Monday, October 13, 2008

Focus on Franchising

This posting was written by John W. Arden.

News and notes on franchising and distribution topics:

 The tightening of the credit market is having an adverse effect on franchising, impacting current franchisees wanting to remodel their existing locations and prospective franchisees wanting to open new outlets, according to an article (“Credit Crunch Squeezes Franchisees”) in the September 29 edition of the Wall Street Journal. GE Capital is becoming more stringent in pricing and issuing loans for new franchisees and has “essentially put a hold on new loans.” Bank of America has tightened its lending to such an extent that McDonald’s Corp. told its franchisees to seek other lenders for immediate borrowing. “While clearly other resources exist for franchise funding operation, the recent pullbacks of two of the main lenders in the arena are disconcerting,” restaurant industry analyst Sharon Zackfia said.

 In a September 26 presentation, “2009 Franchise Economic Forecast” Darrell Johnson, President of FRANdata, reviewed the current state of franchising in 2008 and made general economic and franchise forecasts for next year. Johnson expressed the opinion that economic stabilization would not occur until at least 2010, that an unprecedented de-leveraging was under way, and that the crisis of credit is becoming a crisis of confidence. He predicted that some franchise sectors will stay hot, new brands will grow at a slower pace, an increasing number of foreign brands will enter the United States, and brand acquisitions will continue. Franchisees demonstrating better performance will have better access to capital, opportunities to buy underperforming units, and opportunities to expand into other brands. On the other hand, marginally-performing franchisees will exit in greater numbers, which will lead to increased litigation. On the upside, rising unemployment usually stimulates franchise development, and younger people are coming on to franchising. In order to gain access to capital, franchisors will need to show financial strength, management experience, operational performance, system performance, and section and industry performance. Johnson struck a positive note in concluding that franchising will grow in 2009. He pointed out that the sector has faced many challenges in the past 20 years, including the S&L crisis and junk bond collapse in the late 1980s, the collapse of long term capital management in 1998, the terrorist attacks of 9/11, and the WorldComm and Enron affairs of 2002. “This crisis is much deeper, but will pass.”

 How franchisors should deal with deficient franchise performance short of outright termination is the subject of a recent “Franchising” column by Rupert M. Barkoff, appearing in the September 30 edition of the New York Law Journal. In the column (“Kinder, Gentler Alternatives to Franchise Terminations”), Barkoff creates a matrix of sorts to help analyze how to treat defaulting franchisees. There are two variables of the matrix—the “character of the franchisee” and the “nature of the breach.” In such an inquiry, there are three types of franchisees—the “good citizen,” the “misguided franchisee,” and the “rogue franchisee.” The nature of the franchisee’s breach can also be divided into three categories—financial, operational, and matters of citizenship.

The first “box” in the matrix concerns the “rogue franchisee” and any type of default. This franchisee is no good for the system, and rehabilitation of this type of franchisee is rare. “In deciding whether to grant clemency in any situation involving a rogue franchisee, the franchisor must not only be willing to forgive, but consider whether the efforts that may be needed to reform the villain justifies the commitment of the appropriate level of resources, when compared to the benefits of applying these resources to other needs of the franchise system.”

The "misguided franchisee" is one who need strong leadership and must be pointed in the right direction. In the case of the “misguided franchisee” who has committed a financial default, “the key step is determining why the franchisee does not have the money to pay his debts.” If the problem is incurable because the franchise does not have cash flow, “it will not really matter what solution is tried, other than debt forgiveness, or injections of new capital.” If the cash flow problem is curable, the options are (1) a permanent reduction in royalty rate or minimum payment; (2) temporary royalty relief; (3) supplemental marketing dollars; and (4) penalties and fines.

How to treat the "misguided franchisee" who has committed operational defaults is a more difficult question, since the defaults are less objectively identifiable. “Absent open defiance, franchisors should be willing to work with franchisees to eliminate operational defaults . . . termination would be an extreme remedy.” Citizenship defaults—ranging from failure to file reports on time to failure to attend conventions and creating disharmony among franchisees—can be difficult to identify and to solve, according to Barkoff. In most of these cases, termination would not be appropriate. A little more attention and perhaps an incentive, like a possible additional franchise, might lead to better behavior.

The question of handling “the good franchisee” is not as problematic. His failures could arise from having the wrong location. The solution might be to close the underperforming unit and help the franchisee move in order to keep him in the system. According to Barkoff, “good franchisees are hard to come by, and the cost of recruiting a new one may well exceed the cost of helping the failed, but good-citizen franchisee solve his problems.”

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