September 01, 2013

Franchising has become a major economic force. According to forecasts from the International Franchise Association, there are over 750,000 franchised business establishments employing more than 8 million people and generating approximately $800 billion in 2013. Not surprisingly, many significant M&A franchise transactions have recently closed, representing a wide variety of industries and transaction sizes, including the Blackstone Group’s $1.9 billion purchase of the Motel 6 and Studio 6 brands and the roughly $4 billion purchase of Burger King Holdings, Inc., by 3G Capital Management.

The trend appears to be accelerating, as the benefits are considerable. Indeed, when you purchase a franchise, you can: 1) expand quickly to more efficiently compete with larger companies or to remove the threat posed by a smaller competitor; 2) focus on a new geographic market or customer base without incurring the expense of attracting new franchisees to these locations or creating new advertising or marketing initiatives; and 3) add new products or services to existing lines, many times with instant name recognition, without incurring the expense or uncertainty of internal research and development.

Nevertheless, purchasing a franchise is like every other investment: There is no guarantee of success and there are numerous issues that cannot be ignored. Moreover, even after the transaction closes, a franchisor may need to comply with certain laws and regulations before attempting to sell a franchise anywhere in the United States. Accordingly, the M&A franchise transaction is a lengthy process and not an isolated event.

This article briefly highlights the basic elements of a franchise, as well as general legal and business considerations in M&A franchise transactions, and also addresses federal and state franchise laws and related requirements that are truly unique to the franchising industry, especially registration.

What Is a Franchise?

Many unfamiliar with franchising believe that franchise laws do not apply to grants of a license, distribution right, or other similar types of arrangements that are not called a franchise. The name given to a particular relationship, however, is essentially irrelevant. Although the definition of a “franchise” varies under federal and state laws, if the following elements are satisfied, the relationship will generally be regulated as a franchise: 1) the franchisee sells goods or services that are identified or associated with the franchisor’s trademark, service mark, trade name, or logo (collectively, the “Mark”), or obtains the right to operate a business identified or associated with the franchisor’s Mark; 2) the franchisor exercises or has the authority to exercise significant control over the franchisee’s method of operation, or provides the franchisee significant assistance in connection therewith; and 3) the franchisee is required to make or commit to make a payment to the franchisor or a person affiliated with the franchisor as a condition of obtaining or commencing the business. As explained in this article, determining whether a franchise exists is just one of many considerations in M&A franchise transactions.

Legal and Business Considerations

There are numerous legal and business issues in any M&A transaction and thorough due diligence is key to determining whether you will realize the intended benefits of the deal. From a legal perspective, a wide variety of documents and records should be reviewed to better understand issues related to securities regulation, labor laws, antitrust, tax, the transferability of assets, affiliate or other third party approval rights, employment-related considerations ranging from benefits to confidentiality and non-competition, and the current or potential likelihood for involvement in excessive or significant litigation.

Particular to a franchise environment, the acquiring entity should also analyze: 1) the strength of the target company’s Mark used in connection with the franchise system; 2) all applicable franchise agreements and related agreements to ensure the legal ability of the acquiring entity to assume such agreements and to identify any areas of conflict or limitation; and 3) the status of the target company’s registration, the details of which are discussed in
this article.

Business considerations during due diligence are vast as well and include review of the target company’s current financials, growth potential (both individually and as part of the applicable industry), existing staff (including whether all or some may be retained), levels of customer satisfaction and business reputation, and overall fit with the acquiring entity, including from a financial, cultural, and vision perspective.

Perhaps the most important business consideration in an M&A franchise deal, however, is the potential impact on franchisor-franchisee relationships as the continued success of the network’s franchisees is tantamount to continued success of the franchisor. At a minimum, an examination as to how any proposed transaction may affect these relationships—including with respect to any change in control and the dynamics of the home/corporate office, overlap of territorial rights, brand dilution, consumer confusion related to post-transaction product and service mixes, and the overall satisfaction of the franchisees—must be performed. The best way for a franchisor to evaluate the potential impact on franchisees is by contacting them directly. Many franchise networks have a Franchise Advisory Council or similar group of franchisees who are selected to represent the franchisees’ voice. By contacting such groups, the franchisor can gain not only insight into the satisfaction of the franchisees, but support for the acquisition down the road, which can pay dividends in the transition process. Understanding the federal and state laws applicable to franchise sales is also vital to the process.

Unique Legal and Regulatory Requirements

A. Initial Steps

Franchise sales in the United States are subject to both federal and state regulation unique to the franchising industry. The Federal Trade Commission (“FTC”) Rule requires franchisors to meet various pre-sale disclosure requirements, including providing a specific Franchise Disclosure Document (“FDD”) to any prospect, but contains no filing or registration requirements. The FDD must contain 23 specific disclosure items which include, among other things, detailed descriptions of the fees, royalties, estimated investment, territory granted, and the franchisor’s business experience, support, and training. In some instances, although difficult to satisfy, exemptions to the FDD filing may be available.

State statutes that regulate franchising can be classified into two general classes: 1) state laws mandating filing or registration of franchise offerings and/or disclosure, and 2) state statutes regulating the relationship between franchisors and franchisees, including issues such as non-renewal, discrimination, termination, and similar matters. If the franchisor fails to comply, the franchisor can be subject to penalties and potential suits depending on the laws of the particular state.

The franchise laws of a state may apply to a franchise sale by the franchisor pursuant to various scenarios, including those listed below, subject to the laws of that particular state:

  • The prospect is a resident of the state
  • The offer originates from or is received in the state
  • The franchised business will be operated in the state
  • The franchise territory being granted is entirely or partially in the state

If a particular state’s franchise laws apply to a franchise sale, then a franchisor must register with the applicable state regulator in the following states: California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin. In addition, Michigan requires a Notice of Intent (to sell franchises) to be filed and a franchisor must file an exemption notice under the business opportunity laws in Florida, Kentucky, Nebraska, Texas, and Utah.

Registration or notice filing is usually required before the franchisor makes any contact with the prospect, except to obtain the prospect’s contact information. Each registration state also typically requires that the franchisor’s FDD adhere to state-specific disclosure requirements before approving the franchisor’s registration. If the franchisor qualifies, there are certain exemptions available from the registration and disclosure requirements.

Once a franchisor identifies those states in which it intends to offer its franchises, counsel may begin the registration process. Franchise registration is a process that is not explained by precise rules and procedures. The published rules and regulations contain only part of the required information. Franchise counsel will become familiar with particular registration customs only by filing registration applications and by responding to examiners’ comments. The initial registration process is time consuming and can easily take three to six months. Maryland typically takes the longest of any state. The state regulators inspect the FDD for compliance with the applicable franchise laws, the proposed agreements, and the franchisor’s financial statements, focusing on its overall financial condition. Once any and all deficiencies in the registration application are resolved, the state regulator will approve the registration and the franchisor can begin selling franchises in that state.

B. Annual Updates, Material Changes, and Amendments

In addition to the initial compliance with federal and state regulations, a franchisor must file revisions to its FDD annually and upon the occurrence of material changes.

Under the FTC Rule, a franchisor must file revisions to its FDD within 120 days after the close of its fiscal year, or on at least a quarterly basis in the event of a material change to the information in the FDD. The timing requirements for annual updates differ in many of the registration states.

As noted, the occurrence of a material change will also require a franchisor to provide revisions to its FDD. A material change is defined broadly to extend to any facts, circumstances, or conditions that have a significant financial impact on a franchisee or prospect, or that are substantially likely to influence a franchisee’s or prospect’s decision making related to the franchise business. Certainly, the occurrence of a merger or acquisition and the resulting change in ownership, or the acquisition of a competitive concept, would constitute a material change necessitating modification to the FDD. In the bulk of the registration states, such modification takes the form of an amendment, which must be separately approved. All franchise sales must cease and all prospects must be re-disclosed, pending approval of the amended FDD. At the very least, assuming the initial registrations were compliant at the time of the merger/acquisition, the franchisor will be required to update its FDD and submit it for approval in the applicable registration states. Similar to the FDD registration, the process for such approval may be lengthy.

C. Sales Process/Internal Requirements

Once the FDD is duly registered, there is yet another series of requirements to abide by to ensure requisite disclosure has been given to prospective franchisees and that the information provided in the FDD is all they receive.

Under the FTC Rule, a franchisor must furnish a prospect with a FDD at least 14 calendar days before the prospect signs any binding agreement with, or makes any payment to, the franchisor. While a few of the registration states have implemented their own disclosure period, a majority of the registration states have adopted the 14-day rule.

In addition to providing the FDD, if the franchisor makes any changes to the franchise agreement (the template for which must be part of the FDD) or will be filling in material blank spaces, such as the applicable territory of the franchise, then the franchisor must provide the prospect a copy of the actual franchise agreement that such prospect will be asked to sign at least seven calendar days before signing the franchise agreement or paying the franchisor any money.

A few registration states also require that any advertisement for the sale of franchises be filed with the state prior to use of such advertisements. This not only extends to written advertisements, but to any postcards, direct mail communications, and brochures. Notably, there is an exception for Internet advertisement, if appropriate disclaimer language is applied and other conditions are met.

Implementing an internal monitoring system for all franchise sales is another critical requirement. While proper disclosure is imperative, the franchisor must also ensure that its sales staff and any officers or directors selling franchises refrain from making any representation to a prospect that is inconsistent with the information provided in the FDD. To be sure, any material inconsistent representation can subject the franchisor and its officers and directors to civil and criminal liability. Thus, it is imperative that the information included in the FDD is accurate, useful, and closely reviewed by all franchise sellers so that there is no desire or need to discuss any outside information.

Conclusion

M&A in the franchising context is an extensive process with a myriad of legal and business considerations, including federal and state registration laws, which must be confronted and examined. Even after the transaction closes, a franchisor may need to comply with certain laws and regulations before attempting to sell a franchise anywhere in the United States.

 

Contact the authors:

Francis N. Rodriguez, Esq. - Kostopoulos Rodriguez, PLLC - francis@korolaw.com

Jessica A. McGrath, Esq. - Certified Restoration Drycleaning Network, LLC - jessica.mcgrath@crdn.com