The Financially Troubled Franchisee

American Bar Association
30th Annual Forum on Franchising
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THE FINANCIALLY DISTRESSED FRANCHISEE

ADVANCED STRATEGIES FOR FRANCHISORS AND FRANCHISEES

Van Elmore
Law Offices of Van Elmore
Denver Colorado

and

Daniel M. Eliades
Forman Holt Eliades & Ravin LLC
Paramus New Jersey

October 10 – 12, 2007
JW Marriott Desert Ridge
Phoenix, AZ

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©2007 American Bar Association

I. INTRODUCTION

It occurs from time to time that a franchisee or several franchisees within a franchise system encounter financial difficulties. This paper explores ways to recognize such problems, methods to analyze those problems and alternative approaches to solve them if possible. If bankruptcy occurs, this paper also provides analysis and commentary on that situation.

One of the best methods to avoid franchisee financial problems is to attempt to require that the franchisee is sufficiently capitalized before the franchise agreement is signed. Careful analysis of the franchisee’s financial capability during review of the prospective franchisee’s application should be given priority. Additionally, Item 7 of the Uniform Franchise Offering Circular (“UFOC”) should be reviewed each year to ensure that a sufficient amount of additional funds are available to handle operational costs prior to the point in time when the unit reaches a break even cash flow.

II. WORK OUT STRATEGIES AND ISSUES

A. Seeing It Coming

There are often more options relative to evaluating the situation and to providing quicker prevention or remedial action if the problem can be identified earlier rather than later. Some indicators or red flags should alert both the franchisor and the franchisee that the future circumstance may worsen. Some of these indicators are:

  1. The franchisee is becoming isolated from the system.
  2. The unit is not being properly maintained, updated or even cleaned.
  3. There are problems and complaints from vendors, other franchisees and from customers.
  4. There are lease defaults.
  5. The franchisee is unable to refinance balloon debt or construction to permanent financing in the event the premises are franchisee owned.
  6. Royalty and other fees due to the franchisor or to advertising co-ops are late or unpaid.
  7. The franchisee is unable to pay operating expenses including those payments due to key suppliers.
  8. The franchisee is frequently restructuring financing/refinancing or there are frequent capital infusions to cover operating losses.
  9. The franchisee has significantly larger accounts payable than other franchisees in the system.
  10. The franchisee has been placed on C.O.D. by suppliers.
  11. The presence of frequent litigation involving the franchisee such as collection actions.
  12. There are wage and hour issues or other problems regarding payment of employees.
  13. There are tax liens or deficits particularly regarding fiduciary tax obligations such as sales tax and withholdings from wages.
  14. A high turnover in management sometimes indicates financial difficulties.
  15. Frequent turnover of accounting firms or the absence of outside accounting assistance.

B. Franchisee Financial Problems May Be More Solvable Than Others

The franchisor should implement a careful watch of franchisee financial reports particularly in the first two years of operation. Often operational failures can be caught early and can be rectified with additional training. In order to maintain a personal stake in the game, the franchise agreement should require that the individual owners of the franchisee personally guarantee the franchisee’s obligations.

In comparison with other defaults by franchisees, financial problems may be easier to solve than other types of problems. For example, unit closures, failure to maintain confidentiality of proprietary information, franchise agreement in-term competition, refusals to meet standards and operational requirements and other problems indicating a difficult or rebellious franchisee may not be able to be solved and may require termination of the franchise agreement. In contrast, a franchisee with money problems may be receptive to assistance from the franchisor and may be willing to cooperate with a work out solution.

C. The Franchisor Must Evaluate The Circumstance

If the indicators and preliminary analysis show that a franchisee has a financial problem, the franchisor must carefully evaluate the situation to best determine an appropriate course of action. The history of the particular unit should be reviewed. Of the problems that have been identified, are they relatively new or have they been repetitive and chronic? Are there personal problems that the franchisee is dealing with that might be causing the difficulties? Does the franchisee have a physical health problem? What is the prognosis? Is the physical problem one that may be short lived or one that will deteriorate? Is the franchisee dealing with family problems? If so, are they of a nature that may improve after a short period or will the family problems probably continue to interfere with the operation of the unit? Mental health issues may also cause the franchisee to be either temporarily or permanently unable to operate the unit.

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