Guiding You Through the Legal Maze^sm

I.     OVERVIEW

         A.     The relationship between a franchisor and a franchisee is a long-term one. The typical franchise agreement may have an initial term of 10 to 20 years plus renewal terms of 5 to 10 years or more. The franchise agreement may, in fact, have unlimited renewal rights ("evergreen"). During such a long time, many things can occur, including:

1.     The franchisee may desire to sell his or her franchised business to a third party as a going concern.

 

2.     The franchisee may desire to transfer all or a portion of the franchised business to his or her spouse or children for estate planning or other reasons.

 

3.     The franchisee, or the principal individual in a corporate franchisee, may become disabled or incompetent.

 

4.     The franchisee, or the principal individual in a corporate franchisee, may die.

 

        B.     In addition to the traditional corporate, conveyancing, tax and other issues associated with the transfer of any business, there are additional concerns due to certain rights which the franchisor may have that are typically set forth in the franchise agreement. These rights may include: (i) the franchisor's option to purchase the franchised business; (ii) the franchisor's right of first refusal to purchase the franchised business; and/or (iii) the franchisor's conditions precedent to its consent to a transfer.

        C.     This Outline will generally address certain issues relating to the sale or transfer of a business and those issues that are unique to franchising.

           In addition to the myriad of reasons why a franchisee may want eventually to sell his or her franchised business, there are a number of reasons why a prospective franchisee may want to buy an existing franchised business rather than buy a new start-up franchise from a franchisor. These reasons include: (i) locating a unit in a more desirable and established location; (ii) purchasing a unit with an existing operating history; and (iii) possibly assuming an old, more advantageous franchise agreement.

            A.         Asset vs. Stock Sale. Since most franchised businesses are owned and operated by a corporation (for limitation of liability and other reasons, notwithstanding that the franchise agreement may have been executed individually), we will discuss the sale of a franchised business through the sale of assets or through the sale of stock in the corporation.

1.     Sale of Assets.

 

                            a.         Advantages

i)     Purchasing assets, not liabilities.

ii)     Stepped-up basis for depreciation and allocation
        of purchase price to assets.

iii)     Pick and choose assets purchased.

 

                            b.         Disadvantages

i)     More complex closing documents including
        conveyance documents.

ii)     Sales tax issues under Section 212.10 of the Florida
        Statutes.

iii)     Possible requirement for consent of franchisor,
        landlord, if any, and other parties having contractual
        relationship with franchisee.

iv)    Depreciation recapture by seller.

 

                      2.    Sale of Stock.

                            a.         Advantages

i)         Simplicity and speed.

ii)         May not require the franchisor's, landlord's or
            other party's consent except where recent
            or sophisticated agreement.

iii)         Avoid possible double taxation by seller.

 

                            b.         Disadvantages

i)         Buying assets and liabilities of the corporation,
            including contingent and undisclosed liabilities.

ii)         Assume existing depreciation schedule of assets
            and tax status of the corporation.

 

The sale of a franchise by an existing franchisee without significant involvement of the franchisor does not require the use of a FOC or state registration. The prior consent of the franchisor is not considered substantial involvement.

        B.     Dealing with the Franchisor. Most newer or sophisticated franchise agreements have provisions giving the franchisor certain rights in the case of the franchisee's proposed transfer of the franchised business regardless of whether the franchisee sells his or her assets or sells his or her stock. However, the franchise agreement should be thoroughly reviewed because the sale of stock may not be addressed. A thorough review of the franchise agreement should be undertaken before an offer of sale is made. A thorough review of the franchise agreement should be undertaken before a purchase offer is made.

1.         No Encumbrancing.

a.     Many franchise agreements provide that neither the franchisee nor any ownership interest in the franchise may be pledged, mortgaged, hypothecated, granted as a security interest for an obligation or in any manner encumbered.

 

2.         "For Sale" Restrictions.

a.     The franchise agreement may provide that in connection with the offer for sale of an existing franchised business, the franchisee is prohibited from putting up a "For Sale" sign at the premises.

 

b.     In addition, the franchise agreement may prohibit the use of the franchisor's trade name and other proprietary marks in connection with the sale and only allow generic advertising (for example, "Restaurant Business For Sale," not "McDonald's For Sale").

 

3.         The Franchisor's Right of First Refusal.

a.     Many franchise agreements provide that the franchisor has the right of first refusal to purchase the franchisee's franchised business on the same terms and conditions as offered by a bona fide unrelated third party purchaser. The reason why the franchisor usually retains this right is to control who may purchase the franchise and also to repurchase franchises and convert them to company-owned units.

b.     If the right of first refusal exists in the franchise agreement, the following must be done:

 

i)     There should be a contingency in the sale agreement
        making the obligations of the seller to sell and the
        buyer to purchase contingent upon obtaining the
        waiver of the right of first refusal by the franchisor.

ii)     A notice should be given to the franchisor in
        accordance with the terms of the right of first refusal
        provision. The notice should include a request for a
        waiver.

iii)    There is usually a time period in which the franchisor
        can exercise the option, hopefully it will be no more
        than 30 days.

iv)    The parties should obtain the waiver of right of first
        refusal in writing.

 

4.         Conditions Precedent to the Franchisor's Consent to Transfer.

a.     Most franchise agreements provide that the grant of the franchise to the franchisee is personal and that the franchisee is prohibited from selling the franchised business without the prior written consent of the franchisor. Usually, the franchise agreement details the conditions in which the franchisor will consent to a transfer, including:

 

i)     Waiver of right of first refusal.

ii)     Absence of both monetary and non-monetary
        defaults by the franchisee.

iii)     General release from the franchisee to the
        franchisor.

iv)     Payment of a transfer fee (from nominal to a
        significant percentage of the initial franchise fee)
        which may or may not include a training fee. This
        expense should be addressed in the purchase
        agreement.

v)     Execution by the transferee of the then-current form
        of franchise agreement, rather than assumption of the
        existing franchise agreement.

vi)    Transferee must meet the requirements of the
        franchisor including reputation, business skills and
        financial capacity.

vii)    Completion of training.

         viii)     Renovation and upgrading of the franchised business
                   which can be substantial dollars.

ix)     Continued occupancy of the premises.

x)      No excessive purchase price.

         xi)      No release of the original franchisee.

 

b.     If the franchise agreement is silent on its assignability, assignment by the franchisee will be presumed.

 

5.     Estoppel Letter from the Franchisor.

 

a.     Regardless of whether assets or stock is being purchased, it is advisable to obtain a written estoppel letter from the franchisor (similar to an estoppel letter from a landlord) confirming the following:

 

i)     Consent to the transfer (if required).

ii)     Waiver of the right of first refusal (if required).

iii)     Acknowledgement there are no defaults by the
        franchisor or the franchisee under the franchise
        agreement and related documents.

iv)    That there are no addenda, riders or modification of
        the franchise agreement or oral or "side" agreements.

b.         This would also be an appropriate time to try to "renegotiate" the franchise agreement on behalf of the buyer, but usually the franchisor will insist on the execution of its then-current franchise agreement without negotiation.

 

    For a variety of reasons, such as health, estate planning, retirement, etc., the franchisee may want to transfer all or a portion of the franchised business to his or her spouse and/or children. The franchise agreement must be reviewed to determine what restrictions and rights of the franchisor exist. These may include:

            A.    Absolute prohibition. In such event, this issue will have to be negotiated with the franchisor.

            B.    Percentage limitation. Sometimes a minority interest in the corporation (5% to 49%) may be transferred by the franchisee to his or her spouse and/or children without the consent of the franchisor. In all other cases, the consent of the franchisor is usually required.

            C.     With respect to an intra-family transfer, the transfer fee may be nominal or waived.

    Most franchise agreements require the franchisee - owner/operator to be active in the day-to-day management of the franchised business. What happens when the franchisee becomes disabled or incompetent? In such event, counsel to the franchisee should review the franchise agreement. The franchise agreement may provide that if the franchisee becomes disabled or incompetent for more than a short period of time (for example, three consecutive months), a replacement manager is required to be hired. The franchisee may also be obligated to sell his or her interest in the franchise within a period of time (for example, six months) subject to the franchisor's right of first refusal and/or compliance with the franchisor's conditions to transfer. Make sure your client is not considered to have been deemed to have abandoned or ceased to operate the franchised business. This could be considered an event of default.

        A.    Required Sale. A typical franchise agreement provides that, upon the death of the franchisee, or, in the case of a corporate franchisee, the death of the principal, the franchise may have to be sold by the personal representative of the franchisee's estate within a period of time (for example, six months) to an approved transferee subject to the franchisor's right of first refusal and/or compliance with the franchisor's conditions to transfer. The failure to sell timely may constitute an event of default under the franchise agreement.

        B.    Life Insurance. In certain franchise systems, usually where the franchisee is a licensed professional where the spouse, children or other third person cannot easily take over the business, such as a medical-related franchise, pharmacy, legal, accounting, nursing, etc., a form of key man life insurance program may have been implemented which is structured as follows:

            1.        The life insurance policy is owned by the franchisor on the life of the franchisee.

            2.         The insurance premiums are split between the franchisor and the franchisee on some basis.

 

  3.         Upon death of the franchisee, the franchisor uses the insurance proceeds to repurchase
              the franchise.

 

    4.        The franchisee's heirs have cash instead of a business they may not have been able to
               operate themselves.

 

This can be a good financial planning tool regardless of the type of franchised business.

           In addition to what a seller has to do vis-a-vis his or her franchisor, a buyer has certain additional responsibilities to ensure that he or she makes an intelligent investment decision.

            A.    Obtain and review a current Franchise Offering Circular or FTC Disclosure Statement from the franchisor. The purchaser and his or her advisors should review it carefully. Understand all of its provisions, including:

1. Whether an exclusive or protected territory exists.

                    2. What items are you required to purchase from the franchisor.

                    3. Duties of the franchisor.

4. Services and support of the franchisor.

5. Performance standards.

6. Insurance requirements.

        B.         Most franchise agreements require the purchaser to sign a new then-current form of the franchise agreement rather than assume the seller's existing franchise agreement. Get a copy and attempt to negotiate, if possible.

        C.         Talk and visit other franchisees to better understand the business and how well the unit you are purchasing is doing.

        D.         Visit the franchisor's headquarters.

        E.         Obtain certain documents from the franchisor:

1. Waiver of right of first refusal;

2. Consent;

3. Estoppel letter.

        F.         Address in the purchase agreement certain provisions, including:

1. The amount of transfer fee and/or training fee and who pays;

2. The extent of any required renovation or upgrading;

3. Personal guarantee by the purchaser of the franchise agreement;

4. Make closing after, and contingent upon, the purchaser's completion of the
    franchisor's training program; and

5. Representation and warranties of the seller with respect to the franchise agreement
    and ancillary documents.

 

G.    Obtain a covenant not to compete from the seller. Don't just rely on the covenant in the
        franchise agreement since it runs only to the franchisor and not to the purchaser.

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