Franchises Face Economic Turmoil

Rupert Barkoff, Kilpatrick Stockton (Atlanta), agreed that franchise growth has not been halted. “I wouldn't say they are stopping [new franchises]. I would say that they are proceeding cautiously,” Barkoff said.

While stating that “it is too soon to tell” what the overall impact will be on the industry, Barkoff acknowledged that some franchisors he has spoken with “are quite worried over who will be buying franchises ' In light of the particular market problems in the last few weeks, I suspect that many prospective franchisees will be a little gun-shy for awhile, assuming they are still employed. It is not a good time to be switching careers.”

The Flow of Loans

The Emergency Economic Stabilization Act, the “bailout package” designed to ease the credit crunch, might keep loans flowing to franchisors, franchisees, and prospective franchisees. Less obvious, but also potentially important, is that the Act speeded up depreciation schedules for a number of business investments, including restaurants. (Race tracks, digital metering devices, and business property on Indian reservations also received accelerated depreciation.)

Now, the cost of upgrades to restaurant buildings in 2008 and 2009 and new restaurant construction in 2009 can be depreciated in 15 years instead of the previous 39.5 years.

“A faster, more accurate depreciation schedule has a direct impact on a restaurant's bottom line,” said National Restaurant Association (“NRA”) President and CEO Dawn Sweeney. The NRA estimates a savings of $7,000 per year for a restaurant that makes a $700,000 investment.

In some situations, franchisors are working with current franchisees to help them arrange credit for operations or expansion. “The successful ones are helping with financing, but it may be through third-party lenders,” said Modell.

“The challenge franchisors face is providing selective (on an as-needed basis) financial concessions or relief without having the whole franchise system looking for a bailout,” said Erik Wulff, partner, DLA Piper US LLP (Washington, DC). “They will typically want to stay away from system-wide relief, but will look at ways of redoubling their efforts to assist franchisees with programs (marketing, purchasing, etc.) that will help their sales and/or margins.”

Regardless, franchisor's support for a struggling franchisee has limits. For example, Modell said he doubted that a franchise would allow a franchisee to delay a royalty payment in the hope that its situation would turn around quickly. “Delaying payments is a recipe for long-term problems,” Modell said. “It is a slippery slope.”

Rise in Bankruptcies

Meanwhile, bankruptcies are rising. The bankruptcy of Bennigan's in late July was a high-profile event that caught the industry by surprise. But smaller bankruptcies have been coming frequently since that time, including the following in the last few weeks: two large Waffle House franchisees, the nation's largest Chevrolet dealer; a Denny's franchisee in North Carolina; and Barbeque's Galore Orange County (California). Meanwhile, on Oct. 2, Mrs. Fields Original Cookies, Inc. announced that its bankruptcy reorganization plan has been approved.

“Franchisee bankruptcies are typically viewed as a threat by franchisors, and the legal framework of working through bankruptcies tends to induce franchisors to try to terminate the franchise agreement before the franchisee files for bankruptcy,” pointed out Wulff. “The franchisee bankruptcy scenario typically [creates] pressures for an early breakup of the relationship.”

More Litigation Possible

What will happen next is anyone's guess. But Modell predicted that if franchisees begin to fail, “that will likely engender more litigation because franchisees frequently feel that if they fail, it can't be their fault.”

Barkoff added that a struggling franchisee might present a franchisor with “a golden opportunity to buy what will become company-operated units; in other cases, the franchisor may try to find a buyer for all or a portion of the stores. This can be a good opportunity to shut down unprofitable operations.”

Kevin Adler is Associate Editor of this newsletter.

Although the fallout from the financial crisis is yet to be complete, the franchise industry seems to be weathering the storm fairly well to date. However, franchise attorneys say that caution is the order of the day and that an extended economic downturn could raise tensions between franchisors and franchisees.

Credit Woes

Inability to obtain credit would presumably affect franchisors' ability to open new outlets, but franchisors have not noticeably scaled back expansion plans ' yet. “Most franchisees opening now had their financing already in place before the current problems hit,” said Charles Modell, Larkin Hoffman (Minneapolis). “That could be the next shoe to drop.” A franchise that was in rapid-growth mode might find it tough to continue at its former pace, he added.

Rupert Barkoff, Kilpatrick Stockton (Atlanta), agreed that franchise growth has not been halted. “I wouldn't say they are stopping [new franchises]. I would say that they are proceeding cautiously,” Barkoff said.

While stating that “it is too soon to tell” what the overall impact will be on the industry, Barkoff acknowledged that some franchisors he has spoken with “are quite worried over who will be buying franchises ' In light of the particular market problems in the last few weeks, I suspect that many prospective franchisees will be a little gun-shy for awhile, assuming they are still employed. It is not a good time to be switching careers.”

The Flow of Loans

The Emergency Economic Stabilization Act, the “bailout package” designed to ease the credit crunch, might keep loans flowing to franchisors, franchisees, and prospective franchisees. Less obvious, but also potentially important, is that the Act speeded up depreciation schedules for a number of business investments, including restaurants. (Race tracks, digital metering devices, and business property on Indian reservations also received accelerated depreciation.)

Now, the cost of upgrades to restaurant buildings in 2008 and 2009 and new restaurant construction in 2009 can be depreciated in 15 years instead of the previous 39.5 years.

“A faster, more accurate depreciation schedule has a direct impact on a restaurant's bottom line,” said National Restaurant Association (“NRA”) President and CEO Dawn Sweeney. The NRA estimates a savings of $7,000 per year for a restaurant that makes a $700,000 investment.

In some situations, franchisors are working with current franchisees to help them arrange credit for operations or expansion. “The successful ones are helping with financing, but it may be through third-party lenders,” said Modell.

“The challenge franchisors face is providing selective (on an as-needed basis) financial concessions or relief without having the whole franchise system looking for a bailout,” said Erik Wulff, partner, DLA Piper US LLP (Washington, DC). “They will typically want to stay away from system-wide relief, but will look at ways of redoubling their efforts to assist franchisees with programs (marketing, purchasing, etc.) that will help their sales and/or margins.”

Regardless, franchisor's support for a struggling franchisee has limits. For example, Modell said he doubted that a franchise would allow a franchisee to delay a royalty payment in the hope that its situation would turn around quickly. “Delaying payments is a recipe for long-term problems,” Modell said. “It is a slippery slope.”

Rise in Bankruptcies

Meanwhile, bankruptcies are rising. The bankruptcy of Bennigan's in late July was a high-profile event that caught the industry by surprise. But smaller bankruptcies have been coming frequently since that time, including the following in the last few weeks: two large Waffle House franchisees, the nation's largest Chevrolet dealer; a Denny's franchisee in North Carolina; and Barbeque's Galore Orange County (California). Meanwhile, on Oct. 2, Mrs. Fields Original Cookies, Inc. announced that its bankruptcy reorganization plan has been approved.

“Franchisee bankruptcies are typically viewed as a threat by franchisors, and the legal framework of working through bankruptcies tends to induce franchisors to try to terminate the franchise agreement before the franchisee files for bankruptcy,” pointed out Wulff. “The franchisee bankruptcy scenario typically [creates] pressures for an early breakup of the relationship.”

More Litigation Possible

What will happen next is anyone's guess. But Modell predicted that if franchisees begin to fail, “that will likely engender more litigation because franchisees frequently feel that if they fail, it can't be their fault.”

Barkoff added that a struggling franchisee might present a franchisor with “a golden opportunity to buy what will become company-operated units; in other cases, the franchisor may try to find a buyer for all or a portion of the stores. This can be a good opportunity to shut down unprofitable operations.”

Kevin Adler is Associate Editor of this newsletter.