CHEEKTOWAGA, N.Y. – Dunkin' Brands has announced its intent to purchase some of the stores of troubled Kainos Partners Holding Company, a master franchise of 56 Dunkin' Donuts shops located in New York, South Carolina and Nevada. Dunkin' will acquire the franchise's stores to be owned and run by the franchisor, and then refranchise them later.

In an email sent out to Dunkin' franchisees, CEO Nigel Travis explained the franchisor's intent to buy the company. "Kainos has been unable to emerge from bankruptcy and has filed a motion seeking an order authorizing bidding procedures to be employed in connection with the proposed sale of their Dunkin' Donuts restaurants and related assets," Travis wrote. "Dunkin' Brands has submitted a bid to purchase a substantial portion of the assets and business operations."

Travis went on to write, "Kainos will continue to operate its Dunkin' Donuts restaurants in Buffalo, NY, Greenville, SC, and Las Vegas, NV until the conclusion of the sale process."

Attorney Adam Siegelheim, chair of Stark & Stark franchise group elaborates, "The implication from Nigel's email is that Kainos is not going to put forward a plan to come out of Chapter 11."

The franchise attorney explains of last Wednesday's deadline set by the court to file a plan and the company's missing it, "They'll remain in chapter 11 but will move to sell off their assets in the ordinary course of business."

Refranchising bankrupt Dunkin' stores

"Dunkin' submitted a proposed order to acquire the assets of Kainos under a 363 sale, which is the code section for selling stuff through bankruptcy," says Jim Balis, who is both chief executive officer and chief financial officer of Kainos Partners.

A "363" sale refers to the sale of a company's assets when it is undergoing bankruptcy, as in a Chapter 11 reorganization. It refers to the bankruptcy code that regulates the procedure, 11 USC §363.

"I think the order will be entered on Monday (March 8) for that proposed 363 sale, says Balis. "Over the next month, we will be marketing units to see if anybody else is interested in buying the assets of Kainos, the debtor."

"It looks like they are going to sell off their assets through a liquidated chapter 11," explains franchise attorney Adam Siegelheim.

Michelle King, director of global public relations for Dunkin' Brands, adds, "Other buyers will have an opportunity to purchase the assets of Kainos subject to bankruptcy court approval. Although a final date has not yet been set for completion of the sale, we believe it to be in early April. In the meantime, Kainos will continue to operate in all markets."

One year's high flyer crashes the very next

Kainos' Balis says that the original franchise agreement that Dunkin' required was for Kainos to commit and build over a hundred units in various states. Kainos received development money when credit was flowing from private equity investor Palisades Capital and senior secured lender CIT.

Founded in 2005, the master franchise quickly built some 56 stores in New York, South Carolina and Nevada.

Dunkin' was pleased.

Dunkin' Donuts honored Cheektowaga, New York-based Kainos Partners as "Developer of the Year" in July 2008, hoping to have the way it grew emulated by others. In a toast given at a ceremony for its award winners, Jon Luther, who at the time was chairman and chief executive officer of Dunkin' Brands, Inc., said: "This room is filled with an accomplished and elite group of leaders from all around the world who represent the very best of the Dunkin' Brands system. I applaud the values and dedication you all bring to this company."

But a year later, Kainos was filing Chapter 11 for bankruptcy protection.

When asked why the master franchise failed and whether the high number of store locations spread out so far from each other and the company's head office had caused the company's downfall, CEO Balis replied, "Unfortunately, I cannot comment on that."

Dunkin' has been caught up in the coffee wars, a price war among McDonald's, Starbucks and others over cups of coffee. Meanwhile, competitors are increasing breakfast offerings to raise revenues in the tough economy. "It is a challenging market," says Balis over his firm's decline. "It didn't help that some of our competitors are advertising very aggressively in the breakfast segment."

Kevin McCarthy, current chairman of the Dunkin Donuts Indepedent Franchise Owners association and a former vice president of real estate and operations at Dunkin' Donuts, thinks that it is a problem of franchisor Dunkin' not understanding the chain's traditional strengths. Speaking strictly on behalf of himself, McCarthy thinks misconceptions caused Dunkin' to use the wrong development strategy.

He stresses that Dunkin' is largely a mom & pop franchise chain. It should grow organically, rather than using large area developers. "Nothing replaces a franchise operator who is on premise," declares McCarthy. He stresses that a slower but more steady growth is  opening a store to get it profitable, and then open another in a fairly contiguous neighborhood that the owners know well.

In a push to grow quickly across the country, Dunkin' veered away from its traditional development model. Former CEO of Dunkin' Brands Jon Luther authorized the selling of master franchise licenses to private equity investors, inviting them to build a number of stores in a market to quickly gain critical mass, grab market share and establish the brand in an area.

The first sign of problems with the growth model was in May of last year when a master franchise, owned by the family behind the Zales jewelry store chain, abandoned its plans to open some 70 Dunkin' stores in Texas after launching just 4.

"There needs to be more patience in regards to franchise development," says McCarthy, who is also an attorney. He thinks that it is the quality of a customer's retail experience that best develops the support for a store. "Impress customers with sterling operations and let customers tell their friends in the flesh and online about it. Once that catches on, they'll begin to grow rapidly."

"Slow and steady wins the race," declares an anonymous Dunkin' Donuts insider.

"What works best is having a hands-on operator who is there tending to customers. You have to put your investors together in the shops with the franchise owner-operators for that to work," he declares.

One South Carolinian, Bruce Tyson, does give insight that the doughnuts by Kainos may not have been up to Dunkin' standards — at least in his mind. He writes on his blog, "I hope that Kainos Partners Holding Company LLC is not what the Dunkin' Donuts brand as a whole has become. They are not like Dunkin' Donuts used to be." He goes on to call the donuts stale and the South Carolina stores often out of the products he has grown to like.

Although the franchises will soon become company-owned or sold off, Balis is uncertain what will happen to the master franchise support staff at Kainos Partners. "No formal decision has been made on that yet," he states.

McCarthy thinks that Dunkin' can learn from these franchising mistakes. He remains hopeful for the future development of the Dunkin' Donuts chain and its new leadership. "It appears that Nigel Travis, the new CEO, has a strong emphasis on improving shop operations. I view that very favorably. If he follows through on strengthening the operations, that will portend very well for the Dunkin' Donut chain."