Patent Valuation From a Practical View Point, and Some Interesting Patent Value Statistics From the Patentvaluepredictor Model

Patent Valuation from a Practical View Point, and Some Interesting Patent Value Statistics from the PatentValuePredictor Model – Rick Neifeld, Ph.D., Patent Attorney, and President of Neifeld IP Law, PC and StockPricePredictor.com, LLC (1)

I. Introduction

My colleague Grover Rutter (see his article in this edition) has presented an excellent review of how to treat patents from a financial and tax reporting standpoint. However, how do you determine the real value of a patent? That begs the question: What factors are relevant to the real value of a patent? You have to know what factors into a valuation before you can address the valuation issue. Let’s start with some definitions, and then address this issue. After that, lets look at the PatentValuePredictor model and some actual valuation data and trends provided by the model.

II. General Valuation Theories

Valuation is an accounting term which means a lump sum of money payable to receive the future benefits of an asset at a particular time. There are three generally accepted accounting theories for valuing assets: market, cost, and income. Market theory values an asset as the present value ascribed to similar assets in an active public market. Cost theory values an asset by the cost of replacing the asset. Income theory values an asset by the present worth of the net anticipated economic benefit of the asset. Can we apply any of these theories to value patents?

III. Valuation Theories as Applied to Patents

Market theory valuation of patents has little or no utility because no two patents are similar enough for the sales price of one to define the value of another. Of course, you can say that patent licensing and sale applies market theory to reach a market price. The problem is that most patents are not bought or sold in an arms length negotiation, and therefore do not have an objective sale price. Even when they are licensed or sold, the transaction is usually clouded by other factors including tech transfer or line of business transfer.

Cost theory is generally inapplicable since a patent cannot be replaced. That is, once the invention is generally known, it is no longer patentable.

Income theorym is applicable in certain circumstances. Patents have known finite terms. If you can determine the income resulting from ownership of a patent over that term, you can assign a value to the patent just like you can assign a value to a long term bond.

Conventional methods using income theory to value a patent analyze micro economic data to determine the anticipated economic benefit of owning the patent. This micro economic data includes market data indicating the gross sales and net income derived from the sale of products attributable to the patent, and any revenue derived from licensing the patent. Applying income theory to micro economic data to value a patent is labor intensive, costly, and complex. This method should include an analysis to determine the meaning of the claims of the patent, a comparison of products to the claims of the patent to determine what products are actually covered by the patent, a determination of the size of the market covered by the patent, and a determination of the cost advantage of the patented technology compared to alternative technologies for that market. A micro economic analysis can be used to prove damages in patent infringement litigation. However, a micro economic analysis of a patent is often cost prohibitive for purposes of business valuation, capital allocation, taxes, and licensing. Moreover, the data necessary for members of the public to perform micro economic analysis of patents is simply not available. This is because that data includes relationships between patents, product lines, product line specific costs and earnings information, and licensing royalty rates and terms. Companies rarely release that type of information to the public. Thus, micro economic analysis of patents is often not feasible.

IV. Problems With Generally Applying Income Theory

I hasten to point out that even income theory valuation based upon micro economic analysis has limited utility in most commercial settings, as opposed to its application in patent infringement litigation. Why? Because patents and products do not have a one to one relationship. They have a many-to-many relationship. As a result, you cannot simply evaluate the value of a patent once you know the financials relating to certain products that the patent covers. To illustrate this point, consider the following two hypothetical situations.

FIRST HYPOTHETICAL SITUATION – UNUSED PATENTS:

A company owns ten patents. The first patent covers a first product, and the company manufactures that product for a hefty profit. The second through tenth patents do not cover the first product, but each one covers some alternative potential product that, if produced, could effectively compete with the first product. No one produces anything covered by the second through tenth patent. Do you allocate all value to the first patent? Surely the other nine patents have actual value to the company! How do you allocate income attributable to sales of the first product to the ten patents in order to assign value to each one of the ten patents?

SECOND HYPOTHETICAL SITUATION – THE MANY-TO-MANY CONUNDRUM:

There are three competing products in a particular niche market and five relevant patents. Patents 1, 2 and 3 each cover the first product. Patents 1, 2, and 4 cover a second product. Patents 2 and 5 cover the third product. You also know of the existence of prior art that indicates a likelihood that some claims in patents 1 and 5 are invalid. As an additional complication, what if it was unclear whether certain of the products were in fact covered by certain ones of the five patents. That is, what if the issue of infringement was not cut and dried? Confusing? You bet! Even if you knew the sales and profit margins for the various products in the hypothetical situations just noted, there would be no simple or logical way to assign values to the various patents. This is all too often the reality when comparing patents and products: there exist many-to-many patent-to-product relationships of uncertain bounds.

What have I told you so far? I have told you that classical approaches to valuation are inadequate. It is time for a new approach.

V. The PatentValuePredictor Theory for Valuing Patents

Now let me tell you about the PatentValuePredictor model for valuing patents. First, you should know that this model is implemented as a web service, and it provides valuations for all U.S. patents and (a provisional valuation of) published U.S. patent applications in real time.

How does the PatentValuePredictor model work? The PatentValuePredictor model simplifies the valuation determination problem by reformulating the problem. It does not attempt to address the many-to-many relationship noted above, and it does not attempt to find and use micro economic data relevant to any particular technology niche. Instead, it substitutes for the foregoing many-to-many quandary and the (generally unavailable) microeconomic data an estimate of an annual sales covered by the patent. The model generates a nominal annual sales covered by the patent based solely upon measurable properties of the patent document and the value of the Gross Domestic Product (GDP). I won’t bore you with the details of the model in this article. You can those details of the model in my earlier article entitled “A Macro-Economic Model Providing Patent Based Company Financial Indicators and Automated Patent Valuations ” posted in the publications sections of both www.PatentValuePredictor.com and www.Neifeld.com. Suffice it to say here that there is a heuristic relationship between measurable properties of patent documents and patent value. For example, generally speaking, the broader the claim protection, the more valuable the patent.

I will tell you that there are good points and bad points about the PatentValuePredictor patent valuations. First, the valuations are clearly statistical in nature and therefore imperfect. However, there is no such thing as perfection in valuation. Moreover, there is as far as I know, no other completely objective and generally applicable method of valuing patents. Furthermore, the Web implementation of the PatentValuePredictor model provides immediate results, and it is far less expensive (currently $100 per patent valuation) than any other method of which I am aware. Finally, as the size of an evaluated patent portfolio grows, the PatentValuePredictor model’s portfolio valuation becomes statistically more accurate. See for example the corporate patent portfolio value charts in my earlier article “A Macro-Economic Model Providing Patent Valuation and Patent Based Company Financial Indicators” posted in the publications sections of both www.PatentValuePredictor.com and www.Neifeld.com.

Finally, there are some other interesting statistics I would like to share with you that relate to valuation of patents. These statistics are derived from the PatentValuePredictor model.

First, there are currently 1,726,307 enforceable patents. To determine actual dollar values, the PatentValuePredictor model currently assumes that the entire GDP is covered by patents. The current GDP is $11.252 trillion. Therefore, the PatentValuePredictor model indicates that each enforceable U.S. patent covers, on average, annual sales of about $6.5 million (that is, the GDP divided by the number of currently enforceable patents). However, profit is, generally speaking, only a small fraction of gross sales, and old patents near the end of their term have reduced value. That explains why the PatentValuePredictor model determines an average value of enforceable patents is only about $2.8 million. To get this result, we calculated the current valuation of each one of the 1,726,307 enforceable patents, and then calculated the average value.

The PatentValuePredictor model indicates that the bulk of the most valuable patents are and have for many years been in the Pharmaceutical or Biotechnology (Pharma/Bio) technology areas. The chart below shows the currently ten most valuable patents and their technology area.

TEN CURRENTLY MOST VALUABLE PATENTS (AS OF 3/11/2004)

Patent

Issued

Current Value ($)

Assignee

Technology

6,517,866 2/11/2003 1,797,722,689 Pfizer Inc. Pharma/Bio

6,500,987 12/31/2002 1,570,968,527 Teva Pharmaceutical Industries Ltd. Pharma/Bio

6,566,344 5/20/2003 1,481,848,538 Idenix Pharmaceuticals, Inc. Pharma/Bio

6,465,496 10/15/2002 1,408,931,126 Teva Pharmaceutical Industries, Ltd. Pharma/Bio

6,452,054 9/17/2002 1,220,308,695 Teva Pharmaceutical Industries, Ltd. Pharma/Bio

6,221,640 4/24/2001 1,194,927,644 Cubist Pharmaceuticals, Inc. Pharma/Bio

6,071,970 6/6/2000 1,107,999,343 NPS Pharmaceuticals, Inc. Pharma/Bio

6,319,919 11/20/2001 1,081,784,355 Davis; Bonnie (Syosset, NY) Pharma/Bio

5,610,034 3/11/1997 1,071,288,767 Alko Group Ltd. Pharma/Bio

6,022,716 2/8/2000 1,069,310,287 Genset SA Pharma/Bio

While the Pharma/Bio tech area has held the lead for most valuable patents, the relative value of the most valuable patents has been increasing for decades. The charts below show the ten most valuable patents issued respectively in 1983, 1993, and 2003, and a relative measure of their value. Note in the sequence of three charts below the trend of the relative value to increase over the decades.

TEN MOST VALUABLE PATENTS ISSUED IN 1983

Patent Issued Relative Value When Issued Assignee Technology

4,399,282 8/16/1983 1,343 Kabushiki Kaisha Yakult Honsha Pharma/Bio

4,375,514 3/1/1983 1,256 Schering, Aktiengesellschaft Pharma/Bio

4,372,948 2/8/1983 974 Kureha Kagaku Kogyo Kabushiki Kaisha Pharma/Bio

4,374,829 2/22/1983 661 Merck & Co., Inc. Pharma/Bio

4,396,617 8/2/1983 660 Duphar International B.V. Pharma/Bio

4,399,276 8/16/1983 605 Kabushiki Kaisha Yakult Honsha Pharma/Bio

4,369,189 1/18/1983 551 Union Carbide Corporation Pharma/Bio

4,410,537 10/18/1983 507 Burroughts Wellcome Co. Pharma/Bio

4,399,148 8/16/1983 499 Union Carbide Corporation Pharma/Bio

4,372,953 2/8/1983 490 Otsuka Pharmaceutical Company, Limited Pharma/Bio

TEN MOST VALUABLE PATENTS ISSUED IN 1993

Patent Issued Relative Value When Issued Assignee Technology

5,252,474 10/12/1993 1,696 Merck & Co., Inc. Pharma/Bio

5,256,558 10/26/1993 969 The Trustees of Rockefeller University Pharma/Bio

5,258,502 11/2/1993 868 Massachusetts Institute of Technology Pharma/Bio

5,268,273 12/7/1993 824 Phillips Petroleum Company Pharma/Bio

5,182,263 1/26/1993 823 Hoffmann-La Roche Inc. Pharma/Bio

5,187,241 2/16/1993 763 International Business Machines Corporation Pharma/Bio

5,262,568 11/16/1993 756 State of Oregon Pharma/Bio

5,198,563 3/30/1993 695 Phillips Petroleum Company Chem/Polymer

5,227,405 7/13/1993 690 Duke University Pharma/Bio

5,196,524 3/23/1993 679 Eli Lilly and Company Pharma/Bio

MOST VALUABLE PATENTS ISSUED IN 2003

Patent Issued Relative Value When Issued Assignee Technology

6,517,866 2/11/2003 3,374 Pfizer Inc. Pharma/Bio

6,566,344 5/20/2003 2,646 Idenix Pharmaceuticals, Inc. Pharma/Bio

6,602,861 8/5/2003 1,252 Research Corporation Technologies, Inc. Pharma/Bio

6,531,282 3/11/2003 1,225 Oligotrail, LLC Pharma/Bio

6,605,606 8/12/2003 1,109 Miravant Pharmaceuticals, Inc. Pharma/Bio

6,665,641 12/16/2003 884 ScanSoft, Inc. Software

6,602,503 8/5/2003 861 Biogen, Inc. Pharma/Bio

6,596,332 7/22/2003 841 Nestec S.A. Foods products

6,602,499 8/5/2003 824 The General Hospital Corporation Pharma/Bio

RE038073 4/8/2003 804 Research Corporations Technologies, Inc. Pharma/Bio

VI. Conclusion

Conventional valuation models are not generally applicable to patents. In addition, where they are applicable, they are labor intensive, and often require a series of assumptions. The PatentValuePredictor model is unconventional in the sense that it applies a modified version of income theory in which a nominal cash flow is determined based upon a macro economic model that applies heuristic rules. It has the benefits of being completely objective, applicable to all patents, inexpensive, and quick. Application of that model to the universe of U.S. patents indicates that the most valuable patents have generally been in the pharmaceutical and biotechnology technology area for the last three decades.

IRS Tax Debt and Benefiting From Tax Attorney Services

IRS tax debt

If you happened to be one of the unfortunate individuals to owe tax debt from your past years, or you have paid your taxes for the current year, and still expect to owe further taxes to the IRS in the form of IRS debt, it’s possible for you to find a solution to redeem your taxes. The actual solution lies in not ignoring to pay your debt. Even though the IRS can collect the taxes up to ten years, it possesses many other powerful options to recover, and chances are it will. If you have outstanding IRS tax debt, the best possible solution is to utilize your savings, or alternatively borrow some funds to clear the debt. By paying your entire outstanding dues, it’s possible to save upon the penalties and fines, which are likely to be levied in case you decide to avail more time and clear your taxes over a period of time. If one borrows against some asset value such as your home, it’s quite possible the interest incurred might be tax deductible. It’s also possible to avail tax relief if you can represent your case properly to the IRS.

Tax attorney services

Since last few years, tax attorneys, and the services offered by them have been in high demand, especially since the tax season is approaching soon. Many taxpayers are likely to need tax help. While selecting your representative to deal with your IRS issues and concerns, it is quite important to retain somebody who can represent you to the best of his or her abilities, and not have conflicts while representing your case to the IRS. Even though the tax attorneys can be quite knowledgeable, properly trained, and have the ability to handle your issues, it is found that they can lack in aggressiveness when it comes to representing you to the IRS. The thing is most agencies like to maintain good terms with the tax authorities, since their entire business is dependent upon special tax clients, helping out tax debtors in availing IRS debt help, and good market reputation. It’s sad that IRS often takes advantage of some timid and docile tax attorneys because it knows that firm prefer to keep a positive image, and IRS can well damage the reputation through propaganda.

It’s generally believed that it’s expensive to retain a good tax attorney to avail IRS debt relief. At a first glance, the client might feel that the tax laws are simple to understand and straight forward. So they often feel they can communicate directly with the IRS and avail an acceptable situation. This could turn out to be a mistake, since IRS rules can be interpreted in many different ways, and IRS is an expert in that. So it’s recommended not to take any chances, and have an effective arbitration by employing the services of an experienced tax attorney to get effective tax debt settlement.

Becoming a Law Student? What to Expect from a Law School Education!

It seems that many people dream of one day becoming a high profile lawyer, setting lofty goals for themselves as they move forward through school. However, without knowledge of how to get into law school and what to expect while there, those dreams can never become a reality. Where does an aspiring law student start? To whom should you turn for more information?

The best place to start your path to law school is by speaking with a prelaw advisor. Your advisor can be found at your undergraduate institution and would be happy to help you determine whether or not you are a candidate, where you should apply, and what course you should follow to achieve your goal.

Law school is not for everyone. Critical thinking and writing abilities are required, as well as a feeling for the humanities (social sciences, natural sciences, art, and other things affecting human experience). An education in logical reasoning, written and oral expression, and critical analysis provide a good basis for acceptance to law school, regardless of your major. Excellent performance and rigorous course schedules are very important in providing an acceptable educational history to a law school.

Law school will equip you to analyze legal issues and stay abreast of the continuously changing laws and policies. A lawyer must be able to think on his or her feet and adjust to the evolving legal environment in which they must function. Lawyers must be able to provide useful and intelligent counsel to individuals regarding the law and its functionality. Clear speaking and writing abilities are also a must. Law school will prepare you for all of the aspects of being a lawyer, as well as teaching the arts of persuasion and negotiation, which also become a large part of a law career.

There is no specific curriculum that a law school follows; they do vary from school to school. However, most states require a lawyer to have graduated from an American Bar Association approved law school in order to earn admission into the bar. These schools provide the basic information and training necessary to take and pass the bar exam. Typically, states require a law student to attend the law school institution for at least three years full time or four years part time. Most law schools, though providing training for different sorts of legal professions, gear their curriculum toward training a lawyer, though some have special programs that gear the learning experience toward a combination of law and other topics, such as business, science, technology, or public administration.

Many law schools will start out their first year students with subjects such as civil procedure, contracts, criminal law and procedure, constitutional law, property law, legal writing, and tort. Eventually, in their goal of training a lawyer, the schools will place students in internships, which are used toward academic credits. Others emphasize using the governmental and legal resources of the community for training purposes.

There are many questions involved in preparing for law school, and this article only touches on some of the basics. Again, the best place to start you off on a successful career path in law is with a prelaw advisor, who can assist you in clearing up any matters not addressed here.

Secure your organization and its business with the help of online legal research service from D-Law

As the name suggests, Online legal research is a completely serious activity belonging to the category of legal group of works. They are absolute set of procedures which are carried out online with the main aim of finding out the statutes, cases, and regulations that can be cited in a brief as authority to support a litigant’s position and to inform the judge of the controlling law in the jurisdiction. Legal search or as we may call it legal research in simple words, can be explained as the process of going through the legal history of the person concerned. Online legal search which is also referred as civil check or even as back ground check by many, is done so as to find out whether the person has been a part of the defendant record in the past or present or even to check whether he is involved in any type of offence; criminal or civil in nature.

This type of online legal search, which is also known as quick case record search, is one of the most important parts of pre-employment screening.  This is because of the simple reason that legal search which is nothing but quick case record search helps tremendously in finding out the background of a person, thereby to making sure that he or she is not an offender by any chance. In the current global business scenario, which is highly advanced and practically dominated by the power of internet, there are many people in the world who misuse the facilities provided by the internet. They with the help of it, even fake their identities to grab a good job opportunity and thus establish their career. And it would absolutely not be wrong to say that these type of activities performed by any person can create severe problems for the organization who give them employment or even for other innocent people. Thus here comes the value of legal search or online legal search which is quicker and more effective and can greatly help the company or even individuals to stay away from all such wicked people.

Now-a-days, online legal research is preferred over simple legal search by most of the people and companies throughout the world because it is far more advanced and effective and thus can give better result. This is because internet is truly one of the fastest mediums of performing any kind of activity.

Therefore if you are a service provider of any nature and therefore need to work in association with some people, then the best way by which you can secure your organization and its business is by taking help of a service provider D-Law who provide legal research services. These service providers will carry out the activity of litigation check to make sure that the particular person who will be associated with your organization in any of the ways is not a part of any type of litigation record.

Buying a Franchise – Evaluating Franchise Investments and Franchise Disclosure Documents – Tips From a Franchise Expert and Franchise Attorney

Millions of people dream about owning their own business. Having the independence that being your own boss brings, the security that no one can fire you, enjoying a good income – and for the most successful – the accumulation of wealth and prosperity. Unfortunately, the cards are stacked against a new small business making it big – or making it at all. An endless stream of problems makes competition from large, sophisticated chains too intense. Many new start-ups end as failures.

Buying a franchise represents a different approach to starting a business.  For an upfront franchise fee plus ongoing royalty payments, the parent company teaches its business model and methods to the franchised-operator who shoulders all operating and financial responsibilities of the outlet. Some statistics are impressive: it is said over 40% of all U.S. retail sales are through franchised establishments. While franchise giants like McDonalds, KFC, H&R Block and Radio Shack are familiar, household names, franchises are available in a wide range of industries. The list of 3,000-plus companies selling franchises span over 100 different industry categories.

American Dream … Or Nightmare?
But just as franchising represents a chance to get rich, it’s also a chance to get stung. An alarming number of franchised operators make less than the minimum wage, working seven days, sixty to eighty hours a week, pursuing an expensive and elusive American Dream that turns into a nightmare. Since the ongoing franchise royalty payment comes right off the top, as a percentage of gross sales or a fixed minimum amount, the franchise company gets an assured revenue stream, even if its franchised units are operating unprofitably and are sold over and over again to new, unsuspecting buyers. The internet is filled with comments of the many people who lost $250,000 and more on concepts like eBay Drop off stores (iSold It), 30 Minute Fitness concepts (Curves), The UPS Store, etc. Yet many of these companies continue to sell and resell franchises over and over again. How do they accomplish that? Because there are enough people who think they can “believe” their way to success, even with a concept or business that’s not working in the marketplace. As discussed below, in many cases franchise investment decisions are incredibly based on emotionalism, not on business logic or even common sense.

Ownership And Being Your Own Boss?
Pride of ownership and being your own boss are highly touted phrases in franchise recruitment ads. But these are more fantasy than reality. Although you get all the financial exposure, headaches and stress of business ownership, what do you really own? A franchise owner is merely licensing a trademark (or service mark) from a company that dictates every detail of business operations. So the real boss isn’t you, but the company that sells you their franchise rights . . . and sea of franchise obligations.

Equity Build up?
But at least you’re building up equity, the ownership value of the business as a going concern beyond your investment of money, to compensate for all those years of hard work and long hours – right? Wrong – at least in the world of franchising. The franchise company reserves rights to acquire your entire business at below wholesale prices if their contract is not followed precisely. The acquisition rights provide for predetermined asset-based valuations, like book or liquidation value. These valuation methods provide bare minimum compensation (the used value of some file cabinets, office furniture, equipment, etc.) and are not generally used to determine the selling price of any business.

Absolutely no compensation is paid for established goodwill, the value of a business that is generating $X in profit or cash flow every month after years of effort, investment and expense – thus eliminating the most valuable ownership asset. Of course, you may be able to sell your franchise to a third party for a sales price that includes an earnings-based valuation. But that’s possible only if:
(a) you can find a buyer who is willing to live within the complexities of a franchise relationship, and
(b) you happen to own a franchise that’s showing healthy profits.

What follows is a bottom-line franchise checklist and tips compiled by franchise attorney and franchise expert, Mr. Franchise, based on reviewing over 500 franchise offering circulars and twenty-eight plus years of experience in the franchise industry – including ownership of a very successful franchise. These factors to consider in making a franchise investment will help you eliminate 95% of the companies you are considering. Then, you can concentrate your efforts on the 5% “cream” of the crop” companies that may deserve consideration. This franchise checklist assumes you’re suitable for and willing to live within the confines of a franchise relationship. It also assumes the franchise company:

(1) has itself successfully operated the concept being franchised for at least five years at multiple locations;
(2) is not plagued by franchise litigation and franchise lawsuits from disgruntled franchise owners;
(3) does not have unusually high franchise attrition rates (owners who have “left the system”); and
(4) has a balanced, fair franchise contract.

SOLD It – An American Dream That Turned Into A Nightmare

An example of a franchise company in trouble that failed to meet basic threshold standards is iSOLD It, an eBay drop-off store franchise. The company started its one and only company-owned store in November of 2003. Just weeks later, on December 10, 2003 they filed an application to sell franchises. The California Department of Corporations didn’t say “What are you thinking? You’ve only been in business a couple weeks, how can you even consider selling franchises?” Nor did they require this be disclosed as a risk factor on the cover page of the Franchise Offering Circular, as it should have. Disclosure responsibilities ultimately rest with the company (and its attorneys), and this will become one of many issues in future franchise litigation.

Instead, the Department simply collected its $675 filing fee and issued an order declaring the franchise registration effective the next day – on December 11, 2003. Then the magic of franchise marketing  took over. By 2006 the company had nearly 200 franchised drop off stores in operation and was touted by Entrepreneur Magazine as #1 in their list of “Top New Franchises for 2007” and #17 on their “Hotter Than Hot” franchise list. Entrepreneur Magazine, which requires franchise companies to submit their FOC’s (Franchise Offering Circulars) for supposed review each year before they’re listed, didn’t consider the high attrition rate (franchise owners leaving the system) or the fact that the audited financials in their FOC showed the company hadn’t operated profitably since 2004 as serious negatives and awarded iSold It the #1 listing for Top New Franchises of 2007. How did all of this happen? It’s yet another bizarre reality in the world of franchising.

The franchise company’s audited financial statements for the year ended 12-31-05 showed an operating loss of $1.1 million. Nine months later, in September of 2006, the net operating loss mushroomed to over $4 million.

In its November 3, 2006 Franchise Offering Circular, the table in Item 20 disclosed a total of 10 franchise owners leaving the system, yet a hand count of Exhibit D-3’s “Former Franchisees” revealed a significantly different number – 44. A similar “discrepancy” exists about franchise transfers. Item 20 says 12 transfers whereas Exhibit D-3 discloses 27.

In a long overdue letter distributed to franchise owners on April 5, 2007, CEO Ken Sully painted a dire picture of an American Dream that had turned into a nightmare. Mr. Sully’s letter admitted the company has not been profitable since 2004 (according to the audited financials, the company showed its one and only operating profit of $356,286 in 2004 before the precipitous downward spiral of 2005 and 2006). Over 60 franchised stores have closed and many more are struggling for survival. Mr. Sully observed “Tragically, many individuals who believed passionately in the potential for the category have lost sizable investments, including homes and retirement savings.”

Lost homes and retirement savings? How could such a travesty happen? I counseled a number of persons considering an iSold It franchise and warned all of them against the investment. Fortunately, they followed my advice. The concept was never proven in the marketplace before franchise efforts began, violating the most basic Franchise 101 precept. I also felt the management team lacked strong franchise credentials and the five-day training program was woefully inadequate. Finally, the franchise company was operating increasingly in the red and had a high attrition rate (owners leaving the system). It didn’t take a lot of brain power to see this was an accident waiting to happen. I predicted the bubble would burst and, sadly, it did.

Common sense could and should have prevented so many people from losing so much. Unfortunately franchise sales persons appeal to emotions (passions and potential, to use Mr. Sully’s terms) and strive to keep common sense and business logic out of the buying equation. If a franchise company is able to obtain a ranking on a media list, the sale is even easier. Reprints of high rankings on lists, like Entrepreneur Magazine, are included in the package given to franchise buyers, who are lulled into a false sense of security and begin to stumble over each other in a rush to sign up before someone else takes their desired territory (another favorite closing technique used to sell franchises).

iSold It! amended its FOC at the end of May, 2007 to add some long overdue risk factor language to the cover page of its Franchise Offering Circular. Hmmmm… maybe they read my comments above and did a little research. The new FOC cover page risk factor language says their “franchise system is still new and unproven.” That’s very interesting. How can they say a franchise system, that’s approaching its fourth anniversary, is “still new?” Maybe they’re looking at things from a ‘how old is our universe’ perspective? The word “unproven” is another play on words. The system is most certainly proven in the sense that many people, to quote Mr. Sully, “have lost sizable investments, including homes and retirement savings.” So why not use this quote directly in their Franchise Offering Circular? Answer: can’t sell any franchises that way.

In an August 31, 2007 Business Week article, CEO Sully claimed it wasn’t necessary to disclose these risk factors in the FOC. His reasoning: “We told everybody that this is sort of like the wild, wild West” he says. “It’s a brand-new concept and nobody knew for sure where it was going.” Disclosure was added to the UFOC recently, he says, “because of the number of stores that weren’t understanding the complexity of the business.” Hello? You don’t tell your franchise investors after the fact what you were required to disclose in the FOC before they bought so they could make an informed investment decision. That’s the purpose of franchise disclosure laws. And claiming written disclosure of risk factors in the FOC is not necessary if a prospective buyer hears a salesman’s verbal wild, wild West story ignores franchise disclosure responsibilities and is really an admission the company failed in this regard. With its amended FOC, the company incredibly continues marching forward with franchise marketing efforts.

Now, let’s consider the franchise checklist and factors to consider before any leap into franchising.

INDUSTRY TREND
Is the franchise in a cutting-edge industry that is doing well currently and is projected to do well in the future despite any economic slowdown? Education and home-improvement services are stable categories. Food is over-saturated generally and, except in exceptional circumstances, is not worth the high investment, long hours, headaches and marginal income.

TOTAL INITIAL FRANCHISE INVESTMENT
In general, don’t expect a franchise that requires a five-figure initial franchise investment to produce a six-figure income. As with most things in life, you get what you pay for. On the other hand, don’t assume a six-figure investment will lead to a six-figure income level. Be realistic and conservative. Is the total initial franchise investment range (including working capital) $125,00 or less; and the maximum investment less than $200,000? You can find solid companies in this investment range if you’re willing to look around.

Don’t forget to consider long-term financial commitments, particularly the real property lease (see discussion below under “LEASING AND LOCATION”). Also, the working capital estimate (called “additional funds” in Item 7 of the company’s franchise offering circular) does NOT cover operations up to the break-even point. It only covers a short initial phase (usually only three-months) of operating costs As the break-even point (where revenues cover all operating costs) may not happen for one, two or more years, knowing only what it’s going to take to get you through the first 90 days is not helpful – in fact it may set you up for financial suicide. In many cases, reaching the break-even point can require more reserve funds than the total initial capital investment. Don’t ever forget the name of Item 7 in the Franchise Offering Circular: “Initial Investment.” If you don’t have enough reserve capital to reach the critical break-even point, your entire investment will go down the drain and franchise failure occurs.

One franchise owner in a relatively low investment and low operating cost window cleaning franchise said his biggest surprise was how long it actually took his franchise to be profitable. Going in, he thought it would take 12 to 15 months. It ended up taking twice that time. Fortunately, he had enough reserve capital to make it there, but declined to say what his actual franchise profits or income level were once he reached “franchise profitability.” If you’re operating just above the break even point and making less than minimum wage, is that anyone’s definition of success?

REAL BUSINESS
Is this a legitimate retail business, as opposed to a “work out of your home” operation? The vast majority of work out of your home concepts produce marginal income at best.

FRANCHISE MANAGEMENT EXPERTISE
Does the management team of the franchisor (the company selling you the franchise) have executives with demonstrated past achievement and experience in operating a franchise company (not just persons who have sold franchises)? If not, this is a big RED FLAG. Many companies enter franchising and fail to realize they are in a brand new business – one requiring entirely different management skills and abilities to navigate franchise relationships. A seasoned franchise management infrastructure must be in place. If the franchise management team lacks strong franchise credentials, or does not receive ongoing advice from qualified individuals, you might as well take a trip to Las Vegas with the money you’re intending to invest. Your chances of making vs. loosing money are roughly equal.

NORMAL WORKING HOURS AND DAYS; SUFFICIENT FRANCHISE INCOME LEVEL
Will the nature of the business allow you to work a normal five-day, forty-hour workweek? Life is too short for the seven-day, sixty to eighty hours a week, workaholic lifestyle that destroys health, family and pocketbook. Financially, we’ve calculated the true hourly rate for franchise owners who work these workaholic hours and discovered many are making far less than the minimum wage. One couple who operated a $200,000 fancy pizza franchise in an upscale mall were shocked to discover they were making fifty cents an hour each. Hardly an income level to recoup or justify the franchise investment. Many more fast-food franchise operators make even less, or operate at a loss until their funds, retirement savings, homes, etc. are exhausted. Buying a franchise in a non-food industry doesn’t necessarily improve the franchise profit picture. In a 2006 article “Mail Boxes Etc. Owners Fighting UPS Conversion,” a Mail Boxes, Etc. franchise owner who operated his franchise since 1993 reported profits for a typical MBE store like his were $16,000 per year after paying royalty and advertising fees to the franchise company. That calculates out to about $8.33 per hour for a forty-hour work week, approximately the wage of an entry fast-food worker.

Another major shortcoming of disclosures in the Franchise Offering Circular is not telling you how much money the franchises in the network are making. Instead of answering what is the most important question in a franchise investment decision, the franchise disclosure laws make this “optional” for the franchise company to answer or not. If they do answer this critical question, it will be found in Item 19. But don’t hold your breath – more than 90% of franchise companies “decide” not to answer this question. It’s another bizarre reality in the world of franchising. Although they collect complete monthly (and in many cases, weekly) financial profit and loss statements from their franchise owners, and know exactly how much their franchises are making (or losing), more than 90% decide not to share this information before you buy one of their franchises. A number of franchise salespersons have told persons asking this question: “the franchise laws don’t allow us to answer that question.” Nothing could be further from the truth.

And just because you’re a business executive making a 6-figure income now, don’t assume this income level will be duplicated in a franchise investment just because the company “approves” your application. One such executive, despite a plethora of negative feedback from current and past franchise owners who’d lost everything, marched forward with her franchise investment in a 30-minute fitness concept. Despite her 6-figure income, she didn’t invest a dime in professional franchise evaluation advice and stated she was taking a leap of faith, hoping to build her wings on the way down. Build her wings on the way down? Sound’s (and is) crazy, but this happens all the time. Due to the ploys of the franchise salesperson, too many franchise investment decisions are based on emotionalism. Prior business skills, business sense (and even common sense) are short-circuited. Needless to say, if this business executive made a similar investment decision for her corporate employer paying the 6-figure salary, she would be promptly fired.

MINIMUM NUMBER OF EMPLOYEES
Can you operate the franchise business with 6 or fewer employees? Managing dozens (or in the case of some fast-food operations – hundreds) of minimum-wage teenagers who are constantly quitting or simply not showing up for work is a royal pain in the ….. Well, you know what we mean.

LEASING AND LOCATION
For most retail franchises, the triple net lease of the location is the biggest financial commitment, larger than the total franchise investment. Yet, the typical real estate lease and its ramifications are not required disclosure in any Franchise Offering Circular (FOC). For example, an estimate that you’ll need 2,000 sq. feet of space with expected rental of $5 to $10 a foot per month is normally disclosed in the Franchise Offering Circular’s initial investment table as Leased Real Estate $10,000 to $20,000. A footnote to the investment table may say “assumes 2,000 sq. ft. at $5 to $10 a foot.”

But, that’s only the beginning of a much longer story. The lease is normally a 5 to 10 year triple-net lease. So, the financial commitment made when the lease is signed is at least $600,000 (at $5/foot for 5 years) to $2,400,000 (at $10/foot for 10 years). And this doesn’t include substantial, additional obligations to pay all of the landlord’s yearly property taxes, insurance, common area operating expenses, etc. With hundreds of thousands (or even millions) of dollars in financial obligations at stake, personal guarantees and other risks, more than just a warm, fuzzy feeling that everything will work out is necessary.

Key questions to ask here:

(a) is the franchise you’re considering one that can be operated in a low rent commercial business zone? Avoid franchises requiring the costly expenses and triple-net leases of a visible retail storefront and the extravagant rent associated with areas of high foot traffic, like shopping malls. You’ll sleep much better at night.

(b) What’s your total financial commitment under the lease?

(c) Do you have sufficient liquid assets (or a willing, sufficiently liquid third party guarantor) to meet the landlord’s lease qualification standards?

If you don’t, you might as well forget about investing in the franchise. Or even worse, getting involved in a questionable franchise and business model, then realizing you’ve made a big mistake – and discovering you’re on the hook personally for a $500,000+ lease obligation.

A related real estate variant is securing a lease with a sufficient term (with renewal options) to recoup your investment and make a profit. In July, 2005, an attorney in her mid-forties purchased an existing ice cream store franchise for $375,000 believing it to be a “once-in-a-lifetime opportunity.” Trading her briefcase for an ice cream scoop, she attended the company’s 11-day Ice Cream University and assumed operations of the ice cream store. Turned out it was an opportunity – but only to inherit a store with numerous problems. These problems included (but were not limited to) a lease that would expire the following summer and a landlord who’d previously announced the lease would not be renewed. Rather than pay the $100,000-plus in relocation costs, the attorney returned to the practice of law, but is still paying off $350,000 remaining on the loan taken out to buy the once-in-a-lifetime franchise opportunity. Although there’s a franchise lawsuit pending, it’s yet another case of “franchise fever” – this time attacking a professional no less. Who would ever commit to paying $375,000 for an existing retail franchise without checking out the l-e-a-s-e? Sound’s like another bad attorney joke, but I can guarantee she’s not laughing. Business fundamentals were ignored or forgotten in the rush to acquire the opportunity of a lifetime. And I’m willing to bet not a dollar was spent on competent, pre-investment franchise advice.

IMAGE AND LIFESTYLE
How does flipping burgers, scooping ice cream and cleaning restrooms fit the image of what you want to do for a living? Investing in a franchise will be the most important financial and psychological decision you ever make. Many prospective franchise owners fail to realize they’ll be wearing virtually every hat at some point, from salesperson to bad-debt collector, from firing employees to bathroom janitor. The franchise owner is usually the first one to arrive in the morning – and the last one to turn out the lights late at night. And you’ll need to forget about corporate perks like paid vacations, paid holidays and sick pay. In their place, substitute financial pressures, unexpected events and money draining out of your savings and retirement accounts. Does the typical working day and responsibilities of the franchise you are considering fit your personal image and desired lifestyle? You can experience some of this BEFORE you invest by working for a couple weeks in an outlet owned by one of the existing franchise owners.

TRUE FRANCHISE VALUE
Buying a franchise from a “blue chip” franchise company that has spent decades and hundreds of millions on advertising to develop their brand can make a lot of sense. These companies have “true franchise value” that compensates for the long-term disadvantages of ongoing royalty and advertising fund payments. Often these additional payments literally mean the difference between earning a profit and operating at a loss. In unknown franchise chains with little or no brand recognition, you the franchise buyer are building their brand from scratch, and are saddled with severe, long-term competitive disadvantages.

In these unknown franchise chains, you have to ask yourself a simple, common sense question. What value is the company giving you that you couldn’t learn on your own by working at one of their locations as an employee for a couple months? Franchise truth be told, what most unknown franchise companies are selling is just a business opportunity – teaching you how to get into a new business venture. But unlike a business opportunity seller that charges a one-time fee to help get you into business, they call it a “franchise” and charge ongoing royalty and advertising fees like they’re a McDonalds or other blue chip franchise company.

The reality is they’re not a McDonalds type franchise – not even close to one. In the majority of these lesser-known franchise chains, you’d be much better off starting an independent business on your own. You can learn most or all of their so-called “secrets” in the franchise interviewing process and by talking to (and possibly working a short time for) existing franchise owners.

FRANCHISE PROFITABILITY & “SUCCESS”
Dr. Timothy Bates’ study released in 1993 by the Entrepreneurial Growth and Investment Institute in Washington, DC (and another study published in 1996) was the first to compare start-up costs, franchise profitability and franchise failure rates for franchised vs. nonfranchised firms. In his analysis of some 7,270 firms over the test period, Dr. Bates found that startup capital for a franchised business averaged $85,293 compared with average startup capital for nonfranchised firms of $30,156. In 1987 nonfranchised firms reported average pre-tax net income of $19,744 as compared to a loss of (-$1,548) for franchised firms. Dr. Bates concluded “Despite their larger revenues, much better capitalization, and their supposed advantages of affiliation with a franchisor parent firm, the franchisees lag behind cohort young firms in profitability and rates of survival.”

The franchise companies ignore both studies by Dr. Bates, pretending they never happened. Instead, other techniques are employed. For example, some franchise companies use misleading success statistics to sell their franchises. Their promotional materials say franchises generally enjoy a 90% success rate, compared to less than 20% for independent firms. These figures are based on unverified information supplied thirty years ago by a select, non-representative group of franchise companies. A full third of the companies receiving “questionnaires “ elected not to participate. There was no verification of any of the information supplied by the franchise companies, not even random, spot checking. Nor was any effort made to identify franchise companies who, along with the franchise owners in their chain, had gone out of business.

Even more recent “studies” saying nine out of ten franchise owners (90%) consider their franchise to be somewhat or very successful also suffer from serious methodological flaws. These were simply telephone surveys of franchise owners who were still in business and asked to say (with absolutely no definition of the term “successful”) whether they felt their business was “very unsuccessful,” “somewhat unsuccessful,” somewhat successful” or “very successful.” Franchise owners who had gone out of business or bankrupt were not included in the survey.

Even if terms are defined and a representative sample obtained, franchise owners can be a quirky group. Hence the need, as in Dr. Bates’ studies, for review of financial data. I remember evaluating an existing franchise for a client. I asked the current owner of the franchise if his business was successful. He said it was very successful. But his financial statements revealed a different picture. He’d never taken a dollar out of the business for himself, never made a profit in two years of operation, and was on the verge of bankruptcy. Another owner of a bakery franchise, interviewed by Business Week, says being successful in franchising means “adjusting your definition of success.” He says he makes a profit, but declined to say what it is, or if he’s ever recouped his $250,000-plus initial franchise investment. Incredibly, he insists he’s in business “for lifestyle reasons, not profit reasons.” Huh? Probably a quote from the company’s franchise recruitment materials. In the world of franchising “success” and “profitability” are very subjective terms.

FRANCHISE BROKERS WHO FIND YOUR PERFECT MATCH?

Does the franchise you are considering have its own in-house marketing department, or does it utilize outside franchise brokers? The use of franchise brokers is a definite red flag. First, it indicates the franchise company is not very serious about who it lets into the franchise network, or even worse, they’re desperate to sell franchises. Second, franchise brokers receive a substantial commission up to 50% or more of the franchise fee you’re paying the franchise company. Franchise Broker Realities: (1) Their service is definitely not “free” despite these and other similar misrepresentations. It’s really common sense – how could anyone offer a “free” service and survive in business? Unfortunately, the common sense part of the brain tends to short circuit when the franchise brainwashing process begins. The simple truth is if you buy one of the franchises they’re hawking, your money goes to the franchise company, then into the broker’s pocket. If anyone ever calculated how much time they spend to collect their $15,000 or $20,000 commission, it’s probably a lot more than a brain surgeon earns. (2) Franchise brokers definitely do NOT have your best interests in mind. They will do or say whatever they have to in order to close a deal and earn their commission.

Many franchise brokers claim they will help you find a franchise company that is the perfect match for you. In the beginning it sounds good. There’s some personality testing and review of your personal finances. At the end of the day, it turns out they only represent (and steer you towards) a handful of small franchise companies you’ve never heard of before. A detailed analysis often reveals these highly touted franchises produce mediocre or even below minimum wage financial performance. Yet franchise brokers don’t mention this, and individuals continue to rely on their recommendations, believing the broker represents them. Nothing could be further from the truth.

Also, many franchise brokers call themselves franchise consultants. A franchise consultant is usually an independent adviser who offers advice to others (usually franchise companies or firms that want to franchise their business) for a fee. This makes their advice more impartial in theory as long as they are not compensated by third parties. Because they are not legally required to disclose actual or potential conflicts of interest, it’s important ask questions. For example, if you’re using a franchise consultant who is recommending the “best franchises,” are they paid anything by the companies on their list? This could be a commission, kick-back or consulting fee. As mentioned, many franchise brokers call themselves “franchise consultants” to hide their true identity. So, make sure if you’re dealing with a franchise consultant, he or she is not really just a franchise broker in disguise.

FRANCHISE DISCLOSURE LAWS
The franchise disclosure laws, while requiring franchise companies to give you certain, limited information, don’t come close to protecting your interests. For example, as discussed above, Item 7 of the Franchise Offering Circular only requires an estimate of additional funds for 90 days as part of the investment information. But economic reality is you need to know the additional funds you’ll need to reach the break-even point, which can be years away, or your entire “initial” investment will go down the drain. You’d think this type of information would be required by franchise disclosure laws, but it’s not.

FRANCHISE REGISTRATION LAWS
Don’t ever assume that because a company has registered its Franchise Offering Circular in your state, someone at the state has approved or reviewed the document in your favor. Franchise registration is obtained by simply forwarding documents and paying a filing fee – period. In most cases, franchise offering circulars are given an extremely limited review to ensure state-specific disclaimers are present.

I remember filing a registration application for a new franchise company in a state with a reputation for being one of the “toughest” franchise registration law states in the country. After the three-week review period set forth in the statute had gone by, and not hearing anything, I called the examiner assigned to the application. After looking through his files, he finally found my client’s offering circular and application. He apologized for entirely misplacing the file and promised to immediately review the application and call me back. Ten minutes later, he called to say he’d finished and was making the registration effective that day. Ten minutes of review and the franchise company was given the state’s green light. This is not an isolated case – it happens all the time.

WHAT STANDARDS MUST A FRANCHISE COMPANY MEET TO SELL FRANCHISES; ARE THERE ANY REQUIREMENTS TO FRANCHISE A BUSINESS?
Incredibly, the answer is – none. There are no minimum standards or requirements to franchise a business except preparing a Franchise Offering Circular. It’s yet another bizarre reality in the world of franchising.

You and I could have no background in any business, form a new corporation or LLC, capitalize it with only $1, put together a Franchise Disclosure Document and file it with any franchise registration state. While the offering may be subject to an impound or escrow requirement because of the low capitalization ($1), we’d still get “registered” and be able to sell as many franchisees as we want.

In these 14 franchise registration states, we may not be able to receive any money until each franchise actually opened, but simply posting a bond would alleviate this difficulty in the franchise registration states. And in the vast majority of states there are no franchise registration laws, so we’d be able to sell franchises and collect fees with impunity once we compiled our Franchise Offering Circular. The federal FTC Franchise Rule doesn’t protect against this risk either – it only requires disclosure (i.e. provide a Franchise Disclosure Document) and has no registration component or minimum standards for franchise companies.

Basic investor protections and requirements found in both federal and state securities laws for over 50 years were never carried over to franchise investments. While most non-blue chip franchise companies could never even qualify to sell you a single share of stock in their company, they are entirely free to collect unlimited franchise fees, ongoing royalties, equipment and other purchases, as well as cause you to incur financial obligations totaling hundreds of thousands of dollars, or even millions in some cases. This isn’t information you’re likely to find in the glowing articles about franchising and franchise companies prevalent in the media.

CLOSING REMARKS
Remember, you are the only guardian when it comes to your franchise investment. It’s definitely an environment where the phrase “Buyer Beware” applies. So, before you sign on the line and make what will undoubtedly be the most serious financial and emotional commitment of your life, get all the facts and figures.

One couple I counseled after-the-fact, invested $2 million in a new franchise company. The contract they signed gave them no right to terminate, no matter what the franchise company did or didn’t do. Of course, the contract gave the franchise company unlimited termination ability, a right it had exercised. The franchise company’s management team had no one with experience in running a franchise company. Incredibly, the couple had not spent a dime on legal or business advice before investing $2 million. The once friendly franchise company had transformed into a formidable foe and was poised to take over their franchise. Sadly, this happens too frequently in franchise investments. Decisions are made on fuzzy feelings and emotionalism. In an effort to save a couple thousand dollars, franchise investors risk homes, retirement savings, everything they have. Then they scratch their heads in amazement later on after inevitable and often horrific problems develop, wondering how they could have been so nearsighted.

Another indispensable level of inquiry is whether you’re getting true franchise value and whether you’d be better off doing the business on your own. In the overwhelming majority of franchises touted by unknown companies, franchise value isn’t there and doing the same thing independently makes better economic sense and actually decreases the risk of failure.

Finally, and this applies to franchise investments as well as investing in any business venture, develop a plan to succeed but also plan a franchise exit strategy that minimizes financial risk in case things don’t work out. Both plans need to be thought through before the investment is made. Don’t wait until problems develop to start thinking about a franchise exit strategy – by then it’s usually too little, too late.

For more information, visit the Franchise Foundations Website.

© 1990-2008, Kevin B. Murphy, B.S., M.B.A., J.D. – all rights reserved