Harold Kestenbaum on Franchising Your Business

Q: Can you tell us how the franchise industry has changed in the 32 years that you've been involved with it? I envision a period of founding pioneers of now-famous brands, where the founders disappeared as their chains matured. Nowadays, private equity firms are active in franchising.
HK: Most of the pioneers are no longer around. One that I think is left is Fred DeLuca [co-founder of Subway sandwiches], and he's kind of young compared to the others you're talking about. He's actually my age, and he's done pretty well at Subway, but you're right. The Colonel Sanders [founder of KFC], the Rosenbergs [founder of Dunkin' Donuts], they're all gone. Most of them are now owned by private equity firms, although Subway's the exception. DeLuca still owns the majority interest in Subway. The personal nature that used to be is gone. Private equity firms want to make their buck and they want to get out. Then it was totally different, when the franchises were owned by the likes of Dave Thomas [founder of Wendy's], etc.

Q: You have a dual role, which is fairly unusual. In addition to being a franchise attorney, you help start up franchising firms. I guess that begs the question on why does it take an attorney to know how to successfully start up and run a franchising business as opposed to, say a Harvard MBA?
HK: It doesn't, necessarily, except for one thing, franchising is a very regulated industry. If you don't know the laws and regulations, you're going to be winding up doing business, and potentially doing it illegally. I can't tell you how many companies over the years have franchised without knowing it, for example, or are franchising and doing things that they shouldn't be doing because they don't know what the law is. So unlike the manufacturing of widgets, which is not really very regulated, franchising is heavily regulated.

Q: When you talk about regulation for start-up franchisors, are you talking about the preparation of a franchisor's disclosure document for potential franchisees?
HK: Yes, and the Federal Trade Commission, and the 15 states that require registration. More and more states are getting involved, and more and more foreign countries are getting involved in [franchise] regulation as well.

Q: Isn't there a conflict between your two roles as attorney and business adviser? For example, if you are preparing a franchisor's disclosure documents...and a company officer comes to you and says, "As a college student I was convicted of stealing traffic cones. Because it was a federal offense, it was a felony." The disclosure document requires criminal disclosure. How would you handle it as an attorney since you have attorney-client privilege, and the law mandates that you keep that information confidential? But then wearing your business consultant hat, don't you have a conflicting obligation to tell the start-up franchisor since it needs to be revealed?
HK: If that's the case and they tell me, then my response is it's got to be disclosed. If you don't want it to be disclosed, then you shouldn't be in the company. I mean, that's just the way franchising is. Most franchise systems start out by hiring a franchise lawyer. So it's impossible to get around that issue.

Q: In your 30 years of watching franchise brands come and go, what's the worst disaster you've seen in a franchise system?
HK: Personally I've had clients over the years come in and come out, thankfully for me most of my clients were never involved in any litigation so the answer is that they created for themselves, didn't cost them a lot of money, but I've seen stuff over the years. In fact, I just read yesterday about a company in Florida called Cuppy's. When I read the article, I said, "Wow! Things like this happened 30 or 40 years ago before we had disclosure. I didn't realize that companies were still trying to do this and take money and give the franchisee nothing in return. But I guess it's still going on.

Q: Blue MauMau has covered Cuppy's quite a bit.
HK: I know you have. Franchising regulations really started back in the late 1960s when 60 Minutes did an exposé on a company called Wild Bill's Barbecue. There was a company that did exactly what Cuppy's did. They took the money and they never gave them anything. The founders ran away with the money. That was when the FTC started having their hearings and a couple years later we had the FTC Rule.

Q: What would you advise someone who has a small business or envisions a neat business concept and they'd like to utilize the franchising model to dot the country with their franchises?
HK: First of all, I'd have them read my book because the book really talks about what a company like that should do and how they do it. If the person comes to me and they've been in business for a month or a couple of months, I'm going to tell them that it's too soon. And even in the book, if you're not in business for six months to a year and you haven't proven whatever it is you're doing financially, then you're not ready to franchise. The model has to work, for you and for the franchisee. If the franchisee can't make money, then don't think about franchising because it's not going to work.

Q: How many company units do you think a franchising firm should have?
HK: I've done it with one and I've done it with twenty-one. I mean it depends. It's certainly more than zero. If you don't have an operating prototype, you'd better get one before you start the franchise. I've had too many people come to me with quote, "ideas" about franchising a business that doesn't even exist.

Q: When small businesses become start-up franchisors, is there a discrepancy of self-interest between franchisees and franchisors that your small business clients need to understand?
HK: Here's my philosophy. I don't like to use the word "partnership" because it has legal connotations, but the reality is the franchise relationship is really a partnership. And both partners have to make money and both partners have to be happy. It can't be one-sided in either direction because if it were, it wouldn't work. So if the franchisor is really a greedy individual who's looking to make a million dollars and not care about whether the franchisee survives or not, this is not for them. They should open up company units and be happy. You've got to want the franchisee to make money. Because if the franchisee makes money, you're going to make money because they're going to pay you a royalty. So there's got to be a happy coexistence.

Q: Is there a certain kind of businessperson that you look at and say, you know, this is a good franchisor match for franchisees?
HK: It's hard to say when they first walk in the door. I meet them for the first time and they look like great people. They're real nice. And then a year or two later I find out that franchisees hate their guts. It's hard to tell. Sometimes I read their minds. Sometimes I don't.

Q: How bad can it be if there's a real mismatch between the franchisor's style and the franchise owners? Does a budding franchisor with latent tyrannical tendencies come up to you and say hey, what kind of hidden clauses can we put in the franchise agreement to protect my rights just in case we have to really zap these guys?
HK: Actually, most of the clients I deal with rely on me in terms of what I'm going to put in the agreement because they're not familiar with the legal aspects of it. They're only interested in the business side of it.

Q: If there are a number of really unhappy franchisees in a system, what would you suggest a franchisee do to affect change in that franchise system?
HK: The easy answer is he can sell the unit. But that begs the question. If there are a number of franchisees who are not happy, then there may be something inherently wrong, and if the franchisees have a franchise advisory council, then maybe it's time for them to sit down with the franchisor and have a conversation to find out what's going on. Because if it's more than just one, then there's a problem. If it's one person, then maybe it's that person and maybe his personality is not quite on board, but if it's multiple franchisees who are not happy then there has to be something wrong with the system.

Q: One criticism of franchise advisory councils is that they can be puppets of the franchisor. Council members don't tell the emperor that he's not wearing any clothes. Do you have suggestions on how to build an effective advisory council?
HK: If the franchisor picks the advisory council, they're going to pick the ones who are their best friends. And that's not the way to do it. Have the franchisees select them, not the franchisor. If the franchisees pick the people or the franchisees volunteer, then it's difficult for the franchisor to make that kind of a selection.

Q: Now let's go the other way. Let's say that the franchisor has a do-nothing franchisee bum, or as you describe them so much more politely in your book, the "recalcitrant franchisee." How should the franchisor deal with him?
HK: I usually tell my clients to have a face-to-face meeting with the [problem] franchisee. Find out what's wrong. Maybe they just don't fit in the system and should sell the unit because they're never going to change. So the way to do it is try to find a buyer for them, and get them out of the system. Short of that, I guess one thing you could do is harass them a little bit and send in a secret shopper if it's a retail operation to see what's going on, to make sure if they start doing things a little bit wrong, start sending the notices out. Always keep a file. For those franchisees who are not toeing the line, you really need to have a file on them in case there's a litigation. But trying to get them to sell the unit is one of the best ways to get them out.

Q: What major lesson do you hope that the reader of your book So You Want to Franchise Your Business will take away?
HK: If you want to franchise your business, be prepared. It's not easy. It's not something that you take lightly. And it's a real business. It's an industry, and if you want to grow, and you want to be like McDonald's, you want to be like Subway, you have to do it right.

Gordon & Rees LLP/Harold L. Kestenbaum Esq
He can be reached at hkestenbaum@gordonrees.com or 516-542-5913