Due Diligence in a Franchise System Acquisition

Authored by Lane Fisher, Attorney & Founder of FisherZucker LLC

Generally, the goal in conducting due diligence on a franchise system has the following functions:

(a) determine whether the franchisor’s historic and current business practices comply with applicable federal and state franchise and business opportunity laws and regulations;

(b) determine whether the individual franchise agreements with franchisees are assignable;

(c) identify the key terms in the franchisor’s standard forms of franchise agreement, including the length of each relationship, renewal rights, royalty and advertising fee structure, transfer rights, and
covenants against competition and schedule any deviations from the standard terms;

(d) determine any territorial rights and rights of first refusal that may have been granted to franchisees;

(e) determine which franchisees are in default of their obligations under the franchise agreement; and

(f) evaluate any pending or threatened legal or regulatory action and prior settlements.

The purpose is to identify contractual terms that may pose a hindrance to the purchaser’s ability to assume the franchise agreements, make changes to the system post-transaction, or create liability for the franchisor entity going forward. The due diligence also should identify at-risk revenues and determine the ease with which franchisees can exit the system and continue to operate.

Once legal compliance and the key contractual terms are identified and the problems or challenges are understood, the parties will be in a position to discuss effectuating cures and negotiating appropriate indemnification and holdback provisions in the purchase agreement. In addition, depending on the findings of the due diligence review, the structure of the transaction may change, for example, from a share purchase to an asset purchase in order to better protect the purchaser from potential liabilities. None of these discussions can occur in a vacuum and are inherently tied to the results of a comprehensive due diligence review.