A franchise development gone very, very wrong

By popular demand, we are re-posting this article as it contains several warning signs regarding how things can go poorly without proper oversight.
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In order to stay up on the industry and its latest trends for our clients, we routinely interview owners of recently opened or under-construction salons suites facilities, franchised or independent, and then follow up a year later to gauge their experience. One of our partners had an hour-long phone call this week with a recent franchisee of one of the “big six” franchisors.  Here's what he told us:

This franchisee was pretty smug and confident when we started our discussion, but by the end of our talk, I think he was seriously regretting his decision, realized there wasn’t anything we could do for him, and that he was stuck.  He paid a $45,000 franchise fee, and in return he essentially got a set of guidelines, a pat on the back and a “go get ‘em tiger”. No help with site selection other than some advice on rejecting a few locations, no site due diligence (a major issue was revealed during demo), no lease advice from the franchise or verbiage that would hold the landlord accountable for something like that, no design or space planning, some ridiculous marketing advice and was (in our opinion) sold a bill of goods regarding the strength of his position and the competition, which is significant. He was basically on his own. From the numbers he shared, he may never get a return on his capital and it is going to take him a very long time just to get to break even on monthly cash flow (if he ever does).  The loss of his retirement nest egg is a very real likelihood. During our conversation, he told shared several reasons why he invested in the franchise and chose his location. 

1.  "Beautiful facility design advantage"
He was convinced by the franchisor that his product will allow him to compete easily in any market.  ("The quality of my product is so great that we won't have problems attracting tenants.") The reality is that three other operators in very close proximity also have quality product (beautiful facilities), with a fourth to be built soon.  He seemed to not realize that once a certain design threshold is met, the advantage of one over the other becomes an issue of personal taste, with no advantage for this franchisee.  We pointed out that none of his competition is a "ghetto" facility and any advantage he thinks he has is one of subjective taste. The design advantage scenario might be realistic for a new operator moving into an area with an old, run-down or dated facility, but the perceived advantage of a "beautiful design" diminishes or is eliminated when other operators have reached that same threshold. Later, after reviewing his plans, it was obvious that in an attempt to squeeze as much rentable space as possible into the facility, he had created suites that are typically smaller than his competition.  While on the surface that might not seem significant, tenants are VERY aware of this, as they carefully evaluate a space since they will be spending so much of their time there.

2.  "Financial advantage"
His site has three other operators in his direct vicinity (with another planned), all independents with no royalty obligations, but somehow he has been convinced by his franchisor that he can compete with them even though he has a burden of nearly $40k/year in royalty fees that his competition does not have (not to mention his huge up-front franchise fee).  That's like starting a marathon carrying a 30lb backpack. Since he didn't get much help from the franchisor with his lease (he was directed to find a local broker for help (another bad idea)...more on that later), he ended up with what he thought were great lease terms, when in fact, they are not competitive at all. Additionally, in order to establish his franchise, he has taken on a huge debt load, a burden that at least two of this three competitors do not have. So in summary, he is carrying a royalty obligation, bad lease terms, and a huge debt load, and now he has to go compete? That backpack just got loaded to about 75 lbs.

3. His market's over-supply of product/competitive evaluation
After we reviewed his "design and financial advantages", we talked a bit about his market. He located his facility right across the street from a long-established independent, and within a quarter mile of two other facilities that had opened within the last year and are only about 30% filled. In his direct vicinity, there are approximately 40 open suites available, and he is adding 37 more to the market. Additionally, the long-established operator across the street from him has ten facilities in the area, and is planning another about five miles away. Historically, when this operator opens a new site, he partially populates it with tenants from his other facilities that live closer, so chances are that another 10-20 suites will be added to the market, all of them in beautiful facilities. That brings the total of available suites to roughly 90-100 (a HUGE number in just a quarter-mile radius). It is likely to take him years to fill his facility to a break-even point. This problem is exacerbated by the fact that one of these other operators appears to be in a desperate cash-flow situation and has been steeply discounting his suites, driving down the price for all operators in the area. 

4.  Pro forma analysis
This franchisee told us that he has $850k(!) into the project (includes everything: franchise fees, construction, start-ups costs, etc.). While on the phone we plugged his numbers into our spreadsheet, and we were was just astonished. Not even having all the information, it appears that, in a BEST CASE scenario, with aggressive occupancy and high lease rate assumptions, he will net about $40-$50k per year. That is not a very good ROI on an actively  managed investment, and he likely has 18-24 months of negative cash flow until then.  While his position is that he only has a small portion of his own capital invested, he seemed to not realize that his highly leveraged start-up has him personally on the hook for that huge amount through personal guarantees, and will prevent him from expanding once he submits his balance sheet to get more funding for future facilities. 

5.  What he got from his franchisor
As we continued our discussion, he explained that he was starting to realize that he didn't get much help from his franchisor. He was provided with a set of guidelines, some encouragement and some exciting stories about other franchisee's successes, and then was essentially released to build his business. (He also told me about the marketing advice he received, some of which bordered on the ridiculous.)  Some due diligence and a guiding hand from an experienced operator would have gone a long way to helping him avoid much of this, but for the most part, he realized that he was on his own. The worst part was that if he could make this work and wanted to expand, he was stuck in a obligation to the franchise, so there was no way out.  

Summary
So much went wrong with this, but it’s a common story.  This poor franchisee likely has some sleepless nights ahead of him. At the end of the day, the franchisor has his money and a significant percentage of this poor guy’s future revenue stream…and for what?   We feel badly for him, truly.  Anyone going into a franchise situation should be aware of what is truly deliverable and what isn’t.  Our experience generally is that franchisees are on their own much more than they expect to be. Don't be taken in by someone else's success story. Every market is different, and the risk is too high to not perform due diligence seriously and thoroughly.