Midnight move: This time into the gutter

Restaurant dispute 20081211

middlefingerThe top image is from a Canadian Press article by Nelson Wyatt called Passersby stunned as restaurant contents emptied into Montreal street.

It also hit Canada’s evening television news program, The National and resides on the CBC website where some rapidly growing comments are worth checking out.

  1. What the hell happened here?
  2. Whay would a Montreal, Canada franchisee simply rip everything out (including cash from tips!) and leave them on the street?

There is a perfectly good and rational reason for this. These were the actions of a perfectly sane, far-sighted and indeed shrewd small business investor.

  • he or she realized they were going bankrupt no matter what they did (things they can control +/- = wisdom),
  • they did what they thought was the noblest thing to do which was to deny the franchisor and bank their profits on this churn while
  • demonstrating a fine French Canadian tradition of exiting with a some self-respect intact (see bottom image).

Here is what might have happened if this is like other franchise relationship meltdowns I have seen in the last 10 years:

Normal Contract Terms:

  1. The franchisee leases the premises from the franchisor (who then leases it from the landlord). The franchisee is the subleasee: he pays the franchisor who (you hope) pays the landlord. This may or may not have been the case here. (How quickly a new body can be installed indicates a franchisor head lease position.)
  2. The franchisor has the legal right to withhold their approval if a franchisee brings forward a proposed buyer. Some do it to drive an exiting franchisee into a corner.
  3. The operator’s franchise agreement with the franchisor says: “If the franchisee breaches the agreement, in any way at all, (70 pages long, including operating manuals, debt payments, appendices, etc.) then that automatically means that the lease has been breached (cross-default: much easier, faster, cheaper to throw a franchisee onto the street than to sue them under the body of the agreement).
  4. It appears that there were some franchisee free riding but we’re only hearing Enzo’s side of the story. I don’ t think his life savings were on the line because of his “training and operational deficiencies”. Yeah right.
  5. On a breach with a “non-compliant” [shithead] franchisee, the franchisor and/or landlord can padlock the store but they can’t touch the equipment or supplies because it’s owned by the franchisee.
  6. The franchisee is therefore faced with: the right of ownership without any rights to the location to operate the business.

The next step is what happens 99% of the time:

  1. The franchisee acts like a sheep. He sells either to (1) the franchisor (who operates for a short or long time) or (2) to a new sucker (I mean, Canadian small business franchise investor). Seldom do they debrand and become independent.
  2. The franchisee sells because they think their business is worth, say, $400,000, and if they’re “a good little boy” the franchisor will let them keep 100% of the money.
  3. The franchisor (knowing that the business is a dog or wanting to crucify this franchisee as a lesson to the flock) lets them keep 20% instead of the normal 15% because they can control the sale 4 or 5 different ways

What I think happened THIS TIME:

The franchisee saw through the trap. He knew or suspected that they were going bankrupt no matter what they did and that the equipment was already “underwater” (ie. it was of zero value to them but tied to massive debt. The only value it held was, mostly, in-place to the franchisor).

  • The bank financed it for, say, $100,000 based on a bogus appraisal 12 months ago.
  • The bank’s own receiver would only realize 15% disposal.
  • The franchisor would re-buy the equipment (very specialized, an idiosyncratic sunk cost to be technical about it) on the day of auction and
  • then sell on to the next more compliant investor (Sucker2?).

Also he may have been wised to the fact that franchise bankers and franchisors have an “understanding”: long-term, very lucrative relationship spanning the whole franchise system over many years versus one lonely loser family.

ANALYSIS: Going bankrupt for either $300,000 or $250,000 or $450, 000 doesn’t matter very much, does it? The equipment may have actually been used when they opened up (when  they thought they’d be getting new.) The money that appears to be thrown away (on the street) was very minor when compared to the operating losses that have already take place.

The franchisee and his spouse as guarantors of the bank’s debt for the equipment (if they’re not already personally liable under the franchise agreement). btw: Incorporating a franchised business? Simply putting your lawyer’s kids through school.

And with the bank being able to have up to 90% of their loan paid for (if the equipment loan was cut from the Canada Small Business Financing program).

  • What do does the bank care if some street people in Montreal were carting away a small businessperson’s life saving?

Ah: The beauty of dealing with other people’s money.

  • the franchisor (franchisee’s life savings) and
  • the bank (the franchisee and spouse’s bankruptcy).

Of course, this is all entirely speculative.

One Response to Midnight move: This time into the gutter

  1. Carol Cross says:

    I understand the scenario that you have painted, and your speculations are probably right on target. I’m sure that the failed franchisee was on notice to remove the property from the premises, or open up and pay up and cure the default, etc . . . or fire sale the assets for a pennies on the dollar to the Franchisor or to a third party buyer. I read in our daily newspaper within the last year where the State came in to possess the property of a franchisee because of sales tax owed to the State. What are the security rights of the landlord and the franchisor when the equipment and special fixtures, etc. are owned by the franchisee and there is no bank loan involved and no actual default on the startup debt?

    Maybe it was an act of desperation and revenge! Or, maybe it was the Landlord who gave up on both the failed franchisee and the franchisor and just wanted the space back to try to rent to someone else. Probably the Landlord had the legal right to evict and remove the property of the defaulting franchisee after legal notice of eviction. I’m sure the Landlord could do this and still hope for a judgment from the court based on the personal guarantee of the lease by the franchisee to the franchisor — that is, if either the franchisor or the franchisee had assets that weren’t in bankruptcy.

    However, often, in franchising, the franchisee’s lease is negotiated directly with the Landlord and the co-terminus lease-franchise default term is contained in an addendum to the franchise agreement that both the Landlord and the Franchisee and the Franchisor have signed. The franchisor reserves the right to assume the lease, etc… or NOT to assume the lease when the default takes place.

    The addendum to the lease wherein the franchisee is directly responsible for the lease offers the advantage to the franchisor and the landlord of keeping the failed franchisee on the hook when the business assets are sold for pennies on the dollar to a new franchisee who must then sublease directly from the original franchisee. If the new franchisee doesn’t make it, the original franchisee is still responsible and the Landlord can get a judgment from the Court against the original franchisee. The franchisor also can apply pressure on the failing franchisee to cooperate with the new prospective franchisee and the Landlord by indicating that they will ask for liquidated damages, owed royalties, because of the “abandonment” of the business if the business is not sold in a fire sale to a new buyer who will sublease the premises and continue in the service of the franchisor.

    Often, the “churning” of failed units is premeditated by the franchisors and the lenders and the landlords because they KNOW that there are always failing franchisees who may still have assets who will try to save themselves and their remaining assets and avoid actual bankruptcy by cutting their losses and getting OUT from the hundreds of thousands of dollars in debt owed on the lease that is personally guaranteed by the franchisee as well as the liquidated damages (owned royalties) that the franchisor says are due upon closing up the business. The long-term franchise agreements and leases that ignore the reality of the known startup failure rate of all small businesses act to ensure that the business assets of the failed franchisees will be available to the franchisor or a third-party buyer, an agent of the franchisor in return for pennies and assumption of the lease obligation.

    The courts, of course, uphold the personal guarantees on the leases and if the failing franchisee wants to cut his losses and stop the monthly losses and ultimately prevent bankruptcy, the failing franchisee necessarily must continue to pay on the debt for the equipment and startup when he gives the business away, but he will at least get out from under the debt on the lease, avoid bankruptcy, and also protect whatever assets that he may still possess — if another franchisee takes over the business and subleases from the franchisee for the balance of the term of the lease. It’s a gamble but what choice do franchisees have? They can’t continue to remain in a business that is draining their financial recourses every month and not producing enough in revenue to pay on the startup debt. If they have to pay the balance of the term of the lease and liquidated damages, this in itself will put them at greater risk of bankruptcy.

    This class of franchisee failures; i.e. those who want to CUT THEIR LOSSES under the only terms available do not show up on franchise loan default lists, etc. and are not clearly visible to new buyers of franchises and to investors in franchisor systems. or to the banks and lenders.

    Obviously, this fact and the housing bubble that provided the opportunity to borrow on the equity of the home that kept rising in value has contributed to the durability and the great growth of franchising in the United States these past thirty years. Many franchisees perhaps dug the hole deeper with loans on their home equity hoping to eventually breakeven and save their investment. This class of franchisee failures is a subsidy of the franchise industry made possible because of the ineffective regulation of the sale of franchises to the public. This ineffective regulation of franchising that abets “churning” may have consequences that are not yet fully revealed in our economy.

    Many franchisors develop management practices and FDD’s and franchise agreements that permit them to attain visibility (that implies viability) based on the capture of the assets of this particular class of franchise failures. They use their visibility to raise money in IPO’s and in Securitizations and do not reveal the “churn” mechanism to investors or new buyers of franchisors, or to the federal regulators.

    This class of “franchisee-failures” is generally required to sign confidentiality agreements and releases as a condition of the fire sale to a second generation franchisee. This kind of “churning” goes on outside of the view of new buyers of franchises and government regulators —and, unfortunately, outside of the view of the innocent investors in the “paper” of the franchise systems themselves.

    Like

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