January 09, 2009
The credit crunch has affected all retail industry and consumer discretionary spending. Franchisors need to take bold steps to survive, much less prosper, during this storm. Banks are reducing their customers’ borrowing capacity because of the need for banks to have sufficient capital to support the potential draws on their credit lines. Here are some strategies that can make a difference for both franchisors and franchisees.
Refinancing and restructuring
Banks are lending and private equity is investing where additional capital injection looks like a safe bet. Valuations in many industries have now decreased to a more realistic 4x to 6x EBITDA, with requirements of 2x EBITDA in equity. Lenders look more toward historical performance and investors look more toward future performance. Both are assuming that the economy will remain flat for the short and mid-term. Franchisors must structure their businesses to accommodate these historically low valuations and conservative lending criteria.
Now is the time to talk to landlords about restructuring leases. Landlords are making unprecedented deals to keep their malls occupied and lit, and will offer great deals for new space. Landlords may also modify rent structures to realistic base rents, or they may adjust the percentage rent allocation to assume more business-cycle risk. Concessions can also be gained from lenders and vendors, but all efforts at restructuring should suggest effective, realistic plans with long-term benefits for all. This may include opportunities to recapture the concessions at a later time, such as on sale of the business or particular units, and may even entail some downsizing to achieve a lower cost structure. Experienced professionals and advisors are essential in this process, as they will consider all cost-saving opportunities necessary for effective solutions. Many franchisors are encouraging their franchisees to use restructuring professionals and may provide recommendations for those professionals.
Preparation for the storm
Now is the time to ensure that your legal structure is solid. Check to see if all legal formalities are maintained, the corporate minute book is up to date, and ownership of all assets is properly documented. It is generally prudent to use separate entities to isolate intellectual property assets from entities that tend to originate claims, such as operating or real estate affiliates. Franchisors should determine whether their leases can be eliminated and at what cost, and should calculate whether going dark is a viable business strategy to eliminate unprofitable locations. Determine whether the leases can be assigned or subleased, even to a tenant that would pay lower rent. Identify possible exposure to withholding taxes and other sources of personal liability, and deal with those risks. Take an inventory of your insurance coverage, buy-sell agreements, and all contacts that require valuations, to determine whether these agreements make sense in the current economic environment.
Many franchise companies with company-operated units are selling some company units to raise cheap capital and to grow the system. The likely buyers should be well-experienced and well-performing operators already within your system, preferably with locations nearby. The offering price should be reasonably calibrated in current market conditions. You may be required to take back paper, although the financing can be structured as a one-year balloon just to allow time to find more permanent financing. The franchisor should structure the deal to maximize the ability of the franchisee to finance the project. For the right buyer, short-term royalty deferrals are not uncommon. Franchisors can maximize the possible success of the refranchised unit by completing all improvements before sale. In a pinch, the franchisor could even enlist other franchisees to temporarily operate the location for sale so that the remodeling execution risk is eliminated.
In a slow economy, franchisors should make an extra effort to benchmark the financial performance of their franchisees, as well as to monitor their compliance with brand standards. The brand equity value of the franchisor has a direct correlation with maintaining operating standards. Raising operating standards often improves the financial performance of both the franchisee and the franchisor, as consumers perceive more value in a strong brand. Now is the time to decide whether underperforming units should be kept and which should be provided with an exit strategy. If a franchise system’s documents are in proper form, the threat of a franchisee bankruptcy is a minor diversion and can often be minimized or eliminated in a work-out. Bankruptcy counsel should be contacted for advice whenever a franchisee bankruptcy is considered to be a realistic option. By retaining bankruptcy counsel, franchisors will gain the knowledge to negotiate the best deal for themselves.
In this precarious environment, it is critical that franchisors assess their vulnerability to a prolonged credit crisis and contraction in the economy. By retaining experienced counsel and consulting industry advisors, franchisors may be able to capitalize on numerous opportunities to survive and to thrive. Nixon Peabody is helping many companies to weather the economic storm by developing and implementing strategies that result in stronger, more efficient companies.
Craig R. Tractenberg, Partner
Franchise & Distribution
Litigation & Dispute Resolution