Rescuing a franchisee business

How insolvency experts turned around struggling franchisee businesses.

When a franchisee company facing insolvency needs rescue, directors must carefully consider several issues before exploring restructuring options. Key issues include:

• Intellectual property: By placing the franchisee company into voluntary administration (VA) or a small business restructuring (SBR) plan, the franchisee company may lose its right to use the intellectual property associated with the franchise business, such as images, brands and logos.

• Stock supply: the franchisee may be unable to purchase stock if they receive it through the franchisor or its affiliates.

• Premises: The franchisee may lose their right to occupy the premises if the franchisor holds the head lease.

If the franchisee company must be wound up due to unpaid debts, directors should also consider:

• Franchisor take over: Subject to the terms of the franchise agreement, the franchisor may have the right to take over the franchise, or shut the site.

• Security interests: The franchisor may hold a general security interest over the franchisee’s assets, thus a secured creditor in a liquidation.

• Personal liability: Directors may be personally liable for any debts the franchisee owes to the franchisor or landlord, including potential lease obligations, if a personal guarantee is in place.

• Director penalties: Directors may face penalties if the franchisee’s PAYG, GST and superannuation guarantee debts were not reported within the required timeframes.

At Worrells, we have guided many distressed franchisee businesses through financial difficulties. We believe the keys to a successful restructuring are:

• engaging with the franchisor and key stakeholders (e.g. landlord, key suppliers, etc.) and work collaboratively with them before and during the insolvency process.

• distinguishing between company-only debts and directors’ personal liabilities.

Here are three examples of where we have successfully assisted franchisee businesses in restructuring or winding up processes while minimising directors' personal exposure.

Case 1

This company acquired a franchise business of a well-known overseas milk-tea brand. It commenced operations just few months after the commencement of the COVID-19 pandemic. The lease was signed directly with the landlord and the Company was required to adhere to the design fit out at a cost of over $300,000.

The business struggled during COVID-19, and despite rent relief from the landlord, the Company fell behind on rent payments for a number of months. With no other major creditors, the director considered closing the business but was concerned about the personal guarantee on the lease, potentially exposing him to two years of rent liability if a new tenant could not be found. Two neighbouring shops had been vacant for six months, adding to this concern.

A broker was engaged to sell the business. Initially, the landlord was supportive but lost patience as rent arrears grew, threatening to repossess the premises within three days. The broker was negotiating with potential buyers, so it was essential to keep the business running to continue the sale.

The director sought advice from Worrells and we recommended a VA (voluntary administration). There are a number of immediate benefits of appointing a VA, for example, the VA appointment prevents unsecured creditors from enforcing claims, stop the landlord from repossessing the premises (which would allow the VA to continue the sale), and protect against personal guarantee enforcement.

Every franchise agreement is different, so it is best to find out from the franchisor how they will react to an appointment. The franchisor in this instance confirmed that they would not immediately take back the franchise but were open to speaking with potential new tenants/franchisees for the milk-tea shop.

We also informed the landlord that the VA will seek a new tenant while continuing to pay rent, which the landlord agreed to.

With the VA in place the sale continued and a buyer was found within three weeks. This limited the director’s personal liability to the outstanding rent, most of which was covered by the bond. Without this approach, the landlord likely would have repossessed the premises, leaving the director exposed to ongoing rent obligations until a new tenant was found.

Case 2

The company operates a gym from leased premises as a franchisee. The business was severely impacted by COVID-19 lockdowns. Movement restrictions prevented clients from attending fitness classes, leading to a revenue decline and depleted working capital. By the time the director approached us, the business had accumulated a tax debt of $180,000.

A cash flow assessment revealed:

• Franchise fees and rent were current, with both agreements set to expire in seven months and both in the process of being renewed.

• If the business went into liquidation, the director would be personally liable for approximately $100,000 in unpaid rent and franchise fees

• the business could otherwise remain cash-positive for at least 12 months, without its current debts.

We recommended a small business restructuring (SBR) plan, but asked the director to first discuss the potential restructuring with the franchisor and landlord to ensure open communication. Fortunately, both parties were supportive of the proposed SBR, so we then commenced the work.

Without prior support from the franchisor and landlord, the director could have faced significant risks, including:

• Potential termination of the franchise agreement by the franchisor.

• Lease termination by the landlord for overdue rent.

With the ATO as the sole creditor, we helped the director implement an SBR plan involving a $50,000 contribution from borrowed funds within seven days. This allowed a distribution of circa 25 cents in the dollar to the creditors, which was accepted by the ATO. The final distribution was completed within a month.

Case 3

In this case, the company had operated as a franchisee fast-food restaurant in NSW since 2016. When we were approached by the director, the ATO had initiated winding up proceedings with a hearing scheduled in just a week. Compounding the problem, the director received director penalty notices (DPN) for unpaid PAYG withholding and GST, totalling about $120,000. These DPNs already expired. 

Our discussions with the director revealed that the government-imposed lockdowns during the COVID-19 pandemic period, coupled with delays in adjusting pricing and costs led to a significant decline in revenue, increased costs, and reduced working capital. Consequently, the company faced a debt of approximately $280,000, primarily due to tax liabilities.

Despite these challenges, the director believed the business was still profitable and worth saving. We outlined a two-pronged approach: first, address the winding-up hearing and second, negotiate with creditors to compromise the company’s debts.

Our rescue plan included:

• placing the franchisee company into an SBR plan immediately.

• the company engage a solicitor to apply to adjourn the winding up hearing under section 453Q of the Corporations Act. This would allow time to formulate an SBR plan and negotiate with the ATO.

• advising the director to secure funds to reduce the DPN debt.

• developing a restructuring plan to offer a better return to the ATO compared to immediate winding up.

The director successfully borrowed funds and paid $80,000 towards the DPN, reducing the company’s debt by nearly the same amount. By working together with the director and solicitor, we prepared a report and an SBR plan offering a return of 35 cents in the dollar payable within 12 months. When factoring in the $80,000 payment, the actual return to the ATO was more than 50% of the original debt. The ATO agreed that the winding-up hearing be adjourned and eventually dismissed, and the ATO accepted the restructuring plan.

In this case, if we were engaged earlier, we could have saved the franchisee business more money and possibly prevented the director from being liable for the expired DPNs. 

The Director may still need to address any shortfall amount of this DPN account. Refer to our article for details of how the ATO applies payment.

Worrells can help

For more information on the SBR process, click here to download our complimentary guide to small business restructuring.

To read more articles about voluntary administration, click here.

If you’re concerned about the personal liabilities of yourself or your client, have a chat to your local Worrells principals sooner than later. We’re here to help and can take you through the practical solutions available.