The Right Way to Exit a Franchise

By Cliff Ennico

September 11, 2018 6 min read

A lot of corporate executives who have been downsized, especially those in their 40s and 50s, are looking to buy franchises. Their thinking seems to go something like this:

—"My 401(k) has lost a ton of value, and there aren't any safe investments out there right now, so why not use at least some of what's left in my 401(k) to provide an income stream and a future for myself?"

—"Franchises are generally safer than standalone small businesses — you get lots of hand-holding and support from the franchise, and there's a structure to running a franchise that's similar to what you have in a corporate environment."

—"Franchises aren't forever — the typical franchise term is between 10 and 20 years — but that's OK in my case, since all I'm looking for is a bridge until I can retire at age 65 or 70. And at that point, I'll sell the franchise to someone else and have some fun before I die."

That's all well and good, but ... what happens if the franchise doesn't work out?

Most franchise agreements do not allow franchisees to terminate the relationship before the franchise term has expired. The idea is that if things don't work out for whatever reason, it was your fault — you weren't a sufficient fit for the franchise or you didn't give it the old college try — and you should sell your franchise to someone who can do a better job with the territory.

That's OK if we're talking about an established franchise like McDonald's or Burger King — hey, if you own one of these and are having trouble making money, you must be somewhere on Mars.

But the franchises most people are looking at nowadays are early-stage franchises — with fewer than 100 franchisees, and sometimes less than 50 — whose business models are still being tested. If a franchise like THAT doesn't work out, there's just as good a chance it's the franchise's fault as it is yours, and the franchise should let you out of the deal.

What's the real world of getting out of a franchise? First, look at Item 20, Table No. 3 in your franchise disclosure document. There should be a column called "Ceased Operations — Other Reasons." If numbers appear in that column, it's a good sign that the franchise has been letting franchisees end their agreements early by "mutual agreement." You will need to agree not to sue the franchise, not to say anything bad about it when new franchisees call wanting to know what happened, and you will be bound by the franchise post-termination noncompete agreement (usually two or three years). But you should be able to cut your losses.

Next, look at the Obligations of Franchisee After Termination section of your franchise agreement. Some franchises impose an early-termination fee, or liquidated damages, if you ask to be released early. For example, if the franchise imposes a minimum-monthly-royalty requirement on its franchisees, the franchise may require you to prepay all monthly minimum royalties for the balance of the franchise term, sometimes in a single lump sum. Do the math: If you have a 10-year franchise term, your minimum monthly royalty is $500 and you elect to terminate the franchise at the end of year three, that's $500 times 84 months, or $42,000.

I recently reviewed a FDD where the franchise got this right. Here's how this program works:

When a franchisee signs up, she commits to a monthly royalty of 8 percent of her gross sales and signs a promissory note agreeing to pay the franchisor a total of $200,000 in royalties (without interest) during the 10-year franchise term. As the franchisee pays royalties each month, the amount paid is applied to reduce the note so that once her total royalty payments reach $200,000, the promissory note ceases to exist (although she still must pay royalties each month).

If the franchisee wants to quit the franchise before the $200,000 promissory note is fully paid, she has two choices. She can either agree not to compete with the franchise for a three-year period or refuse to sign the noncompete agreement. If she chooses to sign the noncompete, the remaining balance of the $200,000 promissory note is forgiven. If she elects to compete with the franchise, however, the balance due on the $200,000 promissory note becomes payable in monthly installments at 6 percent interest per annum over a five-year period.

If the franchisee elects to quit the franchise after the $200,000 promissory note is paid in full, the noncompete period is reduced to one year and the franchisee doesn't owe anything to the franchise.

An approach like this one not only gives franchisees a choice of exit strategies if the franchise doesn't work out but also demonstrates a little humility on the franchise's part — an acknowledgment that nobody really knows whether the franchise model will work in all locations, in all economic climates and under all circumstances.

Sadly, most franchises are not as enlightened as this one. If you are planning to buy a franchise anytime soon, be sure you understand clearly what your exit strategy will be if things don't work out. And don't buy a franchise if there's even the slightest doubt you can last the full franchise term.

Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series "Money Hunt." This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.

Photo credit: at Pixabay

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