By Laura E. Liss, Attorney, Brown and Kannady, LLC.
Many franchise attorneys use a template letter of intent (“LOI”) when handling a small business purchase or sale, but where a franchise business is at issue, it is advisable to consider additional franchise-specific LOI provisions than those that may be in a standard template.
Among other factors, a franchise-specific LOI typically should consider whether the franchisor will require the purchaser to pay different (read: higher) fees than the current franchisee under a new agreement; whether the franchise territory may be modified (read: reduced); the extent to which such higher fees or reduced territory should impact the purchase price; whether and when the purchaser will be required to “refresh” or remodel the business premises to current brand standards; and the process required to obtain the franchisor’s consent to the purchase (including review and approval of the purchaser) and/or to confirm the franchisor will not exercise any existing right of first refusal to purchase the business.
Impact of Fee and Territory Changes
Most franchise agreements are written for a set term of years, and the fees and territory contained in these agreements typically are fixed during this period of time. Upon a transfer or sale of a franchised business, most franchisors require the new franchisee to sign the then-current franchise agreement, which may contain materially different fees or provide for modifications to the territory upon resale. These occurrences are common, particularly when one of the early franchisees in a system seeks to harvest the value of its investment by selling its rights many years later. The intervening intervening period likely will have brought expanded fees, reduced territories and narrowed franchisor obligations amid the general development and maturity of the franchise system and its business model with which the buyer will have to comply upon the closing.
In order to properly assess and address the fees issue during the LOI stage, you must have a copy of the new franchise agreement that details precisely what these new fees will be. For example, a 1-2 percent increase in royalty fees, plus a 1-2 percent increase in advertising fees, plus the creation of a mandatory local advertising co-op to which 1 percent of gross sales is due (a contribution that was not previously mandatory, but will be for the buyer) likely means that the revenue of the franchised business will decrease by 3 to 5 percent after the sale. Assisting your client to understand this reality – which may involve redoing projections and revising past financial statements in order to capture the true impact of these new fees – is an invaluable step, and should be accomplished prior to arriving at an initial purchase price, to avoid confusing or alienating the seller through a subsequently proposed reduction.
Similar guidance is needed if the territory is to be reduced upon the sale closing, to ensure that the agreed-upon sale price eventually reflects the revenue allocable to that sub-area.
Refresh and Remodeling Costs
Obligations to refresh or remodel the business premises can arise both during the term of the franchise agreement, as well as a condition of renewal of the franchise rights occurring at expiration of the agreement. These obligations – and a desire to avoid their substantial inherent costs – often are among the key motivations that prompt franchisees to sell their businesses. Knowledgeable and informed counsel can help their buyer (or seller) clients value and apportion these costs appropriately in the deal.
By obtaining a clear picture of the scope of the refresh or full remodel obligations from a design and cost perspective (e.g. are the estimated costs $15,000 or $75,000?), the length of time during which the buyer may be required to cease operations to complete the work (to account for lost revenue), and any fees that will be due to the landlord of the premises or other professionals or for grand reopening marketing, you can help your clients properly allocate the risk and cost between the buyer and seller. Further, an informed understanding as to when the remodel must be completed (e.g., within six months or three years of the sale closing?) should impact such cost-sharing discussions, including whether the seller should be required to complete such work prior to closing.
Attempting to negotiate the purchase of a franchised business in the absence of these data points is inadvisable; detailed discussions with the franchisor regarding post-closing expectations for the premises will accordingly be necessary as early as possible.
Right of First Refusal and General Franchisor Consent Compliance
Last but not least, it will be critical to obtain confirmation of the franchisor’s written declination to exercise its right of first refusal to match the purchase of the franchise business. Virtually all franchise agreements provide the franchisor with the right to match any offer by a third-party, often less the goodwill value, and to repurchase the location rather than allowing the sale to go through. This is a common practice where the franchisor is “un-franchising” itself by retaking outlets to be run as corporate locations, or where a dispute is anticipated regarding a required territory reduction. Both the buyer and seller must be informed of the franchisor’s right of first refusal, so, as to avoid a later dispute. In addition, because franchisors typically have the additional right to object to certain aspects of the sale or to the qualifications of the buyer itself, obtaining the franchisor’s prior approval of both the sale terms and the buyer is required, which means that it is critical to communicate with the franchisor early and often during the negotiation of the sale.
This article was previously published in the Colorado Bar Association Business Law Section Newsletter.