Digging into franchises – The Due Diligence Minefield

By Barry Kurtz

Business Law Today March/April 2007

Franchise companies are hot properties these days, and no wonder. Apples to apples, they’re generally more profitable than nonfranchise companies, so they present tempting targets for financial buyers with lots of cash – for example, your friendly neighborhood private equity group, which has been particularly active in buying up franchise companies in recent years.

But the due diligence involved in any deal Involving a franchise company is a minefield far more hazardous than that involving a nonfranchise company and business lawyers who set out to lead their clients through it must follow a disciplined process designed to learn as much as they can about the intricate relationships between the franchisor and its franchisees–the key to the profitability of any franchise operation.

Indeed, those relationships are the heart of what the buyer of a franchise company acquires, along with intellectual property in the form of a brand and possibly other unique assets. What is more, those relationships consist of formal agreements governed by both federal and state law and informal practices unique 10 each franchise enterprise, and it is crucial that the legal due diligence probe and gauge all of these elements carefully.

What information do business lawyers need to dig up in any transaction involving a franchise company? Where will they find it? What troubles await the unwary in the due diligence minefield?

What the Federal Government Wants from Franchisors

The states take the lead in regulating franchisors, but that doesn’t mean that the federal government follows a hands-off policy when it comes to franchisors. In fact, irrespective of the differing requirements of the states, the Federal Trade Commission Act imposes six important requirements on franchisors under what is known as the FTC Franchise Rule (16 CFR 436.1):

Franchisors must provide a potential investor with basic disclosures in writing about the franchisor and the franchising opportunity at least 10 business days before The investor signs any franchising agreement or makes any payment (Part 436. t (a)). In making these disclosures, franchisors may follow a format prescribed by the Franchise Rule or guidelines prepared by state franchise law officials for UFOCs.

Franchisors must give potential investors a copy of their standard franchise and related agreements at the same time as they provide the basic disclosures, and must provide potential investors with final copies of all documents relating to the franchise investment, including their standard franchise and related agreements, at least five business days before signing (Part 436.1 (g)).

If the franchisor makes any earnings claims, they must have a reasonable basis, and the claims must be given to potential investors in writing at the same time as the basic disclosure (Parts 436.1 (b)-(d)).

Similarly, any advertising containing earnings claims must disclose the number and percentage of existing franchisees who have achieved the claimed results (Part 436.1 (e)).

Franchisors must offer to refund deposits and initial payments to potential investors, subject to conditions in their disclosure documents (Part 436.1 (h))

Franchisors may provide potential investors with promotional or other material, but such material may not contradict information provided in the disclosure documents (Part 436.1 (f)).

Franchisors who fail to comply with these requirements court significant trouble, including injunctions under 15 U.S.C. § 53(b) and civil penalties of up to $11,000 for each violation of the Rule (15 U.S.C. § 5(m)(1)(A)). In addition, the FTC may seek asset freezes against corporate and personal assets of key franchise officers and directors as well as other forms of redress the courts may find necessary to remedy injury to consumers.

– Barry Kurtz

Start with the last question, since the things that can go wrong in the purchase of a franchise company are plentiful. Imagine the buyer of a franchise company who sells expansion rights to a new and promising territory 10 one franchisee only to discover that the seller has already sold them to another. Imagine the buyer who learns that some franchisees pay lower fees than others for, say, the advertising, marketing, or training assistance that the new franchisor is obligated to
provide. Imagine the buyer who learns too late that the seller has violated the franchise laws of one state or another, generating fines that are now the legal obligation of the buyer. Last but not least, imagine the buyer who discovers 30 days after the closing that the seller failed to disclose pending sanctions by state regulators that could make it impossible to sign up new franchisees in their state for, say, one to three years.

Now, not every problem is a deal killer. If both buyer and seller are anxious to do a deal, they can find ways to shape their transaction to accommodate nearly any problem short of disaster-so long as the problem is visible to both as they negotiate their deal. It is the unknown that can kill a deal or make it go bad down the road, and it is the job of the lawyer who undertakes to guide a buyer through the due diligence incident to a franchise deal to make sure that what might otherwise remain hidden does not pop up later on as an unpleasant surprise.

The crucial document in any franchise operation is the uniform franchise offering circular or UFOC. The leg.1l due diligence process begins with a careful inspection of the UFOCs used by the franchisor in each state where It has done business over the last four years. Loosely akin to a prospectus for a stock offering, the UFOC details the financial and legal elements of the franchisor-franchisee relationship and includes information about the financial investment and other commitments required of franchisees, the services to be offered by the franchisor-for example, training services and marketing help-and the business and professional background of the franchisor and its senior executive team, including any bankruptcies and securities violations, among other items.

In 13 states–California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin-franchisors must file their UFOCs with the state attorney general or some other state official. Six states-Florida, Michigan, Texas, Utah, Nebraska and Kentucky-permit franchisors to file one• page ”exemption filings” exempting the franchisor from the stales’ business opportunity laws. Nebraska and Kentucky also require the filling of a copy of the UFOC. The rest generally impose no filing requirements on franchisors so long as they meet the filing requirements of one of the 13 states requiring registration or comply with the FTC Franchise Rule, which imposes six important requirements on franchisors (see sidebar).

The first thing to determine in inspecting the UFOCs is whether the franchisor has properly registered Its offering Circular when and where required and whether either state officials or franchisees have instituted disciplinary or legal action against the franchisor. If the latter is the case, the inspection of UFOCs will sometimes turn up only a cursory reference to the same, making it necessary to track down and inspect other records – for example, court filings and regulatory records-to obtain a full description of any problems or deficiencies.

As is often the case in any due diligence effort, the lawyer must exercise Judgment in assessing any problems uncovered in the record. What was the nature of the complaint? How did the franchisor respond? In the case of either regulatory action or litigation, was the underlying problem serious? Minor? Intentional? The result of clerical error? Was it an isolated incident or part of a pattern of behavior?

The lawyer should also inspect a certain number of franchise agreements actually signed and in use by the franchisor and its franchisees in each state in which the franchisor operates, to ensure that their terms match up with those in the standard agreement contained in the UFOC. The caution here is that some franchisors enter into special agreements with specific franchisees – for example by offering them territorial or expansion rights not offered to others-and it is important to identify such arrangements before the closing of the purchase because the buyer of a franchise company generally takes on all of the obligations of the franchisor.

Put another way, the goal in inspecting a certain number of franchise agreements actually in use is to determine whether the contractual relationships between the franchisor and its franchisees are consistent throughout the system and, if not, to dig up enough information for the buyer of the franchise company to assess what impact any differences could have on Its value.
Indeed, since two important keys to the value of a franchise company are the uniformity and predictability inherent in consistent business practices of both franchisor and its franchisees, any deviations from the norm may have a substantial impact.

For the same reasons, it is important to Inspect all of the legal agreements between franchisor and franchisees, Including promissory notes or security, or other agreements Incidental to any offers by the franchisor to provide special financial or other assistance to potential franchisees, whether entered, into when the parties first began doing business together or later on. The inspection must also take care -to uncover all obligations on the part of the franchisor regarding marketing, advertising, training, and other business functions including leases, since these are costs that may be assumed by the buyer and hence should be reflected in the terms of the deal. In some cases franchisors themselves lease property and sublease it to their franchisees, and in others franchisees do the leasing on their own. Whatever the arrangement, the inspection must detemime whether the terms of the leases agree with those of the agreement between franchisor and franchisee, and whether third parties-for example, the owners of the property in question-have any rights of approval over lease transfers and other matters affecting the operations of either franchisor or franchisee.

It is often the case that the lawyer will find these and other important records-for example, notices of late payments or default by franchisees, correspondence detailing disputes with franchisees, and records of events surrounding the termination of franchise agreements, which can be acrimonious-in the offices of the franchisor.

On the other hand, what the lawyer finds in the offices of the franchisor will sometimes only hint at trouble, making it necessary to expand the due diligence search into courthouses, statehouses, and other repositories of public records, often resulting in a considerable expenditure of time and effort.

In all cases, the lawyer must remember that the goal of the legal due diligence incident to any deal involving a franchise company is to gain a
clear picture of the business practices of the franchisor and of the relationships between franchisor and its franchisees, all the while looking for signs of trouble
(see sidebar). Thus the due diligence effort must be disciplined and thorough so that all parties to the deal-whether seller, buyer, Investor group or lender-will have a complete picture of the risks and opportunities inherent in the deal and can adjust the terms of a purchase agreement accordingly.

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Legal due diligence checklist

The business lawyer doing due diligence in the purchase of a franchise company must track down a great many documents to gain an accurate picture of the relationships between the franchisor and its franchisees.

Then the real work begins, since it is also necessary to inspect the documents in detail and draw up representations and warranties holding the seller of the franchise company responsible for any agreements or information contrary to or inconsistent with the documents inspected or information provided during due diligence.

Here is a proposed checklist of the documents and information the lawyer should obtain and review:

  • Each UFOC used by the franchisor in all states in which the franchisor has done business for the last four years, including all state-specific addenda;
  • Each signed franchise agreement and area development agreement, if applicable and all ancillary agreements and attachments used in the last four years;
  • AU signed amendments to franchise agreements and area development agreements used in the last four years;
  • Drafts, proposals, unaccepted or otherwise unsigned amendments to franchise agreements and area development agreements used in the last four years;
  • All correspondence to or from any state agency regulating franchise offers and sales in any state in which the franchisor has done business for the last four years, including registration orders and exemption filings;
  • AU orders and correspondence issued by or received from all such state agencies for the last four years and a list of all pending franchise
    registration and exemption filings;
  • All consent orders, assurances of discontinuance, notices of violation, offers of settlement, settle­ment orders or other orders and
    rulings in effect or, to the knowledge of the seller, threatened that would prohibit or impede the buyer’s ability to offer or sell franchises or enter into franchise agreements;
  • All communications to or from the Federal Trade Commission, if any, or any agency of any state in which the franchisor has done business, or has attempted to do business, for the past four years, whether in the nature of an inquiry or otherwise-for example, communications to or from agencies that regulate offers or sales of business opportunities;
  • All royalty relief agreements, forbearance agreements, settlement agreements, general releases, cancellation agreements, termination agreements and purchase agreements (for the reacquisition of franchised units) with franchisees and area developers, whether signed, unaccepted or other­wise unsigned since the date the franchisor first became registered to sell franchises;
  • List of all persons who acted as franchise salespersons or brokers to offer or sell franchises and all salesman disclosure forms filed with each stale’s agency that regulates franchise offers and sales for the last four years ;
  • All policy announcements, memos to franchisees, newsletters, reports, etc., issued to franchisees and area developers since the date the
    franchisor first  became registered to sell franchises;
  • All notices of breach, default and termination issued to franchisees and area developers since the date the franchisor first became registered to sell franchises;
  • All claim and demand letters received from franchisees or area developers since the date the fran­chisor first became registered to sell
    franchises;
  • All print advertising published to advertise the franchises;
  • All flyers and brochures used to advertise the availability or offer or sale of franchises;
  • All Web site advertising availability or offer or sale of franchises;
  • List of all pending sales of franchises and area development rights;
  • List of all pending transfers of franchises and area development rights;
  • List of all pending franchisee outlet openings and closures;
  • List of all franchises and area developers not current in the payment of their obligations 10 the fran­chisor with the details of such defaults;
  • List of all area developers not current under their development obligations with the details of such defaults;
  • List of all franchisees and area developers whose franchises and area development rights were transferred, canceled, terminated, not renewed, reacquired or who otherwise left the system since The date the franchisor first became registered to sell franchises;
  • List of all litigation and arbitration matters between the franchisor and franchisees and area devel­opers filed, settled, adjudicated or otherwise resolved since the date the Franchisor first became registered to sell franchises;
  • Copy of all acknowledgments of receipt from each franchisee who received a UFOC since the date the franchisor first became registered to sell franchises;
  • List of memberships in franchise organizations such as International Franchise Association.

In deals involving large numbers of franchisees, it becomes impractical to obtain and inspect every document on this checklist, of course. In such cases, the lawyer should sample a number judged reasonable by the client and shape the language of any representations and warranties accordingly.

– Barry Kurtz

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Los Business Law Today March/April 2007, Copyright © 2007, All Rights Reserved.
Reprinted with permission.