There are approximately 267,400 chain restaurants in the United States, according to the NPD Group’s fall 2010 restaurant census. Over the last few years, the industry has struggled as household discretionary spending declined and consumer confidence weakened. Earlier in 2011, the outlook brightened slightly for consumer-driven businesses, but when the U.S. debt was downgraded in August, it generated new fears about the economy and sent confidence tumbling again.

All restaurants strive to differentiate themselves in the market by offering a memorable dining experience for good value. This value proposition is maintained by providing quality food, ambiance, a desirable location and good service at a competitive price. If the consumers’ perceptions of value decline, so will customer counts and revenue. Couple these declines with rising commodity costs and heavy fixed costs such as rent, and the result will likely be a negative cash flow. In order to succeed, it is more important than ever for management to be flexible and proactive to change in all areas of a restaurant’s business.

Many restaurants operate within the franchisor/franchisee business model, and these relationships have become particularly strained in the current economy. By definition, a franchisee is an entrepreneurial-minded person running his or her own business under a larger system with a recognized brand, owned by franchisors. When times are tough, franchisees typically respond by taking steps to improve operations and preserve the bottom line across stores. These changes can range from minor belt-tightening moves to closing one or more unprofitable locations.

Unfortunately, many restaurant franchisees do not currently have the flexibility needed to make changes at the local level due to strict and complex franchise agreements (FA). The goals of franchisors and franchisees are not always the same, and this complicates the ability of franchisees to efficiently restructure in a timely manner — and in the current economic environment, this can spell trouble for franchisees.

Challenges in the Franchise Business Model

The franchise business model is constructed and governed by the FA between the franchisor company and the franchisee. Although these agreements come in endless varieties, most are built on a general concept that the franchisor is in command of the brand and the franchisee is acquiring a license to operate a business based on that brand. The agreement contains well-defined provisions about standards of operation, image maintenance requirements and obligations of both parties. In most cases, these agreements favor franchisors, which determine all pricing, promotion and product offerings; set guidelines for store construction; control a national advertising fund that franchisees pay into; and sell supplies franchisees must purchase. Franchisees pay an up front franchise fee and a monthly royalty fee based on percentage of sales, and in exchange, have the right to use the name, receive training, location planning assistance and other defined business services from the franchisor.

Over the years, these agreements have been hardened through litigation as franchisors have sought to control franchisees and protect their brand. Individual franchisees or franchisee associations[1] have been forced to take their cases to court to modify certain provisions, but major franchisors also have more legal firepower to craft strong contracts and fiercely defend them. One thing is clear: Oral commitments mean nothing. If it isn’t stated in the agreement, then the court will not uphold it. Thus, in difficult economic times, franchisees often find their hands tied when making decisions about restructuring the business.

Fierce Competition

Many economic factors are contributing to franchisees’ difficult situations. Declining household income and increasing gas prices have translated to less frequent visits and prompted consumers to trade down to lower priced restaurants. At the same time, commodity costs are rising, yet restaurant operators are reluctant to raise prices for fear of diluting their critical value proposition. All of these factors have led to intense pricing and value competition among restaurants, and franchisees are feeling the heat of this battle.

Consumers now favor chains where leaving a tip[2] is not customary. This has caused significant revenue decreases at many popular chains in the casual dining segment, such as Chili’s and Applebee’s. However, this shift hasn’t been a boon to all quick serve restaurants (QSR). Even fast food chains are struggling financially due to competitors offering lower-priced options. For example, Subway’s $5 foot long sandwich promotion has become a clear winner in this segment. Shortly after Subway introduced it, Quiznos attempted to counteract the promotion with its $4 Torpedo. The attempt to bring customers back was unsuccessful as the sandwich, served in an oddly shaped size, was not perceived as a better deal. Since 2008, Quiznos has closed nearly 1,500 locations, according to an August 2011 article in the Denver Post. Supermarkets are also proving to be competition in various segments, as they offer high-quality frozen entrees and fresh prepared foods. Even major delivery pizza brands like Pizza Hut and Dominos are facing competition from newer, gourmet frozen pizza offerings.

Franchisors may react to competitive markets by running a national promotion employing any number of special offers, such as two-for-one deals or limited time offers — both of which are price reduction strategies that drive store traffic. While this will increase revenue, it typically results in a decrease in growth profit margins, which may not be made up in volume of sales. Meanwhile, franchisors expect to continue to receive the normal royalty based on revenue and is often the purveyor of the majority of the chain’s food.

Location, Location, Location

The old adage about location still applies in today’s market, with the quality of a restaurant’s location being essential to long-term success. Great management will rarely overcome a poor location. Franchisees are often faced with market dynamics that can cause a location to be downgraded from a “keeper” to a “closer.” These can include proximity to vacancy-plagued shopping centers and strip malls, road closings, changed traffic patterns and new local competition that cannibalizes customer count. In a capital-constrained situation where there is no cash available for additional advertising or store upgrades, the already-declining customer count will dwindle even further. The operative question then becomes, “given all we know now, would we open this store again?”

Closing a store is a tough decision for a franchisee. It represents an equity opportunity that will be lost along with the contribution to corporate overhead. There are also the cash costs of shutting down the physical facility and trailing obligations to the landlord. If the property is owned, it may sit on the market for a long time while these carrying costs continue. Franchisees also face a “Catch 22” as their strict agreements often prevent them from closing unprofitable stores without triggering a cross-default on the licenses of their open stores. Many agreements provide an exclusive right to a territory, which requires a minimum number of locations to be open. Franchisors will also claim a loss of royalties and advertising funds.

Lack of capital prevents franchisees from opening a new store in the territory to offset the closing store. Franchisors hold the ultimate weapon in the threat of termination of the agreements.

Franchisees’ Breaking Point

Ultimately, this has become a David versus Goliath fight for franchisees. Recently, some franchisors of aging chains have been making decisions about brand direction that are at odds with their franchisees’ desires. Stalemates like this are nothing new in the franchise world; however, this time may be a little different. Major national franchisors, such as Yum! Brands have been aggressively expanding into emerging markets such as China and India. Growth rates in these markets are far exceeding those in the U.S., especially for aging domestic brands that are perceived as “new” internationally. This leaves U.S.-based franchisees highly skeptical about the support they are receiving versus support going to the emerging markets.

The FA sets strict standards and timetables for store remodeling, and franchisors enforce them vigorously. Without a clear brand strategy in the U.S., franchisees are wary of making any new investments in their stores. The level of investment required often exceeds the stores’ valuation, and there is no proof that a “lift”[3] from the remodel will occur. The lack of reinvestment in older brands precipitates their decline while newer concepts attract “fresh” capital. Thus, newer chains are able to gain market share by differentiating themselves through trendier environments and aesthetics that seasoned restaurant chains lack.

This leaves franchisees of aging brands caught in a spiral of decreasing margin dollars, insufficient capital to remodel and a falling customer count due to a decline in perception of value. The drop in actual cash also leads to an inability to service debt, royalties and advertising fund payments.

Some franchisors have assisted their franchisees with financing of remodeling costs while others have simply said “borrow more from your lender.” In today’s credit markets, this has not been a viable alternative, especially if the franchisee is behind on debt service. Restaurant loans are made on the basis of enterprise value, which is tied to the ability of the business to generate cash flow and not on the physical assets. The exception is the value of any owned real estate. Struggling franchisees face difficulties securing the extra money to make the necessary upgrades unless they can demonstrate to the lender that these capital expenditures will increase cash flow. The franchisee is thus caught between the franchisor and the lender. Recently, this kind of standoff has prompted franchisors to terminate the FA, forcing the franchisee to file for bankruptcy. In several restaurant bankruptcies in 2011, the primary cause cited was the debtor’s inability to refinance debt to fund store upgrades.

Looking Ahead: Can the Model Succeed?

To succeed, both parties need to fulfill their obligations in the FA. The competition is too strong to do otherwise in a market that remains well below pre-2008 levels. No business or location has an economic right to life and so an entrepreneur has to be free to make decisions to redeploy capital to improve return. Short-term steps to conserve cash and decisions with a longer-term effect such as closing a store need to be analyzed and executed quickly. Franchisors have an obligation to do the test marketing, creative ad work and strategic planning to enhance the brand, which results in a stronger value proposition. The franchisees’ own feedback in these areas needs to be included in the process because the brand declines when business decisions get bogged down between franchisors and franchisees. It’s in their mutual interest to work together to build a profitable brand.

Ultimately, the franchisors can choose to terminate a franchisee and the lender, the indispensable third party, can also decide not to continue funding. Lenders need to see a business plan with a sustainable cash flow, as cash flow is the source of the enterprise value. Thus, a tripartite agreement needs to be reached to preserve value for all stakeholders.

John Kokoska is a managing director in BDO Consulting Corporate Advisors Atlanta office, and has over 25 years of professional experience in the management of financially distressed and underperforming companies in various industries, including retail, distribution, healthcare service, manufacturing, catalog mail order and national franchising. Kokoska has completed numerous assignments as a turnaround consultant and financial advisor to include serving as interim CEO and CRO.

Richard S. Hauer is a managing director in the New York office of BDO Consulting. He has over 25 years of commercial, real estate experience specializing in the maximization of real estate assets and the mitigation of liabilities during distressed situations. Hauer leads teams of professionals to represent owners, operators, users and lenders in order to manage, restructure and maximize the value of their investments.

[1] Franchisee associations are in two varieties. First, there is the “official” association typically authorized by franchisors. Second, there are “unofficial groups” formed to bring litigation on specific matters.

[2] Consider that a restaurant that rings up $1 million in annual sales actually generates nearly $1.2 million spent as the percentage of tips approaches 20%. This percentage is double what the restaurant owner expects on the bottom line. A family instead, may opt to visit a “fast casual” store where the food quality is just as high and tipping is not necessary.

[3] Franchisors have been reluctant to divulge the results of their corporate store remodeling results, so there is no return on investment (ROI) benchmark.