• Avoiding And Managing Financial Crisis: Budgeting and Planning to Save Your Franchise Business
  • May 2, 2003
  • Law Firm: Buchanan Ingersoll, Professional Corporation - Pittsburgh Office
  • Do you sometimes feel like the captain of the Titanic, with your business taking on water and no aid in sight? It is a familiar nightmare, shared by all executives at one time or another. Only it seems more personal to the franchise executive who is often the founder or the major influence in the franchise concept, with whom the employees, franchisees, and the public associate the business. The high visibility of franchisors renders the management of the financial crisis more difficult, and calls for more creativity than for other businesses.

    Why is your business hurting, and are you sure you know why? Do others know your secret, and if the secret leaks out, will the walls come tumbling down? Why do competitors in the same industry seem to be doing so well, or at least seem in a better position? How can they handle the pressure when you seem to be ready to crack? How can you cope when doom is knocking on the door?

    The test of the executive is to overcome the challenges, confront the risks, and deal with the issues with clinical detachment and surgical precision. Now is the time to get optimistic, but realistic.

    Are these signs of growth or trouble?
    Growth and financial distress are often partners. Like children, businesses demonstrate growing pains. Your business is growing when you can measure its impact: If your business has "build," when it has momentum, when it is on the lips of everyone in your industry, when you are a "player," a "force," a "happening," then you have reason to believe that your finances will improve. You are not the only manager of a business that has trouble making payroll, using tax payments to fund more important operations, floating vendor payments and having difficulty keeping inventory at the most efficient level. In the current economic environment, such financial pressures can be caused by the unusual phenomenon that wage pressures are increasing faster than inflation, causing profit margins to be squeezed.

    You should be more concerned, however, if you cannot support the sales force when you need to allocate funds for developing new franchisees and markets. Trading quality for growth and reputation for market share are fundamental decisions with long-term consequences that, unfortunately, may have been decided during a temporary period of tight cash flow. Try not to let short-term events influence the long-term growth of your business.

    Your business plan and financial discipline guide long-term growth. When times get tough, the tough test their business plan and measure its effectiveness. Did revenues meet expectations? Did your business increase its revenues by executing an improved marketing strategy, or did it simply benefit from a rising tide in a strong economy? The distinction is critical because you want to know if you are increasing your market share and converting potential customers into actual purchasers of your goods and services.

    Executing the business plan and then being able to measure its execution are the keys to evaluating your business and avoiding financial crisis. Through budgeting, planning and meaningfully (as well as honestly) measuring the results, you can methodically evaluate the direction of your business. It is up to you to adjust your business strategy once you interpret the data and draw your own conclusions.

    Managing the crisis
    You have to put together a crisis business plan, based on a ruthless evaluation of your assumptions, where they failed, and what you must do over a specific time to turn the business around. Then you can talk about money. Moving forward requires more money, and you must collect and analyze the data now before you can determine your minimum cash requirements to implement your crisis business plan. Your crisis business plan has a "burn rate," i.e. the amount of money your business will burn to implement the plan. Your crisis business plan also shows increasing profits when the plan is implemented. You now have the tools you need to hunt for the working capital.

    Internal sources of capital in a crisis
    If your business solution suggests opening more franchised outlets to increase profits and market share, your company's financial strength may be better allocated toward subsidized financing to start-up and expanding franchisees. Equipment leasing arrangements with limited guarantees by the franchisor may allow existing franchisees to expand to new markets, to try unconventional sites, and to allow some potential franchisees to enter your system.

    Subsidizing franchisee growth may be the long-term answer to your problem, but your business may not survive long enough for the new outlets to become profit centers. Subsidizing franchisees trades immediate cash flow for long-term growth. If your business needs money to keep the lights on, subsidizing franchisees through preferred financing arrangements, or even through royalty deferments, should be avoided. A better solution to royalty deferment is to have a lender in place to fund repayment of past due royalties of the franchisee so that the lender, and not the franchisor, is acting as the franchisor's bank.

    In order to conserve capital, you may wish to revisit your litigation strategy. Would your company benefit from aggressively pursuing slow paying franchisees, or would it merely stir up a hornet's nest of litigation? Should your franchise agreements contain arbitration clauses to help you manage counterclaims, or do you need the litigation option more than risk management?

    Can you generate the cash internally necessary to implement your crisis business plan? Cutting costs through layoffs is the tried and true method for survival. It does little to build your business and is costly to morale. Right-sizing your business is best if it is implemented before cash flow reaches a crisis. The same could be said of other expense reductions because they increase margins, but at the cost of losing momentum and morale. If the problems are obvious to the employees, vendors and franchisees, then preserving human capital may be as important as finding new capital, and it may be necessary to attempt new approaches to generate cash flow.

    External sources of capital in a crisis
    Different lenders look at different attributes of a franchise system in order to assess credit risk. Find the lender that treats your business as having more collateral than merely your office equipment, receivables and company stores. Your goodwill is valuable, as are your franchise agreements and royalty stream. Your trademarks may have the opportunity to be exploited in a different manner, if only you had the plan and the funding for your new plan. If your lender doesn't understand the potential of your business, find another lender.

    Great variability and discretion exists among banks, and even banking officers, and smaller banks often will be very competitive and aggressive in catering to new business. Find a bank that offers higher risk loans, if you are in that category, but negotiate as if it is only a temporary loan you need as a bridge to the long-term relationship.

    Have you gone to your vendors for help? They have grown with you, and their fortune is tied to yours. Your vendors may agree to extend repayment terms which could give you the additional months of forbearance you require to execute your plan. Vendors are also sensitive to seasonal attributes of your business, and may be willing to extend payment terms in your weak season as long as you agree to remain current in the strong season. Your vendors should remain loyal to you as long as you remain loyal to them.

    Altering the system to generate capital
    Is it time to sacrifice assets? This can occur in two ways. You can share a part of your system, or you can divest a part of your system. When you share a part of your system, you are partnering. When you sell a part of your system, you are spinning off assets. Both are excellent ways to generate cash and to provide for long-term growth. Both should not be considered without exploring the long-term consequences. In strategic partnering, you are lending your system or trademark to others to create synergy. Your strategic partners may be willing to compensate you for such a license as profits are earned, or in the form of royalties. It is sometimes possible to negotiate for advance royalties, or a signing fee, to compensate your company for lost opportunity costs in partnering with someone else. Even without cash advances, partnering can be used to convince your lender that you are more bankable. If a strong concept is willing to partner with you, then the bank might be more willing to jump on the bandwagon.

    Spinning off assets usually requires that you sell something valuable, an operating asset which you are sacrificing for short-term gain. In franchise companies, this is not always true because it may require more effort to service franchisees than the royalties produce. Unlike most businesses, however, the franchisor has territory or term to sell. Franchise agreements can be extended for one-time fees, in exchange for immediate payment of past due fees, or in exchange for fees that in the future will be paid on time.

    Franchisees may want territory that the franchisor cannot exploit, for expansion or protection against encroachment. The franchisor may also sell the franchise agreement back to the franchisee, and license the franchisor's name on an annual basis. Franchisors have successfully collected future royalty fees, with a discount, by tearing up the franchise agreement and replacing it with a trademark license. This not only accelerates the cash that would have been generated over the future term of the franchise agreement, but also eliminates the cost of the services that the franchisor would render in the future. For companies desiring to withdraw from distant markets, the option of converting franchisees to licensees becomes a "win-win" for everyone.

    Flourishing in bankruptcy
    Bankruptcy is considered the last resort not because of its risk, but because it is so effective. When used as an offensive business strategy, rather than as merely a shield against creditors, it provides a fresh start and authorizes the use of legal mechanisms available under no other circumstances. Upon filing a Chapter 11 bankruptcy, the company remains in possession of its assets and is granted a moratorium on most payments.

    Filing bankruptcy stops the lenders from foreclosing, landlords from evicting and litigation from proceeding. It is intended to give breathing room for 120 days while a plan to reorganize is formulated, and then additional time in which to obtain creditor approval for the reorganization. It is the most efficient method resolving creditor disputes, and the bankruptcy laws are intended to strongly favor the entity filing bankruptcy.

    Franchisors have a fairly good record of surviving bankruptcy and reorganizing to become stronger companies. The best example is probably The Southland Corporation, franchisor of the 7-Eleven convenience stores, which is now a highly touted stock on Wall Street. The Southland Corporation filed a "prepackaged plan" which accelerated the bankruptcy procedure and minimized most of the risks of filing bankruptcy. The prepackaged plan consisted of vendors agreeing to particular treatment in advance of filing bankruptcy, and forcing disagreeable creditors to accept the will of the majority as required under bankruptcy law. Prepackaged plans are now fairly commonplace and are easily formulated before filing bankruptcy.

    Franchisors filing bankruptcy often can obtain financing during the bankruptcy that they could not obtain before because the debtor-in-possession lender can obtain bankruptcy court permission to subordinate other creditors. Bankruptcy also permits the rejection of burdensome contracts, allowing the lawful breach of these contracts with limited consequences. For example, the franchisor can threaten to reject some franchise agreements and retain others, which might cause the burdensome franchisees to come to the bargaining table. Leases and subleases can be assumed or rejected based on the business judgment of the debtor.

    Imagine the power of these options in cases where a master franchisee or developer exists. The debtor is able to reject the rights of the master or developer, and exploit the rights of the master or developer to collect the royalties from the sublicensees. Although the master or developer may have a damage claim for the rejection of that contract, the damage claim is part of the reorganization and may be spread over a period of years, without interest.

    Although it is true that many companies do not survive Chapter 11, this is rarely true for companies with prepackaged plans or companies with sound business prospects. Without a firm direction when filing, the debtor will flounder, rather than flourish. Filing bankruptcy also exposes the company to public scrutiny and may result in the wrestling of managerial control or ownership from management. Bankruptcy is a powerful tool, and works best for management that is committed to a turnaround plan to preserve the viable franchise concept.