Given the fact that they replicate a tried and tested model rather than blazing trails like regular start-ups, franchises have always been perceived as a stabler economic bet than entrepreneurial business. But this doesn’t mean they’re immune to running into financial difficulty. The recent high-profile insolvency of Quiznos, the submarine sandwich franchise, in the States has left more than a few franchisees wondering: what happens to their business if their franchisor runs aground?
It’s not always easy for a franchisee or anyone else outside of the main company to recognise signs it may be struggling. On occasion, insolvencies and bankruptcies amongst franchisees can be the trigger that sets larger events in motion. Tim Carter, partner at Stevens & Bolton, the law firm, highlights a recent example. “The franchisor’s insolvency was born out of the fact that a number of its franchisees went bust,” he explains. “The franchisor held the head leases on a number of the properties, so it became liable for rents when the franchisee underlessees became insolvent, leading to its own insolvency.”
However, even if most of the franchisees are in rude health, it doesn’t necessarily mean all is rosy back at the ranch. “It’s probably a little naive to think just because the underlying franchise income is being paid up that there is no risk,” Carter says. As with any business, there are plenty of things that can cause a franchise to founder. “Maybe it’s expanding too quickly, maybe the revenues just aren’t sufficient to keep it afloat, maybe it was other interests that the companies have apart from the franchise business.”
Irrespective of the underlying cause, when a franchise runs into financial difficulties, the directors are obligated to take quick action. “In this scenario, there is a shift in where the duties lay, away from the shareholders and toward creditors and minimising their losses,” says Carter. This inevitably means the company’s directors need to consider entering into an insolvency process and take professional insolvency advice.
As in any business, there are two main forms this can take, which have radically different connotations for franchisees. Almost certainly the preferred form for any company will be administration, in which the company is placed into the hands of administrators to address its financial problems. As Carter explains, this has several objectives. “The first one is to save the corporate vehicle itself,” he says. However, this is the best case scenario and is a rare result in insolvency situations.
“The second objective is to effectively achieve a better return for creditors than would otherwise be achieved if the company were broken up,” Carter comments. One method of achieving this would be to sell the company as a going concern; in this scenario its important to note that all franchise agreements will still be valid and legally binding, sold as a part of the company’s value. Obviously, this can be an ideal solution for the franchisee and means it will be very much business as usual. “They’ve got a new person supplying them with stock and the merchandise that they need to carry on the franchise.”
However, there are other methods of maximising creditor returns that are perhaps less favourable to the franchisee. “The administrator has a duty to all of the creditors: they have to act in their best interest,” Carter explains. In some cases this will involve selling off some of the main company’s existing assets at a cut rate, which can obviously undermine the franchisees’ own positions.
If administration fails or is for some reason untenable, then the only other option is liquidation. “Liquidation is much more terminal,” Carter says. “It’s effectively a fire sale of all of its assets.”
If a franchise is being broken up in this way, a franchisee might wonder what happens to the franchise agreement they hold with the entity entering an insolvency process. Essentially, the contract is null and void. “If the franchisor goes into liquidation and is not able to continue its obligations under the agreement, we would argue that there’s a repudiatory breach,” Carter explains. “The franchisee under common law principles is able to accept that breach as bringing the franchise agreement to an end.”
But when you’ve ploughed years into your business this may not feel like much of a win, particularly as in normal cases after the close of a franchise agreement the franchisee would be bound by a non-compete clause to prevent them using the experiences they’ve gained to set up a rival business. Fortunately, it seems somewhat unlikely a court would side with the franchisor if they tried to hold their former franchisees to this. “They will say: ‘it’s because of your fundamental breach they terminated: you’re now not able to prevent them from continuing to trade because it competes with your business’,” explains Carter.
However, this doesn’t mean a franchisee is entirely safe if they are still making use of assets that technically belong to the franchisor. With a lot of asset-reliant franchises – for example food franchises that require specialist equipment – a loan will commonly be extended at the beginning of the process to help purchase them. “If that loan is repaid on the entry into the insolvency process, those fall outside of that franchisor’s estate so nothing can be done,” Carter comments. “However, if they’re unpaid, effectively what the liquidator or administrator would look to do is recover those assets.”
One asset the franchisees definitely won’t be able to hang onto is the brand itself. Obviously if there is any perceived value in the franchise’s intellectual property (IP), it will almost certainly be sold off to pay its debts. Carter explains: “Ideally, they will want to sell the brand and underlying franchisee business as a going concern to someone else who’s prepared to take that name and carry it, and the business, on.”
Franchisees desperate to hold onto their brand do have another option however. Carter points to one high-profile case in which a group of franchisees actually banded together and bought the IP for themselves. But whether this is the right solution will very much come down to the franchisee and IP involved. He explains: “The franchisees have to make a decision: whether it’s such a pull that it is worth buying the IP or whether they just want to carry on under a different name.”
Whilst there are certainly no guarantees when a franchisor becomes insolvent, it’s important to know that just because the main company runs into trouble it doesn’t mean that franchisees don’t have every chance of keeping their business afloat.”