When a franchisee is in financial distress and looks to either close shop or otherwise get out of the franchised business, a franchisor often has an opportunity to step in and salvage the business by facilitating its resale to a new franchisee.
In these circumstances, a franchisor is faced with the dilemma of how to best structure the resale of the franchisee’s business. What are some of the options available to a franchisor in framing the resale of a failing franchisee’s business?
Overall Options for a Resale of the Distressed Business
Subject to availability and the facts of an individual case, a franchisor may be able to choose from the following alternate strategies when seeking to replace the franchisee of a distressed business:
- Requiring the existing franchisee to resell the business to a third party, with the consent of the franchisor. The resale by the existing franchisee to a third party must comply with the assignment provisions of the existing franchise agreement, which includes payments of fees, transfer fees, and approval and training by the franchisor of the buying new franchisee.
- Requiring the franchisee to resell the business, as in subparagraph (i), above, together with the franchisor’s help in the operation of the business during the interim period, and the franchisor’s help in the search for a replacement franchisee.
- Terminating the franchise agreement, taking over the operations of the franchised business, and then reselling the assets of the business to the replacement franchisee.
First Scenario: Resale by Franchisee
In the first scenario, the franchisor is merely requiring the existing franchisee to resell the business and does not necessarily do much more than following the requirements of the assignment and transfer provisions in the existing franchise agreement.
At the time of the resale transaction, careful attention needs to be given to whether the franchisor has “effected the transfer” in dealing with the purchasing franchisee under section 5(7)(a)(iv) of the Arthur Wishart Act, as set in the decision of 1518628 Ontario Inc. v. Tutor Time Learning Centres, LLC, in which case the franchisor is required to deliver to the purchaser a disclosure document as required under the Act, with all material facts about the distressed business.
Second Scenario: Resale by Franchisee, under Franchisor’s Operation
In the second scenario, the level of the franchisor’s involvement in the operation of the franchised business before the resale, and in any negotiations and discussions with the replacement franchisee, will have an impact on whether the franchisor “effected” the resale transaction by virtue of its level of involvement. Apart from disclosure issues, this scenario often gives rise to disputes with the existing franchisee about the nature of the franchisor’s involvement in the operation of the business during the interim period.
Third Scenario: Takeover by Franchisor
In the third scenario, the franchisor almost steps into the shoes of the franchisee and becomes the owner and operator of the franchised business, as well as the vendor of its assets. Among other obligations, this presumably gives the franchisor access to all financial information of the distressed business. Therefore, the franchisor would be likely required to fully disclose this information to the replacement franchisee in a disclosure document.
If the franchise system is in a retail industry, such as fast-food (often called the “Quick Service Restaurant” industry), coffee or other mainstream markets that appeal to the masses, where a replacement franchisee is typically readily available, a franchisor may wish to consider taking advantage of its post termination options by taking over the location (assuming that such rights exist in the franchise and lease agreements) and reselling it to a third party, as set out in the third scenario.
On the other hand, if the franchise system is in a niche or specialized market, such as moving, health care, or other systems where a replacement franchisee is typically drawn from a more or less specialized industry or trade, rather than the general public, the franchisor should be more cautious before taking over the franchised business, particularly if locating a replacement franchisee is expected to take some time.
Most standard franchise agreements in Canada provide the franchisor with the right, upon termination of the franchise agreement, to purchase the assets of the franchised business on a net book value basis, i.e., without accounting for goodwill and net of all equipment depreciation, among other accounting allowances. The net book value of the franchised business often ends up as a very nominal amount of money.
The mechanics of exercising this option are not always simple or straightforward, due to, among other complications, secured debts and sometimes the appointment of a receiver by one of the secured creditors over the franchised business assets.
Subject to these complicating factors, the contractual option of a takeover at net book value, at its core, presents the franchisor with an opportunity to give the distressed business a new lease on life by restructuring its underlying financial cost and affording the replacement franchisee an opportunity to re-establish the business’s financial viability.
Upon taking over the franchised business, a franchisor would, subject to secured debt, rent arrears and lease issues, realize on its own secured interest (assuming the franchisor has registered a general security agreement – the “GSA” – against the assets of the franchised business).
The realization of the assets under the GSA must be done, as a so-called “self-help remedy”, by first obtaining a proper appraisal of the assets of the franchised business. The appraisal will form the basis for what is payable to the franchisee by the franchisor, subject to outstanding debts. The franchisee’s outstanding debt obligations often far surpass the appraised net book value of the assets. In those cases, the value of the assets will be offset by the debts.
Choosing among the three scenarios in trying to preserve a failing franchised business should be done through a pragmatic analysis of the many legal as well as business considerations.
Where negotiations with an existing franchisee are not practical, a franchisor should consider enforcing its rights on a timely basis in order to maintain the viability of the business. It helps for a franchisor to try to negotiate with the existing franchisee, if and where possible. For a franchisee, negotiating with the franchisor in good faith may mean the ability to quickly recover some of his or her losses. All parties have a vested interest in the successful resale of the business and its transition to a replacement franchisee.