Buying a Franchise Company: Do Your Due Diligence
Looking under the hood, kicking the tires isn’t enough.
By Barry Block
While a pre-acquisition investigation (due diligence) should be part of every acquisition, there are special issues that potential purchasers of a franchise company should consider.
Some of these special issues arise because of certain legal requirements applicable to franchisors. These include the obligation under U.S. federal and state law to provide pre-sale disclosures in the form of a franchise disclosure document and the obligation to register in certain states before sales are made. Special issues also arise because the acquired franchise business is heavily dependent on independent contractors (franchisees) who may represent the franchisor’s local presence, marketing arm, public face and, in many cases,
most important customers.
Read the Disclosure Document Intelligently
The selling franchisor company should present the buyer with a written document with extensive information about itself. That document is the franchise disclosure document or, for earlier years, the uniform franchise offering circular, even if there is no separate private-placement memorandum. The buying company’s management and due diligence lawyers should read it carefully and critically.
The buyer’s lawyers should carefully review several years of disclosure documents to assure technical compliance. There are many sections management should consider as well. The litigation history disclosed in Item 3 of the disclosure document is one obvious candidate. The second obvious candidate is the information in Item 20, which covers the number of outlets by state, as well as the number of franchisee terminations, non-renewals, transfers and other departures. Management should consider how fast the seller is growing and also the rate of turnover—that is, how many franchisees are leaving. A high turnover rate would be indicative of a potential problem, which the buyer’s management needs to understand.
In a healthy franchise system, the franchisees as well as the franchisors are successful. The disclosure document or UFOC may or may not provide financial performance representations, formerly known as “earnings claims,” in Item 19. If those financial performance representations are provided, management should review them and the documentation behind them, which the seller is required to have. If the seller does not provide financial performance representations in Item 19, the buyer should request financial performance information for the franchisees anyway. The seller is likely to have a great deal of information on the financial performance of its franchisees, even if it has chosen not to disclose this information in Item 19.
Review Past Compliance with Registration and Disclosure Requirements
The buyer will want to be sure that the seller is in compliance with the U.S. federal and applicable state franchise registration and disclosure requirements.
This will require a review of the seller’s registration files to verify that registration filings have been made where necessary and on a timely basis. The buyer will also want to review the type of feedback and comments the seller has received from the various state regulators. Most of these comments may be harmless but could also indicate systemic problems, opposition by disgruntled franchisees or an unfriendly regulatory environment based on, perhaps, past violations or difficulties.
Registration is only part of the compliance equation. Timely delivery of the registered disclosure document to prospective franchisees is also required. To this end, the seller’s contract files should be reviewed to determine that the contracts are properly signed, that the receipts for the franchise disclosure documents are properly signed and dated and that franchisees were provided a sufficient waiting period before the contracts were signed.
There is no substitute for the drudgery of reviewing the seller’s regulatory files and contract files. Young lawyers and legal assistants are used to this type of suffering. It is unlikely that the buyer will want to review every contract file of a large selling franchisor, but a significant sample should be reviewed. Of course, if files are kept electronically, a more efficient review may be possible.
Review Procedures for Compliance with Registration and Disclosure Requirements
Compliance review should not live by files alone. With the advent of electronic data rooms and other cyber-communication, due diligence may require less travel than before, but it is still important for some members of the due diligence team to visit the seller’s offices. This may or may not be necessary for a document or file review, depending on how the seller maintains its files, but it is important for other reasons.
Management of the buyer will want to meet and take the measure of the seller’s management. Representatives of the buyer should, similarly, meet and talk with the seller’s franchise compliance team about how they handle compliance issues. One reason for this is to be sure that the seller’s compliance team is knowledgeable and competent.
There are also technical issues to discuss. For instance, the buyer will want to know how information is gathered each year for inclusion in the disclosure document and how that information is documented. Is the seller thorough and systematic? Are the directors, officers and managers disclosed in Item 2 of the disclosure document required to complete questionnaires on an annual basis?
Another issue is how well the seller trains its sales staff to comply with the disclosure requirements. This would include not only delivery requirements for disclosure documents, but also the importance of not making financial performance representations outside of the disclosure document.
Review the Seller’s Franchise Agreements
The buyer will want to review the seller’s franchise agreements. This would include not only the current form of franchise agreement, but also the past forms under which many franchisees may still be operating and any agreements with negotiated terms at variance with the standard forms. Even if the current form of franchise agreement has provisions that would allow the buyer to implement its future plans, there may be past agreements or negotiated terms that could be a hindrance.
The buyer will want to make sure that the franchise agreements give the buyer sufficient authority to make post-acquisition changes to the franchise system as it deems necessary. It is also important that the franchise agreements do not make any promises that the buyer cannot keep. Such promises might include exclusivity provisions that prevent the buyer from owning competing outlets (which it may already own).
The buyer will want to examine how the franchise agreement has evolved over the years. The revision of certain provisions may be based on problems in the system and the buyer should be aware of them. For instance, the addition of a clause banning reverse engineering by franchisees of certain formulas provided by the seller may very well have arisen as a result of franchisees trying to reverse engineer the formulas in the past.
If the signed franchise agreements include negotiated changes, the buyer will also want to know if the negotiated changes are rare or are commonly-required by franchisees. Also, the buyer should determine the scope of any negotiated additional obligations of the seller and whether the negotiated changes indicate a difficult relationship with particular franchisees.
The buyer should also confirm that the seller enforces the franchise agreement as written. For instance, if there is a minimum royalty requirement, does the seller enforce it? A course of dealing at variance with actual contractual terms may be regarded legally as an amendment to the contract, and the buyer should be aware of this.
Review Potential Vicarious Liability Issues
Vicarious liability, which is liability by a franchisor for the acts of a franchisee, may often be a concern for the franchisor. The buyer should review the circumstances and frequency of claims made by third parties against the seller based on acts of its franchisees and the seller’s success or failure in defending against these claims.
To limit its potential vicarious liability, the buyer should assure itself that the seller’s franchise agreements require its franchisees to indemnify the franchisor for liabilities arising from the franchisees’ operations. The seller’s franchise agreements should also require that the franchisees carry liability insurance that names the franchisor as an additional insured and that the franchisees obtain, maintain and provide to the franchisor up-to-date proof of insurance, such as certificates of insurance. The buyer should be able to verify compliance with these requirements from the files of the seller.
Review the Relationship of the Seller with Its Franchisees
Because a franchise system is so heavily dependent on its franchisees, the buyer needs to determine critical information about the franchisees and their relationship with the seller. The buyer will want to know whether the franchisees are profitable, successful and still enthusiastic about being franchisees. Are they still willing to continue to invest their time and capital in the franchise system to be purchased?
If there are areas of dissatisfaction, the buyer will want to know what they are and how serious they are. Are these areas of concern limited to a few franchisees or common to many? It has been said that “happy families are all alike; every unhappy family is unhappy in its own way.” This usually does not apply to franchise families. Often the source of franchisee dissatisfaction is common throughout the system. The buyer should determine whether the source of dissatisfaction is widespread, whether it will grow and how it will affect the franchise system after it is acquired. For example, one franchisee complaining that he is paying too much for supplies may not be of great concern, but frequent complaints from a larger group of franchisees may portend trouble from the complainers or raise the suspicion that the non-complainers are silently buying unapproved supplies from unapproved sources.
Sources of information on this matter would include the franchisor, the minutes of meetings of franchisees (such as a franchise advisory committee) and correspondence and e-mails between the franchisees and the seller.
It is also important to talk to franchisees about these issues. This is tricky because the seller may not want the buyer to talk to franchisees prior to some key event, such as signing a definitive agreement or even until after the closing. The seller may not want to disclose the proposed sale until after it closes, and it will not want to give the franchisees the ability to interfere with or change the acquisition transaction. If the seller is publicly-held, there may also be securities law issues concerning how and when the pending transaction will be disclosed.
Nevertheless, the seller should be able to arrange a pre-closing opportunity for the buyer to talk to some franchisees. This would include talking to members of the franchise advisory committee, but also talking to members of independent franchisee associations that may have a different relationship with the seller and talking to multi-unit franchisees, who will have the biggest impact on the post-acquisition success of the franchise system.
The Buyer Should Review Whether It Wants to Be a Franchisor
Finally, the buyer will need to look to itself to confirm that it wants to run the seller’s franchise system. A non-franchise company that buys a franchise company is likely to be surprised by the regulatory requirements and the different way of dealing with outlets that are independently-owned rather than company-owned. The due-diligence process should reveal much about the seller, but the buyer must consider its own capabilities and flexibility as well.
Barry Block is a partner in the Dayton office of the law firm of Thompson Hine LLP. He can be reached at