10 risks to franchisees when companies go bust

GUEST OBSERVATION

The recent voluntary administration of Pie Face has highlighted the uncertainty faced by franchisees if their franchisor goes into administration.

Here are 10 key risks to franchisees of insolvent systems:

1. The risk of little useful information

Many insolvency practitioners do not understand franchising and the nature of the franchise relationship.

Administrators will apply considerable effort to keep staff and creditors informed during an insolvency – the first to ensure they keep the business operating or provide access to records while the administrators sort out the business’ position, and the second to ensure continuity of key supplies. However, franchisees are generally given the bare minimum of information.

Because staff and suppliers are recognised as creditors, they are usually better-informed than franchisees, who may be circulated a form letter when the business is placed in administration, and then hear no further meaningful information until a sale or winding-up announcement is made. Franchisees of insolvent chains often learn more from the media about the future of their livelihoods than they do from the administrators.

2. Loss of consumer confidence

In previous franchise insolvencies such as that of book retailer Angus & Robertson in 2011 and whitegoods retailer Kleenmaid in 2009, the loss of consumer confidence when the businesses went into administration was so great that it accelerated the final collapse.

Angus & Robertson customers were outraged when administrators announced that gift vouchers (many of which were given as Christmas presents only a couple of months earlier) would no longer be honoured, prompting a consumer backlash. During this highly damaging PR, the remaining company-owned and franchised stores were expected to trade on as usual.

When Kleenmaid went under, its franchised and company-owned stores were besieged by angry customers trying to claim the goods for which they had collectively paid more than $25 million in deposits. In rare cases, some were able to buy their goods all over again in liquidation sales to ensure that their newly-built or renovated kitchens or laundries could be completed without further modifications, but many swore they would never buy Kleenmaid again, and actively campaigned against the brand in revenge.

3. Disruption to supply chains

Some franchise systems have preferred supplier arrangements, and others are the primary supplier to their franchisees themselves.

A manufacturer may supply its retail network of company-owned and franchised stores with the majority of their product lines. If the manufacturing facilities are scaled-back, closed or sold separately from the retail network, then a significant risk of disruption to normal supplies exists. A new buyer of the group could decide to close the factory and outsource manufacturing altogether, in which case it is likely that teething problems with a new set of arrangements could also result in supply issues for franchisees.

While it is possible for a franchisee to continue to operate when a franchisor goes bust in networks that have preferred supplier arrangements, the franchisee might find that creditors will become more risk averse and tighten their credit terms, insist on cash up front, or otherwise cap franchisee purchases to a low limit to reduce future risk.

4. Stock dumping

Franchisees of fashion accessory chain Kleins, which collapsed in 2008, found themselves selling goods at cost or below as the administrator sought to liquidate inventory held by the franchisor that could not be returned to suppliers.

In any group where the franchisor has embedded itself into the supply chain and provides inventory to the franchisees, there is the risk that administrators will seek to liquidate inventory as quickly as possible through the network to generate cash, and this may be done at the expense of franchisee margins or in breach of the brand’s established price positioning.

Either way, this can be damaging to a franchisee’s business.

5. Diminished franchisor support

Administrators will question all costs in a business, particularly labour costs. Franchisor head office staff who survived the franchisor’s descent into administration may still be made redundant by the administrators in an attempt to restore profitability and improve the saleability of the business as a going concern, but in doing so often reduce the very resources for which franchisees pay royalties.

Consequently, franchisees of an insolvent system might find that their field support officer has been let go, or now has two or three times more franchisees to support as his colleagues have left.

A reduction in field support is likely to occur concurrently with a reduction in marketing personnel and other head office functions that directly or indirectly provided support, meaning that franchisees will be left more and more to their own devices, and while some may see this as a good thing, it further exacerbates damage to the brand (and therefore, network value) as inconsistencies develop in the group.

At its worst, this could lead to open revolt by franchisees, as happened with Angus & Robertson in 2011 when nearly half the franchisees sought to leave the group en masse while it was under administration.

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6. Pursuit of outstanding royalties

Administrators have no capacity to offset debts owed by an insolvent franchisor to its franchisees, against the royalties owed by the franchisees.

In other words, franchisees have to claim their debt owed by the franchisor like any other creditor, and end up with whatever cents in the dollar might be paid at some future point, but in the meantime must pay 100% of all outstanding royalties to the administrators on demand without argument.

If franchisors have allowed franchisees to fall behind in their royalty payments, administrators will ditch such arrangements and demand full payment immediately as they scrape together cash to keep the business afloat. Unfortunately, this can result in considerable financial pain to any franchisees who owe royalties, and whose business may also be struggling (the reason why they fell behind in their royalties in the first place).

7. Disclaiming of leases or other agreements

When Kleins was placed into voluntary administration in 2008, it was subsequently revealed that the franchisor held the leases on all the stores in the network, including the franchised outlets. Franchisees would then sub-lease the stores from the franchisor, to whom they would pay rent, and then the franchisor in turn would pay rent to the landlord (many of which were major shopping centres).

However, under this arrangement, the rents paid by the franchisees to Kleins were not being passed to the landlords, and the store rents fell behind.

When the administrators took control of the business, they exercised their unique power to disclaim (i.e. terminate) the leases, to reduce their ongoing liabilities in operating the business. The unfortunate byproduct of this action was that the franchisees in terminated outlets were suddenly left with two choices: close the shop and wear the losses caused by the premature ending of their business, or negotiate new leases directly with the landlords and attempt to continue trading.

Many chose to negotiate new leases with the landlords, but found this to be a double-whammy.

In some cases their rent increased because they were now independent operators, and no longer part of a national chain. In all cases, the franchisee would have had to find the cash to lodge the usual rental guarantee (up to three months rent in advance), plus invest in new signage and fitouts, etc, to trade as independents, while at the same time writing-off as unrecoverable large sums of money owed to them by the franchisor under Kleins’ unique income guarantee.

Administrators can and will disclaim leases and other commercial agreements if they feel it is in the best interests of the insolvent entity, even if it is not in the best interests of the franchisees.

However, the reverse does not apply to franchisees, who usually have no rights to terminate their franchise agreements even if their franchisor is in administration.

8. Loss of business value

It goes without saying that any franchisee who might have been planning to sell their business before their franchisor goes into administration will subsequently find it almost impossible to complete a sale until the system recovers from this emergency.

Such a recovery, if one is possible at all, could take years.

Even if the system does recover, a franchisee’s business in future may be worth less than it would have been prior to the administration. This loss of business value can cause major problems for franchisees who are heavily geared and may ultimately sell at a loss, or who planned to fund their retirement using the proceeds from the sale of their business, which may now be insufficient.

Unless franchisees themselves are creditors (which is rare), this loss of franchisee business value, or the imperative to maintain franchisee business value, is incidental to administrators whose sole focus is to maximise the returns to creditors.

9. Significant ongoing personal liabilities

If a franchisor collapses, franchisees may be left without a business to trade if their supply of unique products ceases to exist.

Because Kleenmaid stores sold only Kleenmaid products, when these were no longer available following the collapse of the franchisor, the stores could not switch suppliers and continue to trade.

If this occurs, franchisees may have no choice but to close their stores, while continuing to pay the significant ongoing costs of shop leases, business loan repayments, and chattel mortgages for shop fit outs, fixtures and fittings. These ongoing liabilities can be a blight that weighs down a franchisee long after the collapse of their franchisor.

10. Radicalisation of corporate culture

If a buyer is found for an insolvent franchisor, the new owner will inevitably want to put their own stamp on the business and make changes to ensure its ongoing survival.

The nature of the buyer, and the changes they will seek to implement, might clash with franchisees and appear at odds with the corporate culture under the former owners. For many franchisees, a change of ownership will require them to adapt to new management and new ways of doing things. These changes can be relatively minor, incremental and easily adaptable, or can be major, radical and disruptive to the organisational culture and brand values.

Conclusion

This is not an exhaustive list, but should give pause for thought to any existing franchisee concerned about the future of their network, any potential franchisee who needs to asses the risks of what might happen in a worst-case scenario, and any insolvency practitioner who might one day find themselves managing a franchise network in administration.

Most importantly, this list should also serve as a reminder to franchisors that an inability to adapt to a changing market and poor management has consequences for those around them, especially their franchisees.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level.

This article first appeared on SmartCompany.