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Why struggling chains turn to franchising

As chains such as Steak ‘n Shake and Krystal faced mounting financial problems, they looked to refranchising as a solution, says RB’s The Bottom Line.
Photograph courtesy of Steak 'n Shake

The Bottom Line

This week, burger chain Krystal filed for federal bankruptcy protection, revealing that it has closed 44 locations in recent months.

The filing came just three months after the Chattanooga, Tenn.-based chain said it planned to sell as many as 150 company stores to franchisees. Sometimes, those refranchising deals came along with requirements that the operator remodel the location.

That refranchising effort followed multiple defaults on financial covenants in its loans.

Krystal is hardly the only chain to turn to refranchising as part of a financial rescue strategy. Steak ‘n Shake, another burger chain, said it planned to sell all of its company-run locations to franchisees.

It then proceeded to close a quarter of those 400 locations, saying they were being prepared for that refranchising deal. In reality, those restaurants were simply losing money.

Refranchising is clearly a popular strategy among all sorts of legacy restaurant companies. Franchising an established restaurant chain is more profitable than selling burgers or chicken sandwiches. Franchisors don’t have nearly as many capital expenses. They don’t have to employ low-skilled, high-turnover employees. If a restaurant goes under, they’re just out the 5% or 6% royalty payment rather than 100% of the location’s revenues.

Franchisees have frequently proven their ability to run restaurants better than their corporate counterparts. And if you can’t operate the restaurants, why not sell them to someone else to see if they can?

The issue for many franchises is money. Many of these brands require investment to get sales back up, and they can’t afford it. So they seek to spread out the cost of that investment to a larger number of franchisees.

When it works well, franchisees will eagerly buy the restaurants and build empires. Greg Flynn, who operates the largest restaurant franchisee in the country in Flynn Restaurant Group, turned that company into a massive operation by first acquiring corporate stores from Applebee’s.

At the same time, it seems disingenuous to turn over a money-losing concept to franchisees.

Steak ‘n Shake and Krystal are different examples—the former didn’t file for bankruptcy, and the latter didn’t close restaurants it expected to sell. But both were in need of some drastic action.

As we learned from the Burgerim disaster this week, franchisees take on all the risk. They’re the ones putting up the money to buy the restaurants, after all. And they’re the ones hit with capital cost requirements, potentially high fees for delivery orders and demands for costly discounts to get customers in the door.

Both Krystal and Steak ‘n Shake have used heavy discounts to drive traffic. Steak ‘n Shake, in particular, became heavily reliant on those discounts for customers. When customers turned elsewhere, its same-store sales and traffic plunged. Why would franchisees be able to do any better in that scenario?

And franchising is hardly a panacea, anyway. It simply shifts the risk from one corporate entity to the other.

Jack in the Box, for instance, has spent years selling stores to franchisees. Many of those franchisees are losing money, and the company is embroiled in a dispute with those operators. Its CEO is now leaving after engineering a major overhaul of its corporate operations.

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