But, there are key legal issues of private equity buying franchisees and franchise systems
Attracted by the credible promise of a stable revenue stream in franchisee-paid royalties and limited capital investment, private equity investors’ interest in acquiring franchise chains has been increasing. As equity firms keep buying franchisees and franchise systems, certain legal issues might arise
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 look 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 these decisions require focused attention on the due diligence investigation, which 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: Joint Employer Standard
Under the current joint employer standard, a franchisor may be held to be a “joint employer“ with its franchisees, and it is 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 training, consulting, educational programs, benefits and other benefits that could impact the franchisees’ employees.
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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 you can 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 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.
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 the franchise system’s units are in material compliance with the franchisor’s operation standards. Full-bodied adherence to standards impacting 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 such customer expectations that builds and supports the value of the franchise system.
Especially in older, large systems, the standards and 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.
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.
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 whether the prospective buyer will be entitled to 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. It should 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
Any prospective private equity buyer should consider the restrictions on use and allocate 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 relationships can potentially increase the buyer’s future legal liability to the franchisees.
When private equity is buying a franchise system, it should also consider franchisee complaints about the use of advertising funds, as it is a fruitful area for franchisee claims that could end in litigation involving multiple franchisees.
Additionally, a prospective buyer should examine the loyalty and gift card programs, including reimbursement commitments to franchisees, obligations to other service providers, and the programs’ compliance with applicable law.
Financial Performance Representations
When a private equity buyer is buying a system, it evaluates 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 into 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 result in litigation.
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.