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A Cautionary Tale: How an attorney-turned-franchisee has emerged from the doughnut hole


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Editor’s note: Before you sign that personal guarantee to secure a loan for your franchise, Krispy Kreme franchisee and attorney Richard Reinis has a story to tell you. He partnered with his son-in-law at the height of the doughnut bubble—purchasing 31 Krispy Kreme franchises—only to see it pop. He risked his home and, he says, his family’s inheritance. He and his partners have since emerged from Chapter 11 with 11 more stores and a wealth of knowledge.

 

In 1996, as a successful attorney in Los Angeles, I realized the only business inventory I had built up over the years was my billable hours. I wanted to build a solid income stream for my children and grandchildren.

Then my son-in-law called about joining him in a Krispy Kreme franchise business in Southern California. Back then, Krispy Kreme was a red-hot brand, and we thought we had found the ideal business vehicle.

Our first store opened in La Habra, California in January 1999, and was an instant hit, logging $141,000 in first-week sales, compared to $300,000 to $500,000 per year at the average California doughnut shop. In its first year, the store did an incredible $9 million in sales.

Jay Leno and tremendous growth
When a second store opened eight months later in Van Nuys, California, Jay Leno joked on “The Tonight Show” about no cops being on the streets because they were all at our opening.  While a subsequent 15 percent sales drop-off at La Habra seemed ominous, it was still one of the most successful California doughnut restaurants.  

The business continued to mushroom, following the aggressive growth plan required by the franchise contract. By the end of the second year, Great Circle Family Foods, as our business was called, owned and operated 10 California restaurants, pumping out 70 million doughnuts annually and doing $34 million in sales.

We were obligated to open 42 stores in six years, leaving no room to moderate the growth. At our peak in 2004, we ran 31 stores generating $64 million in sales, more than any other franchisee in the chain.

Signing the Personal Guarantee—no big deal
As the business grew, we consolidated financing, and two large lenders required our managing partners to sign a personal guarantee (PG). Under the terms, the lender could pursue personal assets (homes, bank accounts, etc.) if the loan defaulted. We were “jointly and severally liable,” meaning any one of us could be on the hook for up to 100 percent of the loan in that scenario.

While I worried about signing a PG for a company I didn’t own outright, demand was sky high and I wanted to believe repayment wasn’t an issue.  When I balked at signing, the lenders said no loans could be made without a PG, that every partner would sign one, and that it wouldn’t be called unless there was a misrepresentation or some other serious breach of trust.  

As we opened new stores, we realized the growth plan was unsustainable due to cannibalization and other factors. So Krispy Kreme granted us a year reprieve from the plan if we agreed to get into the wholesale business.

Adventures in wholesale
We struck marketing partnerships with iconic California brands like Walt Disney, UCLA, the L.A. Dodgers and the Los Angeles Times. But the wholesale grocery business was a disaster.

People came to the stores due to the buzz created by the franchises, but instead of the doughnuts being ambassadors of goodwill, they became ambassadors of ill will because of their short shelf life. You can’t have fresh doughnuts delivered to grocery stores and have all of them consumed before they go stal

The perfect storm and the aftermath
With the wholesale business failing, revenue per new store declining, and growth plans eating up cash, the business was not healthy.  Then in 2004, Krispy Kreme told shareholders it would restate all financial reports from 2000 onward.  

In October 2005, Great Circle stopped servicing its debt as its cash flow dried up. Transparency, a new CFO, a workout specialist and some hard work with lenders followed, but it was not enough. I was sued by two lenders to collect on my PG. These cases settled as Great Circle sold 20 of 31 stores and exited the wholesale business.

After two years of negotiations, we agreed to sell the entire business to Krispy Kreme. While we argued bankruptcy was unnecessary, the company insisted on purchasing the assets out of Chapter 11. So we filed in August 2007—only to have Krispy Kreme back out of the deal three months later. By 2009, a newly capitalized Great Circle emerged from Chapter 11 with 11 stores doing $18 million in sales.

But it all came at a steep personal and professional cost. I left myself open to this nightmare because I wasn’t protected, and I underestimated the risks inherent in a PG. Instead of my plan to add value to my kids’ lives, I diluted that value and risked everything my wife and I had worked so hard to buil

Here are some key lessons learned:

•    Tell your family the truth about the PG upfront—not after you’re already in trouble. When you sign a PG, it’s completely unfair to obligate shared assets such as your home and retirement accounts without telling your spouse. You’d be amazed how few businessmen tell their wives, “Honey, I’ve just hocked our house.”

•    If possible, don’t guarantee an obligation for a franchise business you don’t own outright. If it’s a “joint and several” situation, and your stake is just 25 percent, you might think you’re OK, but you’re not. If you’re more liquid than your partners, the bank will go after you if the PG is called. So unless you own 100 percent of the business, think carefully about this. Get your partners and your company to agree to pay their share.

•    Don’t believe the myth that all PGs are created equal: Some will give you a carve-out (which protects the lender in case of a “bad act” by the barrower), while others won’t. Some will offer a burn-off or a cap (a maximum amount to be repaid, saving the barrower interest and attorney’s fees, for example), while others won’t. There are many ways to modify a PG, although it’s harder to do in today’s credit market. I tell people they can walk into the bank and say, “I love my wife more than my banker, so carve out the house.” It can be done.

•    Get insurance for your PG. Don’t wait on this one. You won’t be able to defend yourself once your company defaults.  And if you try, it will be very costly.  By the time the PG is called, the game is over—your equity may be wiped out, your business is in default, and you haven’t protected yourself. Had personal guarantee insurance been around when I signed, it would have given me bargaining leverage and peace of mind I didn’t have.

Richard G. Reinis is a partner in the Century City, California office of Steptoe & Johnson. He acts as lead counsel in mergers and acquisitions of middle-market companies and significant commercial litigation and is still a Krispy Kreme franchisee.

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