The acquisition of a franchise business from a franchisor carries with it risks unique to the nature of the business. The aim of this post is to shed light on some of those risks and to highlight mechanisms, the existence of which can comfort a potential buyer that those risks have been mitigated.
Risk of non-compliance with applicable franchise legislation
The provinces of Ontario, Alberta, British Columbia, Manitoba, New Brunswick and Prince Edward Island each have their own franchise regulatory regime. A staple of the franchise regulatory regime is the requirement that, subject to certain exemptions, prospective franchisees receive a franchise disclosure document, devoid of any material misrepresentations or material deficiencies, at least 14 days before the earlier of the (i) signing of any agreement relating to the franchise, or (ii) payment of any consideration by the prospective franchisee relating to the franchise. The purpose behind this requirement is to ensure a prospective franchisee has sufficient information upon which to make an informed investment decision.
The consequences of non-compliance can be significant. If a franchisor has failed to comply with the disclosure requirements of applicable franchise legislation, a franchisee is typically afforded a right of action for damages against the franchisor and may also have the right to rescind a franchise agreement for a period of 2 years after the “grant” of the franchise. Upon a franchisee’s successful initiation of a claim for rescission, the franchisor is required to wholly compensate a franchisee for its investment, whether direct or indirect, in the franchise business, including the purchase price of the franchise, set-up costs, the cost of inventory, supplies and equipment, all royalties and other franchise payments paid to the franchisor (such as advertisement fund payments), all rent payments (and deposits) and any losses that the franchisee incurred in the operation of the franchise.
A potential buyer should therefore review copies of the franchise disclosure documents given to franchisees over the last two years and any dated acknowledgements of receipt of the franchise disclosure document from those franchisees in order to ensure compliance.
Risk of franchisee default or bankruptcy
A potential buyer’s financial diligence should reveal whether at the time of the acquisition, any franchisee has defaulted on royalty payments or is otherwise in a precarious financial position. However, the financial position of a franchisee at the time of the acquisition might not be a good indicator of its financial position in the future. As such, a potential buyer should evaluate whether sufficient mechanisms are in place to protect the business and allow for its continued operation in the event of a future franchisee default or petition for bankruptcy. The following are examples of such mechanisms:
- a termination right for the franchisor upon a default of the franchise agreement by the franchisee or upon the franchisee’s bankruptcy;
- a right of first refusal for the franchisor to purchase the franchisee’s business upon a termination of the franchise agreement on account of a franchisee default or bankruptcy;
- a right for the franchisor to step into the franchisee’s lease upon either the exercise of the abovementioned right of first refusal or upon a default of the lease by the franchisee;
- a personal guarantee executed in favour of the franchisor; and
- a general security agreement executed in favour of the franchisor by the franchisee and any guarantors.
Risk of damage to the franchise brand
Inconsistency in the operation of any one franchise may in turn harm the brand of the network of franchises. Thus it is essential that a potential buyer ensure sufficient mechanisms are in place for a franchisor to keep the brand consistent across all franchises.
First, a potential buyer should confirm there are contractual obligations to require that franchisees operate in accordance with the franchisor’s standards of operations. Such operational standards should include maintaining a certain franchise layout or design and purchasing from authorized suppliers only, among others. The existence of incentive programs in connection with the franchisor’s standards of operation may serve as an additional mechanism to cause compliance.
Second, a potential buyer should confirm that the franchise agreements prohibit a change of control or sale of the franchisee’s business without the prior written consent of the franchisor. This way, the franchisor is able to maintain complete control over who is operating its franchises, and as a consequence, can better protect its brand.
The above represents only a subset of key risks (and mitigating factors) unique to the acquisition of a franchise business. For more information concerning the subject matter of this post, please contact Norton Rose Fulbright Canada LLP.
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