Navigating Franchise Sales and Competitive Auction Strategies

By Alan Gallup

Franchise businesses, particularly in the retail and restaurant sectors, operate under a unique set of dynamics that distinguish their bankruptcy proceedings from those of independently owned establishments. The intersection of franchisor/franchisee relationships, contractual obligations and brand considerations introduces complexities that influence the trajectory of bankruptcy sales and auctions. This article explores what sets franchise bankruptcy sales apart from other retail and restaurant cases, and uses a recent Pizza Hut franchisee bankruptcy to illustrate how key challenges can be navigated and resolved.

Distinctions Between Franchise and Independent Chain Cases

The bankruptcy process for franchisees differs from that of independent businesses in several key aspects. Franchisors often possess contractual rights that allow them to influence or control the transfer of franchise assets during bankruptcy. These rights can include the approval of potential buyers, right of first refusal, and stipulations regarding the assignment of franchise agreements.

These challenges can be overcome with an understanding of the franchisor’s rights and the elements that might impair the value and recovery to the estate. By collaborating with the franchisor to connect with prequalified buyers, the process is expedited, leading to quicker approvals and faster sale completion.

In franchise restaurants, the franchise agreement provides that the franchisor is responsible for providing a cadre of vendors for the franchisee. Independent chains are likely to have a number of vendor contracts that need to be addressed in a sale, along with any patents or trademarks.

Independent chains often present additional challenges with the quality of the records and accounting methodology. Franchise restaurants are generally required to maintain certain standards and often required to utilize certain bookkeeping and accounting methods.

Franchise assets are intricately linked to the franchisor’s brand, point-of-sale and operational systems. This connection can complicate the valuation and sale of assets, as the desirability and functionality of the assets are often contingent on the continuation of the franchise agreement. In some cases, franchisors have provided operational support or temporary management agreements to stabilize locations during the sales process, thus preserving asset value. These resources are not readily available to independent chains without significant additional costs.

Debtor in Possession vs. Trustee in Franchise Bankruptcy

When a franchisee encounters financial distress, their restructuring or liquidation process can proceed under different legal frameworks, primarily through a debtor-in-possession (DIP) arrangement in bankruptcy or through a court-appointed trustee. Each approach presents distinct challenges and considerations for franchisors, creditors and prospective buyers.

DIP in Franchise Bankruptcy

Under a chapter 11 (or subchapter V) bankruptcy, a DIP retains control over its business operations while restructuring its debts under court supervision. The franchisee continues operating with court approval and negotiates with creditors, landlords and the franchisor to achieve a feasible reorganization plan, which may include selling some or all of its assets.

Many demands are placed on the DIP as they attempt to navigate the bankruptcy reorganization process while they continue to address the daily challenges of the struggling business. It is difficult for a DIP, who will likely have personal guarantees exposed, to distinguish between the best interests of the estate and the best interests of the principals of the estate. It is incumbent on the professional advisors to the DIP to guide them through these matters.

A Trustee in Franchise Bankruptcy

In situations when the debtor is unable or fails to effectively manage the business in a manner that serves the best interests of the bankruptcy estate, the court may appoint a trustee to assume control of the franchisee’s assets and operations. The trustee’s role is often focused on stabilizing the business and facilitating the orderly sale of assets to maximize estate value.

As an independent fiduciary, the trustee assumes responsibility for overseeing the franchisee’s assets and operations. In carrying out this role, the trustee might utilize the franchisee or existing management, or (where warranted) retain outside professionals to support key functions, such as accounting, human resources and operational management. Although the engagement of such professionals can significantly increase administrative costs, their contribution often delivers substantial value by preventing the erosion of asset value typically observed in bankruptcy cases.

A trustee brings added credibility to the process. The market value of the restaurants might be enhanced with a trustee in place vs. a DIP, as prospective bidders’ concerns about the soundness of the assets, transparency and assurance of no successor liability are assuaged.

Regulatory and Lease Challenges

Franchise operations often involve complex leasing arrangements, which can become contentious in bankruptcy proceedings. Many franchisees operate out of leased locations with terms tied to their franchise agreements.

Many franchisors lease or sublease locations to the franchisee, which creates another area of negotiation with the franchisor if lease modifications are sought. It also can create additional friction of the estate seeking to terminate the lease when the franchisor has an interest in the lease. Successful bankruptcy cases have incorporated lease assumption and assignment provisions negotiated with landlords, mitigating risks of location closures.

The opportunity to reject certain underperforming leases presents a strong opportunity for the estate to enhance value. Individual locations’ financial performances can be shared with each landlord to facilitate negotiations of reduced rents, additional terms and other contractual obligations. Landlords who face the prospect of a lease being rejected, with no replacement tenant in sight, will often choose to modify the lease more favorably for the tenant. A rental reduction of a few thousand dollars per year can result in tens of thousands of additional value to the estate. Similarly, the extension of the lease term for a successful restaurant with less than 10 years of property control remaining can increase the value of that restaurant asset by 10 to 20 percent or more.

Franchise Agreements and Bankruptcy: Navigating a Complex Landscape

Central to any franchise relationship is the franchise agreement — the legally enforceable contract that delineates the rights and responsibilities of both the franchisor and the franchisee. In the bankruptcy context, these agreements are considered executory contracts, as they involve continuing duties from both parties. The treatment of such contracts in bankruptcy is pivotal and varies across jurisdiction.

In certain jurisdictions, courts require the franchisor’s consent before allowing a debtor/franchisee to assume a franchise agreement — even when there is no plan to assign it to a third party. This highlights the critical role of franchisor approval in any reorganization effort. In other jurisdictions, the courts will allow the bankrupt estate to assume the franchise agreements and further assign those agreements to a new franchisee buyer, provided that the buyer can demonstrate adequate assurance of future performance.

With a significant portion of the business value being associated with the goodwill that is in large measure derived from the branded image of a franchise, the assignment of franchise agreements is essential to optimizing the recovery for the estate. In some situations, the franchisor will limit prospective buyers to individuals already known or preferred by the franchisor. When franchisors limit eligible buyers to those within their preferred network, it can significantly narrow the pool of prospective purchasers, thus potentially suppressing sale price and limiting outcomes for creditors.

Addressing the Challenge

To address these restrictions, franchisors and debtors frequently employ prenegotiation strategies, such as early restructuring discussions and conditional assignment agreements. These agreements afford franchisors control over the sale process and the selection of the buyer, while also establishing a structured pathway that can expedite the sale and maximize recovery for the estate.

Some debtors strategically select bankruptcy venues with more favorable legal precedents, granting greater flexibility in assuming and assigning franchise agreements. In such cases, prospective buyers must still undergo a thorough screening to ensure that they meet reasonable standards as quality franchisees and can provide adequate assurance of future performance.

The debtor or debtor’s advisors commonly work with the franchisor so that a broad number of prospective buyers can participate in the sale process and thus optimize the recovery. This requires a collaborative effort by both the franchisor and the estate.

In nearly all cases, it is essential for the sale process to recognize the franchisor’s role in the approval process. This involves addressing the prospective buyer’s future obligations under the franchise agreement, including advertising commitments, remodel requirements, management training, franchise fees, transfer fees and franchise term limitations. These factors directly affect the business’s value and, consequently, the estate’s recovery.

Selecting the Sale Process

There are two fundamental approaches to the sale process of franchise restaurants. First, the prevailing approach typically involves a sealed-bid process, where marketing materials, a confidential information memorandum and due-diligence documents are prepared for prescreened, qualified bidders. A bid deadline and prescribed bid format are established, with the estate, in consultation with its advisors, negotiating purchase agreements, selecting a stalking-horse bidder and soliciting overbids.

Second, the live-auction approach has the potential to generate a higher recovery for the estate, but certain conditions must be met for its success. The effectiveness of a live auction largely depends on the principle of supply and demand. It thrives when a substantial number of prospective buyers are assembled in a single location at the same time. The presence of multiple bidders fosters both confidence and competition, thus ultimately leading to higher bids. Another condition for the success of live auctions is ensuring that stakeholders and parties in interest are not only present to observe but are also empowered and prepared to negotiate any last-minute concessions on behalf of the franchisor and/or landlords during the auction.

Case Study: The Pizza Hut Franchisee Bankruptcy and Auction

The bankruptcy of EYM Pizza,1 a significant Pizza Hut franchisee, provides a practical illustration of the complexities inherent in franchise bankruptcy sales. EYM Pizza filed for chapter 11 protection in July 2024 and was operating approximately 140 Pizza Hut locations at the time.

The franchise agreements for these locations were terminated prior to the bankruptcy filing, placing the estate in a precarious position, as the restaurants could not operate without the franchisor’s approval. In addition, the franchisor held near-absolute discretion in determining what prospective buyers would be approved to acquire the franchise locations. Since the franchise agreements were terminated, there were no franchise agreements to assign.

The individual-unit economics revealed that approximately one-third of the restaurants were operating at losses, another third broke even and the remaining locations generated a reasonable profit. Rent for these restaurants was generally low, thus offering limited potential for significant value improvements through rent reductions. The franchisor was approached to consider royalty or advertising concessions to enhance the viability of the loss-making stores, thereby allowing them to remain open, but no concessions were offered at that time. As a result, the debtor closed the underperforming locations, rejected the leases, and shifted focus to the sale of the remaining 77 restaurants.

In preparation for the sale, it was discovered that the franchisor had specific capital expenditure (CapEx) requirements for each restaurant, which would be imposed upon acquisition by a new franchisee. Through negotiations with the franchisor, the scope and timeline for these CapEx requirements were adjusted to provide the new buyer with additional time to complete the improvements. As CapEx is generally considered part of the acquisition cost, any reduction or delay in these requirements benefited the estate by enhancing the value of the assets.

The CapEx requirements created a situation where the marginal restaurants held negative value. To mitigate this, the estate explored the option of selling the leases and equipment outside of the brand (debranding), thereby avoiding the financial impact of the CapEx requirements and new franchise fees. However, no acceptable offers were received for debranding these locations, as a surplus of closed restaurants was available in the market at that time.

Given the market conditions in the fall of 2024 and the limited interest in the brand and this opportunity at that time, it was determined that a live auction would likely fail to attract enough bidders to achieve a favorable outcome. As a result, a sealed-bid sale process with broad marketing efforts was implemented; however, no acceptable stalking-horse bid was received.

The debtor subsequently informed the franchisor that the marginal restaurants would be closed unless additional concessions were made that would provide sufficient value to the estate. Although the franchisor initially rejected this request, an agreement was eventually reached after the debtor began closing these restaurants. This agreement allowed the debtor to continue operating the marginal locations, ultimately enabling the estate to generate value through the auction process.

The revised franchisor’s concessions revitalized market interest, and there was enough interest to conduct a live auction. A decision was made to proceed with a live auction and present the franchise concessions in the revised offering material. More than a dozen prospective buyers’ groups participated in the day-long auction.

During the auction, the franchisor, Pizza Hut LLC, acquired 18 locations across Georgia, Illinois and Wisconsin, more than doubling its company-owned store count, as Pizza Hut continues to operate primarily as a franchised brand. The remaining 59 locations were purchased by various bidders, including PZH Foods Inc., Valor Pizza LLC, KK Mgmt, PH Hospitality Group and Shantilal Patel. The bankruptcy proceedings concluded with a court-supervised auction of 77 restaurants, resulting in a total recovery of approximately $12 million.

Conclusion

The bankruptcy sales and auction processes of franchise businesses are markedly more complex than those of independent retail and restaurant entities. The interplay of franchise agreements, franchisor rights and brand considerations necessitates a nuanced approach to navigating these proceedings. The EYM Pizza bankruptcy exemplifies these intricacies, offering valuable insights into the multifaceted nature of franchise bankruptcy sales and the critical factors that influence their outcomes. Understanding these nuances enables stakeholders — from franchisors and creditors to potential buyers — to better navigate the challenges and opportunities presented by franchise bankruptcy sales and auctions, ensuring more strategic decision-making and operational stability in distressed-asset scenarios.

Alan Gallup is a partner with National Franchise Sales in Newport Beach, Calif., and leads its Asset Recovery Team, specializing in asset recovery through bankruptcy, foreclosure and receiverships. He has overseen the resale of numerous high-profile food service brands, and he has expertise in managing distressed assets for effective optimization and recovery in complex scenarios.