Franchisee: Are You Legally Obligated To Succeed When You Buy A Franchise?

What happens if you buy a franchise and—God forbid—you fail and shut down the business? Are you legally obligated to succeed?

You are if the franchise agreement says you are. What’s worse, you may be required to pay fees even after you’ve failed!  

What does the expectation of success mean?

Franchisors sell franchises with the expectation that the franchisee will succeed. Makes sense, doesn’t it? But let’s take a look at what that really means to both the franchisor and the franchisee.

Most franchisors can sell only a limited number of franchises in a given territory, i.e. the United States. Let’s just say the franchisor can sell 1,000 franchises in all of the USA. Once all 1,000 units are sold, the franchisor has nothing left to sell in the states. Yes, there are foreign territories to conquer, but that doesn’t matter. The franchisor has only a limited number of units to sell in the states and the franchisor’s domestic financial model is based on the anticipated performance of those units alone. 

The real value is not the sale of one franchise

So let’s say you buy one of those units. The franchisor now has one less unit to sell. And while there’s value in the sale,  i.e. you will pay the franchisor an upfront franchise fee, the real value is in the royalty stream that the unit is expected to produce year after year for the franchisor.

After covering sales commissions, marketing and legal fees, franchise fees are commonly re-invested in franchisees. The fees are used to reimburse the franchisor for the cost of training the new franchisee and providing initial support. While a $50,000 franchise fee looks like a big chunk of money—and it is—it may not include even a dollar of profit to the franchisor.

Royalties produce long-term profits

The franchisor’s profit is in the royalties, and the franchisor hopes to collect those royalties for years. In fact, the franchise agreement likely states that you are obligated to pay the royalties for a minimum number of years, commonly five to ten years, or the length of the franchise agreement.

Through the process of training you and helping you open your unit for business, the franchisor may only break-even, or could even lose money. The franchisor knowingly takes that risk because if you operate the unit successfully for at least five to ten years the royalty stream will produce tens of thousands of dollars, a good chunk of it profit to the franchisor. 

A failed franchise hurts the franchisor

Of course, if things don’t go well, you and the franchisor both lose money. The franchisor’s losses include money that was not recovered from initially training and supporting you, plus the loss of royalty dollars that your unit failed to produce. A closed unit also reduces the amount of operating dollars available to the franchisor to cover ongoing costs, and while it adds another unit to the franchisor’s sales inventory, it may impede the franchisor’s ability to sell franchises because prospective franchisees will become aware of the failure. 

Franchisee losses may be more than obvious

Your losses include all the money that you invested, including the franchise fee and all the start-up costs, such as payments to the landlord, professional advisors and suppliers. And unfortunately, your losses may not end when you shut down your business. 

Closing your unit may be a breach of the franchise agreement and may trigger the payment of liquidated damages. After taking the unit off the market and selling it to you, the franchisor expected you to succeed. Now that you’ve failed, and breached the contract, the franchisor may hold you responsible for ongoing fees, such as monthly royalties and advertising dollars, and for royalties dollars that were anticipated from your unit. These fees—along with other obligations that you may owe to a landlord, the equipment leasing company, the Yellow Pages, etc.—may amount to tens of thousands of dollars, burying you in a deeper financial hole.

By selling the business—even at a discounted price—you may be able to curtail these obligations, but that, too, depends on the franchise agreement and, of course, the successful sale of the business. There may not be a market for your failed unit, even at a steep discount. 

Be sure you understand the franchise agreement

No one buys a franchise with the idea that they’re going to fail, but failures occur. That’s why it’s important to review the details of a franchise agreement before you make a commitment to the franchisor. The best way to understand the agreement is to consult with a franchise attorney. The attorney may, in fact, be able to help you negotiate a better agreement, one that does not obligate you to liquidated damages, or at least holds the penalties for failure to a minimum.

Photo image by: crazytales

Categorised in: Buy a Franchise

This post was written by Dr. John Hayes