Private Equity Is Buying More Franchise Systems - Here Are The Key Legal Issues They Are Looking At (2022)

Attracted by the credible promise of a stable revenue stream in the form of franchisee-paid royalties and limited capital investment, private equity investors’ interest in acquiring franchise chains has been increasing.

The examples are too numerous to list, but include the March 2018 Qdoba Restaurant Corporation sale to Apollo Global Management, LLC for about $305 million; and Inspire Brands, Inc.’s, which is majority-owned by affiliates of Roark Capital Group, acquisition of a 12.3% ownership interest in The Wendy’s Company in August 2018 for $450 million, and subsequent acquisition of Sonic Corp. in a transaction valued at approximately $2.3 billion in September 2018. More recently, funds advised by Apax Partners acquired Authority Brands, LLC, a leading franchisor of home services, for an undisclosed amount.

In addition to confirming the stability of the revenue streams, the private equity investor will be looking at other variables such as the existence of hard assets like real property, the stability of the advertising fund, supplier arrangements and the existence of litigation or potential legal claims against the franchise system. And the private equity investor may want to sell the system or certain of its assets quickly, require the franchisees to make capital expenditures to acquire new equipment or offer new services or embark on a program to “clean house” by more robustly enforcing standards and terminating non-performing franchisees.

All of these decisions require focused attention on the due diligence investigation that forms the backbone of any franchise system acquisition. Following is a listing of what I see as the top-line legal issues that any private equity buyer will want to integrate into its due diligence checklist:

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Joint Employer Standard

Under the current joint employer standard in several contexts, a franchisor may be held to be a “joint employer“ with its franchisees based on the degree to which the franchisor directly or indirectly exercises and reserves the right to control the employment terms of the franchisees’ employees. A franchisor does not need to have control over hiring and firing of employees to be at risk. Rather, the risk of being held to be a joint employer can be found in other less obvious activities such as providing training, consulting, educational programs, benefits and other resources that could impact the franchisees’ employees.

A private equity buyer will want to understand the types of control exercised by the franchisor (and reserved in the standard franchise agreement(s)) over the franchise system so it can assess the risk associated with the target business model and weigh it against other factors critical to ensuring the business model can continue to operate as is. This can be done by examining the applicable franchise agreements, operating manuals, standards, programs and policies.

It is also worth noting that the National Labor Relations Board is considering action to clarify the standard for determining joint-employer status under that applicable law so that in order to be held to be a joint employer, the franchisor must possess and actually exercise substantial direct and immediate control over the relevant employees’ essential terms and conditions of employment in a manner that is not limited and routine.

Anti-Poaching Restrictions

Anti-poaching provisions in franchise agreements – that is, provisions that prohibit franchisees from soliciting or hiring workers employed by the franchisor or other franchisees—have come under significant scrutiny as potential antitrust violations. During the past year, at least 15 large franchisors have formally agreed to drop anti-poaching provisions from their franchise agreements in order to avoid antitrust lawsuits by the Washington State Attorney General’s Office.

In addition, private plaintiffs have sued franchisors in putative class actions, contending that anti-poaching provisions in franchise agreements violate federal and state antitrust laws. Some of these lawsuits have survived motions to dismiss and are moving forward.

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Any prospective buyer should confirm the target franchisor’s position on the place an anti-poaching provision has in the franchise relationship.

Standards Enforcement Environment

A prospective buyer may find it difficult to ascertain whether, and to what extent, the franchise system’s units are in material compliance with the franchisor’s operation standards. Full-bodied adherence to standards concerning the nature and quality of products and services is the hallmark of any franchise system. The prospective customer expects to experience a certain level of customer service when engaging the franchise brand and it is that reliable meeting of such customer expectations that builds and supports the value of the franchise system.

Especially in older, large systems the standards and the terms of the franchise agreements requiring compliance with such standards may vary greatly. Newer and emerging franchise systems may still be figuring out the standards that should apply.

Sampling compliance by franchisees in various markets with material operational standards and comparing compliance by franchisees to the published operations manual and other standards the franchisor represents are currently applicable is highly recommended. Standards normally include compliance with a franchisor’s point of sale system (POS) which should provide the franchisor reasonably transparent access to sales information and, hopefully, inventory management data, which is key to understanding unit operations.

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Much can also be determined about standards compliance by evaluating franchisee defaults described in the franchisor’s communications with franchisees – especially those of a repetitive and material nature.

Purchasing Arrangements

A review of the franchisor’s purchasing arrangements including mandatory or required purchases by franchisees of products, suppliers, equipment or services, as well as the revenue the franchisor derives from such purchases by franchisees, is critical to assessing the viability of the franchisor’s revenue streams. Pivotal to understanding whether the prospective buyer will be entitled to enjoy the benefits of such purchasing arrangements, or be subject to additional post-acquisition legal liability because of them, requires the prospective buyer to examine material supplier contracts.

A buyer should determine the franchisor’s termination and renewal rights, whether suppliers are exclusive or not, and whether there are minimum volume purchasing requirements imposed on franchisees, and also confirm whether the rebates, commissions or other payments made by suppliers or paid by franchisees through the purchase price are legally valid and whether they are subject to negotiation or other changes.

These types of inquiries will also allow private equity groups that have a portfolio of franchise brands to leverage efficiencies in their supply chains by consolidating purchasing of certain products and services with a single or limited number of suppliers.

Advertising Funds, Gift and Loyalty Programs

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Any prospective private equity buyer should consider the restrictions on use and the allocation of the funds, as well as the reporting and auditing rights of franchisees. While atypical, consideration of whether the franchisor’s treatment of advertising funds creates a fiduciary or special confidential relationship between the franchisor and its franchisees should be made, as the creation of such relationships can potentially increase the buyer’s future legal liability to the franchisees.

The prospective private equity buyer should also consider franchisee complaints about the use of advertising funds as it is a fruitful area for franchisee claims that can result in litigation involving multiple franchisees.

Additionally, a prospective buyer should examine the loyalty and gift card programs including any reimbursement commitments to franchisees, obligations to other service providers and the programs’ compliance with applicable law.

Financial Performance Representations

If the prospective private equity buyer is evaluating a franchisor that makes financial performance representations to prospective franchisees in its franchise disclosure document, as part of a franchisee or company unit resale program or in the general media, including the Internet, that information should provide interesting insight to the financial health of the franchise system and the care that the franchisor gives to its franchise sales program. These representations are typically in the form of unit- level average gross sales and costs, but can involve a profit and loss statement or a projection or forecast.

In addition to determining whether the financial performance representations are being made in compliance with applicable law, be sure to ask for and evaluate the underlying substantiating information for such financial performance representations. Financial performance representations are frequently the subject of franchisee claims that can result in litigation.

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Since any prospective franchisee is legally entitled to receive this information, it should be instructive to the buyer to see the basis for the financial performance representations the franchisor makes to prospective franchisees and determine whether the franchisor has complied with the legal requirements applicable to any franchisor who chooses to make financial performance representations.

FAQs

What are the critical issues to be given consideration before buying a franchise? ›

What Should I Consider Before Buying a Franchise?
  • The type of experience required in the franchised business.
  • The hours and personal commitment necessary to run the business.
  • The track record of the franchisor, and the business experience of its officers and directors.
  • How other franchisees in the same system are doing.

What is the main disadvantage of buying a franchise? ›

Buying a franchise means entering into a formal agreement with your franchisor. Franchise agreements dictate how you run the business, so there may be little room for creativity. There are usually restrictions on where you operate, the products you sell and the suppliers you use.

What is private equity looking for? ›

In short, there are many reasons why a private equity investor may be interested in your business, including your sector, the stage in your business lifecycle, the location of your business, the valuation of your business or the financial position of your business.

What are the challenges of buying a franchise? ›

10 Challenges Franchisees Face
  • Investing in a Business (Franchise or Non-Franchise) is Risky. ...
  • You Have to Stick to Certain Rules. ...
  • Most Franchises Have a Minimum Net Worth Requirement. ...
  • Owning a Franchise is a Big-Time Commitment. ...
  • Consider Your Community – Will This Franchise Succeed There? ...
  • Expect High Start-up Costs.
15 Jun 2017

What is the most important consideration in franchising business? ›

Important considerations for your franchise model include fee and royalty percentage, terms of agreement, size of territory awarded to each franchisee, geographic areas in which you are willing to offer franchises, the specifics of your training program, and more.

What steps do you need to consider before purchasing a franchise and what is more important and why? ›

Buying A Franchise: 5 Essential Steps To Take Before Investing
  • Assess Your Skill Set. ...
  • Identify Your Passion And Long-Term Goals. ...
  • Calculate Your Investment Level And Future Profitability. ...
  • Speak With Franchisees And Assess The Franchise Disclosure Document. ...
  • Get To Know The Franchisor.

What are 2 disadvantages of a franchise? ›

Disadvantages of franchising for the franchisee
  • Restricting regulations. ...
  • Initial cost. ...
  • Ongoing investment. ...
  • Potential for conflict. ...
  • Lack of financial privacy.

What are the advantages and disadvantages of buying franchise? ›

Benefits and Cons of Franchising: A Summary
Advantages of buying a franchiseDISADVANTAGES OF BUYING A FRANCHISE
Brand awareness already exists for the business, making it easier to draw in an audience and generate profits.Initial investments can be high, and some companies require payment with non-borrowed money.
5 more rows
30 Aug 2021

What are the main advantages and disadvantages of a franchise? ›

franchising-table
AdvantagesDisadvantages
Franchisees may be more talented at growing the business and turning a profit than employees would beFranchisors earn royalties from sales. Franchisees earn money from profits. Achieving growth in both isn't always possible, potentially causing conflict
6 more rows
30 Jan 2015

What do private equity firms look for when they buy a company? ›

Private equity firms look for companies having multiple avenues of growth, including exploring new markets, new locations, sales strategies, customer acquisition strategies, etc.

What happens when private equity buys your company? ›

When a private-equity firm (PE) acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

What makes a private equity firm successful? ›

Whether it's a prospective investment or an existing portfolio company, PE firms should consider the hallmarks of both sales excellence and sales obsolescence. Successful sales organizations are customer-oriented, highly productive, revenue- and profit-centric and excellent at both execution and implementation.

Are franchises a good investment? ›

If you're a fledgling entrepreneur or a seasoned business person wanting to diversify your holdings, you've probably wondered, “Are franchises a good investment?” The simple answer is yes, especially if a great opportunity presents itself. There is an obvious appeal to starting a business via buying a franchise.

Why franchising is a smart business solution? ›

Franchising allows companies to compete with much larger businesses and saturate markets before their competitors can respond. Franchising can help a business grow on both sides of the fence. The franchisors' principal benefit is that they can expand more entities rapidly across different locations.

What is the purpose of franchising? ›

A franchise (or franchising) is a method of distributing products or services involving a franchisor, who establishes the brand's trademark or trade name and a business system, and a franchisee, who pays a royalty and often an initial fee for the right to do business under the franchisor's name and system.

What are the four big factors to consider when selecting a franchise? ›

Before choosing a franchise, take the time to consider these 10 vital signs that the company is the right fit for you.
  • Proven sales record. ...
  • Growing market. ...
  • Competition. ...
  • Repeat business. ...
  • Healthy living. ...
  • Upsell opportunities. ...
  • Profitable business model. ...
  • Personal interest.

What are the factors that influence the success or failure of a franchise business? ›

Here are several key factors that should drive your decision making process.
  • Brand Recognition. The greatest asset a franchise can have is an established brand. ...
  • Industry. ...
  • Profitability. ...
  • Sustainability.
23 Apr 2019

Why do you want to own a franchise? ›

Buying into a franchise, rather than starting your own business, comes with many benefits. Not only do you have the luxury of starting with a business that already has a successful business model, but you can leverage current branding and built-in processes that allow you to hit the ground running.

How would you research a franchise purchase before making the decision to invest? ›

Researching and understanding critical information such as industry trends, market size, franchisor reputation, the FDD, and costs of starting and running your business will help you better prepare to make an informed decision.

What should a franchisee do before going into a franchise agreement with a franchisor? ›

Checklist before signing a Franchise Agreement
  • What is the franchised business about? For example:
  • What will you get when you buy into the franchise? In this regard you should consider:
  • What are your rights and obligations under the franchise agreement? Consider issues such as:
  • What are the fees you will need to pay?
13 Dec 2017

What is the importance of evaluating the risk before making decision to enter into franchising? ›

The sooner they get to the franchise market before you, the more likely it is they'll be perceived as the market leader. From a purely economic standpoint, when concept risk is greater than competitive threat, you should wait before you franchise.

What is the real advantage to a franchise? ›

The primary reason most entrepreneurs turn to franchising is that it allows them to expand without the risk of debt or the cost of equity. First, since the franchisee provides all the capital required to open and operate a unit, it allows companies to grow using the resources of others.

Why do franchises fail? ›

The most frequent causes: lack of funds, poor people skills, reluctance to follow the formula, a mismatch between franchisee and the business, and -- perhaps surprisingly -- an inept franchiser.

What are the 5 advantages of owning a franchise? ›

Five Advantages of Buying a Franchise
  • Much of the work needed to launch a business idea has already been done. ...
  • Not as much, if any, experience is needed to start. ...
  • Support from a larger network of businesses. ...
  • Ability to tap into the collective buying power of the franchisor. ...
  • In cases, financing may be easier to secure.

What is a disadvantage of having a franchise quizlet? ›

Buying into a franchise is not cheap. Franchisers often charge high fees for the right to use the company name. They also charge franchise owners a share of the earnings, or royalties.

Is it better to own or franchise? ›

Bottom line, franchises have a higher overall success rate than startups. Franchises operate under a predetermined business model that has already brought success while independent businesses make adjustments and decisions to their business model as they go.

Which is the main benefit of franchise ownership? ›

The main benefit of becoming a franchisee is that the business will have an established product or service. In franchising, someone has already done the work of developing and establishing a viable business system.

What's the biggest franchise in the world? ›

McDonald's

The company enjoys over $90 billion in global sales and represents the largest franchise network in the world.

What is the red flag in franchising? ›

Red flags would include a high number of franchisee turnover, more outlets closed versus opened, high franchisee turnover coupled with low number of franchisee transfers. A high number of Sold But Not Opened franchises can be a red flag that would require a closer look.

What steps should a potential franchisee take before investing in a franchise? ›

  1. Step 1: Recognize that you're interested in opening a franchise.
  2. Step 2: Figure out which industries you're interested in and how much you can invest.
  3. Step 4: Make a shortlist.
  4. Step 5: Narrow your shortlist by talking to franchisors and current owners.
  5. Step 6: After picking a franchise, visualize your life as an owner.
8 Sept 2017

What should a franchisee do before going into a franchise agreement with a franchisor? ›

Checklist before signing a Franchise Agreement
  • What is the franchised business about? For example:
  • What will you get when you buy into the franchise? In this regard you should consider:
  • What are your rights and obligations under the franchise agreement? Consider issues such as:
  • What are the fees you will need to pay?
13 Dec 2017

How would you research a franchise purchase before making the decision to invest? ›

Researching and understanding critical information such as industry trends, market size, franchisor reputation, the FDD, and costs of starting and running your business will help you better prepare to make an informed decision.

How will you decide on the factors in choosing a franchise business? ›

Top questions to ask when choosing a franchise
  • What are my personal goals? ...
  • What type of industry do I want to conduct business in? ...
  • What are my strengths?
  • What role do I want to play in the business? ...
  • What kind of commitment do I want to make? ...
  • What is my investment budget? ...
  • A strong support system for franchisees.

How much can you make owning a franchise? ›

Franchise owners in the restaurant industry earn an average of $82,000 per year, which is pretty solid considering the salary range of a non-franchise restaurant owner can range from $24,000 to $155,000. Startup costs, however, can range anywhere between $100,000 to millions of dollars.

Do franchise owners have to work? ›

Owning a franchise unit can be demanding, requiring work of 60 to 70 hours a week, but owners have the satisfaction of knowing that their business's success is a result of their own hard work. Some people look for franchise opportunities that are less demanding and may only require a part-time commitment.

How much money do you need to start a franchise? ›

How much does it cost to start your own franchise? Franchise startup costs can be as low as $10,000 or as high as $5 million, with the majority falling somewhere between $100,000 and $300,000. The price all depends on the industry, location and type of franchise.

What are the advantage and disadvantages of franchising? ›

Benefits and Cons of Franchising: A Summary
Advantages of buying a franchiseDISADVANTAGES OF BUYING A FRANCHISE
Brand awareness already exists for the business, making it easier to draw in an audience and generate profits.Initial investments can be high, and some companies require payment with non-borrowed money.
5 more rows
30 Aug 2021

What is the most important key subject in the franchise agreement? ›

Use of Trademarks

One of the main benefits you receive when purchasing a franchise is the use of well-known trademarks. This section lists the trademarks, service marks or logos the franchisee is entitled to use. Has the trademark been in operation for a significant amount of time and is it well known?

What is the main purpose of a franchise agreement? ›

The franchise agreement should outline the rights and obligations of both the franchisor and the franchisee. The main purpose of this contract is to protect the intellectual property of the franchisor.

What are 5 important things to consider when investing in a franchise? ›

But if you're serious about investing in a franchise, there are a few more important things to consider.
  • Understand the business. ...
  • Consider all the costs. ...
  • Size up your commitment. ...
  • Get familiar with a franchise's framework. ...
  • Be realistic about your expected return on investment.
12 May 2021

What is a major risk for a franchise owner? ›

Because many franchises are restaurants, food poisoning is a major concern. If one location's poor standards result in illness, many customers will associate all locations with food poisoning, even if those locations are separately managed. Reputational damage is not limited to food quality, however.

What is the importance of evaluating the risk before making decision to enter into franchising? ›

The sooner they get to the franchise market before you, the more likely it is they'll be perceived as the market leader. From a purely economic standpoint, when concept risk is greater than competitive threat, you should wait before you franchise.

Why franchising is a smart business solution? ›

Franchising allows companies to compete with much larger businesses and saturate markets before their competitors can respond. Franchising can help a business grow on both sides of the fence. The franchisors' principal benefit is that they can expand more entities rapidly across different locations.

Why do entrepreneurs choose to buy a franchise or an established business? ›

A franchise system not only minimizes the risk by having an existing business model, it also gives you a support system for the unknown. Owning your own business is exciting and rewarding, and franchising helps you minimize the risks and maximize the opportunity.

What could happen if a franchisee fails to conform to the franchise requirements? ›

What could happen if a franchisee fails to conform to the franchise requirements? The franchisor will sell the franchise to another franchisee.

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