Franchising and the Business of Sports

Richard S. Brown, PhD Presented for McDevitt and Kline

November 13, 2021

Franchising and the Business of Sports

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About Me

Education �  St. Joseph’s University (B.A.) �  Lehigh University (M.B.A.) �  Temple University (Ph.D.)

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Business Experience �  From 1997 to 2008, I founded and managed a number of real

estate companies in Philadelphia: * Development * Construction * Consulting * Brokerage

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Teaching �  I’ve teach or have taught:

1. Strategic Management/Business Strategy 2. Mergers & Acquisitions 3. Strategic Venture Planning 4. Corporate Governance and Business Ethics 5. Entrepreneurship and Innovation 6. Leadership and Team Building 7. Intellectual Property and Licensing 8. Franchising (alone and with Business of Sports)

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Teaching �  I am currently an Associate Professor of Strategic

Management at Penn State University Harrisburg �  I’ve also taught at the following in years past:

1. Fordham University 2. Temple University 3. Rowan University 4. Rutgers University 5. West Chester University 6. Rider University

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Research �  I currently have 26 peer-reviewed academic journal articles

published �  My research interests include:

* Corporate Political Activity * Franchising * Industry Structure

* Corporate Bankruptcy

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Agenda �  Module 1: Franchising Overview �  Module 2: Sports Leagues as Franchise Systems �  Module 3: The Business of Sports

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Module 1: Franchising Basics

Describing a Franchise �  The best way to describe a franchise is to describe what it is

NOT: * It is not a totally independent entrepreneurial venture * Example: Joe’s Pizza * It is not a corporate run chain * Example: WalMart or Starbucks �  It IS a hybrid of these two phenomenon * It looks like a chain run by a large corporation but has

locations that are owned separately by local entrepreneurs

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Franchising Basics �  Franchisor = Mother Company

* Example: McDonald’s Corporate �  Franchisee = Independent Entrepreneur

* Can be an individual or small corporation * Franchisees buy into the franchise system * Some franchisees own 1 location, some own many

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Franchising Basics �  What does the Franchisor give and get?

* Gives: Rights to allow the copying of its business model 1. Also the rights to intellectual property * Gets: Payments and Expansion

�  What does the Franchisee give and get? * Gives: Payments * Gets: Instant legitimacy, initial training and ongoing

support

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Franchising and IP �  In a franchise system, the franchisor may have intellectual

property (IP) that it allows the franchisee to use as part of the contract

�  Types of IP that franchisees may be allowed to use as part of the franchising agreement:

1. Trade Secrets (Example: Secret recipes) 2. Patents (Example: Machines, Boxes) 3. Trademarks (Example: Logos, Slogans, Color Schemes) 4. Copyrights (Example: Manuals, Directions, etc)

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Chaining �  The opposite of franchising is chaining, whereby a company

utilizes its internal financial and human resources and expands through these internal resources.

�  Chaining allows the company to reap the rewards of smart expansion but also risk losses on poor expansion

�  Companies that chain: Starbucks, WalMart, Five Below

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Companies that Franchise �  Restaurants/Food: TGI Fridays, McDonald’s, Burger King,

Subway, Chili’s, Panera, Taco Bell, KFC, 7-11, Dunkin Donuts

�  Hotels: Marriott, Hilton, IHG �  Real Estate: Berkshire Hathaway Realty, ReMax, Coldwell

Banker �  Tax Services: H&R Block, Jackson Hewitt �  Other: Aaron’s, Ace Hardware, Radio Shack, Jiffy Lube, Jani-

King, Pet Supplies Plus, MAACO

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Not An Either Or Choice �  It would be a fallacy to state that a company either franchises

or it chains. While some companies only chain and some companies only franchise, many companies use a hybrid strategy * Hybrid Example 1: A company that has a middling mix of

corporate-owned to franchisee-owned stores * Hybrid Example 2: A company that chains, but then

franchises only in its international operations

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Chaining and Franchising Goals �  The end goal for each strategy is the same: Quality,

Consistency and Uniformity �  The goal is for you to walk into any outlet of a company that

you frequent and get the same thing regardless if you are in Harrisburg, Manhattan, Iowa, etc.

�  A well-run franchise system should appear like a non-franchised chain or vice versa. They should be indistinguishable if done right.

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Dyadical Incentives �  Franchising dyads, as with other similar structures (such as

JVs), must include incentives for each side or it isn’t logical to join

�  A franchisee must believe that there is enough benefit in joining the system to outweigh the cost in joining

* Assuming the franchisee can start a similar venture outside of a corporate umbrella (Ex: Joe’s Pizza vs. Dominos)

�  The incentives for the franchisor are more clear-cut in that it reaps growth and payments without committing corporate assets

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Franchising Economics �  Fees paid by the franchisee can be placed in two buckets:

Explicit 1. Franchisee Fee 2. General Royalty 3. Advertising Royalty Hidden 1. Franchisor-Mandated Specifications 2. Captive Inputs

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Cost-Benefit For Franchisee Simply put, joining the franchise system makes sense if and only if the following holds: Franchisee Value > Independent Value Let’s determine what goes into each of these inequality terms

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Cost-Benefit

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Examples (www.worldfranchising.com)

Maaco Auntie Anne’s 1.Franchisee Fee: $40,000 1. Franchise Fee: $30,000

2.Royalty: 7.50% 2. Royalty: 7.0% 3.Advertising: $150 per month 3. Advertising: 1.0%

McDonald’s Huntingdon Learning

1.Franchisee Fee: $45,000 1. Franchise Fee: $14,000

2.Royalty: 12.50% 2. Royalty: 9.0% 3.Advertising: 4.0% 3. Advertising: 2.0%

(Note: Rent Additional)

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Franchise Filings and Contracts �  Franchising contracts specify exactly what each side must do

within the term of the franchise agreement * Franchisees normally sign a 10 year agreement although

this length can vary �  Franchisors must file a Franchising Disclosure Document (FDD)

which details the initial offering of franchising that a firm wishes to market

* Used to be called the Uniform Franchise Offering Circular (UFOC)

�  The Federal Trade Commission (FTC) has governmental regulatory authority over franchises under 16 C.F.R. 436 revised in 2007

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FDD The typical FDD consists of the following information: The Franchisor Territory Business Experience Trademarks Litigation Patents, Copyrights and Proprietary Bankruptcy Obligation to Participate in Operation Initial Franchise Fee Restrictions on What Can Be Sold Other Fees Renewal, Termination, Transfer Initial Investment Public Figures Restrictions on Sourcing Representations Regarding Earnings Franchisee Obligations List of Franchised Outlets Financing Financial Statement Franchisor’s Obligations Contracts

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Franchise Agreement �  In addition to the items that must go into the FDD, there are

mandatory sections that are included in the contract between franchisors and franchisees

See https://www.entrepreneur.com/article/286680

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Franchisee Selection �  An important consideration for franchise system success is the

ability of franchisors to be selective in screening franchisees. Some criteria to consider when selecting: 1. Personal Wealth * Liquidity * Net Worth 2. Experience * Entrepreneurial * Management * Industry 3. Geographic Location 4. Idiosyncratic Criteria

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Franchisee Acceptance Rates �  Elite franchise systems will be very selective and, therefore,

have low acceptance (or high rejection) rates. Chick-Fil-A has had rejection rates as high as 96% for franchisee applications

�  Mediocre to poor franchise systems are much less selective and often select on financial background as opposed to industry or managerial background. A guest speaker that I had in a Franchising class years ago used to sell franchises at Quizno’s and he said that to get approved as a Quizno’s franchisee a person “…needed a pulse and $70,000”

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Dysfunction in Franchising �  I am of the belief that franchising is highly non-collaborative

even though textbooks normally include it as a collaborative strategy

�  There are a number of reasons why this may be the case and I will focus on two: 1. Asymmetrical Control 2. Double Moral Hazard

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Asymmetrical Control �  Understand that most, if not all, franchise contracts are

asymmetric in that the franchisor retains the vast majority of control in the franchisor-franchisee relationship

�  This asymmetry leads to tension between the parties as the franchisor can act unilaterally and can even seize control of the franchisees’ locations

*Example: LA Dodgers and MLB

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Double Moral Hazard �  Moral Hazard is defined as the hidden effort of an agent

toward its principal. This can lead to opportunistic behavior. �  Double Moral Hazard is where both the principal and the

agent have the incentive to act opportunistically toward each other because they are simultaneously agents and principals.

�  In franchising relationships, the franchisor may have the incentive to open too many franchisee-owned outlets while the franchisee may have the incentive to free ride off of the franchisor’s reputation * Example: Quizno’s * Example: Rita’s Water Ice

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Successful Systems �  Successful franchise systems balance opportunism with

foresight. The question isn’t “How do I maximize my earnings right now?” but “How do I maximize my earnings over the medium to long term while having a high system survival rate?”

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Successful Systems �  The Franchise Institute https://franchiseresearchinstitute.com/world-class-franchises/ �  Forbes https://www.forbes.com/best-worst-franchises-to-buy/#2b7222882699 �  Entrepreneur Magazine https://www.entrepreneur.com/franchise500/2021 �  SBA Coleman Report https://colemanreport.com/colemans-2020-sba-franchise-and-naics-7a-504-loan-performance-reports/

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Module 2: Sports Leagues as Franchise Systems

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Sports Leagues There are hundreds of professional sports leagues in the U.S. and abroad. We will focus on large, U.S. sports leagues today.

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Major U.S. Sports Leagues �  National Football League (NFL) �  Major League Baseball (MLB) �  National Basketball Association (NBA) �  National Hockey League (NHL)

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Other Sports Leagues of Note �  National Collegiate Athletic Association (NCAA) �  Professional Golf Association/Ladies Professional Golf Association

(PGA/LPGA/Golf) �  Premier League (Soccer) �  Major League Soccer (MLS) �  Canadian Football League (Football) �  Association of Tennis Professionals/Women’s Tennis Association

(ATP/WTA/Tennis) �  Nippon Professional Baseball (Baseball) �  Indian Premier League (Cricket) �  National Rugby League (Rugby)

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Sports Leagues as Franchise Systems �  Sports leagues are franchise systems quite similar to those we

covered thus far (or at least analogous) �  As such, we will consider the league the Franchisor and the

individual teams the Franchisees

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Sports Franchisors �  A sports league is a formal organization and is incorporated

as such. Leagues include: National Football League (NFL) National Basketball Association (NBA) Major League Baseball (MLB) National Hockey League (NHL)

�  As franchisors, the leagues organize the “rules of the game” for the franchisees and this is with respect to both play and finances

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Sports Franchisees �  Each league (franchisor) will then have a number of teams

that will be geographic in nature (franchisees). NFL: Philadelphia Eagles NBA: Philadelphia 76ers MLB: Philadelphia Phillies NHL: Philadelphia Flyers

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Franchise Documents �  We discussed FDDs in Module 1. The equivalent document

for sports leagues will be the league’s constitutions and bylaws

�  Sports leagues are not regulated by the FTC as are typical franchise systems

�  League constitutions will spell out the rights and obligations of each party, most notably of the franchisees (teams)

* Geographic territories are important to maintain local monopolies

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Control in Franchise Systems �  In non-sports, franchisees must give up a lot of rights

contractually * Control rights

�  Franchisors retain the rights to control the operations of the franchisee in almost every respect from pre-opening to the end of the franchise agreement term

�  All of our previous discussion about the asymmetric rights, responsibilities and constraints inherent in such systems hold in sports

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Franchising + Socialism �  But sports leagues have an added idiosyncrasy in that they are

not only monopolies, and not only monopolies within monopolies, and not only franchise systems….but they also follow a socialist model of intra-organizational competition * I use the term “socialism” because we are all familiar with

it, but the more technical term is Anti-Tournament

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Tournament Games �  In Game Theory, a Tournament is a Principal-Agent Game

where the Principal’s problem is to get the average level of effort to increase over a population of agents

�  The Principal must have credible commitment power �  The tournament is set up in a way where the output from the

tournament is an indication of the marginal effort exertion, since effort is partially unobservable * Hidden effort = Moral Hazard

�  A key characteristic of tournaments is the presence of a severe penalty

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Tournament Examples �  Competitive Division Management Model

* Jack Welch and GE * Top Investment Banking and Law Firms

*Grading Curves

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So What is an Anti-Tournament? �  Anti-Tournaments are, therefore, the opposite where agents

have an incentive to reduce effort because of the disincentive to increase such effort * Socialist Political Models * Unions * University Tenure Schemes * Sports Leagues

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Anti-Tournaments in Sports �  Sports leagues are interested in having parity. In other

words, the league must ensure that one team does not consistently dominate the league

�  As such, leagues introduce artificial compression in the system to make outcomes more equal than they otherwise would be

�  Examples of parity in sports are (i) Draft Schemes, (ii) Salary Caps and Floors, (iii) Revenue Sharing

*Each of these can be thought of as being the opposite of fierce competition

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Module 3: The Business of Sports

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Types of Industry Structures �  Fragmented: Many small firms, low barriers to entry, low

profitability, difficulty coordinating horizontally �  Oligopoly: Few large firms, high barriers to entry, high

profitability, ease in coordinating horizontally * Explicitly colluding oligopoly = Cartel

�  Monopoly: One firm, very high barriers to entry, extreme profitability

* Firms that have immense, but not 100%, market power are said to have monopoly power * Monopolies are often geographic and/or regional * Micro-monopolies are situational and not geographic

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Examples of Monopolies �  Public Transportation �  Utilities �  State Lotteries �  Liquor Control Board (State by State) �  Intellectual Property * Patents, Trademarks, Copyright, Trade Secrets �  Sports Leagues

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Sports and Monopoly �  There are two ways to think of sports leagues in the context

of monopoly * External: The league is a monopoly in the output market which excludes the entry of other leagues as competition * Internal: The teams within the league are members of a cartel that collectively make the league monopolistic

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Outcomes of Monopoly Situations �  In a typical monopoly situation, the monopolist earns

extraordinary profits (termed “Monopoly Rents”) �  While we often think that high prices result from

monopolistic behavior, there are other ways that the monopolist can benefit

* Keep price constant, lower quality * Insulated from societal pressures and sanctions * Limit choices

http://www.usatoday.com/sports/nfl/arrests/

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Anti-Trust �  Anti-trust is the branch of competition law that deals with

regulating the behaviors of firms that do or may use their excess market power to harm competition

* In the U.S., this is the Department of Justice Division of Anti-Trust or the FTC’s Bureau of Competition

�  Since sports leagues are monopolists in their individual sport, a number of anti-trust issues have been brought forth in the past

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Baseball and Anti-Trust �  Baseball has the oddest relationship with anti-trust laws in

that it has an anti-trust exemption through a series of federal court decisions and the lack of more specific Congressional legislation 1. See Stuart Banner’s The Baseball Trust for a nice history of baseball’s anti-trust exemption

�  Federal Baseball Club of Baltimore v. National League (1922) �  Gardella v. Chandler (1949)

�  Toolson v. New York Yankees (1953) �  Flood v. Kuhn (1972)

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Football and Anti-Trust �  Radovich v. NFL (1957) �  Sports Broadcasting Act (1961) �  USFL v. NFL (1986) �  American Needle v. NFL (2010)

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The Industry Value Chain Raw Inputs

Firm

Intermediate Goods

Finished Goods

End User

Upstream (Supply Chain)

Downstream (Demand Chain)

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Vertical Bargaining Power How can the previous discussion on vertical relationships be

applied to U.S. sports leagues? At least two ways: * Labor Disputes (Upstream) * Television Contracts (Downstream)

http://www.cnn.com/2013/09/03/us/pro-sports-lockouts-and-strikes-fast-facts/

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Relative Size

�  Estimates for revenue generated by the major sports leagues in the U.S. for 2019 are below. Forbes estimates the entire sports industry in the U.S. generates $500 Billion in annual revenue:

* NFL $15.3 Billion * MLB $10.7 Billion * NBA $ 9.2 Billion * NHL $ 5.0 Billion * NASCAR $ 0.9 Billion

Note: 2019 was used because of the negative effects of COVID on league revenues. Revenues were down a lot in 2020 due to lockdowns

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Is Sports Big Business? I hear the saying that “Sports is big business” or some variant all the time. But the fact of the matter is that ALL sports’ revenues combined in 2019 equals the total revenue for Walmart alone in the same year. So everything is relative. I think we confuse exposure with economic importance

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By Comparison (Figures are Revenue)

�  Premier League $7.30 Billion �  ATP+WTA $0.15 Billion �  CFL $0.20 Billion �  PGA+LPGA $1.40 Billion �  Nippon Baseball $1.30 Billion

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Sources of Revenue �  While the specifics are idiosyncratic to each league, the

revenue categories include: * Broadcast Contracting Rights

* Ticket Sales and other in-person items * Intellectual Property Licensing * Sponsorships/Naming Rights

�  If we categorize these differently, the vast majority of revenues for leagues comes from intellectual property licensing, either through broadcasts (copyright) or merchandising (trademark)

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National vs. Local Revenues �  National Revenues are those revenues earned as a collective

(i.e. league level) and then equally shared amongst the teams * Pooled Broadcast Rights (NFL) * Trademark Licensing (NFL, MLB)

�  Local Revenues are those revenues earned by the individual teams and kept by the teams themselves

* Team Broadcast Rights (MLB) * Stadium Revenues (NFL, MLB)

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Revenue Sharing �  Revenue sharing is the practice of distributing or

redistributing revenues to teams to make the teams more equal on a business perspective

* Makes sense since the league will collapse if there is too much asymmetry between teams…but usually collective efforts by industry participants violates anti-trust law

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NFL vs. MLB Revenue Sharing �  In the NFL, national revenues (Trademark and Broadcast

Licensing) are split evenly amongst teams * Last year, $9.5 Billion was collected by the NFL and then split equally between the 32 teams ($296 Million Per Team)

�  In the MLB, 48% of each team’s local revenues are sent to the league and then redistributed equally between the teams, with each of the 30 teams getting 3.3% of the total pot

* Note that baseball’s broadcast rights are retained by each team and these are not subject to revenue sharing

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NFL Per Team Revenue Sharing

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Expenses: Salary Cap �  A salary cap is the maximum amount of money that any given

team can spend on player’s salaries. It is justified as a mechanism to maintain parity amongst teams just as revenue sharing is:

* Salary Floor (NFL and NBA, 90% of cap) * Hard Salary Cap (NFL, $198.2 Million in 2020 and NHL at $81.5 Million) * Soft Salary Cap (NBA, after cap then luxury tax)

* Luxury Tax (MLB, $208 Million in 2020)

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Team Valuations http://www.forbes.com/nfl-valuations/ http://www.forbes.com/mlb-valuations/

http://www.forbes.com/nba-valuations/ http://www.forbes.com/nhl-valuations/ http://www.forbes.com/nascar-valuations/

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Sports Bankruptcies �  NHL: Pittsburgh Penguins (1975, 1998), LA Kings (1995),

Ottowa Senators (2003), Buffalo Sabres (2003), Phoenix Coyotes (2009)

�  MLB: Seattle Pilots (1970), Baltimore Orioles (1993), Chicago Cubs (2009), Texas Rangers (2010), LA Dodgers (2012)

�  NBA: New Orleans Hornets (2010, Takeover not Bankruptcy)

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