“The Anatomy of a Successful Workout”		«BACK
	by Dennis L. Monroe
	from Franchise Times Articles, June/July 2001 issue

Filing bankruptcy is seldom the appropriate course of action in an over-leveraged franchisee situation. A bankruptcy will extinguish debt, but in many cases will also extinguish the ability of the franchisee to move the business forward. Further, bankruptcy may create a risk of a third party buying assets in liquidation at a ridiculously low price.

In general, to provide for a successful restructure of a franchisee's business, cooperating parties must take into account the following three elements: (1) the franchisor's interests, (2) the senior lender's interest; and (3) the liquidity needs of the company to satisfy all of the competing interests.

Even though most workout situations are not adversarial, there still are a number of competing interests that must be addressed. A successful workout takes into account the following:

1. a revised, restructured debt that allows adequate cash flow to service the restructured debt;
2. necessary capital expenditures to maintain or improve the assets or units;
3. purchase money financing to allow for future improvements;
4. a systematic pay down of overdue current liabilities (specifically accounts payable);
5. the accumulation of a liquidity reserve;
6. incentive plans for employees to retain key employees and keep them engaged throughout the restructure and post-restructure process;
7. closing of under-performing stores; and
8. providing for a buyout or restructure of onerous or above-market leases.

Once you have taken into account all of the above-listed items, senior lenders usually conclude the only way a workout will be successful is to provide the franchisee with some flexibility. Normally the restructured loan provides for a waterfalls approach wherein cash is paid to various obligations in the order determined by the senior lender and franchisor. The waterfalls approach may have the following priority payment list: (i) all operating expenses; (ii) back royalties owed to the franchisor; (iii) restructured senior debt; (iv) required capital expenditure reserves; (v) liquidity reserves; and (vi) other debt. This is by no means a fixed approach, but these are some of the considerations.

In addition to the above items, revised senior debt is the key element of a restructure. In most cases the senior debt facilities are rewritten down to a serviceable level. The lenders take into account an overall debt service level that will result in a fixed charge coverage ratio (at the going market rate). This fixed charge coverage ratio ("FCCR") is the ability of the company's cash flow to cover its fixed obligations. Normally the FCCR is in the neighborhood of 1.2 or 1.3 to 1. This means that the business' cash flow (after paying all required debt service) is adequate to provide for the company to endure future economic downturns or unexpected expenditures. The written down portion of the senior debt is usually converted to a non-accruing obligation or a preferred equity interest in the company. Sometimes we refer to this position as a "hope note". The idea is that the lender "hopes" it will get repaid.

Normally the lenders are asked to take a substantial discount in the repayment of a hope note if the obligation is paid off in a short period of time. Usually the lenders are willing to become, in effect, equity investors with the hope of future repayment.

All successful workouts involve an active franchisor who has a clear understanding of the needs of the franchisee and senior lender. Franchisors may help in creating necessary liquidity and resolving potentially large back royalties and advertising fee obligations that may have accrued during the course of the company's initial problems. A successful workout with a franchisor provides for installment payments of the back debt payments. A franchisor may further provide for a deferral of some of the required capital expenditures and a no-fee extension of the franchise agreement.

Landlords also play a key part in an over-leveraged situation. Landlords many times have a significant number of properties leased to an operator. The tenant often will ask the landlord to provide relief in the form of deferrals or abatements. In many cases dealing with landlords is the most difficult part of a restructure because the landlords have control of sites and, thus, the ultimate trump card (which, in many cases, supersedes the senior lender and the franchisor interest). Therefore, landlords must be approached with a realistic plan that provides for an effective, restructured, long-term lease.

During the past six months there have been a number of successful restructures involving significant franchisees. These restructures have demonstrated to the financial community that franchisees, lenders and franchisors can cooperate to achieve a successful restructure in an amicable manner. It is imperative the franchise community continues to work together to accomplish the kind of effective restructures that will allow this industry to continue to attract both debt and equity financing.