The continuing interest among private equity investors in acquiring and refinancing franchisors has heightened the need for third-party debt financing. While the franchise model is an attractive one, often involving well-known brands and requiring modest capital expenditures, lenders should watch for red flags before financing these ventures.
The franchisor’s primary assets are generally their agreements with the franchisees. The franchisees’ contractual obligation to pay royalties under these agreements is the primary source of revenue for debt service. Therefore, a lender’s due diligence should focus on any operational or financial concerns affecting that revenue stream.
Lenders are most often concerned about issues targeting risks to ongoing royalties paid by franchisees, which could affect the borrower’s ability to service the debt. These areas include:
- Franchisee satisfaction, including signals of franchisee discontent and circumstances that could give rise to major litigation or class actions by franchisees
- Compliance with franchise laws governing the offer and sale of franchises (i.e., disclosure and registration), and state franchise relationship laws governing the ongoing relationship between a franchisor and a franchise
- Franchisee impediments to the growth and development of the franchise system
- Evaluation of the franchise system and identification of potential problems, including patterns of litigation involving franchisees and their customers or employees, joint employer and vicarious liability issues, supplier issues, cyber-security and privacy, franchisee and salesperson training, and insurance requirements and franchisee compliance
Signs of Franchisee Dissatisfaction
From the lenders’ perspective, the most positive aspects are the financial strength and satisfaction of the franchisees, their commitment to the franchise system, the franchisee performance and prospects for continuing and increasing the stream of royalties. Although lenders cannot always speak directly with franchisees regarding satisfaction, franchise executives can provide useful information. This is a key factor because there is a high correlation between profitability of individual stores and franchisee satisfaction.
Prospective lenders should also pay close attention to store-level economics. Are there a large number of franchisee defaults? Are there delinquencies in royalties and advertising-fund contributions? Is there any group activity, such as the formation of a franchisee association, indicating franchisees are banding together to develop strength in numbers? Independent franchisee associations can be a signal of widespread discontent because they are often formed by groups of disgruntled franchisees who share common grievances and seek significant system-wide changes.
As with any business, performance and profitability are subject to many variables, such as the vicissitudes of economic and industry conditions, competition, changes in consumer preferences and the ability of the system to adapt to them, customer retention and the availability of suitable locations and financing.
The lender’s due diligence should include a general internet search for newspaper articles and postings about the franchise. Websites bluemaumau.org and unhappyfranchisee.com, which might uncover any public franchisee complaints, are valuable resources. Other warning signs of franchisee dissatisfaction include the franchisor indiscriminately approving unqualified franchisees and saturating the market.
Franchise Documents & Legal Compliance
Franchise due diligence must include determining whether the franchisor has complied with the unique franchise registration and disclosure laws. Although lender’s counsel will not be able to independently verify much of the factual information contained in the franchise disclosure document (FDD), counsel will review the format, disclosures and related documents to determine if they substantially comply with the Federal Trade Commission (FTC) Franchise Rule and the FDD disclosure guidelines. The lender’s counsel’s comfort level will be enhanced if the franchisor has used knowledgeable and experienced franchise law firms.
The FDD is one of the most important documents for review and contains valuable information about the system. One of its key sections is Item 3, concerning litigation and arbitration. It is not, however, an exhaustive source and should not be relied on exclusively. For example, additional information about threatened litigation and mediations should be included in disclosure schedules to the credit agreement. A large claim or a pattern of similar types of litigation are obvious red flags.
Item 4, which includes bankruptcy of the franchisor and its key management, could also be a cause for concern. Although the franchisor is not obligated to provide financial performance representations to prospective franchisees, if it does provide such information it must be included in Item 19 of the FDD. A careful review of that item is critical. One of the most important sections of the FDD is Item 20, which specifies the number of franchised and company-owned outlets, transfers to new owners, anticipated future sales, terminations and the number of franchises that have been “sold but not open.” A large number of terminations, transfers and sold-but-not-open franchises raises a red flag indicating a possible unhealthy system.
In 14 states, franchisors are required to register their FDDs prior to selling franchises, and they must update them annually to continue to do so. A lender’s counsel will want to verify that the franchisor has properly registered in those states where its sales are subject to registration. Some states will impose financial assurance requirements on those franchisors the regulator believes lack sufficient finances to perform their obligations to franchisees.
Counsel will also review the form franchise agreements to determine if they are well drafted and include provisions that are important to maintaining, growing and adapting to the future, such as the right of the franchisor to transfer and to approve assignments, non-compete and confidentiality agreements; the ability to modify the system and to require the franchisees to update and remodel; the ability to change trademarks; broad rights reserved to the franchisor; class action waivers; the ability to approve suppliers; real estate controls; territories that are not too large and the right to require execution of the current form franchise agreement on transfer or renewal.
Failure to maintain proper records can also be a red flag. Does the franchisor have good systems in place or are they in disarray? Are proper records and fully executed copies of documents maintained (i.e., franchise agreements, acknowledgements of receipt, franchisee questionnaires, personal guarantees)?
There are numerous legal items that affect nearly all franchised businesses, including joint employer issues, vicarious liability of a franchisor for acts or omissions of its franchisees, data privacy and cyber-security, protection of intellectual property, state tax laws, gift cards and escheat issues, ongoing compliance with franchise disclosure, registration, relationship laws and monitoring franchisees’ maintenance of appropriate insurance. Lenders should be aware of all of these.
Acquiring a Competitor
If the loan proceeds are being used by the franchisor to acquire a competing brand, the due diligence should address both brands. Counsel must ensure the currently owned brands’ franchise agreements do not create any encroachment, territorial or intellectual property rights issues, such as the sharing of confidentiality and proprietary information and internal resources between brands. The lender should also determine if the acquiring company could face successor liability for liabilities of the acquired company. Although the intricacies of acquiring a competing brand are beyond the scope of this article, special attention is warranted when a franchisor acquires a competitor.
Legal due diligence is often conducted by special legal counsel with expertise in franchise matters. Part of the lender’s underwriting analysis should include due diligence with respect to business and accounting issues. Legal due diligence is constrained by financial and time considerations and is, therefore, selective. Every relevant document cannot possibly be reviewed and there are inherent limitations to the scope of the investigation. The focus should be on trends and patterns of non-compliance, dissatisfaction or areas that limit the franchisor’s growth. The lender’s legal due diligence will not be as comprehensive as that undertaken by a company acquiring or merging with a franchisor. Of course, no franchise system is perfect.
The existence of red flags must be evaluated in light of the size of the loan and an assessment of the risk that any of the significant red flags will come to fruition. The main question is: Has the legal due diligence raised concerns that would cause lender’s counsel to recommend against granting the loan?