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Franchisor Handbook

When franchisees struggle, fast action may ward off the worst


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All businesses have their challenges, and franchisees are no exception. Unfortunately, franchisors often do not recognize a franchisee has a problem until the royalty check is late.  

While it is the franchisee’s responsibility to operate its business, if you are a franchisor and want to avoid long-term problems with franchised units, you should make it known to franchisees that you are there to help them, and they should call you at the first sign of a significant downturn or operating issue.  

 As a franchisor, you also should be on the lookout for early warning signs of a struggling franchisee. Long before the royalty checks stop, you may start receiving complaints from customers about a franchisee’s unit needing cleaning or repairs, or a service issue. On occasion, an offhand comment in a conversation between a franchisee and one of your employees may foreshadow a more serious problem down the line. A subpar inspection, or even a comment from a supplier whose payments have become delinquent, may be telltale signs that the franchisee is struggling.  

Once these early warning signs appear, you can help your franchisee, and perhaps avoid larger issues down the road, by being proactive in identifying the root of the problem, and offering assistance in addressing it.

Identifying the problem

When a problem manifests itself by way of a missed royalty payment, many franchisors ask their attorney to send a default letter to the franchisee. While it is important to document that you are not ignoring a default, the default letter usually should not be your first response.  More often, the best first contact should be a telephone call from someone in your office who works regularly with the franchisee. Once you understand the issue, you can direct the franchisee to appropriate resources for assistance.  

Identifying the underlying issue will often mean drilling down in conversations with your franchisee. Many business owners shrug off cash flow shortfalls as temporary problems, but having insufficient cash flow is usually a result — and not the underlying cause — of a problem. Perhaps the underlying problem is a simple bookkeeping error, or an illness or short-term road closure that temporarily affected sales. However, it also may be something more serious, like employee theft, or deficiencies in maintaining operating or service standards.  

A careful review of financial statements provided to you by the franchisee will frequently identify operational issues not appreciated by the franchisee. Most franchisees do not have an accounting background, and may not recognize when their expenses or operating metrics are out of line. 

Identifying these issues for a franchisee at an early stage will not only help your franchisee address the underlying problem before cash flow diminishes to a point of no return, but it will also remind your franchisee why your services, and their relationship with you, is important to them.

If you have personnel near the franchised business, a visit to the premises can be invaluable. There is no substitute for experience and hands-on assistance. By walking through the location and observing the operation, you can often identify problems that need to be corrected.

Addressing financial shortfalls

Deficiencies in a business often require an infusion of cash to correct. New equipment may be needed, the premises may need upgrading, and it may be necessary to add personnel.  For some franchisees, these solutions may not seem within reach, unless you can also offer sources of financing.  

In many cases, you will have more contacts and experience than the franchisee when it comes to financing. If there is a significant supplier to the system, you may be in a position to negotiate short-term extended payment terms with the supplier that allow the franchisee to free up cash flow. If that additional cash flow is used to correct operational deficiencies and ensure the long-term success of the business, the supplier benefits from the continued relationship with its customer. When that is not an option, you still may have more experience in approaching lenders than the franchisee, and may be able to help the franchisee identify potential lenders.  

On occasion, the only solution, short of a termination, may be for the franchisee to sell the business. While your franchisee may not be excited about selling a struggling business, often at a loss, if you can help the franchisee understand the direction of the business, and the potential for a total loss, he or she may be more receptive to the prospects of selling the business. Many experienced franchisors will have formal resale programs to assist franchisees in finding a purchaser.  

Getting back on track

Whether or not financing is needed, the franchisee will usually need to make changes to the operation of the business. You can often be of greatest assistance in recommending such changes. Often times, additional training of the franchise and its personnel will be needed, particularly when new employees are brought into the business. While you likely do not have any contractual obligation to provide additional training, this may be the most important and least costly assistance you can provide.  

Assuming the underlying problems can be identified and addressed, your franchisee may still have to deal with payments owed to suppliers. Once again, if they are regular suppliers to the system, you may have leverage to persuade them to negotiate a payment plan.  

Unfortunately, you may be the franchisee’s largest creditor. In those situations, it is often best to “park” your past-due payments and get your franchisee to start paying current fees. As for past due amounts, forgiving them only encourages other franchisees to withhold payments. Instead, consider putting those amounts on a promissory note, with regular monthly (and perhaps even weekly) payments.  

A payment plan gets the franchisee in the habit of understanding he or she must make regular payments, and if a collection action is ultimately necessary, it is easier to collect on a promissory note than on a 50-page franchise agreement. 

You might even offer negative incentives to the franchisee to stay current on the promissory note and future royalties. For example, you could set a high rate of interest on the promissory note (franchise agreements often allow as much as 1.5 percent per month), but agree that all payments will be applied to principal, and all interest (or all excess interest) will be waived if the franchisee stays current on all its obligations to you.  

One more piece of advice: When you offer assistance, concessions or financing not otherwise required by your franchise agreement, have the franchisee sign a general release of all claims it might have against you. Attorneys representing franchisees may argue the release was signed under duress or is otherwise unenforceable, but if new consideration accompanies the release, such as additional assistance or payment deferrals, it will generally hold up. A release can protect you against future claims if at some point the franchisee’s business does fail. 

Charles Modell chairs the franchise group at Larkin Hoffman Daly & Lindgren in Minneapolis. Reach him at cmodell@larkinhoffman.com.

 
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