If an experienced franchisee operating hundreds of restaurants can run into serious financial trouble, what should that tell someone preparing to buy a single franchise?
It should tell them that brand recognition is not the same as profitability.
Meritage Hospitality Group, one of Wendy’s largest franchisees, recently filed for Chapter 11 bankruptcy protection. According to CNBC, Meritage operates more than 300 Wendy’s restaurants. The company reportedly attributed its financial problems to pressures that included declining sales, increased discounting and higher costs.
The bankruptcy does not necessarily mean that Wendy’s is a bad franchise or that every Wendy’s franchisee is struggling. Chapter 11 is designed to permit a business to continue operating while it restructures its obligations. Meritage’s financial circumstances are also its own.
But the filing offers an important lesson for every prospective franchisee: even a nationally recognized franchise system can produce disappointing financial results for its operators.
Link to The Brand Can Be Successful While the Franchisee Struggles The Brand Can Be Successful While the Franchisee Struggles
Prospective franchisees are naturally attracted to familiar names. A well-known brand may have national advertising, a recognizable logo, established products and thousands of locations.
Those things have value. They do not guarantee a profitable franchise.
The interests of a franchisor and its franchisees overlap, but they are not identical. A franchisor commonly receives royalties based on gross sales. The franchisee must pay those royalties and then cover labor, rent, food or product costs, insurance, debt service, required technology, advertising contributions and other operating expenses.
A location can generate impressive sales and still produce little or no profit for its owner.
The franchisor may point to systemwide sales growth, new store openings or increased market share. Those numbers may demonstrate brand strength, but they do not necessarily show whether the average franchisee is earning a reasonable return on the capital invested.
A prospective franchisee needs to ask a different question:
After paying every expense required to operate the business, how much money is actually left for the franchisee?
That is the number that matters.
Link to Gross Revenue Is Not Profit Gross Revenue Is Not Profit
Item 19 of the Franchise Disclosure Document is the section in which a franchisor may provide financial performance information. When prepared properly, Item 19 can be one of the most useful portions of the FDD.
It can also be misunderstood.
An Item 19 disclosure may report average or median gross sales without disclosing net income. It may include mature locations but exclude newer or underperforming locations. It may combine company-owned and franchised outlets. It may present information from only a subset of the system.
The FTC Franchise Rule requires a franchisor making a financial performance representation to explain the basis for it, including how many outlets were included, the characteristics of those outlets and how many achieved or exceeded the reported result. The Rule also recognizes that an individual franchisee’s results may differ.
A prospective franchisee should look beyond the headline number and determine:
- Does Item 19 disclose gross revenue, profit or both?
- What expenses are excluded?
- Are royalties and advertising fees included in the expense calculations?
- Does the information include all qualifying locations or only selected locations?
- How old are the locations used in the calculation?
- How many locations actually achieved the stated average?
An average can be technically accurate while creating an overly optimistic impression. A few highly successful locations may pull the average upward. The median is often more informative, but even a median does not tell the buyer how much debt the operators carry or how much capital they invested to achieve those results.
Link to Discounting Can Increase Sales While Reducing Profitability Discounting Can Increase Sales While Reducing Profitability
Franchise systems often use discounts and value promotions to increase customer traffic. Those promotions may be good for the brand, but the financial consequences usually fall heavily on franchisees.
A discount can increase total transactions while reducing the profit earned on each transaction. If the franchisee must also absorb rising wages, rent, insurance and product costs, additional sales may not produce additional profit.
This is one reason prospective franchisees should not evaluate a system solely by its sales trend. They should understand who bears the cost of discounts, loyalty programs, coupons and national promotions.
Before investing, a buyer should ask existing franchisees:
- Are franchisees required to participate in discount programs?
- Does the franchisor subsidize any part of those promotions?
- Have customer counts increased or decreased?
- Have average tickets increased because of real demand or merely because of price increases?
- Have store-level profit margins improved or declined?
- Can a franchisee opt out of an unprofitable promotion?
A promotional strategy that drives customers through the door may still be harmful if every transaction produces an inadequate margin.
Link to A Franchisee Bankruptcy May Not Appear in the FDD A Franchisee Bankruptcy May Not Appear in the FDD
Here is something many prospective franchisees do not realize: the FDD does not contain a general requirement that every bankruptcy filed by a franchisee be specifically disclosed.
Item 4 requires disclosure of certain bankruptcies involving the franchisor, its parent, certain predecessors and affiliates, its officers and other individuals with management responsibility relating to the sale or operation of the franchises. It does not require disclosure of an independent franchisee’s bankruptcy simply because that franchisee operates within the system.
That does not mean the effects of a bankruptcy will always remain invisible.
Item 20 provides information concerning changes in the franchise system during the franchisor’s last three fiscal years. It includes transfers, terminations, nonrenewals, outlets reacquired by the franchisor and outlets that ceased operating for other reasons. It also provides contact information for certain current and former franchisees.
If a bankruptcy leads to closures, terminations, transfers or reacquisitions, those outcomes may eventually appear in Item 20. But Item 20 generally reports the event affecting the outlet, not necessarily the franchisee’s bankruptcy or the financial reasons behind it. If the franchisee remains in business and its locations continue operating during a Chapter 11 reorganization, the filing itself may not be apparent from the FDD at all.
This is a significant limitation. A large franchisee’s financial distress can provide important information about the economics of the system, yet a prospective buyer may never learn about it by reading the FDD alone.
Link to Item 20 Is the Beginning of the Investigation Item 20 Is the Beginning of the Investigation
The tables in Item 20 should be studied carefully, particularly when they show significant numbers of transfers, terminations, nonrenewals or outlets that ceased operations for other reasons.
But the tables cannot explain the entire story.
A transfer might represent a highly successful franchisee selling at a substantial profit. It might also represent an operator who could no longer afford to continue. A closure could result from poor management, a bad location, excessive debt, weak unit economics or problems throughout the franchise system.
The numbers identify where questions should be asked. They do not provide all the answers.
The most valuable part of Item 20 may be the franchisee contact information. Prospective franchisees should contact a meaningful cross-section of operators, including successful franchisees, struggling franchisees, newer operators, multi-unit owners and former franchisees.
Do not ask only, “Do you like the franchise?”
Ask questions that produce objective information:
- What were your actual startup costs?
- How long did it take to reach break-even?
- Are your margins improving or declining?
- What expenses surprised you?
- How much working capital did you need?
- Have required discounts affected profitability?
- Have the franchisor’s decisions improved franchisee economics?
- If you knew then what you know now, would you make the same investment?
Former franchisees may be especially important. They can explain why they left, what they received when they sold and whether the business produced an acceptable return.
Link to Look Beyond the Logo Look Beyond the Logo
A famous brand can attract customers. It can provide systems, training and purchasing power that an independent business may not have.
But the brand does not pay the franchisee’s bills.
The lesson from any major franchisee bankruptcy is not that prospective owners should avoid franchising or assume the entire system is in trouble. The lesson is that buyers must investigate the economics of the business rather than relying on the strength of the name.
Review Item 19 carefully. Study the trends in Item 20. Speak with current and former franchisees. Investigate large operators. Build a conservative financial model. Determine whether the business can survive a difficult year.
A well-known franchise may be a good investment. But the logo above the door is only the beginning of the analysis.
ABOUT THE AUTHOR
Rush Nigut is a franchise attorney with more than 30 years of experience representing franchisees, franchise buyers, and business owners. He helps prospective franchisees evaluate Franchise Disclosure Documents (FDDs), negotiate franchise agreements, and protect their investment before they sign. His mission at Rush on Business is to help entrepreneurs make smarter franchise decisions through practical legal and business insights.