< How To Buy A Franchise : Legal Advice


What Happens When The Franchise Changes Hands?

by Simon Lord, last updated on 19th January 2011

A series of mergers, acquisitions and buy-outs has resulted in established systems changing hands, changing names or even closing down. Simon Lord looks at the consequences for franchisees

The names involved are well-known ones – and not just to the franchise community. Some of our top brands have been in the news recently. Eagle Boys was bought by rivals Pizza Hut to reduce competition and strengthen Pizza Hut's delivery market. Fletchers acquired Hire A Hubby as part of its strategy both to supply materials through its PlaceMakers chain and install them via Hire A Hubby franchisees. When the Bill & Ben's franchisor failed, the intellectual property rights were bought by its area master franchisees to secure the franchise's future. Levene's the company failed, but individual franchisees bounced back. McDonald's bought Georgie Pie and converted some stores and some franchisees, leaving others to continue trading for a while. It's been all go among the big names in franchising – and where does it leave the franchisees?  

A franchisee's business is dependent upon the franchisor's business skills, management and leadership. The franchisor controls the direction of the business, the support and the speed of change. For the franchisees' businesses to remain viable, the franchisor must remain involved, supportive, financially viable and of good reputation.  

So when the franchisor's business is sold, or the management changes, or a receiver or liquidator is appointed, or perhaps if the franchisor dies, it can have a significant impact on the franchisee. Not surprisingly, therefore, franchisees tend to be concerned about any change.  

Yet if Callum Floyd's analysis of global trends elsewhere in this issue is correct, there will be even more changes to come among franchisors. In these circumstances, what is the position of franchisees and how do they fare under current franchise agreements?  

Business As Usual 

One franchise which changed hands very quietly last year was Hire A Hubby, which was sold to Fletcher Challenge. The franchise, which already had some strategic alliances with Fletcher's subsidiary PlaceMakers, had obvious appeal for the building supplies giant, especially with the emergence of the new 'Do It For Me' sector.  

Existing franchisor Mark Lewis stayed on as managing director of the company and welcomed the access to the power and knowledge of the larger group. There was little media fuss, and to a large extent it remained 'business as usual' for Hire A Hubby franchisees.  

In the event of a franchisor company changing hands like this, it is often the case that it will have little immediate effect upon the agreement between franchisor and franchisee – and indeed, such a change may never matter if the new owner is keen, energetic and diligent.  

However, while the franchisor often reserves the right to approve any new purchaser of the franchisee's business, the franchisee has no right of veto over a franchisor sale. This is not as unreasonable as it sounds: the franchisor selects franchisees carefully to enhance and protect the franchise network for the benefit of other franchisees as well as the franchisor, but it would not be realistic to require a group of perhaps 60 or 70 franchisees to agree to the sale of the franchisor's business. The result is that it is actually possible for a franchisee to be in the position of having an ongoing working and contractual relationship with a new franchisor they know nothing about.  

Although it may take some time to build strong relationships between franchisees and the new franchisor, the outcome is generally positive because the new franchisor will want to protect and build his investment. As a successful franchise depends upon the success of its franchisees, this can be good news. At the very least, a change of owner will usually result in an injection of new energy.  

In some instances, of course, the situation may not be so positive. Where a new owner comes in with a different agenda from the franchisees – perhaps to open more company-owned outlets or to acquire the rights in order to sell the system overseas – existing franchisees may suffer decreasing rather than increasing interest. Under these circumstances, aggrieved franchisees may have some claim under the franchise agreement if they can show that the franchisor has made it clear that he or she does not intend to perform his or her obligations, or that the franchisor has breached or is likely to breach an essential term of the contract which is likely to substantially reduce its benefit to the franchisee. Because franchisor's obligations under franchise agreements are often imprecise, this is usually difficult to argue unless there have actually been a number of breaches. Mere change of ownership, especially, does not constitute grounds for a claim.  

In any event, cancelling a franchise agreement is often not a good solution for franchisees, even if the option becomes open to them. It is not just a case of finding new suppliers and stopping paying the royalties, as some seem to think. Restraint clauses will frequently prevent franchisees from trading in competition with or in an industry similar to that of the franchise for some time after the cancellation takes effect. The franchisee will additionally be restricted from using or divulging any of the know-how he or she has acquired while a franchisee, and cancellation will oblige the franchisee to cease to use the various trade-marks and logos of the franchise operation. For these reasons alone, a franchisee should always seek advice before exercising any right of cancellation.  

The Disappearing Pizza Chain 

The recent sale of the Eagle Boys chain to rivals Pizza Hut introduced a new twist to franchisor sales – one that doesn't seem to be covered in most franchise agreements.  

Eagle Boys entered New Zealand in 1996 when Gavin Cook merged his successful Stallones Pizza operation with Eagle Boys to provide the aggressive Australian chain with an established base from which to enter the New Zealand market. Starting in the South Island the company headed northwards rapidly, building up a chain of 50 franchised stores and grabbing market share wherever it went.  

Last year, Restaurant Brands, the owners of the Pizza Hut brand in New Zealand, asked Gavin Cook if he would like to sell. He agreed – but there was a snag. Although Eagle Boys owned the intellectual property – the brand, the trademark and the systems – they also had ongoing agreements with their franchisees. And Restaurant Brands, which also owns the KFC and Starbucks brands locally, seems to prefer to operate without franchisees.  

The solution was for Eagle Boys to buy back the businesses from the franchisees. Once this was done, they could be sold to Restaurant Brands either to be converted to Pizza Hut stores or to be closed down. The entire deal was reported to be worth $28.3 million.  

Franchisees were apparently approached individually and on a confidential basis to encourage them to sell. They were offered market value for their stores, and all took the deal. Some grievances emerged after signing, particularly when it was suggested that of the $28.3 million, just $16 million was paid out to franchisees. The situation was slightly inflamed by the NBR's Rich List, published shortly after the deal was announced, which mentioned Gavin Cook among its 'emerging rich' section, and by press coverage which focused on 'the risks of buying a franchise'.  

One franchisee told me, 'The situation just wasn't covered in the franchise agreement. We were offered market value for our stores, but there was no allowance made for loss of potential earnings. I was making a lot of money out of my Eagle Boys franchise, and it won't be easy to find another opportunity that lucrative. One of the conditions was a restraint of trade clause, so I can't just set up making pizzas again.'  

Was not signing an option? 'Not realistically. The Eagle Boys brand was going to be run down, and at the end of the seven years franchise term it wouldn't be renewed. And it was all done on a one-to-one basis. If we'd all been in the same room it might have been different.'  

However, most franchisees are reported to be pleased with the prices paid for the buy-back, which apparently ranged between $250,000-$600,000. 'Running a pizza business is hard work, and most people would look to cash up after three years or so.'  

The 'sale-buy back-closure' situation is one which would be difficult to legislate for within a franchise agreement, according to lawyers. Every situation must be decided on its own merits, but in the event of an unusual situation such as the Eagle Boys one franchisees would be well-advised to take informed legal opinion before signing anything. However, it is not unusual for the franchisor to be offered the first right of refusal when a franchisee wants to sell, or even for a clause to be included within the agreement which sets out the method for determining a fair sale price.  

Buying From The Liquidator 

The situation facing the franchisees at Bill & Ben's was rather different. Bill & Ben's is a three-tiered franchise system: there is a head franchisor; area master franchisees who recruit, train and co-ordinate work for sub-franchisees; and sub-franchisees. The franchise specialises in landscape design and construction, garden care, irrigation and pressure washing.  

Earlier this year it became clear, after some earlier financial crises, that the franchisor company could not continue in business. The franchise had been going for over three years in its current form and 13 of the 15 area master franchises had been awarded, but the franchisor had overstretched its financial resources.  

After exploring various options, all 13 area master franchisees got together for a meeting which went on for two days. 'We were all facing the demise of a business which we enjoyed and which we had faith in,' says Mark Wilson, one of the area masters. 'Basically, we asked ourselves three questions. Do we want to continue? Do our franchisees want to continue? How could we continue? Without exception, everyone wanted to carry on.'  

The area masters at Bill & Ben's had been carefully selected for their maturity and management abilities, and their qualities came to the fore at this time. 'When we sat down with the figures and did all the sums, we knew the franchise would be profitable if it weren't carrying the level of historic debt and the overheads that the current franchisor was saddled with,' Mark continues. 'Furthermore, we knew the quality of the system itself was second to none – that has been recognised at the highest level by the judges at the Franchise Awards.'  

With a liquidator being appointed at the franchisor company, the intellectual property and trade marks of the Bill & Ben's franchise were to be put out to tender. 'We had the choice of accepting whoever and whatever the new owner might want, or of trying for it ourselves. We decided to go for it,' Mark explains. This was a brave decision. as it meant that the area masters were prepared to invest more money in the system despite the fact that they themselves were among the largest unsecured creditors of the failed franchisor. 'We were unanimous – call that a measure of our faith in the quality of the system.'  

The area master franchisees had always worked reasonably well together as a group, but this was different. Despite their considerable experience (one an accountant, another ex-head of an industry marketing board, a third a former senior executive with an oil company and so on), they knew they needed assistance to co-ordinate their approach. They recruited Kevin Connell, a consultant and former franchise manager with The National Bank, who had already been involved with attempts to resolve the franchise's problems, to guide them through the process.  

'The liquidator had decided not to go out to public tender on the grounds that if it were publicly notified it would take time and do untold damage to the franchise system,' recalls Kevin. 'There were six interested parties, and the better shape the system was in the better the tenders were likely to be.'  

The franchisee group spent a lot of time and anguish on the tender, taking legal and accounting advice every step of the way and getting an independent valuation before submitting its tender. 'It was an interesting couple of weeks,' admits Mark's wife, Cilla. 'And there was a fair bit of emotion when we heard we'd been successful. That was the day the future of 40 families was determined. Have you ever seen grown men cry?'  

The situation of franchisees buying the franchisor company is not an unknown one, but it can be difficult to make it work. A franchise needs strong direction, leadership and occasional re-investment both by franchisor and franchisees to keep it competitive, and a co-operative structure makes effective decision-making hard. However, if it is properly set up with strong management, as with Paper Plus for example, it can work. The Bill & Ben's master franchisees were well aware of the dangers. Mark Wilson explains how the new company is structured.  

'An equal number of shares is held by each of the area masters and three of the shareholders in the original company. There are two areas still unsold, and so those shares have been allocated and are held in trust. If new areas were to be created further down the track, we would issue new shares. If any shareholder wishes to sell their shares or their franchise, as a first step they must offer the shares back to the company at market value according to an independent valuation.  

'We knew we had to have an independent chairman, and have appointed Kevin Connell to that role. There are two reasons for this: first, we wanted the sub-franchisees to know that in the event of a dispute they had the right of appeal to someone independent rather than a board of area franchisees; secondly, having Kevin keeps us honest in our own decision-making.  

'Franchisor decisions have to be made for the good of the whole franchise, not for the good of area masters. We're all super-conscious of that at the moment. It's as though we have caps that we put on and take off to make suggestions or take decisions. At the very first franchisor meeting we had, I put up a number of things as an area master. Some were rejected, and we all felt that was very healthy.'  

The new Bill & Ben's team have agreed that no changes will even be considered for the first six months of operation as everything settles down again and they learn their new roles. 'The important thing to realise is that the system actually works, and always has,' Mark says. 'Kevin's advice was "Don't fiddle!"  

'Throughout all this the sub-franchisees have never been short of work, and in fact we could do with extra franchisees in many areas – we had legal advice that suggested we shouldn't appoint any new franchisees while the outcome wasn't clear. That was very frustrating for potential franchisees. We had one guy saying "Bugger all this head office business, can't I just sign up and get going?" But of course we couldn't let him. I think it says a lot about the relationships within Bill & Ben's that the sub-franchisees trusted us to do the right thing while they got on with their businesses. The flow of fees never even slowed down.'  

At the moment, all the area masters are rolling their sleeves up to do various parts of the franchisor job as well as their own, 'working on the need to do rather than the nice to do,' as Mark puts it. 'We know we can't run like that in the long-term – not even in the medium term, probably - so we will appoint a general manager a little further down the track. And we know there will be other big decisions to be made too. But we are mature enough to cope with those when the time comes. The franchise is stronger for this experience.'  

As the Bill & Ben's example shows, the liquidation of the franchisor company does not mean the end of the world for franchisees. In their case, the experience and wisdom of the area master franchisees enabled them to make a rational decision and take the necessary steps to put a new structure in place between them. They were also prepared to re-invest in the system, and had the ability to do so. In other circumstances, it may be just one or two franchisees who are prepared to make the investment necessary to take over the franchisor's role.  

'The important thing is to get the best independent advice you can,' cautions Mark Wilson. 'It is inevitably a difficult and emotional time, and you need an advisor who not only knows the legal and financial pitfalls but can also keep calm and offer wise counsel when things are getting fraught. It is not a time to make rash or hurried decisions,' he warns.  

Ensuring Continuity 

While financial difficulties rarely arrive unannounced, the sudden death of the franchisor can cause enormous problems for a franchise system. Around 85% of our franchise systems are home-grown, and many still rely on the knowledge, experience and vision of the original founder for their immediate future. In the event of the franchisor's death, the resulting confusion and distress, and the lengthy period as the estate is sorted out, can cause considerable damage to the franchise system and to franchisees' businesses.  

In addition, as overseas cases have shown, the likelihood of dispute and the danger of the franchisor company being sold to the first or highest bidder can result in system dissolution or failure.  

These concerns have been recognised by a new organisation, Franchise Foundation Ltd, which seeks to provide continuity of management and direction for franchise systems in just such an event.  

'Franchisees make a considerable investment in their businesses and need to know that, in the event of their franchisor keeling over, that investment will not be damaged,' explains Colin Taylor, who is chairman of the company. 'The role of Franchise Foundation is to help ensure that franchisees can enjoy business as usual as far as possible, and engineer the smooth and successful transfer of the franchisor business to a new owner who will have the best interests of both the franchisees and the franchisor at heart. That protects the value of the franchisees' businesses, and ensures the franchisor's estate receives the best possible outcome.  

'In some cases, the new owner may be the franchisees themselves. However, as the Bill & Ben's franchisees found out, you need time to plan and prepare things properly in order to ensure an appropriate structure. If the franchisor or other key personnel dies and all kinds of pressures are being placed on the executors, that planning may not be possible.  

'With a little bit of pre-planning, franchisees and franchisor together can minimise the dangers and actually add value to their investment.' Rather than being called upon to help only when disaster strikes, the Franchise Foundation's service, called Acropolis, is set up with franchisor and franchisees in advance. Funding is provided through life cover, enabling the Foundation to act immediately to protect all concerned should the need arise. Its board consists of five prominent franchise specialists: Colin Taylor, Stewart Germann, Win Robinson, Simon Lord and David McCulloch, enabling it to access the necessary expertise immediately it is required.  

'We have seen how far and how fast franchise systems can slide when leadership vanishes and the direction is unclear,' says Colin Taylor. 'What franchisees need most in such situations is time, experience, continuity and funding. Acropolis is our contribution to providing that.'  

Know Your Position 

The above case studies illustrate a number of different situations in which franchisor companies can change hands. They demonstrate that while franchisees may have very little say in some situations, a change of franchisor is not necessarily a major issue and may provide positive benefits. In other situations, franchisees may be able to take the initiative. The important thing is to be informed and, as far as possible, to be prepared.  

It makes sense for any potential franchisee to examine thoroughly the financial position of their intended franchisor. They should quiz the franchisor company about its management structure and long-term plans. It is also reasonable for franchisees to expect to be kept informed about such matters during the term of their agreement. Franchisees would also be wise to enquire as to whether any form of continuity or succession planning exists in the event of the franchisor's death. Most franchisors will understand the request for some form of continuity planning, providing it is expressed constructively.  

The relationship between franchisor and franchisee is a partnership (though not in the legal sense). It would be naive of franchisees not to recognise that franchisors have their own needs, expectations and vulnerabilities too, and that they are also subject to the uncertainties of business.Careful planning, good communication, the sharing of plans and problems and the determination to resolve issues fairly can lead to a successful outcome whatever the nature of the issue.

 

About the Author

Simon Lord

Simon Lord is editor of Franchise New Zealand magazine, and a director of Franchise Foundation Limited.


This material is copyright © Franchise NZ Marketing Limited, Franchise New Zealand ™ magazine and Franchise New Zealand On Line . While it may be downloaded for personal use, no part may be reproduced in any form whatsoever without the specific written permission of the publisher.


 
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