The importance of franchise due diligence for buyers

When acquiring a business that operates under a franchise agreement, the franchise relationship introduces a third party — the franchisor — whose rights, approvals, and ongoing requirements can fundamentally shape the value and viability of the acquisition. Thorough due diligence on both the franchise agreement and the current status of the franchise is essential to completing the transaction. A failure to investigate these matters before closing can expose the buyer to unexpected liabilities, operational restrictions, and even the risk of losing the franchise altogether.

This article examines five critical areas of franchise due diligence that every buyer should address before closing on the purchase of a franchisee.

Franchisor consent to transfer

Nearly every franchise agreement contains a provision requiring the franchisee to obtain the franchisor's prior written consent before assigning or transferring the franchise, whether through an asset sale, equity sale, or change of control. This is typically a gating item to a transaction. Some franchisors, such as McDonalds, Wingstop, etc., maintain significant control over transfers to franchisees to a certain extent that these franchisors often dictate the purchaser. This consent requirement is one of the most significant gating issues in any franchise acquisition, and it should be the first item the buyer. If a franchisor is not going to consent to the buyer as a franchisee, it is better to learn that early in the process to avoid incurring unnecessary costs.

The buyer should review the assignment provisions of the franchise agreement to understand the specific conditions the franchisor imposes on a transfer. These conditions often include the franchisor's right to approve the buyer's financial qualifications, business experience, and character. The franchisor may also require the buyer to complete its standard training program, execute the franchisor's then-current form of franchise agreement (which may contain materially different terms than the existing agreement), and agree to invest capital expenditures at the franchised location to current brand standards. In some cases, the franchisor may hold a right of first refusal, allowing it to step into the buyer's shoes and acquire the franchise on substantially similar terms.

Because the franchisor's consent is a condition that the parties cannot control, the buyer should address the consent process early in the transaction timeline, preferably during the letter of intent phase.  If the parties have entered into a definitive agreement, the agreement should include a condition to closing that the franchisor's consent has been obtained on terms reasonably satisfactory to the buyer.

Franchise fees and financial obligations

A comprehensive understanding of the fees that the franchisor charges the franchisee is critical to the buyer's financial modeling and valuation of the business. Franchise fee structures can be complex, and a buyer who fails to account for the full scope of these obligations may find that the economics of the deal are materially different from what was anticipated.

The largest fee is the royalty, which is typically calculated as a percentage of gross sales and is payable on a monthly basis. In addition to royalties, franchisees are commonly required to contribute to a national or regional advertising fund, again calculated as a percentage of gross sales. These two fees alone can represent a significant portion of the franchisee's revenue, and the buyer should confirm the precise rates, the definition of the revenue base on which they are calculated, and whether the franchisor has the right to increase these fees during the term of the agreement.  We recommend that buyers conduct a “quality of earnings” review with a qualified financial firm as part of the due diligence process. It is recommended that the quality of earnings be reviewed in the franchise agreement to ensure the exact amount of the fees and to ensure that the sellers have been properly paying the franchisor.

Beyond royalties and advertising contributions, the buyer should investigate whether the franchise agreement imposes technology fees, software licensing fees, training fees, audit fees, transfer fees, or renewal fees. Many franchise systems also require franchisees to purchase supplies, equipment, or inventory exclusively from the franchisor or from approved vendors, and the pricing of these required purchases can have a meaningful impact on profitability.

Good standing of the franchisee

The buyer should confirm that the franchisee is in good standing with the franchisor at the time of the transaction. A franchisee that is in default under its franchise agreement, or that has a history of defaults or disputes with the franchisor, presents a substantially higher risk to the buyer. Outstanding defaults may give the franchisor the right to terminate the franchise agreement or impose additional conditions on the transaction.

Due diligence on the franchisee's standing should include a request for a written confirmation or estoppel certificate from the franchisor stating that the franchise agreement is in full force and effect, that the franchisee is not in default, and that no events have occurred that, with the passage of time or the giving of notice, would constitute a default. This estoppel certificate serves as a critical baseline and should be a condition to closing in the definitive agreement.

The buyer should also review any correspondence between the franchisee and the franchisor, including any notices of default, cure notices, warning letters, inspection reports, and audit results. Particular attention should be paid to any ongoing or recently resolved disputes, as these may indicate friction in the franchise relationship that could carry forward after closing. The buyer should inquire about the franchisee's compliance with operational standards, including facility maintenance, product quality, customer service metrics, and any performance benchmarks established by the franchisor.

A franchisee's poor standing with its franchisor is not merely a legal risk; it can also be a practical one. Franchisors that view a franchisee unfavorably may be less cooperative in the transfer process, and there could be other franchisee financial issues in addition to the franchise agreement.

Geographic territory and exclusivity

The scope of the franchisee's geographic territory and the nature of any exclusivity protections are key business conditions of a franchise. The buyer should examine the franchise agreement carefully to understand exactly what territorial rights the franchisee holds and, equally important, what limitations apply.  Unfortunately, a buyer cannot rely on a franchisor exercising business judgment to not put a competing franchise in the same market.  Hotels and quick-service restaurants frequently permit franchises to open up in the same market, materially and adversely impacting the financial condition of the existing franchisee.

Some franchise agreements grant the franchisee an exclusive territory within which the franchisor agrees not to establish or license another franchised or company-owned location. Other agreements provide for no territorial rights at all beyond the specific site at which the franchisee operates. The buyer must understand where the franchise falls on this spectrum, as the absence of meaningful territorial protections can expose the buyer to direct competition from the franchisor or from other franchisees with the same or similar product offerings.

Pre-closing liabilities under the franchise agreement

A buyer must take care to understand and allocate the risk of pre-closing liabilities arising under the franchise agreement. These liabilities can take many forms, including unpaid royalties, advertising fund contributions, or other fees owed to the franchisor; penalties or damages arising from past defaults; indemnification obligations triggered by pre-closing events; and liabilities to third parties that the franchisee incurred in the operation of the franchised business.

The definitive agreement should contain fulsome representations and warranties from the seller regarding its compliance with the franchise agreement, the absence of defaults, and the existence and amount of any outstanding obligations to the franchisor and potentially hold a portion of the purchase price in escrow for a period of time post-closing to protect the buyer from any undisclosed liabilities.