Have you recently stayed at a branded hotel or eaten at a franchised restaurant where the property was tired-looking and in need of an update? Was the overall experience less than expected due to the worn-out facility? On your next trip, did you make a point to book a room or eat a meal at a competing brand where the facilities and amenities were up to date?
This is happening ever more frequently today. Hotels and restaurants built 10 or 20 years ago now need substantial updating to compete with those of progressive brands. Getting franchisees to invest in updating can be a struggle. Next to the initial costs of property construction, the largest expenditure will come when a facility is updated.
We all know it's not if, but when the refresh or remodeling will take place. The Franchise Disclosure Document may contain specific language stating when the update should take place, but many franchisors have no way to enforce it, and franchisees have limited means to finance it. Some forward-looking franchisors and lenders mandate that the franchisee annually escrow funds for franchise improvement. This is one solution that may cover all or a part of the remodel. A downfall is the limited investment fund choices and taxability of the return.
In better economic times, access to financing was easy. Lenders were around every corner. But the world has changed over the past 18 months. Now lenders are hiding behind every corner. Credit is tight and lenders are few in number, particularly for large-scale remodeling projects. If necessity is the mother of invention, then it's time to look for creative ways to solve the financing dilemma. One such bit of creativity is the use of non-qualified deferred compensation to finance the eventual refresh or remodel.
Deferred compensation has been a staple of executive compensation packages for years. In 2004, Congress introduced section 409A into the tax code. This section was written to address problems perceived and real arising out of certain corporate excesses evidenced by Enron and WorldCom. Section 409A now governs all forms of deferrals not otherwise in the qualified plan system.
A key provision of 409A allows a manufacturer (or franchisor) to sponsor a deferred compensation plan for a service provider or independent contractor (like a franchisee). The resulting plan enables franchisees to save up to 100 percent of their franchisee income pre-tax, and invest it tax-deferred for the needed remodel. When the date arrives for the remodel, the franchisee takes the distribution and pays ordinary income taxes on the money received. If used for remodeling, which is a business expense, the franchisee may be able to expense it again.
Deferred compensation in its purest form has always used the three R's to direct human behavior: recruit, retain and reward. Franchisors' could direct human behavior by using the plan to attract new franchisees and re-sign existing franchisees. To encourage system-wide participation, a franchisor matching contribution could be added, with a vesting provision stating the match can be used only for a refresh or remodel.
By sponsoring a tax-favored savings plan and encouraging participation with a matching contribution, the franchisor is assured that needed updating will take place on schedule. A consistent, positive customer experience is delivered across the system when all hotel properties or restaurants are regularly updated. By being proactive, the franchisor has protected the brand image, provided a much needed financing vehicle for the franchisee and contributed to the goodwill of the franchisor and franchisee relationship.
John T. Geenen is a First Vice President of Investments with UBS Financial Services Inc. He has more than 25 years of experience in the financial services industry. John may be reached at email@example.com