What Do Personal Guarantees Offer?

Obtaining personal guarantees from franchisees should be standard business practice for franchisors. How often do banks lend money to a small business without the owner of the business personally guaranteeing repayment of the loan? How often do shopping center owners lease space to small businesses, whether independent or franchise, without the personal guarantee of the owner ?¹

I will grant you that the sale of a franchise is not the same as the loan of money. It is also different than the lease of space in a mall. It is far more serious. Franchising creates personal relationships. Franchises are not typically granted to entities, but to individuals. Although the franchisor may allow that individual to form a corporation or limited liability company for tax reasons, or for purposes of avoiding liability to unknown future creditors, the franchise is typically granted based on an individual’s qualities, abilities, resources, and assets. The franchisor entrusts in the owner of the franchise all of its training and trade secrets. In return, the franchisee promises to pay royalties or other types of recurring fees to the franchisor. Without a personal guarantee, who will stand behind the business when cash flow is low and times are tough, as inevitably happens to most businesses at one time or another?

The franchisee also promises not to disclose the franchisor’s trade secrets and training, to operate the business in a manner that will not jeopardize the goodwill of the system, to indemnify the franchisor against certain third-party claims, and perhaps not to compete with the system. If the franchisee entity fails, without a personal guarantor, who will be responsible for assuring these promises are fulfilled? Is this really putting a “noose around a person’s neck,” as suggested by Andy Seldin in the companion column, or is it simply asking a man (or woman) to stand behind his (or her) promises?

Perhaps the issue of franchisees signing personal guarantees should be divided into two parts. First, there is the potential financial burden imposed on the individual who must guarantee the obligations of the franchisee to the franchisor. Second, there is the covenant of the owner that it will abide by the confidentiality and noncompete provisions of the franchise agreement. With respect to the latter, there is no reason the principal owners of the franchisee should object to signing their own names to the obligations. The mere suggestion by a franchisee’s owner that it will not be bound to maintain the confidences of the system should suggest to a franchisor that the prospective franchisee is not acceptable. The franchisor should have an obligation to all its franchisees to avoid giving access to the franchisor’s trade secrets and systems to any person without some assurance that the person receiving the information will not use it in competition with the system. To do otherwise puts in jeopardy the very asset that is being licensed to other franchisees.

What about when we are talking about “only money”? Franchisors that charge ongoing royalties to their franchisees are essentially extending credit to their franchisees when they grant the franchise. Every time the franchisee collects a dollar in sales, a certain percentage of that money belongs to the franchisor. If the franchisee is creditworthy, then perhaps credit can be extended without a personal guarantee. If the franchisee is not creditworthy, however, as is often the case when a new entity is formed to operate as the franchisee, why should the franchisor extend credit based only on the entity’s promise to pay when a bank and many of the franchisee’s other creditors would expect a personal guarantee?

When this subject was discussed on the Forum’s LISTSERV, one writer suggested that the franchised business “should stand on its own,” without the franchisee’s owner being required to use his personal assets to pay obligations owing to the franchisor. If the franchisor forced the franchisee to keep its doors open while the franchisee was simply going further into debt, I might agree. However, there are also circumstances where franchisees are making money, yet still refuse to pay their franchisor. Some franchisees simply decide they are not getting sufficient value for their royalty dollar, or that they are not making enough for their own efforts. It is particularly in these circumstances that the owner of the franchise needs to know that he has a personal, legal obligation for those payments, before deciding to unilaterally withhold any amounts. Even in a “typical” case of the franchisee running out of money, however, the franchisee collected the “royalty” from its customers, just as it collected sales tax; why should the franchisee’s owner not be held personally liable for his decision to pocket the collected funds or pay them to creditors other than the franchisor?²

Mr. Selden suggests (as did at least one writer on the LISTSERV), that if a guarantee is required, it should be limited in amount. Unfortunately for franchisees, the typical franchisor guarantee goes beyond the royalty owed by franchisees on revenues collected from customers. Under most franchise agreements, the franchisee is obligated to indemnify the franchisor against lawsuits brought by third parties as a result of the franchised business’s activities. While such indemnification could be essentially a blank check on the part of the franchisee, should the franchisor, whose potential profit from the franchised business is limited to a small percentage of sales, be responsible for the losses caused by the business, or the owner of the franchise, who has the most to gain from the business and the most control over its operations?

Mr. Selden counters my arguments by suggesting that the owners of franchisors do not sign personal guarantees. The fact is, however, that in the majority of franchise transactions, the franchisor is a much larger entity than the franchisee. When the franchisor signs the franchise agreement, it puts behind its promises the entire credit of its company. When a newly formed franchisee signs the agreement, it puts behind its signature only the assets that initially capitalized the company. In those situations, the only way to ensure both sides have significant capital behind their respective promises is to have the owner of the franchisee personally guarantee the franchisee’s obligations. A sophisticated franchisee should certainly understand that most creditors require personal guarantees from start-up entities.³

My colleague is suggesting that a new franchisor would have a competitive advantage by not requiring franchisees to sign guarantees. That may be true, at least until the first franchisee takes advantage of the situation and withholds royalties, breaches obligations of confidentiality, or organizes “royalty strikes” among franchisees, knowing that he has no personal responsibility for his actions. At that point in time, not only will the franchisor wish it had a personal guarantee, but so will most of the franchisees that have invested hundreds of thousands of dollars into their businesses, and need to have the system succeed. At that point, I hope my esteemed colleague wrote a very strong “ CYA ” letter to the franchisor when he first suggested proceeding without guarantees, noting the extraordinary risks the franchisor was incurring in consideration for some uncertain and unquantifiable competitive advantage the franchisees received when first getting started.

Endnotes

¹ Granted, there are landlords of distressed properties that will proceed without personal guarantees. Perhaps the only way they can obtain commitments for tenants is by signing what are essentially one-way agreements to lease properties as long as the tenant wants to stay in business. If a franchisor has a system in distress, or one no good businessperson will make a personal commitment to, then the franchisor needs to reevaluate what it has for sale.

² While the guarantee also covers lost future royalties, few courts have ever awarded lost future royalties unless there have been other breaches by the franchisee that lead to termination and the loss of future royalties. A franchisor whose franchisee simply fails despite the best efforts of the owner would be well advised not to pursue future royalties and subject itself to the “kitchen sink” counterclaim that inevitably follows when each party blames the other for the failure of the business.

³ Mr. Selden and I may not be in complete disagreement on this point. There are situations where large hotel systems deal with large, well-heeled hotel management companies, and those franchisors frequently do not require personal guarantees from the owners of those companies. In those circumstances, both parties to the contract are well capitalized, and both have significant economic incentive to perform their obligations. If the franchisor wants to avoid a claim of discrimination, it should establish an objective net worth credit criteria for circumstances in which it will waive the personal guarantee requirement, and be prepared to disclose that criteria.

This article originally appeared in the Franchise Law Journal, Volume 23, Number 3, Winter 2004. © The American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.