How to deal with failed franchises

By Adrian Hunter | 09 Aug 2019 View comments

What happens when one of your franchisees hits financial trouble? There are serious consequences for failed franchises for both franchisor and franchisee. 

The failed franchise and the franchisee

The loss of the franchise business to the franchisee will potentially result in the company becoming insolvent, meaning the company is unable to pay its debts as they fall due.  This often results when the sale price able to be achieved for the franchise, if any, will be insufficient to enable it to repay all of its creditors (including the ATO) and employee entitlements.  Where the franchisor forcibly ‘steps-in’ and takes control of an outlet, there may be no consideration received by the outgoing franchisee.

An insolvent company will need a formal insolvency solution to resolve the competing needs of company’s financial obligations where there is insufficient money on hand to meet all claims in full.  This liquidation process can be initiated by the company’s directors and shareholders.  

The liquidator acts as an independent third party to ensure that the winding up process is conducted appropriately and in accordance with the Corporations Act. It allows for a realisation of the company’s assets and distribution of the company’s assets amongst creditors.  

It is unlikely the assets will include the franchised business which is normally subject to a terminable licence.

This process not only provides for a managed process that gives the (now former) franchisee clarity as to ‘what happens next’ and enables them to restart their lives but provides the franchisor with a known exit process and reduces their risk of a rudderless ex-franchisee damaging their business (see further discussion below).  

In the event that the company is solvent post-loss of the franchise, it is important for the business to have its affairs wound-up, any creditors paid and its surplus assets (eg cash at bank) distributed to members so tax liability is minimised.  

A Members’ Voluntary Liquidation can be undertaken quickly and efficiently to enable the rapid distribution of funds to the company’s members and its dissolution with ASIC.

The failed franchise and the franchisor

The unscheduled demise or dispute with a franchisee can lead to considerable headaches for the franchisor:

  • reputational damage within its customer base and wider franchise industry
  • negative impact upon its remaining franchisees
  • loss of income
  • loss and damage to suppliers
  • loss in franchise value
  • lack of an orderly handover
  • potential need for the franchisor to step in and run the store / service the location
  • distraction from its core business

By implementing a managed process to resolve any disputes and for the franchisee to potentially exit the business with an orderly transition of the franchise outlet to either the franchisor or a new buyer, many (if not all) of the above issues can be avoided.

How to avoid the worst

During the lead-up to any exit, consideration should be given by the franchisor to the financial state of the franchisee’s exit position and their mental wellbeing.  Failure to do so can result in a disgruntled franchisee who may seek to vent their displeasure at being cast adrift via social media or news outlets.  

A hidden risk for the franchisor should they have a number of underperforming locations that they need to take control off, is that this can lead to the insolvency of the franchisor as they themselves now become contaminated by the stores’ ongoing losses.  These losses can be further exacerbated due to the need to replace the former franchisee with casual staff who are not dedicated to the location’s performance.

The franchise industry is littered with failed franchisors who retook stores to protect their brand, store locations and territories only to find the cash bleed too much for them to bear (particularly where the franchisor is liable for store leases).

As part of any franchisor’s process of good governance, it is best not to cut the ex-franchisees adrift but rather guide them towards a registered liquidator who specialises in corporate (or individual) solvency matters once the franchisor becomes aware of financial distress. 

Illegal phoenixing legislation

Illegal phoenixing (ie where a business is “rebirthed” into new entities associated with the directors or their related parties) within the franchise industry is not unknown.  

For example – on 10 April 2018 a former Noodle Box franchisee was sentenced to imprisonment (suspended) on two counts of fraudulent conduct in relation to allegations of illegal phoenix activity, following an investigation by the Australian Securities and Investments Commission (ASIC).  This matter was reported to ASIC by the franchisor after the franchisee reassigned a number of leases entered into by the company to operate Noodle Box stores to another company which was contrary to a franchise agreement entered into between the company and the franchisor.

As a result of companies being phoenixed or improperly dissolved, the Government released in August 2018 proposed legislation to deter and disrupt the core behaviours of phoenix operators. The reforms will, among others:

  1. make it an offence for company directors to engage in creditor-defeating transfers of company assets that prevent, hinder or significantly delay creditors’ access to those assets.
  2. create a separate offence for any person who procures, incites, induces or encourages a company to make creditor-defeating transfers of company assets. 
  3. make directors personally liable for GST liabilities, as part of extended director penalty provisions.  This is in addition to current potential exposure for SGC and PAYG.

Franchisors, in particular, need to be careful not to engage in b) above when trying to assist their franchisees through a period of financial distress.

This legislation has now been introduced into the Australian Parliament.

Be collaborative

Franchisors’ involved in disputes or financial distress (either their own or when dealing with that of a franchisee) can often benefit from a collaborative approach potentially involving any of the following: their accountants, lawyers and a registered insolvency practitioner.  Having a well-considered plan during these times can provide clarity of outcome and assist all in navigating the future. Seeking specialist help during these times is critical to minimise the impacts to all parties concerned.

Helping business owners, be they franchisors or franchisees, through difficult times is part of the important work accountants and lawyers need to undertake from time to time.  A registered Insolvency Practitioner can also form part of the toolkit used to assist navigate what can be complex and challenging situations.