This article is an extract from GTDT Practice Guide Franchise 2022. Click here for the full guide
Ever since franchises were first introduced into Mexican legislation approximately 35 years ago, they have been considered one of the most convenient and profitable business models for carrying out both national and foreign commercial investments. This is evidenced by the great number of stores and commercial establishments based on a franchise structure within the Mexican territory. Pre-pandemic, this figure stood at approximately 20,000 and this is now set to increase, given that the commercial situation is beginning to normalise. This upward trend is also sustained by the proximity of Mexico’s commercial and geographical partners, the United States and Canada.
In addition, franchise structures in Mexico comprise approximately 500 brands, of which 75 per cent are Mexican and 25 per cent foreign, in turn creating approximately 900,000 jobs as at 2019. Further, according to the information made available by the Mexican Franchise Association (AMF), franchise structures in Mexico account for approximately 5 to 7 per cent of annual GDP. The AMF is a private entity that serves as the foremost organisation in Mexico providing promotion, collaboration and support for existing franchises in Mexico, as well as assistance and advice for aspiring franchisors by giving information on existing franchises and brands in the country, as well as the current landscape of each specific franchise business sector.
The 42nd International Franchise Fair (FIF), which took place in 2019, evidenced the high interest and demand that currently exists in Mexico from individuals wishing to explore and potentially invest in the franchise business model. In fact, it was stated at the FIF that growth of between 8 and 10 per cent was expected within the franchise sector in 2019, as well as an increase of approximately 6 per cent in the number of franchise trademarks and brands. Although, like many industries, franchising has suffered commercially as a result of the covid-19 pandemic, as things return to normality, the trend for growth is envisioned to continue.
As a result of the popularity and widespread use of the franchise model in Mexico, as well as having many types of franchises to invest in, more and more individuals have been looking to invest in this business model by means of the acquisition of well-established franchise enterprises. In recent years, new business models that have arisen from the technology industry, such as crowdfunding, have also resulted in additional growth to an already increasing market.
Nonetheless, it can be difficult to determine which franchise is the most profitable or suitable for each person to invest in or to acquire in the context of an M&A transaction. As such, it is very significant to have extensive knowledge of the potential business or investment that will be made for purposes of the acquisition of a franchise venture or a group of franchises. This is where due diligence comes in and has significant value for the investment in a franchise business.
The due diligence process comprises a comprehensive investigation procedure carried out by the prospective buyer in relation to the franchisor and the applicable franchisees, as well as the franchise’s operations system, across a wide range of fields of practice, such as legal, financial, corporate, tax, labour and any other areas related to the prospective investment or in connection with the franchise itself, the franchisor or the franchisee.
Due diligence is a crucial process for a prospective buyer. This is primarily because it ensures that the investor will be protected and secure regarding the performance of, and income from, the investment. Moreover, in the context of mergers and acquisitions, carrying out full due diligence will allow the potential investor or buyer to determine the value of a group of franchises as well as the best terms for the acquisition of these franchises, including the terms for structuring the acquisition and any potential liabilities and contingencies that may be associated with the franchises.
Due diligence will grant the prospective buyer or investor of a franchise with enough background about the franchise’s operations, knowledge regarding the status of the business and the brand’s positioning and reach in the corresponding market or industry. This will provide a broad view of the franchise situation and what needs to be adapted, improved or maintained for the investment to yield the desired profits.
Franchises under Mexican law
Article 245 of the Federal Law of Protection of Industrial Property (FLPIP) establishes that a franchise exists when, with a licence to use a trademark granted in writing, technical knowledge is transmitted or technical assistance is provided, for the licensee to produce or sell goods or render services in a uniform manner and with the operating, commercial and administrative methods established by the owner of the trademark, to maintain the quality, reputation and image of the products or services distinguished by the trademark.
A franchise in Mexico is formalised by a written agreement. To comply with the FLPIP, the franchise agreement to be executed must contain certain provisions necessary for the operation and management of the franchise; for example, the geographic area in which the franchisee will carry out the activities contained in the agreement; inventory, marketing and advertising policies; and the criteria, methods and procedures of supervision, among other things stated by the FLPIP and its implementing regulation.
Registering the franchise agreement with the Mexican Institute of Industrial Property (IMPI) is recommended as a precautionary measure, as this would be helpful should litigation arise. In Mexico, trademark owners must prove use of the trademark to prevent a cancellation action by any third party; the filing of the franchise agreement with the IMPI would serve this purpose as the franchisee would be considered the owner. However, although it is recommended, there is no legal obligation to record the franchise agreement. To ensure that certain aspects are kept confidential, a short version of the franchise agreement may be recorded with the IMPI.
As noted previously, due diligence comprises an investigation and review process that is necessary whenever a potential franchise investment is going to be made. This allows parties to learn the total value of the investment and the legal standing of the parties, and ensures that the investment will be beneficial for all the parties involved and there are no legal violations or provisions that may affect the corresponding franchise transaction or the operation of the franchise business in the future.
The process will involve research and investigation into every material aspect and element of the potential investment and the parties concerned, and any related information. In Mexico, due diligence procedures are carried out with the broadest scope possible, to prevent any present or future liabilities for the franchisor, franchisee or the potential investor. Nonetheless, although every aspect of the potential investment must be reviewed, the process will depend on the type of investor (potential franchisee), the nature of the investment, the types of activities that the investor pursues, the sector or industry in which it develops its activities, and the commercial agreements between the parties.
In this regard, due diligence for a franchise acquisition transaction should generally cover the following aspects:
- corporate and operational records and documents;
- accounting and financial records;
- tax documents and tax compliance in general;
- bank accounts and loans;
- insurance policies;
- real estate documentation;
- property, building, lands and any encumbrances made to them;
- machinery, equipment and other leased items;
- patents, trademarks, transfers of technology, copyrights and any other applicable industrial property rights;
- data protection and privacy; and
- regulatory compliance.
Due diligence is carried out for potential investments when the parties are already in negotiation or about to enter into negotiation and need certain information to confirm their intention to go through with the investment. The investigation may also be carried out with no knowledge of the other party by executing searches in the appropriate registries, but the scope will not be as broad.
The entire due diligence procedure will be based mostly on the nature of the investor’s business activities and its industry and the assets that will be included in the transaction. In this regard, the first step in the due diligence process will be to collect and review all documentation, records, agreements, governmental permits, files and any other relevant documents or information that may be available to review the legal standing of the parties involved in the transaction, the franchise business and the assets involved, as well as any documentation signed previously with regard to the potential investment.
Furthermore, the due diligence documents must also be reviewed to verify the franchise’s fulfilment regarding its government, tax, corporate, labour and any other type of obligation, as well as to check the total value of its assets and debts. Each document must be individually flagged according to the level of risk that it may pose currently or during the operation of the franchise.
The due diligence procedure must ensure that the investment is as beneficial as intended for both parties and that there will be no present or future liabilities or disputes arising from the assets and properties acquired in the investment, or from any agreement or legal relationship previously entered into by the franchise.
Special aspects in due diligence: franchises Acquisition of a single franchise unit
When acquiring a single franchise unit, it is of the utmost importance for the prospective buyer or investor to carry out due diligence on the desired franchise unit, including any applicable franchisors and franchisees, or any related parties.
When carrying out due diligence on a single franchise business model, the following three main aspects should be considered.
Prior to granting a franchise, and at least 30 business days before executing the franchise agreement, the franchisor must provide the prospective franchisee with the relevant company information in the franchise disclosure document (FDD). This must comply with the minimum provisions indicated in the FLPIP and its implementing regulation. Therefore, from the franchisee’s perspective, it is necessary to ascertain that this information is truthful and complies with the minimum legal requirements.
Additionally, the trademark is one of the most vital aspects to be reviewed when investing in or acquiring a franchise business model as this will be the main brand and image of the prospective investment. As such, it is important to take into consideration all the aspects of the trademark to find out relevant information that may affect or change the way in which the operation will be carried out by the franchisee, such as the reach of the trademark, its effectiveness, value and size, and the industry sector it occupies.
Furthermore, it is important to verify that the trademark is registered with the IMPI, the status of the registration and, of course, whether the trademark is adequately protected, namely whether it has been registered under the correct class, description of goods or services, and current design. Additionally, if licence agreements have been recorded with the IMPI, the term of each agreement and its terms and conditions should be verified.
Incorporation of the company
The corporate standing of the franchisor and franchisee or any other legal corporate vehicles involved in the operation of the franchise should be reviewed to ensure that they are duly incorporated pursuant to Mexican legislation.
In this regard, the documents that should be reviewed regarding the companies involved in the operation of the franchise are the articles of incorporation and by-laws of the corresponding entity, which will be duly granted before a notary public and subsequently filed in the Public Registry of Commerce of the domicile corresponding to its corporate domicile, tax ID and, if applicable, its enrolment in the National Registry of Foreign Investment. The review of these documents will help guarantee that the involved companies were incorporated in compliance with every requirement and formality according to Mexican legislation and that they are operating in full compliance with any applicable obligation or provision.
The final aspect that should reviewed by the prospective buyer is the corporate governance of the franchisor and franchisee, or any other company involved in the operation of the franchise. The corporate governance will be the set of rules, guidelines and regulations under which a company is ruled and governed. These guidelines include the company by-laws as well as any other internal regulations that may have been issued by the company’s management, or any partners’ or shareholders’ agreement that may have been executed, including without limitation any provisions governing the ownership of shares and shareholder agreements.
In addition, the prospective buyer or investor must review the franchisor’s or franchisee’s economic capacity to provide an overview of the potential liabilities arising from the acquisition transaction.
Acquisition of a franchise system
Thus far, this chapter has focused primarily on the aspects that a potential buyer would have to consider when wishing to acquire a single franchise unit. Nonetheless, a bigger investment is also desired sometimes, in which case the transaction may involve the acquisition of an entire franchise system, which in turn may comprise a greater number of franchise premises, including diverse assets, agreements, merchandise, real estate, operational and administrative resources (human, material or economic), permits and licences, and the trademark or any other industry knowledge or know-how that may be necessary to operate the franchise business. We believe that there should be a special focus on these additional assets to prevent any of them affecting the acquisition transaction and the operation of the franchise in future.
However, the specific matters and issues that will have to reviewed in the due diligence process regarding the acquisition of a franchise operation that include diverse franchises will vary depending on the type and nature of the industry the franchise is in and the franchise’s assets. In general, we believe the following areas, in particular, should be considered.
Each agreement that has been executed by the companies involved in the operation must be reviewed. These include, but are not limited to, the following:
- franchise agreements;
- data transfer agreements;
- agreements with franchisees;
- agreements with suppliers;
- financial agreements or loan agreements, or both;
- agreements to supply raw materials;
- real estate agreements;
- agreements with government agencies; and
- collateral and security agreements.
In particular, it is important to check whether any of the above-mentioned agreements have any change of control provisions or any conditions that may be triggered as a result of the acquisition transaction.
The potential investor should meticulously review all the agreements currently in effect for all companies that comprise the franchise business, as this will provide a general overview of the companies’ status of compliance with their obligations, as well as any potential liabilities. A review of all the agreements in full force and effect will provide the potential investor with a more complete picture regarding, among other things:
- the terms and conditions of the agreements;
- any financing or credit terms defined in the agreements;
- the compliance of the parties with the agreements;
- any contingencies that the potential buyer will assume in the business;
- any change of control provisions;
- any assignment provisions;
- the penalties and indemnifications resulting from breach of the agreement;
- any agreements entered with employees; and
- the provisions comprising the lease of real estate necessary for the development of the franchise.
This review will give the potential buyer or investor an overview of the financial status of the target company and its current obligations, and the commercial and legal relations that it may have established with third parties for the operation of the franchise business. These legal relations will be transferred to the potential buyer so it is important to ensure that it has the resources to fulfil the obligations of the company, or to deal with default or breach of any agreements.
Additionally, the potential buyer should verify that the FDD was provided according to the specifications of the FLPIP, otherwise there may be consequences, such as a franchisee demanding the nullity of the franchise agreement.
In general, we believe that the potential buyer should review every agreement, whether it be labour, commercial, services, lease, etc, to ensure, among other things, that the company has no outstanding debts or liabilities.
Government permits and authorisations
It will also be necessary to review whether all the necessary government permits and authorisations granted to the company operating the franchise business are still in full force and effect, and that they allow for the rights covered thereunder to be transferred to third parties (in this case, the potential buyer). This is important as there may be various real estate properties or entities that are part of the franchise business that require certain government permits to continue operating, such as permits relating to operations, civil protection and the environment.
The final aspect to take into consideration when wanting to acquire a franchise business operation is the corporate entities or companies that operate and manage the franchise operation. They should be reviewed to ensure that they are in compliance with their applicable obligations and provisions pursuant to the applicable corporate and commercial laws, as well as any other agreement that may have signed.
In a medium- to large-scale operation, such as one that would take place when acquiring a complete franchise business, several corporate entities may be involved. As mentioned in the context of a single franchise business model, it is very important to make sure that such entities have been incorporated pursuant to the applicable legislation and are complying with all applicable obligations (including those related to corporate, tax and labour), as well as reviewing the corporate link and shareholding structure that exists between them. This is of particular importance as the acquisition of the franchise business may involve the sale or transfer of partnership interests or shares to new shareholders or partners.
The most important documents to review for each company or corporate entity are listed below.
- Corporate documents:
- articles of incorporation, company by-laws, amendments, mergers and capital increases and decreases, along with a copy of the relevant documentation and registration data;
- a list of shareholders and partners;
- a list of members of the board of managers or directors, statutory examiners and officers;
- corporate ledgers;
- shareholders’ and partners’ meetings minutes, including the corresponding annual meetings, and board members’ meetings minutes;
- powers of attorney in effect, including registration data;
- notarial instruments granted in favour of the company;
- agreements or commitments regarding corporate rights and obligations;
- a list of offices, industrial plants, stores and other facilities that operate within the franchise business;
- the interest of companies in other corporations, including contribution value, number of shares or partnership interests held, corporate rights, among other applicable information;
- a description of transactions or undertakings with direct or indirect affiliated corporations; and
- a list of permits and approvals in effect, along with the supporting documentation.
- Bank accounts and loans:
- loan or financing documents, including all related information;
- securities and personal guarantees, including existing mortgages and pledges; and
- a list of bank accounts.
- Land, building and improvements:
- public instruments containing land and building property, including restrictions and liens on these;
- certificates of tax indebtedness;
- leases, trusts or similar agreements regarding land and buildings;
- mortgages and other liens;
- receipts for real estate taxes, and for utilities such as water supply, electricity and gas; and
- construction agreements covering ongoing construction works.
- Machinery and equipment:
- a list of machinery and equipment;
- public deeds containing property of machinery and equipment, including relevant information; and
- import fees and custom declarations regarding machinery and equipment.
- notices of compliance with Federal Treasury Offices as well as state and municipal authorities;
- notices to the corresponding tax authorities on capital increases, address changes, change of corporate purpose, etc;
- federal and local tax returns for the past five years;
- returns covering taxes withheld by the company for payments abroad during the past five years; and
- inspections by tax or administrative authorities during the past five years and the results thereof.
- Intellectual property rights:
- a list of the franchisees, the FDD provided to each of them and the corresponding receipt;
- a list of patents, invention certificates, trademarks, trade names and applications, and the corresponding certificates or applications;
- licence agreements, confidentiality agreements, maquila contracts, management agreements and amendments thereto;
- agreements recorded with the IMPI, such as the short version of the franchise agreement or licence agreement; and
- Insurance and bonds:
- a list of insurance policies, including related information; and
- sureties issued to guarantee the company’s performance.
- a list of immigration permits of foreign employees.
- Labour and social security:
- collective labour agreements;
- a list of employees, including the full name, seniority, position, salary and benefits of each employee;
- individual labour agreements;
- internal labour regulations;
- savings funds;
- pending labour litigation; and
- filing of the company with the National Social Security Institution as well as the certificate of payment of social security fees.
- any additional contract or agreement other than those mentioned above; and
- pending lawsuits or litigation of arbitral proceedings.
In addition, with regard to the party selling the franchise operation, there are certain matters that should be taken into consideration, the most crucial of which is confidentiality. The selling party should ensure that it complies with the transfer process indicated in the agreements and properly carries out the valuations for the franchise system it is selling, which must include every single property, right, asset or element of know-how that is part of the franchise business.
Due diligence represents an investigation procedure that is crucial – for the franchisor, franchisee or an investor – when investing in any type of business or real estate, as it will provide a complete overview of the value, size and benefits of the investment to be made, as well as any drawbacks and potential liabilities or disputes that could arise from the investment. In addition to the general information that needs to be provided as part of a regular due diligence process, franchise business models should also cover the analysis or investigation of certain other aspects specific to the nature and operation of franchises.