Sunk costs: Sucked under by a franchise

March 1, 2009

drowningPeople do not realize that there are hidden dangers in small business and especially franchises.

You stay in a failing franchised business much longer because of a concept called sunk costs.

Sunk costs are investments that cannot be recovered once they have been incurred. You can’t get out of the water or reach the shore safely.

Most franchise investments are even worse because the assets are very, very specialized.

They’re called idiosyncratic sunk costs: assets that are highly dependent on the situation and the control of others. They may have cost you $1,000 but on the free market you could only get $100 for them.

Some examples are:

  1. a sign with a logo you do not own,
  2. proprietary software used for a specific system,
  3. a customer list that the franchisor owns (constrained by a non-compete provision),
  4. a telephone number that is controlled by someone else,
  5. leasehold improvements that are only useful to another franchisee (who is controlled by you-know-who),
  6. a current account balance that can be accessed by your franchisor,
  7. a centralized telephone system that someone can cut you off from, and
  8. specialized vehicles, equipment or the always highly elusive proven business system.

Almost all assets in your business are practically worthless if you fall out of favour with your franchisor. You keep treading water in the false hope that by serving your master, he will let you realize a high percentage of what you have sunk into the business.

Franchisees very seldom ever achieve a tiny portion of what they imagine their business will be worth because they are renters, not owners.


Lawyers are Rats: A top legal scholar exposes the corruption of his profession

January 14, 2009

Maclean’s which started in 1905, is Canada’s first weekly newsmagazine.

In an August 2007 interview, journalist Kate Fillion interviews Philip Stayton, write, former corporate lawyer and dean of the law faculty at my alma mater (The University of Western Ontario).

Interview with Philip Slayton

Ex-Bay street lawyer talks about how lawyers became greedy, unprincipled enablers of the rich

Question/Answer [my emphasis]




As you point out, in 2004 only 44 per cent of Canadians said they trusted lawyers, whereas two years earlier, 54 per cent said they did. Why do people dislike lawyers so much?



What kind of ethical dilemmas does the average lawyer face?


Why are lawyers so miserable?


Why did most of your students go into law?

Is there something else you should have done?

Is this book your penance?


Well, is it self-destructiveness or is it arrogance?


Is yours a widely held opinion?


Is it common for lawyers to become enamoured of their clients?


Why are lawyers now so instrumental in money laundering operations?


The successful implementation of the Information Sharing Project ISP, would:

  1. translate franchise legalese into investor-friendly common English terms,
  2. provide hundreds of real-life examples of common problems from newspapers, public hearings, magazines, internet, etc.,
  3. use an easy-to-use, adult-oriented self-taught search format (think: Google for franchising),
  4. allow an innocent to become a pro very quickly (flattens learning curve by harnessing network effect of the internet),
  5. demonstrate that franchising (rent) has over 200 unique business risks versus non-franchised small business (ownership),
  6. create a true, franchisee-driven Web 2.0 forum by harnessing wikinomics and the inevitability of the Free! market in franchise information,
  7. demonstrate that franchising is practiced identically around the world,
  8. bypass the franchise bar’s monopoly gatekeeping function (cases forwarded on merit not whether or not they support the industry elite’s purposes) ,
  9. allow low-cost [free maybe] worldwide education and self-diagnosis which is independent of the legal profession’s monopoly power on information,
  10. improve access to justice by lowering costs by creating a competitve expert market (supplants franchisebar/legal only with legal, expert system software and  non-legal consultancy markets),
  11. create an opportunity to aggregate resources to fund precedent-setting litigation which is currently suppressed by credence good monopolists who cheat,
  12. separate diagnosis from treatment within the repair cycle (proven to minimize credence good opportunism problems), and
  13. move to solve the lawyer:client opportunism and the don’t-switch-horses-in-the-middle-of-the-race (sunk costs) dilemmas.

Paper-based, 19C linear technology (the law) being electrocuted by hundreds of dissident franchisee blogs, each with an ISP icon that instantly makes the [current economic rents (payments over what is justified: gouging) of a jealously guarded monopoly on information], drop instantly to next-to-zero.

If my analysis is correct, the appropriate regulatory and administrative law response would be to acknowledge and receive an individual citizen’s opinion, but if inaction in the face of demonstrative wrongdoing by “winners” in brokering industrial interests plead either:

  1. resource poverty or
  2. legislative incapacity.

With the passing of the Ontario Arthur Wishart Act (Franchise Disclosure), 2000 (2) was off the table so the only option left was 1.: lack of resources. Mr. Allan MacDermid of the now ironically and historically frequently renamed Ministry of Small Business and Consumer Services played that card: love to help but our hands are tied (no $).

Funny thing is: I never asked the Ontario government for economic help, having determined that this must be a private sector solution. [free download of 2003 ISP Proposal].

BTW: Industry Canada played exactly the same game when I defined Predatory franchise lending in my 2005 paper called, Franchising Opportunism. In 2006 (I intentionally waited 365 days to followup), Mr. Peter Webber said to a consulting proposal I wrote (that he suggested I send to him) that: not enough money to fund any new audit activity.

Mr. Webber suggested that I check back in 5 years when the Canada Small Business Financing Act, CSBFA and Regulations would go up for it next statutory review.

Perspective: In 2005-06, Industry Canada loan program paid out $72.5 million in total claims and my audit service proposal was for $23,200 plus GST for this theoretically self-funded federal program.

Midnight move: This time into the gutter

December 12, 2008

Restaurant dispute 20081211

middlefingerThe top image is from a Canadian Press article by Nelson Wyatt called Passersby stunned as restaurant contents emptied into Montreal street.

It also hit Canada’s evening television news program, The National and resides on the CBC website where some rapidly growing comments are worth checking out.

  1. What the hell happened here?
  2. Whay would a Montreal, Canada franchisee simply rip everything out (including cash from tips!) and leave them on the street?

There is a perfectly good and rational reason for this. These were the actions of a perfectly sane, far-sighted and indeed shrewd small business investor.

  • he or she realized they were going bankrupt no matter what they did (things they can control +/- = wisdom),
  • they did what they thought was the noblest thing to do which was to deny the franchisor and bank their profits on this churn while
  • demonstrating a fine French Canadian tradition of exiting with a some self-respect intact (see bottom image).

Here is what might have happened if this is like other franchise relationship meltdowns I have seen in the last 10 years:

Normal Contract Terms:

  1. The franchisee leases the premises from the franchisor (who then leases it from the landlord). The franchisee is the subleasee: he pays the franchisor who (you hope) pays the landlord. This may or may not have been the case here. (How quickly a new body can be installed indicates a franchisor head lease position.)
  2. The franchisor has the legal right to withhold their approval if a franchisee brings forward a proposed buyer. Some do it to drive an exiting franchisee into a corner.
  3. The operator’s franchise agreement with the franchisor says: “If the franchisee breaches the agreement, in any way at all, (70 pages long, including operating manuals, debt payments, appendices, etc.) then that automatically means that the lease has been breached (cross-default: much easier, faster, cheaper to throw a franchisee onto the street than to sue them under the body of the agreement).
  4. It appears that there were some franchisee free riding but we’re only hearing Enzo’s side of the story. I don’ t think his life savings were on the line because of his “training and operational deficiencies”. Yeah right.
  5. On a breach with a “non-compliant” [shithead] franchisee, the franchisor and/or landlord can padlock the store but they can’t touch the equipment or supplies because it’s owned by the franchisee.
  6. The franchisee is therefore faced with: the right of ownership without any rights to the location to operate the business.

The next step is what happens 99% of the time:

  1. The franchisee acts like a sheep. He sells either to (1) the franchisor (who operates for a short or long time) or (2) to a new sucker (I mean, Canadian small business franchise investor). Seldom do they debrand and become independent.
  2. The franchisee sells because they think their business is worth, say, $400,000, and if they’re “a good little boy” the franchisor will let them keep 100% of the money.
  3. The franchisor (knowing that the business is a dog or wanting to crucify this franchisee as a lesson to the flock) lets them keep 20% instead of the normal 15% because they can control the sale 4 or 5 different ways

What I think happened THIS TIME:

The franchisee saw through the trap. He knew or suspected that they were going bankrupt no matter what they did and that the equipment was already “underwater” (ie. it was of zero value to them but tied to massive debt. The only value it held was, mostly, in-place to the franchisor).

  • The bank financed it for, say, $100,000 based on a bogus appraisal 12 months ago.
  • The bank’s own receiver would only realize 15% disposal.
  • The franchisor would re-buy the equipment (very specialized, an idiosyncratic sunk cost to be technical about it) on the day of auction and
  • then sell on to the next more compliant investor (Sucker2?).

Also he may have been wised to the fact that franchise bankers and franchisors have an “understanding”: long-term, very lucrative relationship spanning the whole franchise system over many years versus one lonely loser family.

ANALYSIS: Going bankrupt for either $300,000 or $250,000 or $450, 000 doesn’t matter very much, does it? The equipment may have actually been used when they opened up (when  they thought they’d be getting new.) The money that appears to be thrown away (on the street) was very minor when compared to the operating losses that have already take place.

The franchisee and his spouse as guarantors of the bank’s debt for the equipment (if they’re not already personally liable under the franchise agreement). btw: Incorporating a franchised business? Simply putting your lawyer’s kids through school.

And with the bank being able to have up to 90% of their loan paid for (if the equipment loan was cut from the Canada Small Business Financing program).

  • What do does the bank care if some street people in Montreal were carting away a small businessperson’s life saving?

Ah: The beauty of dealing with other people’s money.

  • the franchisor (franchisee’s life savings) and
  • the bank (the franchisee and spouse’s bankruptcy).

Of course, this is all entirely speculative.

YouTube says Franchising is slavery

October 28, 2008

YouTube will become a very effective means of information sharing for franchise investors.

This is the first general franchise message [ie. it’s not this brand or that brand that is acting in a predatory fashion] to hit YouTube. It reflects the reality that all franchise relationships have the same characteristics, the same tools or potential; everywhere, all around the world.

What makes franchising different than independent business is its ability to ransom your life savings. This is done because, at the moment you sign, your investment instantly changes from 100% liquidity to next to zero [transforms into a sunk cost]. You imagine yourself in control but have lost 100% control of your assets.

New franchisees come to realize quite quickly that they go along with the franchisor or they will be punished. Many franchisees kid themselves; hoping upon hope that their masters will allow them to exit by selling to the next sucker. That rarely happens because the franchisor makes more money the less you make at re-sale.

Over years and after signing a confidentiality agreement, investors realize that it was always this way: the moment you signed, 90% of what they put in was always at the franchisor’s absolute use. The sunk cost nature is the source of a franchisor exercising their discretion in a one-sided manner (opportunism).

  • The franchisee’s near total net worth is tied to the whims of a party that has next-to no penalties if they choose to act in a dictatorial manner.

Soon I think we will have a franchising channel with dozens of trademark correspondents bringing back information that is not constrained by government decisions, coerced confidentiality provisions or SLAPPs.

That is very good news for good systems and not so good for opportunistic ones.

  • And this should be applauded by all stakeholders that want to improve quality, in what we perceive to be a free market economy.

Shouldn’t it?

Thanks to the folks at BakersDelightLies.com for bringing this out.

Sunk Cost Reality: Post-signing relationship conversation

October 15, 2008

Franchisor to franchisee:

OR: Les the new poo-extraction technology will cost you $100.

EE: So the non-logoed dog poop scoop, in the real world, costs $5.00. Right?

OR: Right.

EE: But I have to buy this propriety equipment from you, right? [tied buying]

OR: Right.

EE: So I end up paying 20 times as much for the scoop, does that sum it up the situation?

OR; Yup.

EE: And if I don’t want to [as any sane independent businessperson would do]…?

OR: I can terminate you and refuse any potential buyers and other nonsense which deprives you of, say, 90% of the $100,000 you’ve sunk into your business. Sound fair, Les?

EE: So my decision is either:

  1. lose $95 by saying yes or
  2. lose $90,000 plus the exit costs by saying no. [Prospect Theory]

Is that a fair comment?

OR: Is that a fair comment, what?

EE: Is that a fair comment…sir?

OR: Yes, Les. You’re coming along.

Sunk costs as they compound business risk are a unique and little discussed aspect of franchising. Law makers are particularly negligent in not putting each post-signing franchisee buying decision in its appropriate context. Franchisees often look stupid in hindsight because sunk costs are not taken into account.

  • Context is everything in the bizarro world of a franchise relationship.

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