The following is part of a series of short articles to assist individuals and companies who are contemplating buying a franchise.

While certain aspects of acquiring a franchise are similar to acquiring any other type of business, there are a number of considerations that are unique to franchising.  In addition, depending on whether a purchaser is buying a new franchise, an existing franchise from a franchisee, or an existing business from the franchisor, different approaches may have to be taken in order to complete the transaction.

In addition, some franchise transactions do not involve large amounts of money.  Accordingly, a purchaser must keep this in mind by striking a balance between leaving no stone unturned and doing what is practical in the circumstances.  When striking this balance, it is always important for a purchaser to be aware of any risks being taken so that he or she can decide whether or not to proceed on that basis.

Asset or Share Transaction

Most purchases of a franchise, especially in the case of a new franchise or one involving the franchisor as seller, will involve a purchase of assets rather than a purchase of shares.  Even in the case of a purchase from an existing franchisee, the asset transaction is normally chosen by the purchaser to limit its exposure to any liability problems of the selling company.  Generally, the selling company has only one major asset and that is the franchise business being sold.  Once the purchase price is received by the selling corporation, it is used to pay secured creditors, trade creditors and any amounts owing to the franchisor including any franchise transfer fees.  Any balance is then normally distributed to the principals.

Therefore, in the case of an asset sale, the selling company may have virtually no assets remaining shortly after completion of the transaction.  In the event that a purchaser is expecting to rely on an indemnity from the selling corporation for any breaches of representations or warranties in the purchase agreement, the collection on that indemnity may be practically impossible.  A guarantee of or an indemnity from the principal of the selling corporation should be obtained, but beware that the guarantee or indemnity may also be of limited value.  Many guarantors of small businesses have the title of their primary assets, such as their homes, owned by a spouse or a family trust leaving no assets to fulfill any indemnity claim.  Even if there are assets available, most franchise transactions are so small that going to court to settle any post-closing problems may be completely impractical for the purchaser.  As a result, the moral of the story for any purchaser is to take particular caution at the outset of the due diligence phase at the beginning of the transaction to determine any potential liability issues, through inspection or otherwise, or, as set out below, to require a holdback from the closing funds to deal with any hidden liabilities.

In both an asset and a share transaction, the consent of the franchisor to transfer the franchise is generally required.  Most franchisors will require a new franchise agreement to be entered into and will require the purchaser to meet all of the conditions of transfer that are set out in the agreement.  As a result, attempting to structure a share purchase to take advantage of favourable terms in an existing franchise agreement will likely not succeed.

Disclosure

The Arthur Wishart Act (Franchise Disclosure), 2000 (the “Act”) requires that a franchisor deliver a disclosure document to a prospective franchisee at least 14 days prior to the payment of any monies by the franchisee or the signing of any agreement with the franchisor.  Although there are some narrow exceptions to the requirement set out in the Act, most franchisors are proceeding cautiously and providing disclosure documents in almost all cases.

As a result of the disclosure requirements, a purchaser would be wise to have any purchase agreement contemplate a closing date which would allow enough time for the franchisor to be notified of the pending transaction, to prepare a disclosure document, and for the potential franchisee to have at least 14 days to review the document in accordance with the Act prior to closing.

Due Diligence

The purchaser should be encouraged to conduct thorough due diligence on the franchise system and the franchise unit being purchased. The purchaser should carefully review the disclosure document and should particularly focus on the listing of existing and terminated or former franchisees.  Randomly contacting as many existing franchisees as possible should provide the purchaser with insight as to the strengths and weaknesses of the franchise system.  It may also serve as an introduction of the purchaser to these individuals who may form an informal network of support if the purchaser does in fact become a franchisee.  From the list of former franchisees, a purchaser should contact as many of them as possible to determine their reasons for leaving the system.  This will help identify any common problems that might exist amongst those who have already left the system.

A purchaser may also find it helpful to obtain as much information as possible from any competing or related franchise system.  This competitive analysis may assist the purchaser to assess the reasonableness of the financial and business terms of the franchise to be acquired.  It may also provide the purchaser with valuable information regarding the particular industry it is entering into and any trends that may impact the business.

Franchisors often include pro forma statements of earnings as part of the package that they prepare for the purchaser for the purpose of obtaining bank financing.  If properly prepared, the pro forma should be a reflection of average sales of similar sized franchise locations in the franchise system.  The purchaser should be encouraged to review the pro forma statement and to speak to both existing and past franchisees to determine whether the individual costs are in line with those that are outlined and to determine whether the revenue numbers provided are realistic.  Although franchisors make it very clear on the pro forma statement that the franchisor is not making a representation or projection of future sales or profitability, the franchisor has at least an obligation to ensure that the numbers are based on reality.  Failure to do so may attract some liability to the franchisor.

Potential purchasers of franchises should also focus on the cost of supplies for the business.  Almost all franchise agreements require the franchisee to buy inventory items, equipment and leasehold improvements from suppliers designated by the franchisor.  The purchaser should determine whether the costs of these items are at fair market value or whether they have a considerable mark-up.  One of the main advantages of joining a franchise system is that franchisees should have the benefit of the group purchasing power of a large organization.  The cost of most items should be at lower prices than the franchisee can obtain on its own accord.

The foregoing are just some of the preliminary considerations for a purchaser of a franchise. As with the acquisition of any other type of business – whether franchised or not – a purchaser must also carefully review all other information related to the business including, without limitation, all historical sales figures and profitability reports to become fully aware of its potential for success

For more information on franchising, contact Derwin Wong or Hailey Kersey by phone at (416) 368-0600 or by email at dwong@businesslawyers.com or hkersey@businesslayers.com.

 Revised October 2015

© Morrison Brown Sosnovitch LLP, 2015 All rights reserved.