Can Lease irregularities cause a System to Dissolve?


This is a very good question.

My quick answer would be: It depends on how smart franchisees are versus the klutz'(s) bluster.

Franchise systems don’t explode from lawsuits or adverse publicity: They simply get collapsed with the franchisees’ money spirited away.

No franchisor fights to protect a loser trademark: It’s too cheap to build another. What’s a franchisor anyway: A telephone, some contracts and a bunch of second-rate guards.

There are 3 types of franchisees:

  1. the happy (happy with ROI, debts paid),
  2. the touch-and-go (barely ok), and
  3. the desperate (hemorrhaging cash daily: they want out).

Principle: If the leasing arrangements are filthy enough, a group of #3 franchisees could band together to have a s.o.b. franchise lawyer negotiate their exit (releases: both ways).

For example: Let’s say 30 recruiting franchisees chipped in, say, $3,000 to buy their permanent freedom (out of the industry).

Question: How would the other stakeholders likely react?

Franchisees #1 & #2: Some may join the exit group but most would hate what #3 is doing. They would apply huge pressure on the franchisor to let them go, with no strings attached. They realize that head office are scum but don’t want to risk thier trademark being dragged through the mud.

Leasing Company(ies): There are two kinds that are confusingly named:

(1) The kind that signs up the fresh meat. They are really a subcontracted marketing arm of the franchisor, created to fold up like a cheap suit when the fraud sausage explodes. Under any half-assed franchise law they would be considered a franchisor associate and be held legally responsible for all of their misrepresentations. They provide the franchisor’s TLC.

(2) A leasing collection company that didn’t count on a blog to expose a ticking fraud bomb. They bought illegal leases (mixed intangible with tangible assets: this is illegal). (1) goes on to sell the next sucker into future bankruptcy while (2) looks like Bambi on FranchiseFool’s highway. The lease can be assigned an infinite number of times depending on which frontier is crossed.

Being confronted, both (1) and (2) would shut up and never take action, especially since the franchisor and a lease company share office space.

This is reinforced when a little birdy told me that a franchisee simply walked away (no lease payment, no royalty) in October 2008 (no attempt to call or collect). Also they realize that the exiting group could turn around and sue them into the 22nd century for using capital leases to finance intangible assets. IRS issues, folks.

Franchisor: They’ll sign the release papers that the group’s lawyer presents in very short order. They will have received hundreds of emails and telephone calls. The franchisees #1. & #2. (who are actually still paying royalties since sales have dried up) will grab them by the short and curlies and impress upon them their desire for the franchisor to play this straight (a first in their God-forsaken life).

It would be unnecessary for a franchisee advocate to ever have to reveal who’s who in this hypothetical scenario. No fuss, no muss. Look the other way as a few slip under the wire and head for the forest.

Of course everything’s cool unless anyone is ever, even unintentionally or remotely, threatened for exercising their freedom of speech rights.

If you want out,  just let me know.

3 Responses to Can Lease irregularities cause a System to Dissolve?

  1. Carol Cross says:

    Les! You kind of lost me on this “lease” thing. While I know that you know that the matter of the lease is an important element in the premeditated squeeze of franchisees to give their businesses away in a fire sale of the hard assets, etc…when they have failed to thrive, I’m not sure what you are saying in the above post.

    Leases that are personally guaranteed under different arrangements —a sublease from the franchisor, or a co-terminus lease default agreement between the franchisor and the landlord, etc… do guarantee that the franchisee can be squeezed to give the business away when they fail to thrive and they default on the lease payment and/or the payment of royalties to the franchisor.

    I am facinated with your comment: “using capital leases to finance intangibles. IRS issues, folks.” Could you be more explicit?


  2. Les Stewart says:

    Carol, The lease I’m talking about here is the financing of the the initial purchase of the franchise, not the real estate kind.

    Franchises can be purchased with life savings, SBA 7(a) loans or, increasingly, a 3rd party lease. The franchisor sends the candidate to an allegedly arms-length company that bundles the purchase together: franchise fee, other fees, plus whatever capital needs the franchisee needs.

    Once the lease is created, it can be assigned to any other leasing company.

    The franchisee continues to pay the original or assigned leasing companies demands.

    The problem is that there are laws that need to be obeyed in capital lease arrangements. For instance, tax laws treat capital assets and intangible assets differently.

    As you and I and FranchiseFool readers know by now (and your excellent questions are always welcomed, btw) franchisors, sales agents and financing sources often work VERY, VERY closely together while maintaining the legal pretense of being independent companies.

    As we both hope, maybe the U.S. regulators and public are getting tired of the “anything that moves, let’s screw it to the wall” mentality within financing. The pendulum might just be swinging back for those franchisees who shake off the effects of drinking the Kool-aid.


  3. Carol Cross says:

    Yes! I think the U.S. regulators ought to look at the franchising of IP and Brand franchisors where securitizations are involved, and especially when securitizations are used to take over franchisors in LBO’s by the private equity investment companies in cooperation with the banks.

    Intuitively, this all sounds very “dodgy” as you would say. While securitization is legal and doesn’t involve tax evadence, it does involve tax avoidance that works to the advantage of the avoiders and is legal under current Treasury Regulation and law.

    It galls me that all of this becomes possible in franchising because of the lack of transparency of the “risk” involved insofar as presale disclosure to new buyers of a retail franchise. The lack of transparency is, of course, in the US, enabled by the FTC rule and the State FDD’s that permit franchisors to obscure the risk of failure and/or lack of profitability that is known to the franchisors from new buyers of franchises.

    This lack of transparency on the bottom of the pyramid of the franchise system must translate to some difficulty for those who rate these franchisor IP securitizations because the “churning mechanism” of some systems is not visible until too late, perhaps! A franchise system who has a great percentage of their franchisees standing at breakeven or less will of course be more vulnerble to failure when the black swans start to swim in the economy.

    Hopefully the pendulum will swing!


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