IFA Legal Symposium: Financing Remains Immense Problem for Franchisors

At peak a few years ago, more than 300 new brands came to market per year, said Darrell Johnson, CFE, who is CEO of consulting firm FRANdata Corp. He credited the surge in new brands to a strong economy and the entrepreneurial bent of franchisors, as well as aggressive lenders. But he also said that franchise attorneys can take a share of the credit or blame, depending on one's perspective. “Attorneys have been eager to help franchises register ' and made registration [of a new franchise] easier. It can be argued that it's easier today to become a franchisor than a franchisee,” he said.

Unfortunately, many of those franchise brands introduced a few years ago were underdeveloped or unproven business models, said Johnson and Zeidman. “We saw four times as many new brands started, many of these with no company-owned units,” said Zeidman.

Speaking from the perspective of a franchisor that has been competing with startups and established competitors alike, John McDonald, president and COO of Service Brands International, pointed out how the entire industry was affected when capital flowed too readily. “What we are concerned about is that when undercapitalized franchisors start and fail, it affects us all. Service Brands is now playing to our strengths and our stability in comparison,” he said. “We can consider buying those brands [that are in distress].”

Yet, struggling brands might leave a legacy that will last for a while, in the forms of unpaid lenders and dissatisfied franchisees. “When the rain falls, it falls on the just and the unjust alike,” Zeidman said. He added that if new franchisees fail in very large numbers, “you could not dismiss the possibility of hearing rumblings” about adding more requirements on franchisors before they can sell franchises, such as having to own a minimum number of units.

Capital Access and Performance Reporting

Today, capital for franchise expansion and even for operation of existing units is hard to obtain. Franchisors must adapt to this fundamentally changed environment, said Johnson. “Up until 2008, franchisors had preferred lenders that they might have worked with for 15 years ' and they benefited from having lenders who understood franchising. Now they have withdrawn ' and it's not due to the performance of franchising. It's due to [federal] lending standards,” he said. “This is now a franchisor problem, not just a franchisee problem.”

Franchisors must learn to work differently with lenders. For example, because the national lenders that once supported franchising have now mostly exited the business, a franchise operator that is moving into a new geographic region will have to find a new partner, said Johnson. Regional franchisors might need to work with depository banks, which have entered into the business that had been dominated by other types of lenders. However, Johnson pointed out that depository banks “want more than your loan. They want your cash management, and more.”

McDonald concurred that franchisors have to become more involved in the financing process, particularly in assessing early in the discussions with a prospective franchisee if the prospect will be able to qualify for funding. “You have to 'own' the franchisee's part of the process,” he said.

Franchise attorneys will get into the action because they help franchisors draft Franchise Disclosure Documents (“FDDs”) and the Financial Performance Reports (“FPR”) that can be part of the FDD. According to Johnson, 35% of franchise brands offer FPRs today, as compared with 18% in 2006. “Also, franchisors are providing more detail on them ' bankers are demanding it,” he said. “Performance matters ' and this is not a bad thing. Capital markets are bringing a level of discipline to franchising, and that is healthy.”

With new types of banks entering the field, Johnson said that franchisors and attorneys will need to learn to speak bankers' language. “We know what Item 20 [on an FDD] is all about, but to a community bank it's new ' and it doesn't look good in a sense of business continuity,” he said.

Zeidman pointed out another trend that is pushing franchisors to provide more financial information: experienced franchisees. Today, it is estimated that 53% of franchisees are multi-unit operators, he said. “The franchisees are becoming more sophisticated, and they are able to hold their own, especially when working with less-experienced franchisors,” he said, particularly the largest franchisees, which account for a disproportionate number of units.

Providing more performance information will become a competitive necessity, but it carries risks. Zeidman warned that sophisticated franchisees will hold franchisors to account for earnings claims. “Companies will have to live with the statements in their FPRs,” he said. “You can't just shrug and say, 'Our lawyers told us we could do and say that.'”

Financial Struggles of Franchisees

While the long-term outlook for franchising is positive, panelists at another IFA session, “Franchisee Receiverships and Bankruptcies: How to Balance the Rights of Franchisors with the Rights of Secured Lenders,” discussed the near-term problems that some franchisees and franchise systems are incurring.

Franchisors should be alert to “early warning signs” of a franchisee's distress, said Steve Rafferty, vice president, franchising & business development for Burger King Corporation. Beyond the obvious signs such as missed royalty or advertising fund payments, Rafferty said that missed payments to suppliers, deferred facility upgrades, late rent payments, and excessive cutbacks in basic operations are signals of a franchisee's distress. “On a rare occasion, you might even get a call from an employee who has not been paid,” Rafferty said.

Franchisors should have a designated team to work with franchisees in distress, said Kathie S. Lee, vice president and associate general counsel of Starwood Hotels & Resorts Worldwide, Inc., and that team should work promptly with franchisees that are showing signs of trouble. Before declaring a franchisee in breach of a contract, a franchisor should assess why the franchise is in trouble. “Is it an isolated incident, does it reflect seasonality of the business, or is it part of a bigger pattern?” she asked.

“You need financial transparency from your franchisee in order to be able to decide,” Rafferty added. “Before entering into a payment arrangement, promissory note, or settlement agreement, a franchisor should always require and review updated financials of the franchisee entity as well as individual guarantors.” With multi-unit operators, franchisors should look at the franchises on a unit-by-unit basis because some are probably more financially viable than others, he said.

Panelist Valerie P. Morrison, partner, Wiley Rein LLP (McLean, VA), emphasized that when a problem has just emerged, franchisors need to act decisively to protect their interests before a franchise goes into receivership or bankruptcy proceedings. “Use the negotiation with the franchisee as an opportunity to clean up the franchise contract,” she said. “You can enhance your rights by having the franchisee admit to its debt ' and get reaffirmation of its obligations under the franchise contract if it has not been terminated.”

A franchisee that is in financial difficulty is probably missing payments to secured lenders, as well as to its franchisor and suppliers. Secured lenders can turn to receiverships when debtor businesses have violated loan agreements. “The reason for this preference can be boiled down to one word: control,” wrote the panelists in their IFA paper that accompanied their presentation. “In a receivership action instituted upon default, the secured lender typically (i) files the complaint initiating the receivership action; (ii) files the pleadings seeking the appointment of a receiver; (iii) selects the receiver, subject to approval of the court; and (iv) drafts the order setting out the terms and conditions under which the receiver is to operate the franchised business and, where applicable, sell the secured lender's collateral. Moreover, unlike a bankruptcy setting where, by statute, all creditors have the right to vote on a plan and object to proposed actions of the debtor in possession, and all parties in interest have standing to appear and be heard on any matter, a receivership action proceeds down a course chosen by the secured party.”

Yet, the priorities of a secured lender do not necessarily match those of a franchisor. In particular, franchisors must be alert to protecting their brand when a franchisee is in receivership. Occasionally, a franchisor might wish to challenge a receivership if, for example, “a proposed receivership order may empower a receiver to operate a franchised business without regard to the terms of the franchise agreement,” the panelists wrote.

In fact, most elements of a contract entered into prior to federal receiverships are not enforceable in receivership, with one major exception: the franchise's brand and trademark. “In cases where the receiver intends to operate the franchised business, the ability of a franchisor to grant or withhold intellectual property licenses provides a franchisor with substantial leverage in negotiating terms with the receiver that other contracting parties generally do not possess,” the panelists wrote. “In these negotiations, the entire panoply of franchise contract provisions are at play, including for example, duration, payment provisions, operational requirements, continuous operation provisions, sale restrictions, rights of first refusal and the like.”

Further strengthening franchisors' leverage is a provision for automatic, noncurable default and termination, effective on the appointment of a receiver. The panelists suggested that attorneys review their franchise contracts to ensure that such language is included.

When workouts and receiverships do not succeed, a bankruptcy filing might follow. Franchisees might choose to pursue a bankruptcy filing at any stage of the process, said Morrison, because they typically have more control than they do in a receivership.

Kevin Adler is associate editor of this newsletter.

Conversation at the 41st annual International Franchise Association (“IFA”) Legal Symposium in Washington, DC, focused on the challenges that franchisors and franchisees are facing in obtaining financing for continuing operations and expansion, as well as other impacts of the two-year U.S. recession. As the U.S. economy recovers, franchise entrepreneurs and attorneys said that lending has yet to return to corporate America.

The tough funding environment has significant implications for franchise businesses, said a panel of legal and business experts in the keynote panel at the conference. Perhaps surprisingly, the panelists said that the impact of the recession will not be universally negative, because a stronger, smarter franchising industry is poised to emerge from the wreckage. With lenders looking much more carefully at franchise brands and individual franchisees, the weaker operators that were able to obtain funding in the past will not be likely to gain market entry in the future.

“In the last few years, [new] franchise registration has looked like the dot-com boom and bust,” said Philip Zeidman, partner, DLA Piper US LLP. “The numbers doubled early in the decade, and then they dropped back below the levels of 2004.”

At peak a few years ago, more than 300 new brands came to market per year, said Darrell Johnson, CFE, who is CEO of consulting firm FRANdata Corp. He credited the surge in new brands to a strong economy and the entrepreneurial bent of franchisors, as well as aggressive lenders. But he also said that franchise attorneys can take a share of the credit or blame, depending on one's perspective. “Attorneys have been eager to help franchises register ' and made registration [of a new franchise] easier. It can be argued that it's easier today to become a franchisor than a franchisee,” he said.

Unfortunately, many of those franchise brands introduced a few years ago were underdeveloped or unproven business models, said Johnson and Zeidman. “We saw four times as many new brands started, many of these with no company-owned units,” said Zeidman.

Speaking from the perspective of a franchisor that has been competing with startups and established competitors alike, John McDonald, president and COO of Service Brands International, pointed out how the entire industry was affected when capital flowed too readily. “What we are concerned about is that when undercapitalized franchisors start and fail, it affects us all. Service Brands is now playing to our strengths and our stability in comparison,” he said. “We can consider buying those brands [that are in distress].”

Yet, struggling brands might leave a legacy that will last for a while, in the forms of unpaid lenders and dissatisfied franchisees. “When the rain falls, it falls on the just and the unjust alike,” Zeidman said. He added that if new franchisees fail in very large numbers, “you could not dismiss the possibility of hearing rumblings” about adding more requirements on franchisors before they can sell franchises, such as having to own a minimum number of units.

Capital Access and Performance Reporting

Today, capital for franchise expansion and even for operation of existing units is hard to obtain. Franchisors must adapt to this fundamentally changed environment, said Johnson. “Up until 2008, franchisors had preferred lenders that they might have worked with for 15 years ' and they benefited from having lenders who understood franchising. Now they have withdrawn ' and it's not due to the performance of franchising. It's due to [federal] lending standards,” he said. “This is now a franchisor problem, not just a franchisee problem.”

Franchisors must learn to work differently with lenders. For example, because the national lenders that once supported franchising have now mostly exited the business, a franchise operator that is moving into a new geographic region will have to find a new partner, said Johnson. Regional franchisors might need to work with depository banks, which have entered into the business that had been dominated by other types of lenders. However, Johnson pointed out that depository banks “want more than your loan. They want your cash management, and more.”

McDonald concurred that franchisors have to become more involved in the financing process, particularly in assessing early in the discussions with a prospective franchisee if the prospect will be able to qualify for funding. “You have to 'own' the franchisee's part of the process,” he said.

Franchise attorneys will get into the action because they help franchisors draft Franchise Disclosure Documents (“FDDs”) and the Financial Performance Reports (“FPR”) that can be part of the FDD. According to Johnson, 35% of franchise brands offer FPRs today, as compared with 18% in 2006. “Also, franchisors are providing more detail on them ' bankers are demanding it,” he said. “Performance matters ' and this is not a bad thing. Capital markets are bringing a level of discipline to franchising, and that is healthy.”

With new types of banks entering the field, Johnson said that franchisors and attorneys will need to learn to speak bankers' language. “We know what Item 20 [on an FDD] is all about, but to a community bank it's new ' and it doesn't look good in a sense of business continuity,” he said.

Zeidman pointed out another trend that is pushing franchisors to provide more financial information: experienced franchisees. Today, it is estimated that 53% of franchisees are multi-unit operators, he said. “The franchisees are becoming more sophisticated, and they are able to hold their own, especially when working with less-experienced franchisors,” he said, particularly the largest franchisees, which account for a disproportionate number of units.

Providing more performance information will become a competitive necessity, but it carries risks. Zeidman warned that sophisticated franchisees will hold franchisors to account for earnings claims. “Companies will have to live with the statements in their FPRs,” he said. “You can't just shrug and say, 'Our lawyers told us we could do and say that.'”

Financial Struggles of Franchisees

While the long-term outlook for franchising is positive, panelists at another IFA session, “Franchisee Receiverships and Bankruptcies: How to Balance the Rights of Franchisors with the Rights of Secured Lenders,” discussed the near-term problems that some franchisees and franchise systems are incurring.

Franchisors should be alert to “early warning signs” of a franchisee's distress, said Steve Rafferty, vice president, franchising & business development for Burger King Corporation. Beyond the obvious signs such as missed royalty or advertising fund payments, Rafferty said that missed payments to suppliers, deferred facility upgrades, late rent payments, and excessive cutbacks in basic operations are signals of a franchisee's distress. “On a rare occasion, you might even get a call from an employee who has not been paid,” Rafferty said.

Franchisors should have a designated team to work with franchisees in distress, said Kathie S. Lee, vice president and associate general counsel of Starwood Hotels & Resorts Worldwide, Inc., and that team should work promptly with franchisees that are showing signs of trouble. Before declaring a franchisee in breach of a contract, a franchisor should assess why the franchise is in trouble. “Is it an isolated incident, does it reflect seasonality of the business, or is it part of a bigger pattern?” she asked.

“You need financial transparency from your franchisee in order to be able to decide,” Rafferty added. “Before entering into a payment arrangement, promissory note, or settlement agreement, a franchisor should always require and review updated financials of the franchisee entity as well as individual guarantors.” With multi-unit operators, franchisors should look at the franchises on a unit-by-unit basis because some are probably more financially viable than others, he said.

Panelist Valerie P. Morrison, partner, Wiley Rein LLP (McLean, VA), emphasized that when a problem has just emerged, franchisors need to act decisively to protect their interests before a franchise goes into receivership or bankruptcy proceedings. “Use the negotiation with the franchisee as an opportunity to clean up the franchise contract,” she said. “You can enhance your rights by having the franchisee admit to its debt ' and get reaffirmation of its obligations under the franchise contract if it has not been terminated.”

A franchisee that is in financial difficulty is probably missing payments to secured lenders, as well as to its franchisor and suppliers. Secured lenders can turn to receiverships when debtor businesses have violated loan agreements. “The reason for this preference can be boiled down to one word: control,” wrote the panelists in their IFA paper that accompanied their presentation. “In a receivership action instituted upon default, the secured lender typically (i) files the complaint initiating the receivership action; (ii) files the pleadings seeking the appointment of a receiver; (iii) selects the receiver, subject to approval of the court; and (iv) drafts the order setting out the terms and conditions under which the receiver is to operate the franchised business and, where applicable, sell the secured lender's collateral. Moreover, unlike a bankruptcy setting where, by statute, all creditors have the right to vote on a plan and object to proposed actions of the debtor in possession, and all parties in interest have standing to appear and be heard on any matter, a receivership action proceeds down a course chosen by the secured party.”

Yet, the priorities of a secured lender do not necessarily match those of a franchisor. In particular, franchisors must be alert to protecting their brand when a franchisee is in receivership. Occasionally, a franchisor might wish to challenge a receivership if, for example, “a proposed receivership order may empower a receiver to operate a franchised business without regard to the terms of the franchise agreement,” the panelists wrote.

In fact, most elements of a contract entered into prior to federal receiverships are not enforceable in receivership, with one major exception: the franchise's brand and trademark. “In cases where the receiver intends to operate the franchised business, the ability of a franchisor to grant or withhold intellectual property licenses provides a franchisor with substantial leverage in negotiating terms with the receiver that other contracting parties generally do not possess,” the panelists wrote. “In these negotiations, the entire panoply of franchise contract provisions are at play, including for example, duration, payment provisions, operational requirements, continuous operation provisions, sale restrictions, rights of first refusal and the like.”

Further strengthening franchisors' leverage is a provision for automatic, noncurable default and termination, effective on the appointment of a receiver. The panelists suggested that attorneys review their franchise contracts to ensure that such language is included.

When workouts and receiverships do not succeed, a bankruptcy filing might follow. Franchisees might choose to pursue a bankruptcy filing at any stage of the process, said Morrison, because they typically have more control than they do in a receivership.

Kevin Adler is associate editor of this newsletter.