Mergers and Acquisitions of Franchise Systems

• Author: Kevin P. Hein and Ted Pearce
• Pages: 425-472

425

CHAPTER 6

Mergers and Acquisitions

of Franchise Systems

Kevin P. Hein and Ted Pearce

Contents

6-1. Introduction to Mergers and Acquisitions . . . . . . . . . . . . . . . . . . . . . . . . . 426

6-2. Identifying the Acquisition Target . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

(a) The Reasons Sellers Seek to Sell and Purchasers Seek

to Purchase Franchise Systems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 426

(b) Identifying a Seller or Purchaser . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 427

(c) Evaluating a Franchise System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 428

6-3. Preparing the Confidential Interest Memorandum and Negotiating

the Letter of Intent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .431

6-4. Stock versus Asset Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 434

(a) Stock Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .435

(b) Asset Acquisition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .436

(c) Tax Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436

6-5. Conducting Due Diligence . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 439

(a) Franchise Disclosure Documents and Franchise Agreements . . . . . . 439

(b) Franchisees in Renewal Pipeline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

(c) Trends in Franchise Sales and Unit Counts . . . . . . . . . . . . . . . . . . . . 440

(d) Franchise Financing Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 441

(e) Supplier Contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442

(f) Leases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 442

(g) Franchisee Satisfaction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443

(h) Franchisee Litigation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 444

(i) Management of the Advertising Fund . . . . . . . . . . . . . . . . . . . . . . . . . 444

(j) Special Deals Given to Franchisees . . . . . . . . . . . . . . . . . . . . . . . . . . . 444

(k) Territorial Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 445

(l) Franchisee Associations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

6-6. Negotiating the Purchase Agreement and the Credit Agreement . . . . . . . 446

(a) The Purchase Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

(b) The Credit Agreement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447

6-7. Ongoing Operations during Sale Process . . . . . . . . . . . . . . . . . . . . . . . . . . 448

(a) Effect on the Franchise Sales Process . . . . . . . . . . . . . . . . . . . . . . . . . 448

(b) Preservation of Filing Exemptions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449

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426 Franchise Law Compliance Manual

(c) Notifying Existing and Prospective Franchisees . . . . . . . . . . . . . . . . . 450

(d) Managing the System after the Transaction . . . . . . . . . . . . . . . . . . . . . 452

6-8. Posttransaction Legal Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452

6-9. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 453

Notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .453

Exhibit 6-1: Sample Letter of Intent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

Checklist 6-1: Sample Due Diligence Checklist . . . . . . . . . . . . . . . . . . . . . . . . . 460

Checklist 6-2: Sample Closing Checklist . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 470

6-1. Introduction to Mergers and Acquisitions

Over the past 10 years the franchising landscape has changed dramatically.

Where the franchise landscape was once populated by nascent individual fran-

chise systems owned by their founders, today there are many franchise systems

that have been consolidated or are now owned by strategic as well as private

equity groups. As organic growth of franchise systems becomes more challenging,

growth through acquisition or consolidation has become the norm.

This chapter addresses the core issues that form the basis for a merger and/or

acquisition of one franchise system by another or the acquisition of a franchise

system by outside investors or a combination of both. In addressing this issue, the

topics explored in this chapter include what motivates franchisors to acquire

other systems or to be acquired, what a purchaser should consider when finding

a target, how transactions are structured, due diligence considerations, what

issues generally arise during a transaction, and what should be considered when

governing a franchise system after an acquisition. These issues are all interrelated

and should be considered together when determining whether a system-wide

transaction is viable for both the purchaser and the seller.

Three sample documents are provided in the exhibits section of this chapter.

Exhibit 6-1 contains a sample letter of intent that outlines a number of the issues

that should generally be agreed upon prior to entering into negotiations for a

definitive purchase agreement. Checklist 6-1 outlines many of the issues that

should be reviewed as part of the due diligence process in a franchise company

merger and acquisition transaction. Checklist 6-2 is a sample closing checklist for

use in the acquisition or sale of a franchise company.

6-2. Identifying the Acquisition Target

(a) The Reasons Sellers Seek to Sell and Purchasers

Seek to Purchase Franchise Systems

There can be many reasons that precipitate a desire to sell or purchase a franchise

system. A primary motivation for the founders seeking to sell their system is the

ability to realize a significant return on their initial investment in the franchise

concept. Additionally, as the franchise system evolves, often the founders come

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Chapter 6 Mergers and Acquisitions of Franchise Systems 427

to understand that they are not suited to take the system to the next level, whether

that means accelerated growth domestically or internationally or growing the

product or service offerings. Conversely, a purchaser may determine that a pur-

chase of another franchise system, competitive or otherwise, may be the solution

for in-filling markets where the purchasing company has not been able to grow

organically. A purchaser also may determine that its franchise structure presents

management with a platform to operate multiple systems, either in the same or a

different product or service category. The reasons supporting an acquisition of a

franchise system are legion. These decisions are often driven by the immediate

needs of the particular system, which will in turn dictate what a purchaser or

seller will seek from its sale and how it will seek and identify the proper acquisi-

tion candidate.

The opportunity to complete an acquisition or the sale of a franchise com-

pany will be viewed from different sides of the same prism based on whether one

is the purchaser or the seller. Will the franchise system that the purchaser wishes

to acquire provide it with a sufficient return on its investment? Conversely, for

the seller, is in fact the franchise system truly marketable? While the purchaser

and seller will conduct different analyses, they both will analyze the health and

future prospects of the target franchise system.

(b) Identifying a Seller or Purchaser

In identifying a target, the first thing that a purchaser will do is to examine the

market for the products and services for the franchise system it seeks to acquire.

How will the market change and how fast will this occur? If a purchaser acquires

a particular franchise system it will be critical for the purchaser to understand the

future of the market for the products and services that are at the core of the system

it intends to purchase. Additionally, understanding the specific market will

enable the purchaser to determine the level of investment necessary to be able to

realize a specific return on its investment. A purchaser may seek to purchase a

heritage brand, which is to say a brand that has a powerful and historically rec-

ognizable trademark, but the system may need to be materially refreshed. In that

situation the purchaser should understand that substantial investment will need

to be made to the basic infrastructure of the system and will, therefore, likely seek

a substantial discount off the asking price.

Alternatively, a purchaser may seek a younger franchise system that has

growth opportunities and a strong track record. The price may then be dictated

more by the growth potential of the particular system. By the same token, a pur-

chaser may seek to add multiple young brands to its stable of brands to balance

its portfolio of older and more established brands. Identifying the target will be

dictated by the purchaser’s business strategy. Whatever the identity of the target,

there will be some common characteristics in all targets. For example, in the con-

text of automotive repair franchise systems, as services offered to consumers

become more consolidated into a brand that offers an array of services, franchi-

sors have incorporated multiple brands offering different services so that the

combined system of multiple brands can realize synergies in advertising, training,

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