Due Diligence on Franchise Systems

AuthorJohn Baer, Mark Kirsch, and Beata Krakus
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
Due Diligence on Franchise
John Baer, Mark Kirsch, and Beata Krakus
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.
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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,
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:
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.
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).
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