Turning Around Struggling Franchisees

When franchisors should step in - without legal liability

Two years of tight credit and reduced consumer spending have left many franchisees reeling and put a serious crimp in franchisors' royalty streams. Workout professionals and bankruptcy attorneys experienced in franchising discuss what franchisors can do to help turn around distressed units - without spending scarce funds or getting themselves into legal hot water.

"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 asks, where will they find the funds to get professional counsel or an investment banker to help them?

That's where franchisors come in - in fact, must come in - if they hope to keep their systems strong through the ongoing economic storm, one unit and one operator at a time, and continue to grow their brand.

For struggling franchisees, low morale and aging assets not only undermine their ability to service their debt, they also distract operators from improving customer service and growing their top-line revenue - which reduces franchisors' royalty streams. For these franchisees, says Burke, "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 good 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 Barry Blum, a partner with the Miami-based law firm Genovese, Joblove, and Battista, 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," he says. However, he adds, "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." 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 Burger King's Franchisee Financial Restructuring Initiative.

And while it's operations experts, not lawyers, who can turn a distressed unit from red ink to black, a franchisor that exercises too much control could cross a line and get into legal liability issues - so it's prudent not to exercise direct 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."

"The more you do as a franchisor, the more your exposure," agrees 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.

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 causes. 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?

"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.

When a franchisor offers any type of royalty abatement to help a franchisee, they can reasonably request to examine the books at that time, says Gilbert. "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.

For distressed franchisees deemed worth saving, 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...."

"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."

Time for the "SWAT" team?

Larger franchisors often have an in-house "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 or in-house expertise to step in, determine the cause of the problem, and offer help. And though it's a call most franchisors 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.

"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 (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. This may mean replacing the existing management structure. "If your incumbent management hears we're coming, it's not a good thing."

Says Bromberg, "It's hard to separate pragmatism from the emotionalism. 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, legal, and personal obstacles a franchisor must overcome when dealing with troubled franchisees and distressed units, essentially they don't have a choice, says Blum. "If you have 100 units and 10 are in trouble and you let those 10 go," he says, the entire system feels the pain. Instead, the franchisor should do all it can to help its 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."