Turnaround Artists: Buying Distressed Properties has its Rewards--And Risks

It seems there really is a silver lining in every cloud. And the recent economic downturn has deposited a little of that silver at the feet of some multi-unit franchisees who can tolerate risk and don't mind a little "remodeling" work.

Today, opportunities abound to buy distressed franchise units from other troubled or bankrupt franchisees--often for pennies on the dollar. If they have the stomach, these "rescuers" can snatch up these units, turn them around, and watch the dollars flow in.

It's a strategy that contains risks, for sure, but done right can offer serious rewards. Multi-unit franchisees like John Metz, David Ostrowe, Don Rottinghaus, and Lyndon Johnson all know firsthand the ins and outs of taking over distressed properties--and they're not always successful.

"We've done this a lot and I love the opportunity," says Don Rottinghaus, a multi-unit franchisee with 329 Subway units in Kansas and Oklahoma. He estimates that during the last two decades he's purchased between 75 and 100 troubled units from other operators and turned them around.

"A lot of people build a unit, run it for a while, lose interest or let it get run down, and then they just want out," he says. "If I see a store that's doing, say, $5,000 a week in sales, and all of the other factors are right, I know I can rework that unit and get it to $12,000 a week in sales."

John Metz prowls the Florida bankruptcy disclosure listings looking for great deals (or steals). Of the 30 Denny's restaurants he operates in the Southeast, 25 were acquired as distressed properties. Nearly all of his takeovers have been bankruptcies. "We specifically look to buy in territories where there are distressed properties," says Metz. "With a little TLC, we can make them healthy again."

David Ostrowe says he became known as the "fix-it guy" when he was working in the corporate offices of Church's Chicken and Taco Bell years ago. "It was my job to help fix distressed units, so I learned a lot about how to do it." Today, as a multi-unit franchisee with 10 Burger Kings, he's on the lookout for distressed properties to buy. He stays in close contact with lenders in his area and has his finger on the pulse of the Burger King community in Oklahoma.

"I've purchased a half-dozen units out of bankruptcy and another half-dozen from troubled existing owners," says Ostrowe. "It's a great strategy for me."

Jeff Rogers, now a consultant, was CEO of the Heartland Food Corp., a company that once purchased 120 Burger King restaurants out of bankruptcy--all at once. Heartland also did a number of smaller deals of 10 to 30 units at a time over the years, growing to 248 units. He, like Metz, Ostrowe, and Rottinghaus, had a specific approach he followed when taking over a bankrupt or troubled franchise unit.

"All of our turnaround successes were dependent upon making the right choices and having the right people in the right places," says Rogers.

Challenges abound

While it may not be as complex as acquiring a Fortune 500 company, taking over distressed franchise units has its own share of obstacles.

Rottinghaus says all distressed properties can be explained in one of two ways. "In my experience, it's either a poor operator or a bad location." In the case of a poor operator, he says that he can take over the unit and turn it around easily. The property may only need some basic aesthetic work such as a good clean-up or remodeling. Otherwise, he says, the trouble can be found in operations, "It's just having processes in place, creating and managing a healthy cash flow, and relying on systems that work."

But a bad location can be difficult, if not impossible, to overcome. That's why Rottinghaus says he will sometimes buy a distressed Subway at a "C" location, shutter it, and quickly move it to an "A" location nearby. That may sound like more trouble than it's worth, but he says the formula works and he's done it time and again.

"I can usually get a decent price on the unit because it's troubled and the owner wants out," he says. "If there's a great site nearby, it's worth the expense for me to move there because I know the current location is not working and I can double revenue and make up the difference pretty quickly by making the move."

Metz says one of the first rules in taking over distressed properties is to avoid bad locations altogether, for example areas where neighborhoods have declined and/or other commercial businesses have packed up and moved out.

Ostrowe agrees, "Some spots are just jinxed. There's a location I know that has been five different concepts in the past five years and they have all failed." He estimates that he walks away from nine out of every 10 distressed deals he looks at.

Rottinghaus concurs, adding that he simply walks away if the price is not right. "I always say we will buy the worst of the worst and turn them around, but the price must be right."

Unlike Metz, Rottinghaus avoids bankruptcy deals and prefers to work directly with the seller before the business reaches bankruptcy.

When Metz does find a place he'd like to take over, he negotiates the deals with creditors and banks and says he's learned to be thick-skinned. "I've flown across the country before to make an offer only to be thrown out of their office," he says. But they usually call him back and the deals go through at or close to his original offer. "You definitely have to be comfortable with rejection."

Ostrowe knows a thing or two about dealing with the high emotions that are often generated when taking over distressed properties.

"When you're trying to take over a business that's in bankruptcy," he says, "people are mad." He says sometimes the seller will go to remarkable lengths to see the new buyer fail. "That validates his failure. I've seen them sour the employees, taint the food, or just spread a bad word about the new owner."

Existing employees--and their attitudes--are a critical part of a new owner's turnaround challenge, says Rogers. "When we began the rescue of a unit we acquired, we were looking to build a workplace culture of trust, recognition of profitability goals, and a strategy that could be understood by all." And there's no room for discrimination or harassment of any kind, he adds.

"Inventory and cash controls were stepped up immediately after we took control," says Rogers. "A system of rules and regulations gets out a clear message of our operating process."

Ostrowe agrees. "We bring in our own cash register system on day one. I want to know exactly where the cash is," he says.

Rottinghaus says that's a good idea and points to one struggling unit he took over. "The operator had been stealing cash right off the top, so as soon as we took over we were already making more money!"

Return on investment

Taking over distressed properties can be a tough business, but the payoff can be well worth the investment of time and money.

When you take over an existing business, says Ostrowe, "You already have plumbing, electricity, heating and AC, equipment, and furniture."

In most takeovers, however, at least some remodeling is imperative. "One of the first things we do is give the place a little facelift," says Metz. "We may have to fix leaky roofs, update equipment, change the décor, do some landscaping, and add some new signs."

Ostrowe agrees, adding that, "For us, it's important to keep the unit open throughout the takeover and remodel process. Fix things as you go. It shows customers that you are changing things right before their eyes." He also says a "dark unit" is ripe for vandalism or theft.

The hard numbers for Ostrowe are attractive. "An average new build BK for me is going to run around $1.1 million," he says. "I can almost always get into an existing unit for much less." Even a unit in dire straits has its own attractions. Last October, Ostrowe took over a closed Burger King unit that had been housing homeless people. He says it had been stripped of anything of value. He was able to take it down to the foundation, and build it back up for about $585,000.

Once Metz takes over a distressed unit, he evaluates employees and separates the wheat from the chaff. It's when he implements what he calls his "special sauce."

"We immediately set up our generous bonus program for managers: 10 percent of sales and company car to drive." He says this drives increased performance.

Rottinghaus also believes the human factor is significant when rebooting a unit. "We always try to bring a fresh, positive attitude to the unit after takeover. Get started on the right foot."

That's critical, agrees Ostrowe. "Most existing employees are waiting to see how you're going to operate. We try to be fair with them and explain how this change is going to be good for everybody." He says the problem employees make themselves known quickly and are dealt with accordingly.

Despite the enormous potential upside in taking over distressed units, it doesn't always have a fairy-tale ending. Says Metz, "There have been a couple of units we've taken over that we just haven't been able to fully turn around. Everything is in place and it should work, but it just hasn't."

But he says he's not giving up on them. "Our cost of entry was so low, that we can afford to keep working on them. With a little TLC I'm sure we can bring them around."

Legal Analysis

Thinking of taking over an underperforming unit? Franchise attorney Lane Fisher, of Fisher & Zucker in Philadelphia, says you'd better consider the following to avoid legal potholes.

• Vacancy. Find out how long the unit has been closed. There's a big difference between a unit that's been closed for a few weeks and one that's been shuttered for several months or years. Each has its own, unique challenges.
• Crime. Were there any crime or law enforcement-related issues at the unit? Ask questions about the neighborhood, obtain police reports, and make every effort to analyze any crime activity at the business and in the area. Think due diligence.
• Health. Likewise, check with public health officials concerning any health- or food-related citations. In addition to overcoming a past reputation for poor food quality and/or health concerns, you may have to deal with liability issues.
• Trademarks. Beware of potential trademark infringement. For example, says Fisher, if you take over a former Pizza Hut with its signature red roof, you'll likely have to scrap the property, or at least have the roof changed--or risk hearing from Pizza Hut's legal counsel.
• Liens. Research any pre-existing liens. For example, with restaurants, there could be liens against some or all of the equipment. Do your homework and work with these creditors before you make the deal.
• Critical vendors. If the unit you're considering has equipment that will need servicing or maintenance, check with those providers before you buy. They may have had some bad experiences with the previous owners and--especially if there is only one authorized repair vendor--resolve any old issues and get on good terms with them.
• ADA compliance. If you're considering an older property, chances are you may be facing some renovations to comply with the Americans with Disabilities Act (ADA). You'll be looking at things like adding wheelchair-accessible ramps and equipping bathrooms for handicapped individuals.
• Alcohol. A liquor license could pose another obstacle. Find out if you can take over the existing license or if there will be any difficulties in obtaining a new one.
• Asset sale or stock sale. Are you buying the assets of the business or the stock of the company? If you buy the stock, you inherit all of the corporation's liabilities. Generally, it is easier to avoid being responsible for the prior business's liabilities if you purchase the assets. Minimizing the risk of "successor liability" should always be a consideration at the forefront of any purchase of a distressed property.
• Transfer of leases. Always review the leases carefully to determine if the seller has the authority to assign the lease without the lessor's consent. You don't want to purchase a business and take an assignment of the lease only to find out that the landlord or equipment lessor considers the assignment to be a default under the lease.
• Enforcement of the agreement against the seller may be difficult. In the agreement of sale, the seller will make promises about the business and will undertake to perform certain obligations. Recognize that the buyer may not be able to fulfill these obligations because of poor financial condition. This is especially true in the case of a corporate seller. Take steps to protect and secure the seller's performance of their obligations. These steps may take the form of an escrow agreement, a personal guaranty of the seller's owner, or a number of other mechanisms. It doesn't matter what the seller promises if you can't enforce the promise.

Door #1 or Door #2?

Distressed franchise units for sale typically come in one of two forms: bankruptcy, or an existing owner scrambling to get out. There are some distinct differences between the two that buyers should know.

Bankruptcy usually results when all else has failed. Everyone is unhappy (previous unit owner who's lost his shirt, the employees who have lost their jobs, vendors and creditors who are owed or have lost money, and finally, the bank or financial institution left holding the bag). As a result, the bank is eager to unload the assets. Swoop in at the right time and you can make the deal, and fast. But, as John Metz points out, "You still may have to bid against other buyers." Buying out of bankruptcy can also be a more tidy procedure from a legal standpoint than buying from a distressed owner.

Existing owners often try to sell as a last resort to avoid bankruptcy. It can be a simple process, but beware of the unit's financial situation: who is owed, and how much. Due diligence is essential. Often under this scenario, the unit remains open and employees are cautiously positive about potential changes for the better. The seller is often just glad to get out and the buyer can look like a real hero.

Checklist for Success

Think you have what it takes to buy a distressed property and turn it around? Multi-unit franchisees John Metz (Denny's), David Ostrowe (Burger King), Don Rottinghaus (Subway), and Lyndon Johnson (Church's Chicken) gave us some insight into how they evaluate deals. Review this checklist before you get started.

1. Mystery shop the unit. There's no better way to get a sense of what's right, and what's wrong, with the place.
2. Look at the market. "Does the brand have relevance and a customer base in that market?" asks Johnson. Do the demographics still match up with the product?
3. Is it in your "zone of expertise"? Stay in your field of knowledge. "I know I can't cut hair," says Ostrowe, "so I don't look at hair salons."
4. How old is the unit? "This is a long-term decision and you may be in for some serious renovations," says Johnson. Unfortunately, sometimes you won't know the hidden costs until after the purchase.
5. Proceed with caution. "I once had a guy try to sell me a unit with a burned-out kitchen," says Rottinghaus.
6. Review the unit's customer surveys. You can pick up critical data here.
7. How involved was the previous owner/operator? "Did he live in the area or manage from afar?" asks Ostrowe.
8. Review financials and sales information whenever and wherever you can. "When considering taking over a poor performer, the first thing I want to know is what are their sales?" says Ostrowe.
9. Don't over-leverage or bite off more than you can chew. It's going to take money, people, and time to turn a distressed store around. "We only do one turnaround unit at a time," says Metz.
10. Don't be afraid to walk away from the deal. Stick to your price. "Determine what you will pay and don't budge," says Johnson.
11. Keep all deals in perspective. "Don't drink your own Kool-Aid," says Ostrowe. "None of us is invincible." Retain a healthy dose of humility.