Franchises in Workouts

imagesMany small business owners teamed up with franchises when opening their first business in order to be able to work with an already established brand and to have the training and marketing support necessary to succeed.  However in a down economy, the franchise royalties become like any other financial obligation and cause stress on the cash flow. Despite what other organizations may tell you about the role of franchises in workouts, they do play a very critical role.  Any workout plan that does not address the franchise relationship is likely to fail or be interrupted.  That being said, workouts and settlements can still occur for franchise businesses.  What the business owner and the creditors involved need to understand is that the franchise has a vested interest in controlling the outcome of any territory.  They would preferably like a location to remain open and generating revenue (and therefore royalties) but if a location is to be closed and liquidated by a secured creditor, franchises like to be part of the process so that they can minimize the damage by selling the territory to another franchisee and beginning the process of opening a new location within the territory.

It is really quite simple.  Franchises want as many locations open as possible within their territory that can reflect their brand and their products in a positive way.  By doing so they increase their output and their revenue.  By understanding this and understanding what recourse they have against a franchisee in default, you can create a strategy that includes the franchisor by meeting their needs, along with satisfying both the business owner and creditor as well.

To understand what recourse a franchise may have against a defaulted franchisee, you must examine the franchise agreements and look for the following areas:

1. DISCONTINUANCE OF USE OF MARKS: This section details under what circumstances the franchise can demand that the franchise stop using the trademarks, trade names, and other restricted intellectual property.  By doing this, they essentially render the business useless because the name of the location is a trademark, so being open for business under that trademark would violate the demand to cease and could create additional financial liability

2. TRANSFER FEES AND FRANCHISE FEES: These types of fees are usually large lump sum fees that are required if a franchisee wants to sell one of their franchise locations or if they want to restructure their entity to take in new investment dollars.  These fees are meant to hinder any material change from occurring in ownership of a franchised location without the consent of the franchise.  Ignoring or avoiding these fees could result in a complete termination of the franchise agreement.

3. RIGHT OF FIRST REFUSAL: This section, if present, gives the franchisor the right of first refusal anytime the business owner is interested in selling a location.  That means that the franchise will have a predetermined amount of time to match the purchase price of any potential buyer, and if they do, they are guaranteed the right to purchase the business location.  Rights of first refusal can often times cause other transactions to fail simply due to the amount of time granted in the right of first refusal.

4. TERMS & REMEDIES OF DEFAULT: A franchisee can be in violation of their franchise agreement a number of different ways.  From being in default with certain creditors, to not having the correct signage up, to not meeting other imaging requirements, to being behind on royalty and advertising fees.  This section of a franchise agreement details what rights the franchise has when an operator is in default.  Many franchises include the right to close down the operation and step in themselves to run the operation with their management.  Other secure their obligations with a UCC and have rights to liquidate the company forcefully.  This section of a franchise agreement must be read and understood completely in order to create a workout strategy that does not trigger any events of default.

Once a franchise agreement is read and understood, a workout plan should include the franchise as a stakeholder in the transaction.  By communicating up front the goals you want to achieve and how they align with the goals of the franchisor, you can gain the cooperation and support of the franchise when conducting a workout.  Some will even modify franchise agreements to meet the requirement of the workout.  Attempt to exclude the franchise from the workout process and you take a huge risk that the franchise decides to shut you down.

Before entering into a negotiation with your franchise or your creditor, you should have a professional review your franchise agreement with you.  Reading the entire agreement, and especially focusing on the areas discussed above, will detail exactly how involved your franchise will need to be in your workout process.

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