Franchise Expansion in 2022 May Be Constrained by Capital Shortages and Legislative Restrictions

Editor's note: This article is the last in a four-part series exploring the restaurant franchise boom over the past 22 months. The first three articles can beviewed here。

As the restaurant industry trudges through the final months of the second pandemic year, many restaurant franchisors are still betting on strong growth in 2022. Experts say this confidence is not unfounded, given that healthy operators have used pandemic-induced market shifts to their significant advantage this year. Susan Grueneberg, a partner in Cozen O'Connor's franchise practice, noted that the biggest difference between franchising in 2019 and 2021 may be the distrust of corporate workplaces, which has attracted more first-time franchisees.

"People will say... I'd rather trust myself and my ability to run my own business, and franchising seems like a logical choice," Grueneberg said. "I think there's been pent-up demand for buying franchises."

Keri McWilliams, a franchise attorney and partner at Nixon Peabody, echoed similar sentiments. She speculated that more people are willing to take risks on franchise investments because they are impressed by surging diner demand and affordable real estate options, and view pandemic disruptions as a "temporary dip." "If you want to get into a new industry, the best time is when prices are lower, because sometimes rents are cheaper," McWilliams said.

Grueneberg said it has also become easier for franchisors to work with new franchisees as the industry shifts from face-to-face meetings and paper documents to electronic formats. "One truly unintended consequence of the pandemic has been the shift toward more electronic communication. It changed the way disclosure documents are provided or signatures are obtained... DocuSign is used more widely." States have also developed online portals for franchisees to submit documents and communicate electronically, Grueneberg noted, and a national electronic storage system has been established with more states participating, lowering regulatory barriers for franchisees.

"We're seeing more growth in overall franchise development than I've seen in a long time," said Gary Occhiogrosso, founder and managing partner of Franchise Growth Solutions. Occhiogrosso attributes the increase in first-time franchisees and established operators eager to open new locations partly to low interest rates. "We've been focused on having clients strengthen franchisee financing options, whether it's making sure they're SBA-registered or ensuring their Item 19 and FDD (Franchise Disclosure Document) are really polished so bankers can truly understand performance," he said. "The cost of capital has been the lowest in maybe 50 years, or even lower."

The past two years have also brought cheaper restaurant construction opportunities due to diners' widespread interest—and in many cases preference—in off-premises dining occasions. As a result, franchisors have shifted store designs toward smaller units with little or no dine-in space, making multi-unit deals more affordable for small and mid-sized franchisees. "I think franchisees will gravitate toward concepts that are easier to operate, require fewer employees, and have lower food and labor costs," said Paul Tripodes, vice president of franchise development at Aloha Poke.

But experts predict that not all pandemic changes will benefit restaurant franchising, and the challenges currently plaguing the industry are likely to continue into 2022, or even worsen.

Legislative and financial headwinds could temper franchise growth

One of the most pressing issues for restaurant franchisees? Anthony Marks, a partner and franchise team leader at Bryan Cave Leighton Paisner, believes access to capital is a major hurdle in the absence of federal support, such as the depletion of Restaurant Revitalization Fund money. Occhiogrosso said this may not be a concern for multi-brand professional franchisees, but if the Federal Reserve begins tightening rates and inflation rises, small and mid-sized franchise buyers could face new headwinds. "That would certainly slow down (franchise expansion)," he said.

Occhiogrosso predicts that the current glut of prime restaurant real estate—filled with second-generation spaces left by shuttered restaurants—will also shrink in 2022. "A lot of developers right now aren't building projects for various reasons. Material costs are high, there are no tenants... (Developers) are certainly doing less than they were pre-pandemic," he said. "I think the cost of capital and the difficulty of finding the right locations will start to catch up with the economic rebound, and that will certainly temper the rapid growth in franchising over the past year or so."

Grueneberg said global disparities in pandemic recovery could also reshape the U.S. restaurant market. She predicts that in countries where vaccination remains difficult, restaurant companies may consider establishing a foothold in the U.S. market because their domestic growth is hindered. On the other hand, international franchise growth for U.S. brands could continue into 2023 due to differences in pandemic impact. Nevertheless, several restaurant chains have recently announced overseas franchise agreements. Muscle Maker Grill signed a deal to develop 40 locations in Saudi Arabia, and Wayback Burgers is partnering with WB Burgers Asia to open 60 locations over 20 years.

Domestically, Marks warned that restaurant franchisees could soon face regulatory changes surrounding franchising. "There's a legislative backdrop to all of this... the PRO Act from the federal government." The Protecting the Right to Organize Act of 2021 (PRO Act) includes a joint employer standard that prohibits franchisors from interfering in franchisee-employee relationships, but franchisees would then be liable for any labor violations occurring in their businesses. The bill was introduced in February, considered by the Senate in March, but no further action has been taken.

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"I think the cost of capital and the difficulty of finding the right locations will start to catch up with the economic rebound, and that will certainly temper the rapid growth in franchising over the past year or so."

Gary Occhiogrosso

Founder and Managing Partner, Franchise Growth Solutions

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At the state level, new legislation around franchise regulations is already brewing. For example, California Assembly Bill 5 (AB5), which reclassifies millions of independent contractors as employees, took effect in January. AB5 includes the ABC test to define whether a worker is an employee or an independent contractor. The test also applies to franchisor-franchisee relationships to determine whether a restaurant should be liable for its franchisees' labor issues. There are concerns that AB5 could be used as a new standard for evaluating franchisors' joint employer liability—if a business relationship satisfies the ABC test, the franchisor would be deemed responsible for franchisee violations, and according to Franchise Law Solutions, nearly all franchise relationships satisfy that test. The Dunkin' Donuts Independent Franchisee Association, along with other franchise groups, filed a lawsuit against California over the law last fall.

"This could change franchising, or change how it's interpreted," Marks said of AB5. "Government intervention could further complicate the recovery."

Grueneberg said the digitalization of franchise relationships could also become a stumbling block for small and mid-sized restaurant chains, despite its convenience and flexibility. "Sometimes selling franchises can be very exciting and easy, but getting them operational, getting the business off the ground, and having the resources to assist franchisees in doing so can sometimes back up, and I think that's a real challenge for smaller systems," she said. "It's a bigger challenge than... technology can solve."

Flexible franchisees will weather the storm

Despite these obstacles, experts say there is still room for restaurant franchise expansion in the coming year. But franchisees need to be selective about the companies they partner with to ensure long-term survival in the pandemic environment. "Flexibility will determine which businesses succeed or fail over the next two, three, five years. It's going to be a challenging operating environment on multiple levels," McWilliams said. "For small and mid-sized franchisees, it's important to ensure they generate reliable revenue, not just relying on dine-in and sit-down dining."

On the franchisor side, Marks expects competition for high-quality operators to emerge as restaurant companies develop growth plans, echoing the high rate of M&A in the restaurant industry this year. "There's a lot of confidence in the franchise space right now, and overall that's positive," Grueneberg said. "I think (franchise growth) will continue, and I don't think it's just about available real estate. Buying a franchise is sometimes not entirely a strategic decision, but an idea that people genuinely like. Hopefully (operators) have done all the research and found the right one, but the idea of being your own boss is very appealing."