By Andrae Marrocco , McMillan LLP

Franchise systems present a valuable investment proposition for strategic and financial investors. The appeal of robust, long-term, and diversified royalty income streams, proven business concepts, potential for scalability and expansion, shared expansion costs, and the goodwill and strength of an established brand has increasingly caught the attention of private equity, family offices, and other sophisticated acquirers. Set out below are several critical franchise specific considerations for investors exploring the acquisition of a franchise system?

Immediate Red Flags. Certain deficiencies rise to the level of immediate red flags including the following. (1) High franchisee turnover and/or poor franchisee satisfaction/culture within the system. Franchise systems with such attributes do not thrive and, in many cases, may be on the decline. (2) Weak unit economics, declining same-unit sales, or challenging broader economic conditions (eg emerging or shifting market dynamics). Franchise units are the engine of the franchise system; if not functioning optimally, the franchise system’s value is impaired. (3) Overall lackluster rating on legal documentation, system compliance (and enforcement), and significant litigation with franchisees and third parties. The latter elements individually may be explainable and ameliorable, but grouped together could be a perilous sign.

Weak Brand Strength/Infrastructure. Franchise systems must possess a proven replicable business concept that is adaptable across markets. There ought to be a sound platform and associated infrastructure to conduct the existing corporate operations and units including manuals, training programs, ongoing consultation, franchisee communication strategies, compliance monitoring, marketing, technology, processes for modification, and updating products and services, etc. Strong franchise systems possess a blueprint for building out that platform and infrastructure (for future growth and expansion).

Poor Unit Economics. Investors must analyze the certainty and recurring nature of the ongoing royalty revenue (together with other revenue such as technology fees, supply arrangement fees, etc) independently of one-time fees (eg initial franchise fees). Additional important inquires include the following. (1) Consider carefully the remaining term on franchise arrangements and the likely percentage of renewals together with the age, demographic, and level of sophistication of the franchisee population, jurisdiction and regional trends or differences, and payment delinquencies. (2) Watch for suspect sources of revenue (eg self-dealing) as well as concentration among small pools of franchisees. (3) Explore the future potential for royalty stream growth including through increased same-unit sales, an increase in the franchisee population, or the introduction of new products and services.

No Protection. The core assets of a franchise system are the intangible assets such as intellectual property (trademarks, trade secrets, copyright, patents, etc). Has the existing franchisor taken appropriate steps to protect its owned or licensed intellectual property rights (through registration, contractual covenants, conduct with franchisees etc)? Investors should assess whether the franchisor has conscientiously policed its intellectual property rights. Equally important is the investigation of whether there is scope to protect the intellectual property in jurisdictions that form part of the growth strategy.

Impaired Human Capital. In some cases investors will look to keep existing management (or at least part of it) in place. This necessitates due diligence on each member of the team, their current roles and responsibilities, confirmation that all of the typical franchise system roles and functions are covered, together with an analysis of where things might fit post-acquisition. A number of circumstances with respect to human capital can create inauspicious conditions. For example, the imminent retirement of key personnel like senior franchise development or franchise operations managers where there are no trained replacements. Of equal concern is the risk that key personnel will leave shortly after completion of the acquisition.

Unhealthy Systems. Franchisees have been referred to as the “lifeblood” of a franchise system. It stands to reason that the franchisor’s relationship with franchisees is critical to the health of the system. If that relationship is characterized by constant tension, disagreements, defaults, and a high turnover of franchisees, it may not bode well for any incoming franchisor. The existence of franchisee associations can be a symptom of a previous or current unhealthy system (eg particularly where the association was established for the purposes of mounting a challenge against the franchisor). On the flip side, the non-existence of a franchise advisory council (typically established to permit franchisees a forum to voice their ideas and concerns, and to have regular meaningful communication with the franchisor) can also be symptomatic of an unhealthy system.

Breaking the Rules. Franchising has become increasingly regulated and is also an increasingly litigious area of law. The remedies available to franchisees under franchise laws are strict and extreme. It is critical that franchisors be in a position to demonstrate compliance with all applicable franchise laws. This includes keeping appropriate documentary records to establish that: (i) franchise sales, disclosure, and other processes were carried out in a manner that complied with applicable franchise laws, (ii) any earnings projections or estimated operating costs provided were based on reasonable assumptions and were appropriately substantiated, (iii) there has been ongoing compliance with franchise laws. Non-compliance with franchise laws creates significant exposure for acquirers, and is not taken lightly in their due diligence and assessment.

Bad Deals. The franchisor’s contractual rights and obligations with respect to its franchisees frames the franchise system’s legal structure. A second-rate approach to drafting, negotiating, and implementing franchise agreements (and ancillary agreements and arrangements) with franchisees may render a franchise system unacceptable. Numerous versions of franchise agreements with different terms, “one-off” side deals, and/or poor record keeping may make understanding the rights and obligations vis-à-vis the franchise system a lengthy, complex, and uncertain undertaking. Any respite or concessions made with respect to a franchisee’s financial obligations may be harmful to the economic assessment and viability of the franchise system.

Stuck or Prohibited. There may be unfavourable or prohibitive provisions that stand in direct opposition to growth and expansion plans. For example: (i) near ending or extended term and renewal provisions (depending on the investors plans may be of concern), (ii) the precise breadth and limitations of system modification rights and obligations may be incongruent with strategic plans, (iii) the nature and scope of territorial rights granted to franchisees (including exclusivity terms) may stifle growth strategy and structure for particular regions (for example, where large development areas have been granted with long development terms), (iv) inferior reservation of rights may prevent expansion through alternative distribution channels or the achievement of economies of scale (eg not being able to leverage the same infrastructure across multiple franchise systems), or (v) termination rights that are too lax for franchisees and/or too onerous for the franchisor may also present challenges.

Outdated Technology. Franchisors face a precarious three-way intersection of increased accountability and regulation over consumer privacy, a growing volume and sophistication of cyberattacks on consumer data, and the expanding boundaries of franchisor liability for matters arising at the franchise unit level. It is imperative that franchisors maintain, update, and make continual investments in their technology systems to ensure that they are operating at optimum levels. Looking at technology as an asset, in many cases, technology is a critical aspect of the competitive advantage that franchise systems have in their particular market. Accordingly, aging technology can translate to loss of market share.

Industry-specific considerations exist in many M&A transactions, franchise M&A transactions are no different. An understanding of the franchise business model, the underlying assets, and the sorts of issues and challenges that can arise in that context is critical when looking to acquire a franchise system.

About the author:

Andrae Marrocco is a partner in the Toronto office of McMillan. His transactional practice is focused on advising domestic and international businesses on franchise & distribution matters and corporate/M&A transactions. He has particular expertise in complex franchise arrangements, franchise system mergers and acquisitions, and cross-border/international transactions. Andrae can be contacted at andrae.marrocco@mcmillan.ca.

The contents of this article formed part of a longer article co-authored by Andrae Marrocco and Mike Bidwell, President and CEO of Neighbourly, a US franchisor with over 20 franchise concepts in the repair, maintenance, and enhancement of homes and properties sector (with over 3,300 ultimate franchisees).