“Two Great Ideas”		«BACK
	by Dennis L. Monroe
	from Franchise Times, June 2003

Case Study No. 1

Franchisor A ("Zora") is a very successful system. Zora has a number of large, multi-unit operators who have done very well. However, like many systems, the large, multi-unit operators have a substantial amount of fixed rate debt. This fixed rate debt has high prepayment penalties. In addition, because it is a fixed rate debt, the lenders have prohibited additional indebtedness on restaurants used as collateral.

Zora had experienced steady increases in sales. However, over the last few years, sales have begun to flatten out. In fact, for the first time in its history, Zora's system has had a year of declining comparable sales.

Zora remodeled a number of corporate stores and found that sales after the remodeling increased as much as 30%. Zora knows all its franchisees will benefit from remodeling even though the remodel cost per store is approximately $120,000. Further, Zora realizes that even with significant sales improvement, most of its franchisees cannot obtain financing for the remodels because the collateral associated with these remodels is of little value. Also, any potential lender for the remodels is going to be reluctant because of (1) the underlying debt; (2) the superior position of the original senior debt and (3) the priority collateral position in case of a default.

How should Zora respond?

Zora should identify the primary lenders to its franchise community. It should then carefully review a representative sample of the loan documents used by the franchisee community for the specific lenders. Zora should meet with these lenders. If the lenders are reluctant to finance the remodels, Zora should work out an intercreditor arrangement where the senior lenders agree that if a new lender will finance these remodels, the new lender will be able to (in case of a default) share the proceeds upon disposition of the collateral on a pro-rata basis. This type of intercreditor arrangement will assure the new lender a sharing with the superior senior lender of the value from the business enterprise, thus lowering the collateral risk for the remodel lender.

This approach is not going to facilitate money for overleveraged situations but will provide a unique lending approach if Zora is able to show the lender and franchisee an increase in sales volume. This sales volume increase will result in stronger viable stores; thus, the original lender (the one who has agreed to this intercreditor approach), will have more valuable collateral even though there is more debt.

Developing an intercreditor arrangement requires Zora to be pro-active with the lending community and, in effect, negotiate the arrangement. Allowing each franchisee to negotiate this intercreditor arrangement is arduous and probably ineffective. Therefore, the up-front approach by Zora is key.

Case Study No. 2

Franchisor B ("Zorb") is a small franchisor with 30 stores (15 corporate; 15 franchised). Zorb has developed a good concept, and free cash flow for the franchisor is about $500,000 per year (after capex and other reserves).

Zorb knows it will have moderate growth on the franchisee side. Zorb wants to bring value to the company by developing corporate stores. But with the $500,000 cash flow needed for each new store, Zorb can only add one corporate store per year. This type of slow development will not bring the type of value Zorb needs to provide an appropriate return and potential exit for Zorb's investors.

What can Zorb do to increase corporate store development?

Zorb should consider a joint venture approach seeking to raise money for a cluster of two to five newly developed stores. The investors would invest, along with Zorb, solely in the two to five store cluster. The investment would then be leveraged with senior debt into a newly created entity ("Newco") with Newco owning the clustered stores. Newco would pay the investors a return through the cash flow from the clustered stores. A joint venture gives the investors an investment in real assets (they can go "kick the tires" so to speak), and Newco gives Zorb additional stores (which would be franchised stores) with a risk sharing corporate stores approach. This structure usually results in ownership by Zorb of approximately 30% to 50% of the clustered stores (all depending upon the amount of contribution and the value of cash flow). The investors normally have a preferential return of something in the neighborhood of 10% to15%. This preference can be shared with Zorb for a like return on its real cash investment. In addition, Zorb would usually charge a reasonable management service fee and receive a normal royalty.

This joint venture assures Zorb of quality sites with adequate equity. Further, the joint venture does not dilute Zorb's equity or increase its corporate leverage. (Note: New accounting consolidation rules may alter this result.)

Both of the above studies involve fairly sophisticated legal structuring requiring lawyers who understand the complexities of franchise finance, but as this issue of Franchise Times illustrates, there are good lawyers who can help you grow.