The Financially Distressed Franchisee

Franchisors rely on the financial health of their franchisees for both royalty cash flow (the lifeblood of the franchisor’s income statement) and for the continued growth of the system through the continued sale of franchise opportunities. Continuing to recruit new franchisees is impossible, however, if a high percentage of current franchisees are failing financially and operationally.

If more than 10 to 15 percent of franchisees are in financial distress at any given point in the evolution of the franchise system, some analysis may be needed to determine the viability of the franchisor's business model. A high percentage of financially distressed franchisees is also likely to lead to litigation in connection with the franchisor’s attempt to collect past-due royalty payments and/or enforce its ability to collect past-due payments and related rights if the franchisee files for bankruptcy.

If a high franchisee failure rate pattern is beginning to emerge, there are two levels of analysis that must be conducted to diagnose and resolve the problem: franchise system level analysis and franchisee level analysis.

A. System Analysis

• Is a fundamental flaw in our economic model leading to distressed franchisees?
• Is there a pattern among the financially distressed franchisees? By size or type of unit? By region? By number of years in the system?
• Should additional special franchisee training or support programs be developed to address this disturbing trend?
• Are financial reports from our franchisees being gathered and analyzed on a timely basis?
• Were adequate minimum capitalization requirements set in the franchise disclosure document?
• Should changes or stricter enforcement of our collection policies in dealing with our franchisees be considered?
• Are the system's single-unit franchisees being allowed to add additional units too quickly?

B. Situational Analysis

In dealing with an individual distressed franchisee, the following questions need to be asked:

• Does the franchisor want to work with this franchisee (or specific location) to attempt to keep it in the system--or not? If not, what additional steps need to be taken? Are the franchisor’s claims to past-due payments secured or unsecured?
• How well has the franchisor documented its obligations under the franchise agreement, as well as the franchisee’s financial and nonfinancial defaults?
• Is the franchisee facing any short-term or long-term personal problems that may have led to the poor financial performance (e.g., health problems, alcohol or drug abuse, death in the family, gambling, divorce, etc.). If so, will these problems have a permanent impact on the performance of the business? In the case of a divorce or death of a spouse, what involvement did the spouse play in the management of the business? Are other key employees or family members capable and/or available to run the business on a short- or long-term basis? If not, would the franchisee consider the sale of their franchise business before all potential value is lost?
• Where does the franchisee stand with respect to its other vendors, equipment, lessors, lenders, etc.? Has it fallen behind on its obligations or only with respect to its obligations to the franchisor? Has a Uniform Commercial Code (UCC) search been conducted?
• Has an analysis been performed to determine the extent to which the problem rests with the franchisee as an individual (e.g., incapability, laziness, lack of motivation, burn-out, inability to focus, etc.) versus a flaw in the system overall or some external cause, such as weak or changing demographics at the location, increased competition, etc.?
• If action to terminate is initiated, is the franchisee likely to file counterclaims? If yes, has an analysis been performed on the strength of the counterclaims?

Andrew J. Sherman is a Partner in the Washington, D.C. office of Jones Day, with over 2,500 attorneys worldwide. Mr. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies. Mr. Sherman is an Adjunct Professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University where he has taught courses on business growth, capital formation and entrepreneurship for over twenty-three (23) years. Mr. Sherman is the author of twenty-one (21) books on the legal and strategic aspects of business growth and capital formation. His eighteenth (18th) book, Road Rules Be the Truck. Not the Squirrel. (bethetruck.com) is an inspirational book which was published in the Fall of 2008. Mr.Sherman can be reached at 202-879-3686 or e-mail ajsherman@jonesday.com.