IFA Legal Symposium: Financial Concerns Lead Agenda

Financial concerns dominated the discussions at the 42nd annual IFA Legal Symposium, held on May 18-19 in Washington, DC.

While some franchise leaders suggested that the worst of the recession is over, nobody was ready to suggest that an economic rebound is imminent. Franchisors are still searching for the signs of an easing of the credit crunch affecting existing and prospective franchisees.

“We just got our first SBA [Small Business Administration] loan in seven months,” said Ken Walker, CFE, president and CEO, Driven Brands, Inc., which owns the Maaco, Meineke, and other car-care brands.

Joining Walker in the opening panel discussion, Kathryn Kotel, vice president and U.S. general counsel, McDonald's Corp., observed that “the most detrimental impact of the recession has been on financing. We have seen our system lenders become more restrictive, and each transaction is taking more time. Banks are doing more due diligence.”

Steven Aronson, general counsel, Roark Capital, which franchises 16 brands, agreed that lack of financing has affected his company's ability to open new units or to buy more brands. “But the biggest impact has been that franchisees' lines of credit have dried up. This extends beyond not having funding for a franchise to open a second store ' these are cash-flow needs,” he said.

As franchises have struggled, the impact of the recession has filtered down to franchise attorneys. First, there's less work for law firms, especially as work has been shifted from outside counsel to in-house counsel by many franchisors. “Our in-house team has saved us reams of money,” said Walker.

Second, attorneys' tasks have changed. For example, they are being asked to find ways to work with struggling franchisees, rather than filing default and termination notices. “[Roark Capital is] slower on the default trigger,” said Aronson. “But we look at each brand and each situation individually. Why is the franchise struggling? Yet, we also keep in mind that we have an obligation to all of our franchisees, and it's fundamentally unfair if one guy is not paying the fee and 349 franchises are.”

Mediation and alternative dispute resolution have taken on a new urgency. “We want to sit down as business people and resolve problems, find a middle ground,” Aronson said. “We want to prevent really bad feelings from developing ' before they blow up into litigation.”

Driven Brands also is more inclined to work with a franchisee that is behind on payments, said Walker, but only if it sees long-term potential in the franchise operator. “We send in our operations team to try to help them, to right the ship,” he said. “I don't want to lose anybody from our system who has the ability to succeed in the long term.”

Financing Panelists Suggest New Strategies

Even after the economic storm passes, franchisors cannot expect the previous era of relatively loose lending standards to return. Sources of capital such as AMRESCO, FMAC, EMAC, Atherton, Commercial Lending Corp., Textron, Fleet, and Questech have vanished. GE Capital, Irwin Financial, and other large national lenders that were lending mainstays have eliminated or severely curtailed their franchise lending. Three panelists considered how franchisors can help franchisees to obtain financing from lenders that are much more risk-averse than they have been in the past: Ronald Feldman, CEO, Siegel Financial Group, which helps franchises secure funding; Bill Vaughn, vice president of franchise operations for Pearle Vision; and Paul Battista, partner, Genovese Joblove & Battista P.A., who was session moderator.

Franchises will have to turn to local lenders, Feldman said. “But the local banker might not know franchising, or it might not know your brand if you are new to the area,” he said. “That's why you need to think like a banker in your FDD. It can be a tool to help your franchisee get a loan.”

Getting financing from a local lender starts by being on the SBA's Franchise Registry. “If you're not on it, you won't get an SBA loan ' it's that simple,” Feldman said.

The other crucial piece of information to provide to a banker is the franchise system's loan default rate. The SBA tracks information about defaults, but the data can be misleading. For example, a loan that defaults in the first six months because a franchise was sold on wildly unrealistic terms is counted equally with a 10-year loan that defaulted on a fraction of the balance in the ninth year.

For many franchises, putting financial performance data into Item 19 on an FDD remains an open question. Feldman stands squarely in the camp of including the information. “You will be viewed favorably by the lender,” he said, especially if the franchise system is beyond the startup phase and has at least three years of data and 50 operating units.

Yet, because Item 19 also provides only a snapshot of a franchise system, Feldman strongly recommended developing a lender's addenda that is provided to any franchisee that is seeking financing. “That's where you can put all the information that you can't put into an FDD,” he said.

As an example of how one decision can affect another part of the business, Feldman noted that aggressively terminating franchisees will show up negatively in loan-default data, which can then make it difficult for other franchisees to get financing. “Avoid having stores go dark,” he said. “Manage your trouble locations, talk with the landlord, and consider sharing the pain with your franchisee. Even consider giving the store to another franchisee, just to have an operator keeping it going.”

Vaughn presented five elements that will make a franchise system attractive to lenders, and thus help franchisees gain access to capital:

• Proven business concept with compelling value proposition and good consumer research.
• Simple, well-defined operating system for franchisees.
• Effective training system that helps franchisees succeed.
• High-quality, committed franchisees.
• Franchisors that have “skin in the game,” such as a sliding scale for royalties or reduced initial franchise fees.

“The business concept and operating system are fundamental ' you have to have that in place. You build from there,” said Vaughn.

However, there are times when a franchise unit simply can't keep going as it is presently structured; indeed, franchise loan defaults increased 52% in 2008, according to The Wall Street Journal. Battista suggested that a Chapter 11 bankruptcy can be an effective path for the franchisee to get out of a difficult situation and for the franchisor to salvage value from a unit that it wants to keep operational. The Chapter 11 filing will generate an automatic stay that prohibits collection activity by creditors, while allowing cash from operations to fund expenses going forward. “Usually when a franchise is in trouble, it stops paying its franchisor before it stops paying its lease and its loans,” said Battista. “So those creditors have been soaking up the cash that is available; there hasn't been enough cash to pay you. With the bankruptcy, that cash flow is freed up to pay franchise royalties and to pay for products purchased from the franchisor.”

Then, with a bankruptcy filing holding creditors at bay, cash flow can be used to service new debt that's needed to strengthen the franchise unit. Battista said that lenders or even the franchisor might consider making a debtor-in-possession loan to the business. A franchisor also might explore indirect methods of financing the franchise unit, such as encouraging the franchisee's bankruptcy creditor to change the terms of the loan, or asking a landlord to reduce rent obligations. If the franchisor takes over the unit, it might stretch the time period to cure an obligation on an assumed contract.

Solutions are only limited by attorneys' creativity, said Battista. He cited one of his clients who had a bankrupt franchisee that had previously filed a lawsuit against the franchisor. So, the franchisor bought the franchise from the trustee for $10,000 and dropped the lawsuit against itself.

Kevin Adler is associate editor of this newsletter.

Financial concerns dominated the discussions at the 42nd annual IFA Legal Symposium, held on May 18-19 in Washington, DC.

While some franchise leaders suggested that the worst of the recession is over, nobody was ready to suggest that an economic rebound is imminent. Franchisors are still searching for the signs of an easing of the credit crunch affecting existing and prospective franchisees.

“We just got our first SBA [Small Business Administration] loan in seven months,” said Ken Walker, CFE, president and CEO, Driven Brands, Inc., which owns the Maaco, Meineke, and other car-care brands.

Joining Walker in the opening panel discussion, Kathryn Kotel, vice president and U.S. general counsel, McDonald's Corp., observed that “the most detrimental impact of the recession has been on financing. We have seen our system lenders become more restrictive, and each transaction is taking more time. Banks are doing more due diligence.”

Steven Aronson, general counsel, Roark Capital, which franchises 16 brands, agreed that lack of financing has affected his company's ability to open new units or to buy more brands. “But the biggest impact has been that franchisees' lines of credit have dried up. This extends beyond not having funding for a franchise to open a second store ' these are cash-flow needs,” he said.

As franchises have struggled, the impact of the recession has filtered down to franchise attorneys. First, there's less work for law firms, especially as work has been shifted from outside counsel to in-house counsel by many franchisors. “Our in-house team has saved us reams of money,” said Walker.

Second, attorneys' tasks have changed. For example, they are being asked to find ways to work with struggling franchisees, rather than filing default and termination notices. “[Roark Capital is] slower on the default trigger,” said Aronson. “But we look at each brand and each situation individually. Why is the franchise struggling? Yet, we also keep in mind that we have an obligation to all of our franchisees, and it's fundamentally unfair if one guy is not paying the fee and 349 franchises are.”

Mediation and alternative dispute resolution have taken on a new urgency. “We want to sit down as business people and resolve problems, find a middle ground,” Aronson said. “We want to prevent really bad feelings from developing ' before they blow up into litigation.”

Driven Brands also is more inclined to work with a franchisee that is behind on payments, said Walker, but only if it sees long-term potential in the franchise operator. “We send in our operations team to try to help them, to right the ship,” he said. “I don't want to lose anybody from our system who has the ability to succeed in the long term.”

Financing Panelists Suggest New Strategies

Even after the economic storm passes, franchisors cannot expect the previous era of relatively loose lending standards to return. Sources of capital such as AMRESCO, FMAC, EMAC, Atherton, Commercial Lending Corp., Textron, Fleet, and Questech have vanished. GE Capital, Irwin Financial, and other large national lenders that were lending mainstays have eliminated or severely curtailed their franchise lending. Three panelists considered how franchisors can help franchisees to obtain financing from lenders that are much more risk-averse than they have been in the past: Ronald Feldman, CEO, Siegel Financial Group, which helps franchises secure funding; Bill Vaughn, vice president of franchise operations for Pearle Vision; and Paul Battista, partner, Genovese Joblove & Battista P.A., who was session moderator.

Franchises will have to turn to local lenders, Feldman said. “But the local banker might not know franchising, or it might not know your brand if you are new to the area,” he said. “That's why you need to think like a banker in your FDD. It can be a tool to help your franchisee get a loan.”

Getting financing from a local lender starts by being on the SBA's Franchise Registry. “If you're not on it, you won't get an SBA loan ' it's that simple,” Feldman said.

The other crucial piece of information to provide to a banker is the franchise system's loan default rate. The SBA tracks information about defaults, but the data can be misleading. For example, a loan that defaults in the first six months because a franchise was sold on wildly unrealistic terms is counted equally with a 10-year loan that defaulted on a fraction of the balance in the ninth year.

For many franchises, putting financial performance data into Item 19 on an FDD remains an open question. Feldman stands squarely in the camp of including the information. “You will be viewed favorably by the lender,” he said, especially if the franchise system is beyond the startup phase and has at least three years of data and 50 operating units.

Yet, because Item 19 also provides only a snapshot of a franchise system, Feldman strongly recommended developing a lender's addenda that is provided to any franchisee that is seeking financing. “That's where you can put all the information that you can't put into an FDD,” he said.

As an example of how one decision can affect another part of the business, Feldman noted that aggressively terminating franchisees will show up negatively in loan-default data, which can then make it difficult for other franchisees to get financing. “Avoid having stores go dark,” he said. “Manage your trouble locations, talk with the landlord, and consider sharing the pain with your franchisee. Even consider giving the store to another franchisee, just to have an operator keeping it going.”

Vaughn presented five elements that will make a franchise system attractive to lenders, and thus help franchisees gain access to capital:

• Proven business concept with compelling value proposition and good consumer research.
• Simple, well-defined operating system for franchisees.
• Effective training system that helps franchisees succeed.
• High-quality, committed franchisees.
• Franchisors that have “skin in the game,” such as a sliding scale for royalties or reduced initial franchise fees.

“The business concept and operating system are fundamental ' you have to have that in place. You build from there,” said Vaughn.

However, there are times when a franchise unit simply can't keep going as it is presently structured; indeed, franchise loan defaults increased 52% in 2008, according to The Wall Street Journal. Battista suggested that a Chapter 11 bankruptcy can be an effective path for the franchisee to get out of a difficult situation and for the franchisor to salvage value from a unit that it wants to keep operational. The Chapter 11 filing will generate an automatic stay that prohibits collection activity by creditors, while allowing cash from operations to fund expenses going forward. “Usually when a franchise is in trouble, it stops paying its franchisor before it stops paying its lease and its loans,” said Battista. “So those creditors have been soaking up the cash that is available; there hasn't been enough cash to pay you. With the bankruptcy, that cash flow is freed up to pay franchise royalties and to pay for products purchased from the franchisor.”

Then, with a bankruptcy filing holding creditors at bay, cash flow can be used to service new debt that's needed to strengthen the franchise unit. Battista said that lenders or even the franchisor might consider making a debtor-in-possession loan to the business. A franchisor also might explore indirect methods of financing the franchise unit, such as encouraging the franchisee's bankruptcy creditor to change the terms of the loan, or asking a landlord to reduce rent obligations. If the franchisor takes over the unit, it might stretch the time period to cure an obligation on an assumed contract.

Solutions are only limited by attorneys' creativity, said Battista. He cited one of his clients who had a bankrupt franchisee that had previously filed a lawsuit against the franchisor. So, the franchisor bought the franchise from the trustee for $10,000 and dropped the lawsuit against itself.

Kevin Adler is associate editor of this newsletter.