Buying an operating franchise can offer advantages over opening a new location: an established customer base, existing employees, a known location, operating history, and a business that may already be generating revenue. For a seller, a transfer can provide an exit strategy and an opportunity to realize the value built in the business.
But a franchise resale is not simply the sale of a privately held business. The franchisor is usually a necessary participant in the transaction. The seller’s franchise agreement typically gives the franchisor substantial control over whether the transfer can occur and its terms.
Whether you are purchasing or selling an existing franchise, it is important to identify the franchise-specific requirements early. A deal that initially looks attractive can become more expensive, delayed, or even unavailable once the parties review the franchise agreement, lease, and franchisor’s transfer requirements.
Start With the Franchise Agreement
The first step is to review the transfer provisions in the existing franchise agreement.
A franchisor generally wants to ensure that the incoming owner meets its current standards for franchisees. The buyer may be required to submit personal financial statements, tax returns, resumes, credit information, business references, and other materials. The franchisor may also conduct background checks, interviews, and operational evaluations.
As previously discussed, the buyer should not assume that a franchisee with a successful track record will automatically be approved as the next owner. The franchisor may evaluate the buyer under the standards it applies to new franchisees, including minimum liquidity, net worth, experience, and management requirements.
Determine Whether the Franchisor Has a Right of First Refusal
Many franchise agreements give the franchisor a right of first refusal. In practical terms, this may allow the franchisor to step into the buyer’s position and acquire the business or its assets on the same material terms negotiated by the seller and buyer.
This provision should be reviewed early in the process with a franchise lawyer, and not after the buyer has spent substantial time, money, and effort on diligence and negotiations. Sellers should understand the notice requirements and the time period within which the franchisor may exercise or waive its rights. Buyers should understand that a signed purchase agreement may still be contingent upon the franchisor’s decision.
Budget for Transfer Conditions and Required Upgrades
A transfer often triggers obligations that neither party anticipated when first discussing the purchase price. The franchisor may require the business to be brought into compliance with then-current brand standards before approving the transfer.
For example, the franchisor could require:
- New or upgraded equipment, such as a technology-system conversion
- Remodeling, signage, or décor improvements
- Repairs, maintenance, or required replacements
- Payment of delinquent royalties, marketing contributions, or other amounts owed to the franchisor
These requirements can be costly. The key negotiation issue is not merely whether improvements are required, but who will pay for them. Sellers may argue that upgrades principally benefit the buyer after closing. Buyers may respond that the seller should deliver a business that is eligible for transfer and compliant with the system’s requirements.
The parties should quickly identify required improvements, obtain estimates, and clearly allocate the costs in the purchase agreement.
Expect the Buyer to Sign a New Franchise Agreement
In most franchise transfers, the buyer will be required to sign the franchisor’s then-current franchise agreement rather than assume the seller’s existing agreement. This is a critical issue.
The new agreement may have materially different terms from the seller’s agreement, including changes to:
- Royalty and advertising-fund contributions
- Technology fees and required vendors
- Renewal and transfer provisions
- Territory protections and development obligations
- Operating standards
For example, a seller may be paying a 5 percent royalty, while the current franchise agreement requires a 7 percent royalty from the incoming franchisee. A buyer who does not account for that difference may overvalue the business or underestimate future operating costs.
The buyer should review the current Franchise Disclosure Document (FDD) and proposed franchise agreement with experienced franchise counsel before finalizing the purchase price or committing to a closing.
Be Mindful of the Lease, Employees, and Financial Records
The franchise agreement is only one part of the transaction. The parties should also evaluate whether the lease can be assigned, whether the landlord requires consent or a new guaranty, and whether the remaining lease term is sufficient to support the purchase price.
Buyers should also determine which employees will remain, whether key personnel are essential to operations, and whether any employment-related liabilities may follow the business.
Experienced Franchise Counsel Matters
A franchise transfer is a business sale, but it is also a franchisor-controlled transaction with its own contractual and practical risks. Identifying those risks early can help the parties negotiate a realistic price, avoid closing delays, and reduce unpleasant surprises after the sale.
Contact Lusthaus Law
Lusthaus Law’s website is a resource for New York franchisors and franchisees. We have published two downloadable and complimentary e-books and our Insights blog is regularly updated to reflect industry trends and recent achievements in client representation.
Contact us today to learn more about how Lusthaus Law P.C. can help you navigate a clear path for your franchise’s successful future.
