Road Map to Due Diligence in the Acquisition of Franchise Companies

In recent years, there has been a notable increase in the buying and selling of franchise companies, much of which has been driven by private equity investment. However, acquiring a franchise company is more complex than other business acquisitions due to the unique regulatory framework governing franchise operations and the distinct nature of franchise relationships. This article by Amy Cheng and Fredric A. Cohen of Cheng Cohen summarizes the key steps in the due diligence process for franchise acquisitions that Leasecake assists with, and offers guidance on negotiating a purchase agreement to minimize the risks associated with these transactions.

Unique Nature of Franchise Acquisitions

Acquiring a franchise company poses two significant challenges. First, unlike many other businesses, franchise companies typically own few tangible assets. Their primary assets consist of contract rights, intellectual property such as trademarks and trade secrets, and consumer goodwill. These are difficult to value, and assessing a franchisor’s liabilities can be equally challenging, especially when contingent liabilities may not appear on the balance sheet due to franchise laws. Second, much of a franchise company’s value lies in its relationships with franchisees. The strength of these relationships is a critical factor in determining the value of the target company. A buyer must assess the quality of these relationships and the economic health of the franchisees, which can be difficult as sellers often restrict access to franchisees during the due diligence process.

Negotiating the Letter of Intent

When negotiating a letter of intent (LOI), buyers of franchise companies should consider three important factors. First, they must decide whether the LOI will be binding or non-binding. A binding LOI may require immediate updates to franchise disclosure documents, depending on the structure of the transaction. If confidentiality is a concern, a non-binding LOI may be preferable. Second, the buyer should ensure that the LOI outlines the scope of due diligence, including access to key employees, franchise agreements, and franchisee correspondence files. This prevents disputes that could jeopardize the deal later. Third, the buyer should negotiate a period of exclusive dealing, as due diligence can be time-consuming and costly, and the buyer will want assurance that the seller is not soliciting competing bids.

Why Due Diligence is Crucial

Due diligence is essential for evaluating the benefits and risks of an acquisition and determining the appropriate purchase price. Any discrepancies between the price assumptions and the realities uncovered during due diligence may require renegotiation or price adjustments. Franchise-specific representations and warranties are also critical, such as assurances regarding the proper management of marketing funds or the non-receipt of supplier rebates. Another key aspect of due diligence is assessing litigation risks. Buyers need to evaluate the risks associated with pending and potential litigation to gauge the future liabilities they may face.

Due Diligence Checklist

A well-structured due diligence checklist should cover various areas, including franchise registrations, disclosure documents, operations manuals, advertising funds, vendor rebates, accounts receivable, and franchisee agreements. Each area requires careful evaluation to ensure that the franchisor complies with all legal requirements and has properly managed its relationships with franchisees. For example, poorly maintained operations manuals or mismanaged advertising funds can pose significant risks. Similarly, reviewing accounts receivable provides insight into the franchisor’s debt collection practices and potential future disputes.

Evaluating Franchise Agreements and Disclosure Documents

The value of a franchise system lies in the contractual relationships with franchisees, so it is crucial for the buyer to fully understand the terms of the franchise agreements. This includes evaluating transfer provisions, territorial rights, and the franchisor’s obligations to franchisees. Franchise agreements should allow the franchisor enough flexibility to adapt the system in response to market changes, such as introducing new products or rebranding. The buyer should also confirm that the franchisor has complied with all applicable disclosure requirements and that there are no violations that could expose the franchisor to future legal claims.

Assessing Litigation Risks

Identifying and evaluating potential litigation risks is a critical part of the due diligence process. This involves reviewing the franchisor’s litigation history, understanding the types of claims that franchisees may bring, and assessing the likelihood of future litigation. Buyers should be particularly cautious about ongoing disputes or patterns of litigation, as these could indicate systemic problems within the franchise system. A thorough analysis of the applicable statutes of limitations and dispute resolution mechanisms, such as arbitration clauses, is also essential.

Negotiating Definitive Documents

Once due diligence is complete, the buyer can proceed with negotiating the definitive acquisition agreement. This agreement will include franchise-specific representations and warranties, such as compliance with franchise laws and disclosure obligations. Buyers should ensure that these representations and warranties are not limited to the knowledge of a small group of individuals, but extend to all relevant personnel who may have knowledge of franchise operations. The agreement should also include indemnification provisions to protect the buyer from liabilities arising after the acquisition. These provisions can be secured through mechanisms such as holdbacks, escrows, or personal guarantees.

Conclusion

Acquiring a franchise company requires careful planning, thorough due diligence, and strategic negotiation. Buyers must understand the unique legal and operational challenges that come with franchise acquisitions, including the complex regulatory framework and the importance of franchisee relationships. By utilizing Leasecake’s tools and following a structured due diligence process and negotiating comprehensive protections in the acquisition agreement, buyers can mitigate the risks associated with franchise acquisitions and ensure a successful transaction.

This article was reprinted with permission by Cheng Cohen. To read the full article, click here.

To view an on-demand webinar featuring Amy Cheng, Partner at Cheng Cohen, click here.

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