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Getting the house in order - preparing for a franchise business sale

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United Kingdom

The BFA/NatWest survey of the franchising sector in the UK confirmed that franchising is in very good health and continues to expand and mature.

The recent BFA/NatWest survey of the franchising sector in the UK confirmed that franchising is in very good health and continues to expand and mature. An example of this good health is the recent sale of Costa Coffee by Whitbread Plc to Coca Cola, for £3.9billion.

Whitbread acquired Costa Coffee in 1995 for £19 million from founders Sergio and Bruno Costa when it had only 39 shops. It now has more than 2,400 outlets and a strong overseas presence. The deal demonstrates the role that franchising can play in scaling a brand and the value that a franchised network can generate for a brand.

Franchising is a long term business strategy and it is important that franchisors plan for the future by ensuring that the management of the network is well resourced and that it is managed efficiently and robustly from the "get go". In the event that a franchisor requires third party investment or decides to sell the business, a well-prepared franchisor will be able to engage in an investment round or sale process in such as way that may ultimately increase the valuation.

This article considers the key areas which a prospective buyer of or investor in a franchise will want to look at as part of the sale or investment process. By considering these areas at an early stage, franchisors can build processes which will benefit the day-to-day management of the network and facilitate a successful sale or investment process.

1. Due diligence

Prior to sale of investment round, a franchisor should anticipate the type of due diligence which a prospective buyer will wish to carry out on the business and prepare accordingly.

The buyer will want:

(a) to see copies of all franchise agreements and other contracts with franchisees;

(b) to know about individual franchisee’s payment histories, whether they owe anything in respect of initial fees, royalties, advertising fees, and payment for products and whether there are any repayment plans in place;

(c) to know details of historic or pending disputes with franchisees; and

(d) details of franchisee’s who have left the system and why – for example was this a result of a business sale or a business failure?

The buyer may ask for details of franchisees who are currently in breach of the franchise agreement – or who have been in breach over a certain period. The buyer may want to know if the franchisor has received any allegations from franchisees that the franchisor is in breach of the franchise agreement (for example for lack of support) or if there any claims for misrepresentation. The buyer may ask to see copies of the franchisor’s marketing materials for the recruitment of franchisees – to check whether there is any scope for claims of misrepresentation.

The buyer will be interested in the targets overall financial performance but also in the performance of individual franchisees. The buyer will want to see the franchisor’s management accounts showing financial figures on a franchise by franchise basis but the buyer also want to see copies of each franchisee’s annual audited accounts. Most franchise agreements require franchisees to submit these to the franchisor but often individual franchisees may need to be chased to provide accounts – a franchisor. should make sure that a complete set of franchisee accounts is available.

2. International considerations

The buyer will probably want to see:

(a) the disclosure document for the franchise business in that particular jurisdiction – many parts of the world now require a franchisor to provide a document to a franchisee setting out certain information about the franchisor and its franchise network prior to entering into a franchise agreement.

(b) confirmation that the franchise business has complied with any disclosure and/or registration requirements or other franchise laws that apply in each jurisdiction.

If there are plans to grant new franchises during the sale or investment process, the parties also need to consider carefully any practical disclosure issues in respect of prospective franchisees; in other words, at which point in time is the proposed acquisition sufficiently certain so that the franchisor’s disclosure document needs to be revised? Is any existing information contained in such documents misleading as a result of an imminent acquisition or sale?

A buyer should also beware that the sale or investment itself may also trigger fresh franchise disclosure or registration requirements. This will, in each case, depend on the precise structure of the transaction.

3. Intellectual Property

In relation to Intellectual Property Rights (IPRs), the buyer’s due diligence will focus on all trade marks, trade names, copyrights, patents, domain names and other IP rights of the target franchise business.

The buyer will want to know that the target owns all of the IPR that it expects the target to own and that such IPRs have been protected with registrations in all jurisdictions where the franchisor has franchises, and in other countries of major importance where franchises might be granted in the future.

The buyer will also want to know if any of the IPRs are disputed or challenged by third parties and if there is any litigation or proceedings at any Trade Marks Registry in relation to the IPRs.

In order to provide the information that may be requested, franchisors will need to keep good records both on individual franchisee files but also central records. For example, it would be useful if a franchisor kept a breach log of all breach letters that have been sent out by the franchisor to franchisees and information regarding what the franchisee had done to remedy the breach and any follow up actions on the part of the franchisor’s employees.

4. Contractual hygiene

The buyer will want to know that the franchise arrangements between the target and its franchisees are legally enforceable – the buyer will want to see a copy of each franchise agreement and all other agreements entered into with franchisees.  If there are different versions of the franchise agreements - where the agreements have evolved over time - the buyer will probably want an explanation of the differences between the different versions – it is a good idea to keep a chart tracking these differences and what franchisee is on what version of the franchise agreement.

In particular the following are important:

(a) that there is a current franchise agreement in place for every franchisee – that franchisees due for renewals are not “holding over” on franchise agreements that have expired;

(b) that side letters and variation agreements are disclosed – the buyer will be concerned to find out if the franchisor has done lots of different deals with individual franchisees, either extending a franchisee's rights and/or increasing a franchisor's list of obligations;

Franchisors can get in the habit of agreeing to side letters in order to sell franchises without really thinking through the wider implications – it's a good idea to put procedures in place whereby side letters are routinely run past legal advisors.

In addition the buyer will want to know if there are any oral agreements in place with individual franchisees – these may only be fully revealed when franchise managers are questioned  as part of the due diligence process.

In order to stop this happening processes should be put in place to prevent managers making promises to franchisees, minutes should kept of their meetings with franchisees and all requests by franchisees for concessions should be passed up to directors or senior management for consideration with legal advisors. If any concession is authorised in this way, a side letter or variation agreement should be drafted by a lawyer.

The buyer will also want to know if there are any ancillary agreements that are used in the franchise business – what are these and what do they cover? These will include guarantees, confidentiality and non-compete undertakings given by directors and shareholders of franchisees the buyer will want to know that all the relevant directors and shareholders have entered into these – this is can be cross checked by carrying out searches of franchisee companies at Companies House.

The franchisor may have software licences and equipment leases in place and a buyer will want to know if the rights granted to the franchisor in respect of such software or equipment also extend to sub-licensing or sub-leasing to franchisees. These agreements should be checked and any problems remedied.

5. Real Estate

This is a whole specialist topic in itself but there are a few particular issues that a buyer will want to check in a franchise sale where premises are involved.
Where the franchisor holds a head lease of the premises the buyer will want to know if:

(a) every franchisee has a proper sub-lease in place and is not occupying under a licence or tenancy at will  i.e. an informal arrangement;

(b) where necessary, was consent to the underletting was obtained from the superior landlord?; and

(c) do the franchise agreements and sub-leases cross refer to each other?

Whether the franchisor or the franchisee hold the lease of the premises, the buyer will want to know what is the length of each lease - leases with a short term left to run will be a concern for buyer. The buyer may want to know if the lease and franchise agreement have the same term?  If they do not, what will happen if the right to occupy the premises is lost?

The buyer may ask to see termination and release agreements entered into with franchisees that have left the system in order to check if an appropriate release for the franchisor was given by the exiting franchisee.

The buyer may want to review the operational manual – BUT you may want to limit the people who can view it and ensure that those people sign a confidentiality agreement in order to protect the franchisor’s know-how.
And finally a Scottish addendum – for Scottish franchise agreements has a Scottish Addendum been prepared?  This is essential for premises based franchises as property laws in Scotland are different to the rest of the UK.

6. Key areas of risk in the Franchise Agreement

The buyer will want to review the terms on which the franchise business operates in order to check that it contains the type of protection for the franchisor’s brand and system that would be expected in a well drafted franchise agreement and the following will also be of particular concern:

(a) Term - Too short a term and the concern will be that the franchise network could shrink quickly – if the buyer wants to continue franchising. Too long a term (or worse perpetual renewal rights) and it can be difficult for a buyer to introduce change or remove non-performing franchisees.

(b) Renewal - Buyer will want to see that any renewal term is granted on the terms of the then current franchise agreement and will provide for refurbishment of premises and modernisation of equipment or the vehicle used in the franchise business.

(c) Territory - if the buyer already runs a franchise network in the same or similar sector under a different brand it will want to know the exact territorial rights of franchisees in the business it is acquiring to check for territories that overlap with its existing franchisees.  The buyer will want to see a territory described properly in the franchise agreement – with maps/postcodes or written description and will want to know if the franchisor has allowed franchisees to operate outside of these territories.  For example, in areas where the franchise network has no franchisees some franchisees are given informal rights to trade in these areas.  If this was the case the buyer will be concerned to find out if these informal rights have become more permanent.

(d) Post Termination Restrictions - The buyer will want to know that it is protected by properly drafted post termination non-compete obligations, if these obligations are drafted too widely they may not be enforceable

(e) Change of Control Provisions/Assignment - The buyer will check if the franchise agreement contains any change of control provisions - typically as franchise agreements are drafted by franchisors they will not contain any such provisions. In the event of an asset sale, the buyer will want to check that the franchisor will be free to assign the franchise agreement – a well drafted franchise agreement should allow for this but this is something that should be checked.

(f) Re-branding - The buyer may wish to re-brand the franchises of the target and if this is the case it will want to check if the franchise agreement allows it to do this - not all franchise agreements contain these provisions.

(g) Competition Concerns - The buyer will want to know that the franchise agreements comply with EU and UK competition laws. Areas that can cause issues are retail price maintenance obligations, prohibitions on online selling and exclusive supply obligations.

Conclusion
Whether or not a franchisor is actively courting a sale or investment, these steps are all good practice for managing a franchise network and if executed consistently and properly, they will more than pay for their cost when the business is valued.

Authored by Gordon Drakes

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