Stop the Bleeding: What Franchisors can do to Help Struggling Franchisees

Two years of tight credit and reduced consumer spending not only have left many franchisees reeling, they've also put a serious crimp in their franchisors' royalty streams. We asked workout professionals and bankruptcy attorneys experienced in franchising what franchisors can do to help turn around their distressed franchisees--without spending precious funds or getting themselves into legal hot water.

On the development side, the difficulty franchisees have had in finding capital since September 2008 has reduced the number of new units that would be coming on line now--and the effects are rippling through franchise systems, says Barry Blum, a partner with the Miami-based law firm Genovese, Joblove, and Battista. "People are not hitting their numbers. Even if you turn the spigot on right now, businesses that require any kind of facilities won't open for another year."

For units that are open, the drop in consumer spending also is causing a negative ripple, this time in reduced retail sales and royalty streams. "Many franchisees are in debt and need to do a lot of workouts," says Kevin Burke, managing director at Los Angeles-based Trinity Capital, an investment banking firm that has worked with many franchise brands in restructuring and M&A deals. "They haven't taken care of their stores, they don't have a lot of cash or liquidity saved up, and they have to play accounts payable shell games." And, if they don't have the money to pay their bills, he says, where will they find the funds to get professional counsel or an investment banker to help them?

That's where the franchisor comes in--in fact, must come in, if they hope to keep their system strong through the ongoing economic storm, one unit and one multi-unit operator at a time. In the case of a struggling franchisee, low morale and aging assets not only undermine their ability to service their debt, they also distract them from improving customer service and growing their top-line revenue. For these franchisees, says Burke, franchisors have a lot to offer. "The franchisor can come in like a white knight, put some money on the table, and realize that investing in the brand is the smartest thing they can do."

Whether that investment takes the form of reduced royalties or a bridge loan, from a business standpoint it makes perfect sense for the franchisor to step in and do whatever it takes to save distressed units and franchisees, especially a larger franchisee with many units, says Darrell Johnson, president and CEO of Arlington, Va.-based market research firm FRANdata. "Franchisors want to fix things. The challenge you get into is where do you get in trouble if it doesn't work?"

Avoiding liability

The concern, says Blum, is when the franchisor starts to meddle in the franchisee's business. "If they're struggling and the franchisor gets in there and it all goes south, they're going to blame the franchisor," he says. "As a lawyer, sure, yes there's risk, but every day you open the door there's risk."

Blum should know: he was in-house counsel at Burger King from 1997 to 2007, and worked with Trinity Capital's Burke to turn many of the brand's struggling franchisees around through the Burger King Franchisee Financial Restructuring Initiative, announced in 2003. During what Blum described it as a "huge period of economic distress in the early 2000s" for Burger King, Trinity Capital has helped restructure more than 3,000 restaurants of the brand's then 11,450 units. (For more details, see www.trinitycapitalllc.com/news9.htm.)

"Kevin and his group did an amazing job of being a resource for the franchisees and Burger King. Some franchisees had no real understanding of what their financial condition was, or how it would be viewed by lenders, Burger King, or the market if they wanted to sell. They helped them to understand what the market really was," says Blum.

"We were big enough, so we had a much more programmatic approach. We were not that concerned about the legal risk," he says. "The benefit is so much greater than the legal risk. If the franchisee is a dead man walking, in default with lenders and the franchisor, and you step in and try to help, what's the damage claim? 'I was dead and now I'm dead.'?"

In fact, he says, "I think the franchisor almost has an obligation to the other franchisees and to its own shareholders to try to salvage franchisees, at least the deserving ones," he says. "The legal or technical risks are far outweighed by the fact that the franchisor really has to take affirmative steps to protect its system, its royalty stream, and its brand proliferation." However, he adds, don't let the lawyers start to run the business. They can manage the legal side, but it's operations that turns around troubled units.

"The more you do as a franchisor, the more your exposure," says Jan Gilbert, a partner with Haynes and Boone in Washington, D.C. Any termination must be lawful under the franchise agreement and applicable law, he says. This typically means giving the franchisee notice and an opportunity to cure. It's relatively easy when the issue is non-payment of royalties or other fees to the franchisor, versus a shoddy operation where the premises are not clean enough or other standards are not being met because a struggling franchisee is cutting corners to survive. But nothing is guaranteed, even if it seems the situation is black-and-white.

"When you terminate a franchisee and there's no dispute that they owe money, it still can be contentious--the franchisee may claim the system isn't what you said, the point-of-sale system doesn't work, they can't get products, etc.," says Gilbert. "Each franchisee will tell you their situation is different, and to some extent they're right."

To help minimize potential liability, he says, franchisors who grant a royalty abatement, for instance, should condition it on a legal release from the franchisee. That way, says Gilbert, they can't come back and say "The training you gave me six months ago is the cause of this." Also, he says, it's very important to notice any signs of impending problems as early as possible. Once the franchisee declares bankruptcy, an automatic stay takes effect, severely limiting a franchisor's options.

A franchisor that exercises too much control could cross a line and get into legal liability areas--so it's prudent not to exercise operational control, says attorney Richard Pedone, a partner with Nixon Peabody in Boston. "The law generally has a standard of actions you can take or not take without assuming liability for someone else's debts."

"If a franchisor has too much control, courts can determine they're in some way vicariously liable because of that control," says Brian Schnell, a partner with Faegre & Benson in Minneapolis. "That's where franchisors say 'You must do this precise thing at exactly this time.' The way we always frame it, franchisors can say, 'Here's the standard you need to meet, and there are various ways you can do it."

Schnell says it's not so much about vicarious liability--unless the franchisor is going in and operating that location or revising how the franchisee is operating. "The question in my mind if a franchisee is struggling, is whether the franchisor should provide any kind of royalty relief. Is it relief, is it forgiveness, or is it a combination? A franchisor might say, 'We'll give you some kind of deferment for three or six months, but do a note where you pay it back at some point.'"

Details matter

Not all franchisees are worth saving (even if their units are), and curing the symptoms of distress does not necessarily address the underlying cause. Throwing a cash infusion at a struggling franchisee or abating their royalties can keep them afloat, but it won't guarantee a cure. You can throw them a life raft, but if they don't learn to swim, what's the point? Any franchisor involvement must be done in a way that's not just a bailout, but that provides all parties with the ability to work through to a global solution.

Also, one size doesn't fit all--or solve the underlying problems. "The mistake a lot of franchisors make," says Schnell, "is that they don't necessarily go through a detailed analysis of what truly is going on in that struggling franchisee's business, to truly understand it, dissect it, and determine why that particular franchisee is struggling. If you have a blanket statement like 'We have a three- or six-month deferment program and we'll put it in place,' that's just a band-aid approach."

Franchisees typically are obligated to provide financial statements annually to the franchisor. Late or missed royalty payments, as well as on-time payments reflecting lower gross sales are early indicators trouble may be brewing, but it's a red flag when a franchisee doesn't want to provide the books when they're due.

"It's not a problem with the franchisor demanding a copy of the books; when, depends on what the franchise agreement says," says Gilbert. However, when a franchisor offers any type of royalty abatement to help a franchisee, they can reasonably request to see the books at that time. "If the franchisor does something they're not obligated to do under the agreement, they can ask to see the books. I would recommend generally that they do that," he says.

"The trick is to address it early, before the financially distressed franchisee is extremely distressed, says Gilbert. "Their tendency is to fight it, to hang in there." That tenacity, admirable in most situations, can produce some disastrous results. In bankruptcy, he says, "Pennies on the dollar is common."

"The important thing is that if it's approached correctly, the franchisee needs to open the kimono," says Blum. "A lot of franchisees don't accept that. The entrepreneurial person takes lot of risks and has come through tough times, but sometimes the math doesn't work any more. Their fighter pilot mentality can turn against them."

While not all franchisees should (or can) be saved, in the case of a franchisee who a franchisor is willing to work with, Blum suggests the following approach: "Look, we know you're in trouble, we want to work with you, and we know the banks aren't lending, so let's talk. You need to open the kimono. You're saying you can't pay your bank debt, but if we find out you're paying this high rent and it's to your brother-in-law..."

And while there are these basic broad principles, says Blum, it comes down to the individual franchisor and franchisee and their dynamic.

Time for the "SWAT" team?

Larger franchisors often have in-house resources, a kind of "SWAT" team that can parachute in to rescue struggling franchisees--or do triage and determine who's worth saving. Smaller brands, however, often lack the resources and in-house expertise to step in, offer help, and determine the cause of the problem. Though it's a call most make reluctantly, that expertise--not only to find the causes, but also to effect a cure--can be outsourced, at least if you're in the restaurant business.

"We run restaurant chains for other owners," says Mark Bromberg, president and CEO of Apex Restaurant Group in Plano, Tex. "We will step in and run a 40-unit Taco Bell or a 60-unit Applebee's. We're a plug-and-play management group," he says, focused on managing and repositioning restaurant concepts in the casual, quick casual, and QSR sectors.

Bromberg says people who call him include private equity firms that have reached the end of their investors' patience; banks that have foreclosed and need to improve operations quickly to sell the units; bankers with underperforming loans who need to find a way of servicing those loans or take a write-down; and from entrepreneurs who have developed a concept, opened a handful, and want to expand.

"We come in and take a look at fairly large groups of franchisees running into financial difficulty. We analyze what they're doing wrong and what to do about it," says Bromberg, who was brought in to chair the troubled Metromedia Restaurant Group (parent of Steak & Ale, Bennigan's, and Ponderosa Steakhouse) from 2003 to 2005.

"When people call us they know it's intellectually the right thing to do, but emotionally it's like putting your kids in a foster home. They worry we'll destroy the culture--the culture that's costing them a million dollars. We come in and stop the bleeding," he says, which may mean replacing the existing management structure. "If your incumbent management hears we're coming, it's not a good thing."

And when Apex is called in to right a sinking ship, the cure involves more than operational and financial repairs. "It's hard to separate pragmatism from the emotionalism," he says. "The hardest part of my job is getting people to decide before it's too late that we're here to solve the problem."

Duty-bound

Despite all the financial, personal, and legal obstacles a franchisor must overcome when dealing with troubled franchisees, essentially they don't have a choice. "If you have 100 units and 10 are in trouble and you let those 10 go," says Blum, the entire system feels it. Instead, the franchisor should do all it can to help those struggling operators.

"I think you owe it to everyone else to do this. It's the role of the franchisor as brand owner, brand steward, and leader of the brand to take it on to try to salvage things. If you don't take an active role, it's probably very hard for the franchisee to work it out; or it will get worked out in a way that's not sustainable."

Triage

Kevin Burke, managing director, Trinity Capital

1. Get the data--financial, operational, which includes leases, loans, G&A, unit-level financials, aggregate financial statements--and make sure it's third-party derived. You must have transparency.
2. Once you have that, analyze and assemble it into a triage: A students, B, C, D, and failing.
3. Focus your resources on those that are most critically impaired first, then on the ones that are the largest, and third on the average performers. In that way you optimize your efforts in line with your financial and personnel resources.
4. Get expert advice. There are too many people who make egregious mistakes in this business who assume it's easy (just make a few calls and it's solved), who don't understand the multiple issues surrounding a multi-unit franchisee who's insolvent.
5. Look at this as an opportunity, not as an expense. The opportunity is that there are a lot of systems that haven't made money, except for coupons, discounts, or kids eat free, all destructive to franchisees. No one's being fooled by this. They have not altered their destiny, just rearranged the chairs. Invest some money and get franchisees focused on profitability, not survival.

Bankruptcy

Richard Pedone, partner, Nixon Peabody

1. Gather the facts and imagine what could happen in the worst case scenario: bankruptcy.
2. Check your documents. For example, if you have a lien, make sure it's signed. You're going into a workout with your franchisee and it's your chance to fix any mistakes.
3. Conduct a business analysis: Is this franchisee really worth saving, or is the correct exit a sale? To get rid of a franchisee, you might let them off from their guarantee or franchise obligations going forward. Many franchisees may be personally liable for 15 years' more royalties, or have signed a guarantee and want to get out. The franchisor can use that as leverage.
4. Be realistic about what the franchisee can or can't do. Your franchisee may no longer be able to afford to comply with your franchise agreement.

Options

Jan Gilbert, partner, Haynes and Boone

1. Buy back the unit (typically not what you want to do) and sell or operate it.
2. Offer financial assistance in a number of forms: royalty abatement or deferral, and let it accrue or not. Offer to abate the royalty if the franchisee agrees to spend the money on advertising, upgrading, etc., to solve the problem.
3. Direct national advertising funds to a franchisee's area.
4. Provide operational assistance through a variety of means.
5. Help the franchisee sell the business. Franchisors often receive inquiries and are attuned to which existing franchisees are looking to buy existing locations. Put the two in touch.
6. Look toward terminating the franchisee for default (not the first choice). It depends on how egregious the defaults are, and whether the franchisor thinks the franchisee can resolve the situation.
7. Bankruptcy. A dicey issue for franchisors. Often the franchisor wants to terminate before the franchisee files to avoid an automatic stay. Franchisors cannot terminate when a franchisee is in bankruptcy. If the pre-bankruptcy termination is legally valid, the bankruptcy court cannot reverse it. Both franchisee and creditors would rather sell their assets as a going entity, not piecemeal.

Workout

Mark Bromberg, president and CEO of Apex Restaurant Group

1. Listen. Don't react in a knee-jerk way the first time a franchisee comes to you and asks for financial help in supporting their business.
2. Invest in the resources to have objective professionals inside your organization to jump in and understand what's going on with your distressed franchisees--an internal group genuinely interested not in defending, but in truly understanding what's going on. In the end, analytics are essential in understanding the performance in your units.
3. Empower someone to take charge. Notwithstanding your lender covenants or performance criteria, someone must take responsibility and work day in and day out with franchisees on what is salvageable or viable.
4. Don't rule out "out of the box" approaches. For example, one often-suggested but rarely followed idea is to treat a distressed franchise group as a division of the franchisor by devoting company store resources to turn it around. Franchisors are loathe to go in and actually run them as company stores. Almost nobody wants to do it because they're afraid of post-transition liability, but it has to be done.
5. When the franchisor steps in, it's like bringing in the parents, not to punish, but to deal with the creditors and authorities, to manage the workout or restructuring process. Creditors often have the misplaced belief the franchisor will not let a franchisee go dark under any circumstances, so they play hardball until the well-heeled franchisor comes in. I think the first time a landlord or other creditor understands the franchisor is not the Ford Foundation, but will take the necessary steps to do what's right for the brand, the faster resolution takes place.