Buying an Existing Franchise: What to Look For In The FDD and Franchise Agreement.
By Richard Bayer, Partner, Einbinder & Dunn LLP
In this article we shed light on some of the unique concerns inherent with purchasing an existing franchised business and offer some insight on how to use certain franchise documents to better understand the business being purchased. Hopefully, this can help a potential buyer plan for a purchase of an existing franchised business, whether buying from a franchisor or from a franchisee.
Purchasing an existing franchised business from either the franchisor or an existing franchisee can prove to be a sound alternative to developing a brand-new franchised business. Doing so may combine the benefits traditionally associated with the purchase of a new franchise with the benefits of acquiring a non-franchised existing business. For example, the buyer of an existing franchise can often avoid the difficulties of introducing the concept to that geographic area, thereby saving substantial start-up marketing costs. Purchasing an existing business eliminates the need to conduct demographic studies, site-analysis, lease negotiations and finally, build out of the space. Further, inheriting existing employees can save the buyer from spending significant time and resources building out a capable team of sales and operational professionals. Of course, a franchise resale buyer can achieve other benefits, such as improving operating efficiencies, reducing supplier and labor expenses, creating synergies between the franchised business and other operations, but that isn’t the focus of this article. This isn’t to say that purchasing an existing franchise comes without its challenges, both business-related and legal.
Which Franchise Documents to Review?
A buyer of an existing franchise must carefully review (a) the franchisor’s current franchise disclosure document (“FDD”) to understand the current state of the franchise system, (b) the current form of franchise agreement and related agreements because those agreements are likely to govern the buyer’s contractual relationship with the franchisor, and (c) the franchise agreement and related agreements signed by the existing franchisee, especially in the event of an assignment (see below).
The documentation to be reviewed will vary depending on the type of transaction. When purchasing a business directly from a franchisor or when the franchisor requires a buyer to sign the then-current franchise agreement (which is usually the case), a buyer must conduct a thorough review of the franchisor’s current franchise disclosure document (“FDD”), franchise agreement and related agreements.
If purchasing from an existing franchisee, a buyer would be well advised to compare the franchise agreement and related agreements that the franchisee seller signed alongside the franchisor’s then-current set of agreements. It is likely that significant differences will exist between these versions because franchisors revise their agreements over time to provide benefits to the franchisor which were not contained in earlier versions and/or to modify clauses in response to developments in the franchise system over time. That comparison can yield valuable information, including possible changes to the royalty structure or the inclusion of fees which were not previously assessed, all of which could impact the buyer’s financial projections. The last point is a critical one. A franchise buyer must base its financial projections on the royalty and/or cost structure that will be imposed by the franchisor post-sale. If the franchisee seller was subject to a different structure, the buyer must evaluate the franchisee’s performance under the new structure.
When taking an assignment of an existing franchise agreement, instead of signing the current version, another critical thing to note is the number of years remaining in the term of the franchise agreement (as well as the number of years available in a renewal term). Unless the franchisor is willing to extend the number of years remaining, the buyer will be subject to whatever number of years the seller had remaining. Obviously, number of years remaining will have a significant impact on the purchase price.
Franchise Disclosure Document Analysis
As with any franchise purchase, whether a resale or a new franchise, a buyer must diligently review the franchisor’s current Franchise Disclosure Document. If you are familiar with FDDs, then you will know that they are a tremendous source of information concerning the franchise system, the business experience (Item 2), litigation history (Item 3) and bankruptcy history (Item 4) of the franchisor and the franchisor’s professionals, the fees charged by the franchisor during the term of the franchise agreement (Items 5 and 6), the support that the franchisor may (or will) provide to franchisees (Item 11), and the growth of the franchise system over the last three years (Item 20).
When purchasing an existing franchise, one of the first questions a buyer should ask is why this seller is looking to sell. If the franchisor is the seller, a buyer should ask, among other questions:
- Is the franchisor looking to strategically divest itself of operating units so that it can focus solely on managing and growing the franchise system? If so, is this divestment local, regional or national in scope?
- Has the franchisor determined that it is a poor unit operator or that it lacks the infrastructure to operate the units to their fullest capability?
- Has the franchisor recently acquired this unit from a franchisee exiting the system, perhaps as a result of a negotiated settlement?
The answers to these and other similar questions may be found in the FDD. A review of Item 3 can yield significant information about the state of the franchisor’s relationship with existing franchisees. In it, a buyer can learn whether the franchisor routinely engages in litigation or arbitration with franchisees or vice-versa. A franchise buyer can also learn from an Item 3 disclosure whether the business for sale is being sold as a result of a negotiated settlement by the franchisor and a franchisee. This type of insight can drastically alter a buyer’s leverage, business plan and ultimately, its course of action.
Item 19 of the Franchise Disclosure Document may contain information about the financial performance of the system as a whole (and/or may include subsets of franchised units within the system). A diligent buyer can obtain from the seller financial statements and other information reflecting the actual performance of the business being sold and can compare that information against the information being reported in Item 19. Among other things, the buyer can then assess whether the business is a poor performer, average performer or a well-performing unit. The next steps include determining why the business performs the way it does and what can the buyer do to improve upon that. A further analysis of Item 19 may show that franchised businesses located within a particular geographic area or in a particular type of real estate outperform others. That type of information is invaluable to a buyer looking to determine the likelihood of success.
Additionally, Item 20 of the FDD, will tell buyers, among other things, whether the franchisor has systematically divested itself of franchisor-owned units over the last three years, whether the franchisor engages in the practice of acquiring businesses from franchisees for the purpose of re-selling them (and/or other churning activities).
Franchise Agreement Analysis
The parties must pay careful attention to the transfer provisions found within the existing franchise agreement, which will lay out the steps to be followed to effectuate a valid transfer. The majority of franchise agreements require the franchisor’s prior consent to a transfer. The process to obtain the franchisor’s consent often starts with the buyer having to submit an application to determine whether it meets the franchisor’s then current requirements for a new franchisee. Additionally, the terms of the purchase must likely be divulged to the franchisor because in many instances, the franchisor has reserved for itself a right of first refusal to match.
Buying an existing franchise without the franchisor’s prior consent would have disastrous consequences; many franchise agreements provide that a transfer conducted in violation of these provisions is a default under the franchise agreement and may be grounds for termination. If the violation cannot be cured, the purchaser’s only recourse may be to seek a return of the purchase price from the seller. However, even if the default can be cured, one possible cure may be to undo the transaction. From a business perspective, this too is catastrophic. The seller has likely checked out (or has become possibly unavailable) thinking that he/she is no longer responsible for operating the franchise. Employees have started to report to a new owner and may become disengaged if the transaction is unraveled knowing that the seller is looking for an exit. Vendors have likely changed accounts and supply chain issues may arise if it becomes necessary to reactivate the seller’s possibly defunct accounts. At best, the franchisor takes a no harm, no foul approach and accepts the buyer as a franchisee (likely after confirming that the buyer satisfies the franchisor’s current requirements for a new franchisee).
Virtually every franchise agreement requires a transfer fee of some kind. Most assess the fee against the seller, but some franchisors split the cost between the buyer and the seller. The parties should each be aware of the amount of transfer fee and factor that into the purchase price. Additionally, many franchisors require the buyer to complete the initial training program, at the buyer’s sole cost and expense. Again, buyers should account for that and build it into their acquisition costs. An exception may be made when the buyer is an existing franchisee in that system.
For a buyer of a franchise resale, the transfer provisions are important for another reason. There will inevitably come a time when a buyer decides to exit the system and it is best to have a firm understanding of the transfer provisions contained within the applicable franchise agreement. One additional thing to note is whether the franchisor supports franchisees in transferring their businesses and whether the franchisor passes on to franchisees potential leads for prospective buyers. A franchisor who assists in this area can be invaluable to seller; the franchisor likely has access to a larger pool of potential purchasers than the seller does.
Franchise buyers should also focus on those sections of the franchise agreement that govern the buyer’s non-competition, confidentiality and management responsibilities. Those are critical areas for any prospective franchisee, but even more so for a buyer who owns franchises in several brands. For a multi-brand franchisee, the non-competition provisions must be reviewed to confirm that ownership of the other brands will not trigger a default. If that cannot be confirmed, the buyer will need to negotiate an exception from the franchisor (and possibly franchisors of its existing concepts). Similarly, a multi-brand franchisee must protect the confidential information of each franchisor from being divulged to individuals involved in other concepts. Here, a multi-brand buyer must work with each franchisor to create walls between the buyer’s various brands. Further, while most franchisors allow for absentee ownership, nearly a quarter of franchisors require direct management by the franchisee-owner. This is problematic for multi-brand franchisees that seek to expand their existing network through franchise resales. This too must be negotiated with the franchisor in advance of closing the purchase.
Richard Bayer is a partner with Einbinder & Dunn LLP, a full-service, boutique business law firm with a focus on franchise law. Richard can be reached at Einbinder & Dunn LLP, 112 Madison Avenue, 8th Floor, New York, New York 10016, (212) 391-9500. Online at www.ed-lawfirm.com or via email at [email protected]
Franchise Flippers thanks Richard Bayer and Einbinder & Dunn LLP for contributing this article and sharing their expertise in the franchise space. Franchise Flippers is the premier franchise resale marketplace and resource center. We are dedicated to helping franchise buyers and sellers get win-win deals done. Visit us at www.franchiseflippers.com and learn how we can help you.