Franchisees of iconic American chains are 'hemorrhaging' sales, as operators of IHOP, Pizza Hut, and more file for bankruptcy

Franchisees for Pizza Hut, IHOP, and Subway have already filed for bankruptcy. McDonald's internally warned franchisees that they may have to downsize or sell locations.
"Every franchisee is a small business, and they had to close up, and they're sucking wind," said restaurant industry investor Roger Lipton. "They're hemorrhaging."
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The coronavirus pandemic is proving to be a breaking point for franchisees of some of America's most beloved brands.

While chains are better positioned than independent restaurants to survive the pandemic, many of the best-known restaurant brands rely on independent owner-operators to run restaurants.

Franchisees typically have more support and guidance than independents during a crisis, thanks to franchisors' assistance. At the same time, these business owners are facing the same struggles as the rest of the restaurant industry.

As restaurants across the US are permanently shuttering due to the coronavirus pandemic, experts say not every franchisee is going to be able to stay in business. Struggling owner-operators will be forced to try to sell their restaurants back to the corporate office or other franchisees, or file for bankruptcy.

A Kansas-based Pizza Hut franchisee filed for bankruptcy in early May. So did a franchisee with 49 IHOP locations, which are now set to close. At least one Subway franchisee in Nevada filed for bankruptcy in late April, according to court filings.

"Every franchisee is a small business, and they had to close up, and they're sucking wind," restaurant industry investor Roger Lipton told Business Insider. "They're hemorrhaging."

Even some franchisees of chains that are recovering financially are concerned.

McDonald's recently warned franchisees that while it had earmarked $40 million in aid for franchisees, some may need to downsize or sell off locations. In an email obtained by Business Insider, McDonald's National Franchisee Leadership Alliance pushed back on downsizing demands, telling franchisees "if you weren't considering downsizing pre-COVID-19, it shouldn't be a consideration as a result of COVID-19 today."

The pandemic is hitting restaurants without drive-thru and delivery business the hardest

Denny's full meal Irene Jiang / Business Insider

Not all franchisees will suffer equally, as restaurant owners try to decide if its time to leave the business.

Fast-food chains were able to keep serving customers via drive-thru throughout the pandemic. While sales at chains including McDonald's, Taco Bell, and Burger King plummeted by 20% to 35% in the last two weeks of March, most major fast-food have recovered significantly in recent weeks.

At chains where the bulk of business comes from sit-down customers, including casual dining chains like Applebee's and TGI Fridays and family-style chains like Denny's and IHOP, sales dropped by more than 70% in late March. While take-out and delivery provided limited business, some franchisees decided to temporarily close instead of attempting to eke out to-go sales.

Reopening dining rooms is far from a silver bullet for these chains. Adding new safety measures and rehiring staff to serve customers is a pricey process, Lipton says. With most states capping capacity in dining rooms at 25% to 50%, many sit-down restaurants will not be able to break even, especially if dine-in sales cannibalize the to-go business. As a result, some franchisees that planed to shutter restaurants temporarily may never reopen or may sell their restaurants.

Franchisees' financials prior to the pandemic will also have a massive impact on their outcomes.

John Gordon, the principal of Pacific Management Consulting Group, says franchisees that went into the pandemic with significant debt are the most likely to have to close or sell their locations as sales slump.

These struggling owner-operators are more likely to have entered the business relatively recently, Gordon says, as the costs of becoming a franchisee have risen in recent years. Other franchisees may have gone into debt due to expensive remodels, as franchisors demand updated appearances and technology.

Many franchisees received financial support from chain's corporate offices during the pandemic, with franchisors such as McDonald's , Denny's , and Pizza Hut cutting back on franchisees' costs by deferring payments related to royalties, rent, and marketing.

But, there has also been a shift across the industry towards a model in which fewer franchisees own more locations. Having fewer, larger franchisees can make it easier to operate with thin profit margins, as well as cut corporate costs. McDonald's, for example, went from slightly less than 2,100 franchisees at the end of 2014 to about 1,700 late last year.

Gordon says that the pandemic will accelerate the trend towards chains having fewer franchisees. But, Lipton says that any restaurant company is at risk due to the pandemic not just owner-operators with a handful of locations.

"Small chain, large chain, it's still a restaurant," Lipton said. "Same economics."

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