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Darrell Lea and the franchisee fallout: 10 risks to franchisees of insolvent systems

feature-chocolate-200The recent decision by the owners of the 85-year-old Darrell Lea brand to place the business into voluntary administration highlights the potential risk of insolvency in franchise relationships, especially when it’s the franchisor who becomes insolvent.

The Darrell Lea network includes 69 franchised and company-owned stores. If past franchise insolvencies are any guide, it is likely that franchised stores in Darrell Lea were more profitable than the company-owned stores. Unfortunately for the franchisees of Darrell Lea, or any other insolvent system, there is often little they can do – short of buying out the business themselves – to ensure their future.

Consequently, while their franchisor is in administration, the franchisees of Darrell Lea (or any other insolvent system under administration) are likely to face the following 10 types of risks to their businesses:

1. The risk of little useful information

Most insolvency practitioners have little or no understanding of franchising and the nature of the franchise relationship.

Where administrators will apply considerable effort to keep staff and creditors informed during an insolvency (the first to ensure they keep the business operating or provide access to records while the administrators sort out the business’ position, and the second to ensure continuity of key supplies), franchisees are generally given the bare minimum of information (e.g. the business is insolvent but carry on as usual).

Because staff and suppliers are recognised as creditors, they are usually better informed than franchisees, who may be circulated a form letter when the business is placed in administration and then hear no further meaningful information until a sale or wind-up announcement is made. Franchisees of insolvent chains often learn more from the business media about the future of their livelihoods than they will from the administrators.

2. Loss of consumer confidence

Current media reports indicate that sales have actually increased at Darrell Lea outlets as shoppers rush to stock-up on their favourite treats, presumably in expectation that these will no longer be available if the business goes under.

However, in previous franchise insolvencies, such as that of book retailer Angus & Robertson last year and whitegoods retailer Kleenmaid.

in 2009, consumer responses were very different.

Angus & Robertson customers were outraged when administrators announced that gift vouchers (many of which were given as Christmas presents only a couple of months earlier) would no longer be honoured, prompting a consumer backlash. During this period of highly damaging PR, the remaining company-owned and franchised stores were expected to trade on as usual.

When Kleenmaid went under, its franchised and company-owned stores were besieged by angry customers trying to claim the goods for which they had collectively paid more than $25 million in deposits. In rare cases, some were able to buy their goods all over again in liquidation sales to ensure that their newly-built or renovated kitchens or laundries could be completed without further modifications, but many swore they would never buy Kleenmaid again, and actively campaigned against the brand in revenge.

3. Disruption to supply chains

Some franchise systems have preferred supplier arrangements, and others are the primary supplier to their franchisees themselves.

As a manufacturer, Darrell Lea would supply its retail network of company-owned and franchised stores with the majority of their product lines. If the manufacturing facilities are scaled-back, closed or sold separately from the retail network, then a significant risk of disruption to normal supplies exists. A new buyer of the group could decide to close the factory, and outsource manufacturing altogether, in which case it is likely that teething problems with a new set of arrangements could also result in supply issues for franchisees.

While it is possible for a franchisee to continue to operate when a franchisor goes bust in networks that have preferred supplier arrangements, the franchisee might find that creditors will become more risk averse, and tighten their credit terms, insist on cash up front, or otherwise cap franchisee purchases to a low limit to reduce future risk.

4. Stock dumping

Franchisees of fashion accessory chain Kleins, which collapsed in 2008, found themselves selling goods at cost or below as the administrator sought to liquidate inventory held by the franchisor that could not be returned to suppliers.

In any group where the franchisor has embedded itself into the supply chain and provides inventory to the franchisees, there is the risk that administrators will seek to liquidate inventory as quickly as possible through the network to generate cash, and this may be done at the expense of franchisee margins or in breach of the brand’s established price positioning.

Either way, this can be damaging to a franchisee’s business.

5. Diminished franchisor support

Administrators will question all costs in a business, particularly labour costs. Franchisor head office staff who survived the franchisor’s descent into administration may still be pink-slipped by the administrators in an attempt to restore profitability and improve the saleability of the business as a going concern, but, in doing so, often reduce the very resources for which franchisees pay royalties.

Consequently, franchisees of an insolvent system might find that their field support contact has been made redundant, or now has two or three times more franchisees to support as his colleagues have left.

A reduction in field support is likely to occur concurrently with a reduction in marketing personnel and other head office functions that directly or indirectly provided support, meaning that franchisees will be left more and more to their own devices, and while some may see this as a good thing, it further exacerbates damage to the brand (and, therefore, network value) as inconsistencies develop in the group.

At its worst, this could lead to open revolt by franchisees, as happened with Angus & Robertson last year when nearly half the franchisees sought to leave the group en masse whilst it was under administration.

Jason Gehrke

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Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level.
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