(FORTUNE Small Business) – It may have been Friday the 13th, but Burt Benepal was not in a worrying mood. Benepal, 46, had been opening restaurants for more than 20 years (including outposts of Denny's, Chuck E. Cheese's, and Wendy's), and in February 2004 he was energized about his newest venture: the Ground Round Grill & Bar, which Benepal considered "a good, solid brand." He had agreed to startup costs of about $1 million, but he saw that as a promising long-term investment. Though there were 130 Ground Round outlets in the Northeast and Midwest, he owned the first on the West Coast, and he hoped to open many more in the years ahead.

Benepal's enthusiasm evaporated when he received an alarming phone call from a franchisee on the East Coast: The parent company of Ground Round had run out of money, and it was ceasing operations immediately.

While bankruptcies by nature are unpleasant affairs, this one quickly turned ugly. The announcement came right before the dinner rush on a Friday, when store managers were ordered to tell diners to finish eating and pay their tabs. (Some were sent home with half-eaten meals in takeout containers.) More than 3,000 employees—some of whom had been with the restaurants for over a decade—were let go without severance, and their final paychecks bounced. A few angry workers broke plates and windows and stole steaks and liquor. In at least one instance employees reportedly kept the restaurants open after they were ordered to close and pocketed the proceeds. The company's subsequent bankruptcy filing showed that unsecured creditors, including food and product purveyors, were owed between $10 million and $50 million. CEO Tom Russo was allegedly threatened by former workers and was rumored to have carried a gun with him to the office. (Russo did not respond to requests for an interview, nor did any of the company's management.)

While the bankruptcy meant that the 59 company-owned restaurants would close, 72 franchise stores—owned by local proprietors under license from the chain—stayed open in 19 states. Many customers however, who had read or heard news of the bankruptcy, did not distinguish between a company-owned or franchise-owned store. (After all, by design they are supposed to look the same.) Within a few weeks, Mike Metz, who at the time owned three stores in Pennsylvania, saw sales fall almost 20%. Several franchise restaurants that had been struggling were forced to shut down, says attorney Craig Tractenberg, a partner at Nixon Peabody in Philadelphia who was hired to represent the Ground Round franchisees.

A few big competitors immediately considered buying Ground Round's assets out of bankruptcy, but during the months-long sale process, the franchisees were left to fend for themselves. They considered it crucial that the franchisee-owned restaurants all stay open during that time. Within a few weeks the group elected leaders, hired a law firm, created a buying co-op, renegotiated food contracts—and even introduced a new, low-carb menu. In fact, after the initial scare, being on their own had a certain revolutionary appeal. With no royalties to pay and no corporate office to answer to, life was pretty good. So a few months later, when bids started coming in, the franchisees got the idea of taking their experiment in self-government to the next logical step: Why not pool their assets and buy the company themselves?

Founded in 1969 as part of the Howard Johnson Co., Ground Round was a pioneer in the $37-billion-a-year casual-dining business, predating Applebee's, Bennigan's, and Houlihan's. Early menus listed just 12 items, and most people came for the half-pound burger in a basket (called the Ground Rounder). The restaurants wooed families. Diners got free popcorn and peanuts—they were encouraged to throw the peanut shells on the floor—and the chain introduced the "penny a pound" promotion. (If a young diner weighed 50 pounds, her meal cost 50 cents.) Waiters would yuck it up by giving a kid a barbell before he stepped on the scale. The restaurants had few windows, giving them a dark, cavelike feeling. It was pitched as "warm and cozy, but it was really designed to be energy-efficient during the oil crisis of the 1970s," explains Bob Smith, a franchisee with stores in Vermont and New York.

The headquarters of Ground Round were always something of a revolving door: The company changed owners four times in the 22 years before it went public in 1991. By that time diners were becoming more health-conscious, and the stuffed potato skins and 10 cent buffalo wings (which had once required an investment in bigger deep fryers) had become passé. In 1997, after posting a loss of $1.9 million in the second quarter, Ground Round was bought out for $16.7 million by Boston Ventures, a private-equity firm. Tom Russo, a former president of Howard Johnson who had sat on the board of Ground Round, was named CEO.

Throughout the 1990s Ground Round invested little in updating its concept or marketing its brand. While the franchisees were required to spend 2% of their sales on advertising, the parent company spent less than 1% on ads. As the franchisees embraced creative promotions (Bob Smith launched a "penny a degree" promotion to get families to come on cold days), the corporate stores did not do much to draw in customers. Similarly, while 42 of the franchise stores were renovated in recent years, at $350,000 a location, the parent corporation refurbished only two of the 59 restaurants that it owned outright. The contrast in commitment showed up in sales numbers: The average company-owned store took in $1.5 million in revenue in 2003, compared with $1.75 million for franchised locations. (Some franchisees raked in as much as $2.5 million a store.)

Ground Round took out a $40 million line of credit in 2000 and tapped it for at least $26 million. Boston Ventures had already started selling off many of its locations to franchisees. Although the company sold 39 restaurants in the next two years, that still wasn't enough. The goal was to get down to fewer than 15 company stores, and Ground Round was stuck with 59. It had sold the best stores first, and many that were left were in less popular locations. In 2003 the chain lost almost $7 million on revenue of $107.4 million. While the restaurant selloff had reduced the $26 million debt to about $3.5 million by 2003, the lender wanted the rest paid off in the first two months of 2004.

Ground Round was on track to make those payments as soon as it sold off 19 more stores—deals that were in the works. But the financing for them hit a snag. The delay seemed minor at the time, but it meant the company would default on its loan payment—an agreement that already had been amended six times since 2000. The lender called its loan and exercised its right to clean out Ground Round's bank account. Boston Ventures, which had poured $15.1 million into the company with no return, refused to spend any more. (A spokesman at Boston Ventures declined to comment.) The management team—reportedly worried about being held personally liable for payroll, taxes, and other operating costs—shut the company down immediately.

It wasn't long after the bankruptcy that prospective buyers started sniffing around, and the franchisees—many of whom were angry and felt abandoned by their former operator—wanted to have some say in who would take over. To that end, the franchisees' attorney organized what he called the "beauty contest," a meeting in Philadelphia at which leading Ground Round franchisees could interview the potential purchasers. "We wanted to partner not with the highest bidder but with someone we liked," says franchisee Mike Metz. Potential buyers included the operators of such chains as Carvel and Wall Street Deli. But after a day and a half of meetings, the franchisees were clear about whom they thought would make the most attractive owner: themselves. "We felt we knew as much as them, if not more," says Jack Crawford, 45, a franchisee in Maine who has been with Ground Round for 25 years. "Why not put our own group together to bid on the assets?"

Over the following weeks the franchisees wrote a business plan based on the model of the Best Western hotel chain, which operates as a cooperative. (Crawford's company also runs three Best Westerns, and he stepped into a leadership role to apply the co-op model to Ground Round.) Among other benefits, franchise royalties would be reduced from 4% to something between 2% and 3%.

Winning Ground Round wasn't going to be easy, but the franchisees were organized. They had to come up with a $250,000 deposit to bid on the assets, and all 39 kicked in. Each franchisee also estimated how much he lost due to the bankruptcy. Together the claims reached about $40 million, but each claim stood separately—so if the franchisees wanted to sue, the new owner would have to fight 39 separate lawsuits. "It was a brilliant move of throwing a monkey wrench into the machine," says Mark Bromberg, CEO of Apex Restaurant Group, a Plano, Texas, company that specializes in turning around distressed restaurant chains and that was interested in Ground Round. "It was also unmitigated bullshit. Everyone laughed at it because it was so ridiculous."

Although no one, including the franchisees, thought they would ever get anything near the $40 million, those claims had a huge influence on the sale. Apex, backed by a REIT called U.S. Restaurant Properties, was the only prospective buyer from the beauty contest that bid at the auction, offering $6.5 million. The franchisees bid $1 million. The disparity was so clear-cut that a news article was published saying Apex "Wins Bid for Ground Round." But the deal was still subject to a bankruptcy judge's approval, and the franchisees filed an objection to the Apex offer, claiming that the $6.5 million wouldn't cover the $40 million they believed they were owed. The objection bought the franchisees time. During the next few weeks they scrambled to raise more money ($40,000 from each restaurant and a $2.9 million bank loan), upping their offer to $4.85 million. It was still less than Apex's bid, but it came with an attractive plus—the $40 million claim and the threat of litigation would be wiped out. Suddenly they were a serious contender. On July 7, 2004, the bankruptcy judge approved their offer. The franchisees now owned the brand.

They were ecstatic, but after the news broke some skeptics started saying that franchisee ownership of the parent company could trigger a new set of problems. They wondered whether the inmates would be able to run the asylum. "Franchising is not a cooperative event. It needs professional management," says Michael Seid, a franchise consultant based in West Hartford, Conn. While owning the concept is not a problem, operating it—and performing the franchisor's duties of marketing, promotion, and product development—could be. Apex's Mark Bromberg believes the franchisees, without strong financial backing, will have trouble competing against colossal chains such as Applebee's and T.G.I. Friday's. Says Bromberg: "It's not about saving money in royalties or being the master of your domain. This is about winning the battle for the consumer."

"We have a new model, so it's hard for traditional restaurant companies to grasp," counters Jack Crawford. "But it's working. We have 100% royalty collection, more than 90% marketing participation, and we expect four times the attendance at our annual meeting compared with last year. The numbers are great when there's skin in the game." There are now 71 remaining Ground Round locations, 64 in the co-op and seven run by three franchisees who decided not to join. Systemwide sales are about $125 million, on a par with their performance before the bankruptcy.

Burt Benepal, who was building the first West Coast location when the company went bankrupt, opened his restaurant—with the assistance of a dozen staff members who were borrowed from other Ground Round restaurants—in Richmond, Calif., this past summer. It was five months later than expected, but that kind of delay is not uncommon in the restaurant business. Benepal anticipates first-year sales of $2 million, and he's scouting for a location for his next restaurant, which he plans to open this summer. Jack Crawford expects six to eight new Ground Round locations to open across the U.S. in 2005.

The story of the Ground Round franchisees has made its way through industry circles—no doubt spurred when members of the co-op and their attorney recently spoke about the experience to 1,200 attendees at a franchise conference in Las Vegas. Michael Einbinder, a franchisee attorney at New York City law firm Rosen Einbinder & Dunn, says a client recently asked him what to do if his franchisor went bankrupt, and thanks to the Ground Round story, he had a new answer. "It's an object lesson," says Einbinder. "It makes people realize they have options."