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Last time we asked, given the high number of restaurant concept bankruptcies and money sloshing around in the sector, is there still more upside than downside in the restaurant franchising sector? We can find the answer by looking at where we have been. The U.S. economy is experiencing the second longest expansion in our lifetimes, after recovering from the greatest recession ever. We are still feeling the effects of economic stimulus, low interest rates, recent tax cuts and government deficit spending. This economic caffeine is about to be diluted. We can see it in the sales trends. We can see how to adjust to change by looking at the trends.

We are feeling good, and perhaps need to adjust to the rising headwinds. Top line revenues may appear to be rising, but that may be due to new delivery models. Some restaurants pay Grubhub and Doordash a high percentage of sales to deliver their products and increase volumes. Companies which build deliver and technology into their business increase their profits exponentially. The digital technology allow owners to gain knowledge regarding their customers by analyzing data coming from scan-to-pay systems, order-ahead applications, consumer facing technology and delivery arrangements. The better companies will know their customers better through the use of technology. They will use social influencers to drive customers from the internet to the store fronts.

Increased labor costs and management attention will also challenge restaurant growth, however, there are apps for this as well. Franchisee enterprise systems often can predict and manage labor schedules for franchisees. On resale and financing, technology is one of the strongest selling points, so it pays to invest in technology. Restaurants have even gone as far to provide platforms for their customers, that than relying on Facebook and LinkedIn. But even technology cannot hold back the tide of increased labor costs and responsibilities. Technology cannot eliminate competition through value meals, value pricing and giveaways.

The structural changes involve structuring how we invest in restaurant chains. Technology which educate the operators how to better cater to customers, and help adjust labor and menus will be in demand. Increases in efforts of the operators to improve the customer experience, as the internet has replaced word of mouth referrals. Finally, economic adjustment is needed, to build equity in the business to hedge against the overleveraging of hard assets.  You need that equity there when you need it, and you need to start building it now.

Imagine operating a single restaurant. The food keeps bringing them in, and prices are relatively stable. Consumer confidence is high, unemployment low, discretionary income rising, and people are going out more. Now multiply these variables as if we operated a chain of restaurants, and you will find small changes in any of these variables are multiplied exponentially and take a longer time to adjust for a restaurant chain. By looking across the industry, we can see that big changes may just be beginning, and we can join the change now.

Restaurants continue see investment money pouring in. Papa John’s and Jack in the Box are just two of many franchised restaurant chains undergoing due diligence for acquisition. Focus Brands, Inc., owner of Carvel, McAlister’s, Jamba Juice, Auntie Anne’s, Moe’s Southwest Grill, Schlotzkey’s and Cinnabon, bought Jamba Juice in September 2018 for approximately $200 million. On October 29, 2018, Focus Brands issued $300 million in additional bonds under it securitization facility with an interest rate of 5.184%.  The bonds are securitized by royalties and revenues from the other chains under the Focus Brands umbrella. Undoubtedly, unit economics support this financial engineering of debt, but it seems relatively easy to fund big spends for acquisitions. Is this special to the restaurant sector?

Big acquisition spends are not only prevalent for healthy companies but also distressed companies. Taco Bueno Restaurants, Inc. filed Chapter 11 on November 6, 2018 for its 140-unit company store and 29-unit franchised Mexican units. The reason it filed was because of falling earnings and underperforming restaurants. But Sun Holdings, a multi-concept franchisee listed as the 8th largest franchisee in the U.S., is the stalking horse bidder. Sun acquired the outstanding debt of $130.9 million for about half price and will inject $10 million into operations, and convert its debt claims into ownership of the company. Sun is doubling down on the franchised business.

Similarly, Papa Gino’s and D’Angelo’s filed Chapter 11 on November 6, 2018 for their 141 company owned branded locations, and was franchising 37 locations. It had once been as large at 370 units.  A stalking horse bidder, Wynnchurch Capital, acquired the senior debt of $18.5 million and the second lien position of $34.2 million. Wynnchurch has agreed to provide debtor in possession financing of $13.8 million. There is another $39.9 million in mezzanine financing held by Hartford Insurance Company and Brookside Mezzanine Fund.

Is there more capital available than good ideas and strong restaurant operators? Why are knowledgeable people placing bets on restaurant chains rather than home builders, car manufactures, and other industries? This abundance of capital has resulted and continues to result in the ongoing consolidation of Big Restaurant, franchisors and large franchisees able to leverage their assets and G & A costs. Family offices and private equity are increasing their investment in this sector because of the low barriers to entry and expansion. It allows retirees to buy franchises on credit, and consolidate their holdings to expand. Is there still more upside than downside?

We’ll answer that question in our next post.

To paraphrase Benjamin Franklin, “Those who fail to plan, plan to fail.” That is true in any business, but particularly so in franchising.  Planning is more important in franchising because franchising leverages a business–expanding the horizon of the brand more than a single owner or operator could. Decisions on branding need to balance the effects on employees, franchisees, prospective franchisees and customers. Without proper planning, the brand will grow randomly, without alignment, and will never achieve the momentum necessary to grow exponentially.

Is the Business Qualified to Franchise?

When asking whether a business is qualified to franchise, the question seeks to answer whether there is a sustainable business that could be operated by others through proper training. The business concept needs to be on an upward trend and projector. If the business is merely a fad, it is not worth the investment of time, money and opportunity costs to expand a novelty which will soon evaporate.

The business needs to be capable of being converted into a systematic and replicable business. A franchise business needs to be taught to others so that they can expand and replicate it. The know how needs to be recorded and encapsulated. It cannot be readily copied merely by someone looking at the business from the outside. The business operation needs to have a little mystery and magic. At the same time, the magic, secret sauce or formula for success needs to be carefully guarded from competitors and will require legal protection.

Does the business have operating units which are profitable?

The more profitable and the more units which are operating profitably, the better the franchise system will be. A single location can be franchised successfully, but multiple profitable locations demonstrate that, while location is a variable, the formula for success can work in multiple places, with multiple crews, and much of the problems–which exist in any system–have been identified and fixed. Moreover, the higher the number of successful locations, the higher the probability that franchises will be established without unexpected obstacles.

Does the company have the staff to launch a franchise system?

Running a franchise system requires a sales function to qualify and process prospective franchisees. The franchisees will need some handholding and will need training. Some may be investing their life savings and need franchisor leadership to make the investment. After the investment is made, the franchisee needs to be motivated. The franchisor needs to be a leader and must instill confidence. If the staff or people cannot fulfill these needs, then the franchisor needs to hire or contract for these people to run the franchise company.

Does the company have the money and energy to invest in franchising?

Franchising costs money, but the money is a good investment because franchising has so many positive attributes. Franchising allows franchisees to share in the brand success and provides rapid growth, faster brand recognition with less oversight over the franchisees. The legal foundation for the franchise business structure needs to be properly prepared and that requires an investment in legal work. But wholly aside of the monetary investment is management’s time commitment in establishing the franchise structure, qualifying, training and supporting the franchisees. It requires an investment in legal infrastructure and investment in the people necessary to support and grow the franchise system.

How Big is the Market?

Many franchised business do well by having a narrow niche, but the best companies find ways to broaden the interest. Think about how a mere name change can broaden the business. “Boston Chicken” changed to “Boston Market” to capture customers whose meal preferences did not include chicken.

Write and Test the Business Plan.

Answer all of the questions that someone critiquing your business might ask. Contemplate various sources of grants, investment and funding. Each has positives and negatives, but all should be considered because your franchised business will not be static. Consider various avenues of growth, and the effect of competition. Commit it to writing it down so that you are disciplined and deliberate about it. See if anyone else is doing it the same–or differently–in another geographic area.

Test the business concept with a feasibility study, formal or informal. You can hire a consultant inexpensively. Ask a variety of people what they would be concerned about if it were their company. Business schools often offer counselling or review by students of new concepts. As these students may be your customers, take the opportunity for feedback. One of the main questions to ask is how can your franchisees make a reasonable return on investment.

Planning means anticipating problems and solutions. Planning and feasibility testing can be the difference in a successful franchise system and a failed dream. Good counsel, good accounting and good foresight help to avoid bad outcomes.

Out-of-state franchisors beware of opening a franchise in New Mexico due to the recent decision in A&W Restaurants, Inc. v. Taxation and Revenue Department of the State of New Mexico and the potential for tax liability. The Taxation and Revenue Department of the State of New Mexico (“Dept.”) assessed over $29,000 in unpaid taxes against A&W Restaurants, Inc. (“A&W”) arising from its collection of royalty fees from several New Mexico franchisees.

In 2007, the New Mexico legislature amended the definition of “gross receipts” subject to the state gross receipts tax to include any money or value received from the grant of a franchise employed in New Mexico. Additionally, it removed from the definition of “gross receipts” any money or value received in connection with a trademark license agreement. Based on these definitions, A&W filed a protest seeking abatement of the gross receipts tax. During the course of the tax proceeding, A&W argued that the royalty fees were paid in connection with the trademark license provisions of the franchise agreements, omitting it from inclusion in the gross receipts tax. The hearing officer disagreed and upheld the Dept.’s assessment. A&W appealed the hearing officer’s decision.

The Court of Appeals in this case completed a thorough review of the amendments made by the New Mexico legislature and noted that the intent behind such revisions was to include royalty fees received in connection with franchise agreements subject to the gross receipts tax. Further, the New Mexico legislature wanted to exclude trademark license agreements but not franchise agreements that contain a trademark licensing provision. The Court noted, and A&W admitted, that a franchise agreement would not be entirely complete without a trademark license. With that, the Court upheld the hearing officer’s decision and held that A&W cannot separate out the trademark licensing provisions of the franchise agreement in order to avoid the gross receipts tax.

This decision serves as a reminder to ensure that your franchise agreement adequately protects you in this situation. It is important to keep your eye on similar legislative efforts in the future to appropriately plan for a franchisor’s potential tax liability.

Renewed Efforts to End No Poaching Provisions

Franchisors need to review their franchise agreements and take immediate action in response to the recent onslaught of legal action over “naked no poaching” provisions in franchise agreements.

In a typical franchise agreement, a franchisor will prohibit a franchisee from poaching its or its other franchisees’ employees during the term of the franchise agreement and for a period of time after the franchise agreement ends. Until now, these provisions were fairly commonplace. Franchisors argue these provisions are protect each franchisee’s investment of time and money in its employees, including general managers who sometimes participate in extensive training programs.

Critics of such provisions argue that the practice keeps wages for these employees low and that this is a manipulation of the market. Worker advocacy groups have long pushed for an end to this alleged “anti-competitive” practice. Economists generally agree that no poaching provisions have a negative impact on low-level employee wages.

Moreover, in October 2016, the U.S. Department of Justice (“DOJ”) and the FTC issued guidance that naked no poaching agreements are “per se” illegal–meaning that their very existence violates the law and sets companies up for criminal charges.  The DOJ further stated that it intended to criminally prosecute companies employing naked no poaching agreements. While most observers expected that the DOJ under Attorney General Jeff Sessions would retreat from this position, it has not, citing pro-competitive concerns. In fact, in April 2018, the DOJ initiated a criminal complaint against a number of companies respecting naked no poaching agreements. While the case settled with only civil penalties imposed, the DOJ expressly stated that it was reserving the criminal question and planned to “zealously enforce” the law.

Major Brands Settle After Attorney General Files Suit

In July, seven international brands agreed to no longer enforce the no poaching provisions in response to a lawsuit being led by the State of Washington Attorney General’s Office.

In August, eight more large brands followed this trend. Additionally, several state attorneys general, led by  Massachusetts Attorney General Martha Healy but including the AGs of California, Illinois, Maryland, Minnesota, New Jersey, New York, Oregon and Pennsylvania, have sent investigation letters to eight large international franchisors regarding each of their no poaching agreements.

This is only the beginning of the attack on no poaching provisions. In the past year, civil antitrust actions have been filed by employees of franchisees of several large international franchisors.

The potential liability under these actions could be substantial because the class sizes could be immense with treble damages and attorneys’ fees potentially being awarded in any franchisee employee victory.

McDonald’s Loses Bid to Dismiss

McDonald’s’ recent motion to dismiss was denied so the case against that company will proceed. The outcome of this case will be closely watched as a test case for this issue overall. The need to act is further supported by the fact that Senator Elizabeth Warren (MA) and Senator Cory Booker (NJ) are strong advocates of removing the “no poaching” provisions and have introduced legislation to make these acts illegal.

And the DOJ is bringing a criminal antitrust complaint against franchisors for what they call vertically assisted, horizontal conspiracies to fix labor rates, allegedly in violation of Section 1 of the Sherman Anti-Trust Act.

The time to address naked no poaching provisions is now. Franchisors should not wait until the update of your franchise disclosure document in 2019. If you need any assistance navigating through this process, the franchise team at Fox Rothschild is more than happy to assist.

Change is inevitable in a franchise system, and disclosure then becomes a concern. Disclosure may be a business issue for the existing franchisees, but it becomes a legal issue in the offer and sale of franchises. The question is whether the information would be considered by a hypothetical purchaser of a franchise as significant. Case law is sparse, but certain registration states, such as New York, provide examples of material change requiring disclosure.

Examples of material business changes that must be disclosed are closures or buybacks of five percent or more of the franchises in one year, change of control, management, corporate name, state of incorporation, and commencement of any new product, service, or model line increasing the investment or risk of the franchisee, and discontinuing or modifying the marketing plan of system where the total sales affected could be 20% or more of the franchisor’s business. Material financial changes or defaults will also require disclosure.

Often the timing of the disclosure is problematic because some states require immediate disclosure. In the case of a merger discussion, no disclosure is required until definitive or binding contracts are signed. A non-binding letter of intent does not normally trigger a disclosure obligation. Some material changes must be disclosed immediately and some not for 45 days.

Best practices suggest ceasing new sales until counsel has had an opportunity to review the material change and the steps for disclosure are agreed upon. Even in regulated states, protocols are in place to allow sales during the change process and allow disclosure and sale with subsequent disclosures to occur when necessary.

On Fox’s Immigration View blog, my partner Alka Bahal provides a detailed exploration of the I-9 inspection process, in the wake of a recent surge in I-9 audits carried out by the U.S. Immigration and Customs Enforcement (ICE) agency. All employers in the United States are required to have a Form I-9 on file for all employees to verify their identity and authorization to work in the United States.

We invite you to read Alka’s information-packed post addressing concerns facing employers:

Employers Beware: ICE Is Ramping Up I-9 Audits to Record Levels

I recently attended a very informative panel discussion at this year’s IFA Legal Symposium in Washington D.C. earlier this month on addressing data security risks in franchise systems. The panel, consisting of two attorneys with Bank of America Merchant Services provided some good tips and takeaways for franchise systems:

  1. Do tabletops.   Your franchise system should have a data response plan in place for various potential breach scenarios and practice the plan regularly by conducting tabletop exercises. The last thing you want an executive officer of your brand doing after a breach is googling “Is it illegal to secretly pay $100,000 in Bitcoin to a hacker?”

    47541066 – data breach level to maximum modern conceptual meter, isolated on white background
  2. Consider Standardization of POS Systems. While franchise systems may be reluctant to impose additional requirements in fear of vicarious liability claims, the potential exposure for data breach liability may outweigh those considerations. Engage a consultant to find weak spots in your system. Move away from the hodgepodge of various POS Systems and require all franchisees upgrade to current technology. Unless there is an overriding business need to maintain customer data, consider whether it is possible to have franchisees process data directly with vendor – instead of franchisor’s network. Consider advance technologies like point-to-point encryption and tokenization.
  3. Wait to Register Domain Name. If there is a breach and the franchise system will design a site for customers to determine if data was compromised and obtain instructions on credit monitoring, then do not register a domain name too far ahead of the public release of the breach. It may be a tip off to watchful third-parties who may publicize the breach before you are ready.
  4. Collaborate Efforts. When a breach initially happens, it is not helpful to immediately point fingers. Collaborate your response efforts with the franchisees. Telling a franchisee it is their responsibility and not helping to mitigate damage and address the issues does not help the brand.

Franchise systems have a unique set of potential hurdles when it comes to data breaches but with good policies and practices, brands can reduce risk exposure to protect both the franchisor and franchisees.

Succession plans ask what will happen when the principal owner/operator is not available.

Copyright: deklofenak / 123RF Stock Photo

A succession plan may be coordinated with an estate plan, which contemplates dispositive transfers through sale, and other means. The disposition can also occur by wills and trusts, buy-sell agreements, augmented by life insurance and family partnerships. A valuation of the business is often a key element in any exit strategy, and the succession plan, estate plan and valuation should be coordinated. These issues need to be coordinated with any restrictions that may exist under a franchise agreement on sale or disposition. In addition, state law may invalidate or alter some of these restrictions. For these reasons, the succession planning probably should be coordinated with lawyers familiar with both franchise law and estate planning.

Confronting the Key Questions

  • How will the business continue if the operator unexpectedly exists, becomes incapacitated or dies?
  • Should the business be continued or liquidated in the unexpected exit of the operator?
  • Would it be better if the business were sold in a planned sale?
  • In the absence of the operator, who will be on the making these key decisions and should a team be established now?

All of these issues require business and tax planning by a team of professionals.

Make the Decisions.

For the next generation, will ownership be separate from management? If the business is transferred to the children, do they have the experience, skill and motivation to take over? If not, the compensation plan to retain key employees needs to executed now.

Who will be on the succession team and trusted advisers? These specialists should include a franchise attorney, CPA or financial advisor, valuation specialist and a tax savy estate planning attorney, Judgment calls need to be made and the franchisee needs to be well informed.

As Benjamin Franklin said, “Those who fail to plan, you are planning to fail.” Make your succession plan decisions early, and with good counsel to maximize your goals.

Fox Rothschild LLP has deployed a new mobile app to assist companies, including franchisors, as they rush to comply with the European Union’s General Data Protection Regulation (GDPR) – a complex set of new data privacy rules with major implications for businesses.  The app – GDPR Check – helps businesses catalog their data management practices and policies to determine necessary steps to comply with GDPR when it takes effect in May.

“The pending implementation of GDPR will impact all companies that process or control the personal data of any EU citizen,” said Mark G. McCreary, chief privacy officer at Fox Rothschild and co-creator of GDPR Check.  “Every business, regardless of where it is headquartered, will be responsible for complying with these sweeping new data privacy rules when collecting or processing Personal Data,” said Daniel L. Farris, co-chair of the Fox’s Technology Group and co-creator of GDPR Check.

Even if a business does not collect personal data from EU citizens, the GDPR requirements apply to that business if it provides services to another business that must comply with GDPR.  Failure to comply with the regulations can result in fines of up to €20 million (approx. US$24.7 million) or 4 percent of global annual revenue in the prior year.

GDPR Check maps an organization’s data management practices in 17 areas that are key to determining compliance, including:

  • Types of data collected
  • Privacy policies (external and internal)
  • Consent
  • Data retention
  • Breach readiness

The app produces a report for each key area that a company can share with its attorneys and compliance team.

GDPR is intended to protect the rights of EU citizens to control the use of their personal data, including customer data such as birthdates, mailing addresses, IP addresses, product purchases and payment information, as well as supplier data, employee data and “sensitive data” such as health information, race, and sexual orientation.

This is the second app Fox Rothschild has launched in the data privacy space. The firm also maintains Data Breach 411, which provides easy access to applicable state statutes and breach notification rules to enable in-house counsel and compliance professionals, in the midst of a data breach crisis, to quickly identify controlling law and relevant guidance.

GDPR Check is available for free download in the Apple App Store and Google Play stores.