a sales dollar should be allocated for wait staff, kitchen staff, bar staff, or management. In my case, the cost to replace lost, stolen, and damaged eating utensils amounted to several thousand dollars per year. It should be noted here that many pro forma statements are general in nature and such expenses are overlooked or, if included, are not clearly detailed or outlined.
I acted as my own accountant because I am, in fact, an accountant by training. And, in the process of doing my due diligence I spent well over a week doing computer modeling in an attempt to determine the validity of the most important number: sales! Sales are important because high revenues can provide some slack to offset any errors or omissions. My model was based on a number of factors, for example, population demographics, disposable income, and expected population growth patterns for the future. In addition, I performed an analysis of dining out out statistics, for example, I examined the amount expended per capita, consumption patterns, and average distances traveled. With respect to the location of the franchise, the old real estate platitude certainly applies, the three most important things are: Location, location, and location! Therefore, one should study the traffic patterns, accessibility, parking, and other consumer draws, such as theatres, banks, or liquor stores, in order to determine if the location is economically feasible. For example, the parking must be close, above ground, well lit, and free from through traffic or street crossings. Thus, shopping mall parking tends to be ideal for consumer oriented retail businesses such as family restaurants.
Because the franchise in question was in the initial stages of entering the Ontario market, it was vital to study the few franchises that had already been established. This is more difficult to do than one might expect, for example, the franchisor has a host of reasons why actual audited financial statements can not be provided. Thus, the potential franchisee is often left to his or her devices to try and determine whether or not the franchise is profitable or the proper fit for the franchisee.
Marketing and Misrepresentation
Sales people seem to feel compelled to exaggerate the value or performance of their product to make a sale. Hence, the franchisor will tend to exaggerate sales and profits while embellishing other aspects of the franchise being sold. To whit, it is rare to see a franchise pro forma statement that depicts a loss in the initial stages of operation, although that is precisely what should be expected. As a result, the franchisee may come to view the franchisor s enhanced claims as misrepresentation; thus, problems and disputes often follow the opening of the franchise.
On the other hand, many franchisees buy their franchises with unrealistic expectations about the potential for financial gain. All too often the franchisee will not seek professional advice, and may even ignore advice that does not agree with their preconceived notions. As a species, we often see and hear what we wish and repress that which we deem to be disagreeable or stressful. Clearly, the need for sober second thought or a cooling off period can not be over emphasized when purchasing a franchise!
Operating a Franchise
One buys a franchise for a number of reasons: the chance to become financially independent, the psychic pleasure of being your own boss, the freedom to set your own hours, an enhanced life style, and a host of other reasons that vary from one individual to another. In my case, I went from being a university professor and successful business administrator to washing dishes and cleaning toilets literally over night, and these are just a few of the tasks for which you may not be prepared. Simply put, some clich s are clich s for a very good reason; for instance, the new franchisee soon learns that there is some truth in the clich If you want something done right - Do it yourself!
In theory, one of the main reasons for buying a franchise is the training and operating expertise that comes with the franchise. However, those claims of expertise may also prove to be more embellishment. In spite of their claims to the contrary, my franchisor proved to be a very poor operator. In fact, their so-called A team lost in excess of $200,000 during the three-month start-up period while the restaurant operated at capacity producing sales numbers that were well beyond the franchisor s projections. Recall that the goal of the franchisor is profit maximization for the franchisor. Thus, it should come as no surprise that the A team, a ragtag collection of low paid, contract, head office employees, was billed to the franchise at a substantial hourly rate that generated substantial gross margin for the franchisor. Clearly, the franchisor maximizes its gross margin on everything supplied to the franchisee, including training costs.
As an accountant, I was able to deduce that losses were accumulating even without the benefit of a first class information system that had been promised but never delivered. Nevertheless, the franchisor argued that no such losses were occurring, and that they knew what they were doing another exaggeration. Once the losses were confirmed, the franchisor gave no explanations or restitution; they simply blamed the franchisee for any losses, removed the training team, and left the franchisee to die . It should be noted here that franchisors make money several ways; the collection of franchise fees is only one of those ways. In addition, the franchisor makes a substantial lump sum when a franchise is sold. Therefore, the franchisor is quite willing to resell or flip the franchise. Remember, it is all about profit maximization for the franchisor. Thus, if a few eggs have to be broken or more precisely a few franchisee nest eggs to accomplish that goal, so be it.
Actual Financial Statements
Clearly, it best to obtain the actual financial statements of actual operating franchises for the purposes of analysis if the most optimal purchase decision is to be made. However, franchisors are quite reluctant to provide actual statements. Nevertheless, after sufficient prodding, they may provide financial statements where the unit and identity of the franchisee are withheld. In my case, the franchisor provided actual financial statements for a unit that was currently being operated. Unfortunately, it was some time later before I was to learn that the financial statements provided where for a unit in Florida. Due to the fact that alcohol and fresh produce prices are vastly higher in Canada than Florida, the financial statements depicted financial results that were impossible to attain in a Canadian setting.
Actual Franchise Operations
Once the franchise is operational, the startup losses normally accumulate quite rapidly. It is at this time that the franchisee becomes aware of the fact that it may take some time to obtain results that are remotely close to the results shown on the pro forma statements provided by the franchisor. Of course, the fault for any discrepancy between actual results and the pro forma statements is the fault of the franchisee. In any event, using the pro forma statements as targets, we were able to turn the unit around and eventually become the most successful unit in the system with respect to both revenues, and costs. However, like every other franchise, we were unable to achieve any of the pro forma numbers. Although we were was able to come close to some of the pro forma numbers, many proved to be quite unrealistic. Ironically, my numbers were used by the franchisor for demonstration purposes at the annual franchisee meeting, a meeting which this franchisee was not allowed to attend.
Conclusion
Beware of pro forma financial statements provided by franchisors, oftentimes these statements are simply a sales tool that has little if any relationship to what one can expect from operating the franchise. Beware of actual financial statements provided by franchisors; these statements may also be a sales tool that has no relationship to what one can expect from operating the franchise in the jurisdiction in which it is located. Beware of any other statements made by franchisors, often those statements are simply a sales tool and has little if any relationship to reality.
The franchisee / franchisor relationship is not a symbiotic relationship, nor is it a relationship of equals, it is a relationship designed to maximize earnings for the franchisor. Moreover, the franchisee represents a number of different revenue streams for the franchisor; franchise fees are only one of those revenue streams. In summary, are pro forma statements marketing, mendacity, or malfeasance? In the case of my franchise, the answer could be any one of the three or all three depending upon the timing of the question.
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