Administrators have no capacity to offset debts owed by an insolvent franchisor to its franchisees, against the royalties owed by the franchisees.
In other words, franchisees have to claim their debt owed by the franchisor like any other creditor, and end up with whatever cents in the dollar might be paid at some future point, but must pay 100% of all outstanding royalties to the administrators on demand without argument.
If franchisors have allowed franchisees to fall behind in their royalty payments, administrators will ditch such arrangements and demand full payment immediately as they scrape together cash to keep the business afloat. Unfortunately, this can result in considerable financial pain to any franchisees who owe royalties, and whose business may also be struggling (the reason why they fell behind in their royalties in the first place).
When Kleins was placed into voluntary administration in 2008, it was subsequently revealed that the franchisor held the leases on all the stores in the network, including the franchised outlets. Franchisees would then sub-lease the stores from the franchisor, to whom they would pay rent, and then the franchisor in turn would pay rent to the landlord (many of which were major shopping centres).
However, under this arrangement, the rents paid by the franchisees to Kleins were not being passed to the landlords, and the store rents fell behind.
When the administrators took control of the business, they exercised their unique power to disclaim (i.e. terminate) the leases, to reduce their ongoing liabilities in operating the business. The unfortunate by-product of this action was that the franchisees in terminated outlets were suddenly left with two choices: close the shop and wear the losses caused by the premature ending of their business, or negotiate new leases directly with the landlords and attempt to continue trading.
Many chose to negotiate new leases with the landlords, but found this to be a double-whammy.
In some cases their rent increased because they were now independent operators and no longer part of a national chain. In all cases, the franchisee would have had to find the cash to lodge the usual rental guarantee (up to three months rent in advance), plus invest in new signage and fitouts, etc, to trade as independents, while at the same time writing off as unrecoverable large sums of money owed to them by the franchisor under Kleins’ unique income guarantee.
Administrators can and will disclaim leases and other commercial agreements if they feel it is in the best interests of the insolvent entity, even if it is not in the best interests of the franchisees.
However, the reverse does not apply to franchisees, who usually have no rights to terminate their franchise agreements even if their franchisor is in administration.
It goes without saying that any Darrell Lea franchisee who might have been planning to sell their business before the company went into administration will now find it almost impossible to complete a sale until the system recovers from this emergency.
Such a recovery, if one is possible at all, could take years.
Even if Darrell Lea does recover, a franchisee’s business in future may be worth less than it would have been prior to the administration. This loss of business value can cause major problems for franchisees who are heavily geared and may ultimately sell at a loss, or who planned to fund their retirement using the proceeds from the sale of their business, which may now be insufficient.
Unless franchisees themselves are creditors (which is rare), this loss of franchisee business value, or the imperative to maintain franchisee business value, is incidental to administrators whose sole focus is to maximise the returns to creditors.
If a franchisor such as Darrell Lea does collapse, franchisees may be left without a business to trade if their supply of unique products ceases to exist.
Because Kleenmaid stores sold only Kleenmaid products, when these were no longer available following the collapse of the franchisor, the stores could not switch suppliers and continue to trade – likewise with Darrell Lea.
If this occurs, franchisees may have no choice but to close their stores, while continuing to pay the significant ongoing costs of shop leases, business loan repayments, and chattel mortgages for shop fit outs, fixtures and fittings. These ongoing liabilities can weigh down a franchisee long after the collapse of their franchisor.
If a buyer can be found for Darrell Lea, or any other insolvent franchisor, the new owner will inevitably want to put their own stamp on the business and make changes to ensure its ongoing survival.
The nature of the buyer, and the changes they will seek to implement, might jar with franchisees and appear at odds with the corporate culture under the former owners. For many franchisees, a change of ownership will require them to adapt to new management, and new ways of doing things. These changes can be relatively minor, incremental and easily adaptable, or can be major, radical and disruptive to the organisational culture and brand values.
An extreme example would be if Darrell Lea was bought by a foreign company, who decided to outsource all production, rather than make chocolates themselves, and then proceeded to develop other distribution channels in addition to the current retail footprint. Alternatively, a buyer may seek to focus on production and wholesaling, and disengage from retailing altogether.
Such possible extremes would result in a radicalisation of the corporate culture, leaving franchisees with a familiar brand but in a very unfamiliar organisation and operating environment.
This is not an exhaustive list, but should give pause for thought to any existing franchisee concerned about the future of their network, any potential franchisee who needs to asses the risks of what might happen in a worst-case scenario, and any insolvency practitioner who might one day find themselves managing a franchise network in administration.
Most importantly, this list should also serve as a reminder to franchisors that an inability to adapt to a changing market and poor management has consequences for those around them, especially their franchisees.
Hopefully this will not be the end for Darrell Lea but, for many of its franchisees, it could be the end of the way they view the Darrell Lea brand and franchise model.
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for nearly 20 years at franchisee, franchisor and advisor level. He advises both potential and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News & Events, a fortnightly email news bulletin on franchising issues and trends.
Jason Gehrke blogs regularly about franchising tips and trends for SmartCompany.
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level.
