Due Diligence on Franchise Systems

• Author: John Baer, Mark Kirsch, and Beata Krakus
• Pages: 77-127

I. OVERVIEW AND GOALS OF FRANCHISE DUE

DILIGENCE

Mergers and acquisitions involving franchise companies and franchise

systems have many unique characteristics that differentiate them from

acquisitions of other businesses. Franchise companies are not simply

an amalgamation of hard assets such as real estate, factories, and wid‑

gets. Franchise companies include, and are built upon, many intangible

assets and multiple layers of relationships with franchisees and vendors.

These intangible assets are an addition to, and often dwarf, the company‑

owned businesses (e.g., restaurants, retail stores, etc.), which would be

the typical assets of a target company. Prospective purchasers and their

counsel need to recognize the special attributes of franchise companies,

and must tailor their due diligence to obtain the information most vital

to the acquisition/purchase/investment decision. Many of the valuable

assets held by a franchise company are contract rights (i.e., the franchise

agreements) and intellectual property (i.e., the trademarks, condential

operating systems). In addition, the ability to operate successfully after

the transaction may depend in large measure on the relationships inher‑

ent in a franchise system, including the relationships with franchisees,

with the system as a whole and with vendors. Therefore, certain aspects

of the due diligence investigation of the franchise assets and relation‑

ships differ from the evaluation of other types of businesses.

Another reason that the acquisition of a franchise company poses

unique challenges not always present in other acquisitions is that the

77

Due Diligence on Franchise

Systems

John Baer, Mark Kirsch, and Beata Krakus

3

Vines_Mergers_20140521_13-42 FINAL.indd 77 6/3/14 1:26 PM

franchise systems, and the assets that comprise franchise systems, are subject to

a considerable amount of federal and state regulation. Failure by the target fran‑

chisor to comply with the laws may provide state and federal agencies, as well

as private parties (i.e., franchisees), with rights to pursue signicant remedies1

that could derail an acquisition or negatively impact the value of the assets to

be acquired. Therefore, the determination of whether the target franchisor has

complied with the law can become a valuable, but time‑consuming, labor‑inten‑

sive, and document‑heavy process. Further, as a result of there being different

stakeholders in the franchise network—the franchisor’s management team and

investors, franchisees, prospective franchisees, suppliers, and vendors, franchi‑

sees of a competing acquiring brand, and customers of the franchise system—the

due diligence must also evaluate these individuals, groups, and entities, and their

relationships with one another.

A. Due Diligence—Generally

In any merger or acquisition transaction, whether the target is a franchise com‑

pany or not, the buyer (and the seller) must assess the strength and defects of the

assets, evaluate potential liabilities, and predict future growth and protability.

The buyer will consider and try to answer several threshold questions: (1)What

assets will be acquired in the transaction? (2)What liabilities will be acquired?

(3)Where is the value in the target company? (4)How should the assets and liabili‑

ties be valued—for pricing of the transaction and for future growth? (5)What will

the surviving entity do with the business after the acquisition or investment? and

(6)To what extent is the existing management capable of expanding and growing

the enterprise after the acquisition? Whether the acquiring company is purchas‑

ing assets, purchasing the equity of another company, or purchasing less than a

controlling interest, the buyer must obtain detailed information to answer these

questions. How the buyer acquires that knowledge is the heart of due diligence.

B. Analysis of System and Assets

The fundamental purpose of due diligence is to enable the buyer (or seller) to

evaluate the underlying value of the assets and/or the business, and, sometimes

more important, the liabilities and “defects” in the assets, and to critically assess

1. Violation of state franchise laws may give rise to claims by franchisees for actual

and punitive damages and/or injunctive relief, or in some cases, rescission. The state

authorities may issue cease‑and‑desist orders, bring an action to enjoin unlawful con‑

duct or enforce compliance with the laws, or impose civil penalties, penal nes, or jail

sentences. Violations of the FTC Franchise Rule may result in civil penalties, injunctive

relief, consumer redress, or cease‑and‑desist orders issued by the FTC.

Mergers & Acquisitions of Franchise Companies, Second Edition78

Vines_Mergers_20140521_13-42 FINAL.indd 78 6/3/14 1:26 PM

the nancial and operational viability and health of the target franchise network.

In addition, due diligence should be designed to enable the prospective purchaser

to review and analyze the seller’s operational, nancial, marketing, and legal struc‑

tures, the seller’s compliance with applicable laws, the ability of the purchaser

to operate the seller’s franchise network following closing, and/or the ability to

merge the seller’s franchise network into the purchaser’s franchise network or

portfolio of businesses, if applicable. While an asset sale will generally allow the

purchaser to avoid acquiring many of the liabilities of the seller,

2

many of the due

diligence considerations will be the same if the transaction is an asset sale or stock

sale. The buyer must investigate and evaluate the franchise company’s assets,

its management, its franchisees and franchise relationships, its compliance with

franchise laws (and other laws and regulations), its operations, potential liabili‑

ties, and many other aspects of the franchise system. Franchise due diligence is

not simply, or solely, about the franchisor’s compliance with franchise laws and

the franchise agreements, and assessing hard asset value. This due diligence is

also about analyzing the various relationships that comprise a franchise network.

As part of the due diligence evaluation of franchise agreements, legal compli‑

ance, and franchisee operations, a prospective buyer will evaluate, among other

things, the following elements of a franchise system:

1.

Unit-Level Economics: A meaningful part of the due diligence process is

spent digging into unit‑level nancial and operational performance. No other

measurement is as critical—if the franchisees are not successful, the brand

will have difculties growing, and all of the other positive attributes of the

system have little or no value.

2.

Senior Management: The leadership behind a franchise concept often deter‑

mines the overall success of the franchisor. Some franchise networks, despite

2. The general rule regarding “successor liability” is that where one company sells

or otherwise transfers all of its assets to another company, the latter is not liable for the

debts and liabilities of the transferor. The four recognized exceptions to the general rule

of successor liability include: (a) an express or implied assumption of liabilities; (b) a

consolidation or merger of two corporations; (c) the mere continuation of the seller in

the form of the purchaser; or (d) the transaction is entered into fraudulently in order

to escape responsibility for debts and liabilities. For a discussion of successor liability

issues in franchise company transactions, see Schwartz v. Pillsbury Inc., 969 F.2d 840, 845,

Bus. Fran. Guide (CCH) ¶10,059 (9th Cir. 1992); Sterling Vision DKM, Inc. v. Gordon, 976

F. Supp.1194, 1201, Bus. Fran. Guide (CCH) ¶11,271 (E.D. Wis. 1997); Wine Imps. of Am.,

Ltd. v. Gerolmo’s Liquors, Ltd., 563 F. Supp. 163, 166 (E.D. Wis. 1983); Buske v. IHSS, Inc.,

499 N.W.2d 300, Bus. Fran. Guide (CCH) ¶10,160 (Wis. Ct. App. 1993); and Ata‑Boy, Inc. v.

Nat’l 60 Minute Tune, Inc., Bus. Fran. Guide (CCH) ¶10,011, No. 90‑673‑FR, 1992 WL 35868,

at *2–3 (D. Or. 1992).

79Due Diligence on Franchise Systems

Vines_Mergers_20140521_13-42 FINAL.indd 79 6/3/14 1:26 PM