According to statistics regularly published by franchising organisations, about 70% of franchise networks disappear after three to five years. To a large extent, this reflects the normal lifecycle of many businesses which – after early success – fail to adapt to market realities, and die. However, another factor to be considered is the effect of restructuring and M&A transactions (and the consequent consolidation) on franchise systems. This update focuses on some of the issues raised by acquisitions of franchisors and the impact that such transactions may have on the sustainability of franchise networks.
As with any acquisition, the takeover of a franchise network is generally aimed at promoting growth potential, broadening the scope of products and services and achieving synergy between the buyer's group and the target. This is why acquisitions of franchisors are generally treated as traditional M&A transactions, with the same steps (ie, conducting due diligence, structuring the acquisition, finding the appropriate pricing structure and negotiating the terms of the purchase, including representations, warranties and indemnities). However, franchise-related mergers and acquisitions are distinct in that there is a third party at the table apart from the buyer and the seller – namely, the franchisee.
Whatever the structure of the transaction and type of purchaser (eg, strategic or financial buyer, competing or non-competing buyer), the success of the acquisition will largely depend on the degree to which the buyer anticipates potential issues with the target's franchisees (and sometimes the buyer's own franchisees) that may result from the acquisition.
Must a franchisor or its shareholders inform existing or prospective franchisees about a potential acquisition of the franchisor's business?
French law does not require the franchise disclosure document (which must be provided to any prospective franchisee before entering into a definitive franchise agreement) to give any information relating to a forthcoming acquisition or change of control of the franchisor. In fact, the identity of the direct and ultimate shareholders of the franchisor need not be stated in the franchise disclosure document. Similarly, in respect of existing franchisees, there is no requirement to update the franchise disclosure document when an M&A transaction is contemplated.
French case law provides many examples of situations where a franchisor has been held liable for failing to disclose to its franchisees the past developments of its franchise network properly (eg, the succession history between different franchisors, their financial situation or the bankruptcy of previous franchisees). Nonetheless, in the context of a planned change of ownership of the franchisor, there is no constructive 'duty to speak' to the franchisees.
What are the main issues to focus on during due diligence?
Valuation of a franchisor primarily relies on the value of the brand it owns and the solidity of its franchise agreements. This is because the franchisees are the actual owners of the sale businesses – not the franchisor, which relies on such businesses to get royalties and fees from the franchisees.
Beyond the typical issues which an investor will look at in any acquisition, some issues of critical importance in the context of franchise-related M&A include:
- the term and termination provisions of the franchise agreements;
- the potential restrictions to the continuation of the franchise agreements (see below);
- the territorial protection from which the target's franchisees benefit;
- the extent of the franchisor's rights to vary the concept, products and services, names and trademarks during the agreement;
- the impact of the deal on franchisees' property leases and third-party vendor relationships;
- the level of protection of the IP rights related to the franchise (including trademarks, designs and patents);
- the quality of the franchisor's management team (including the terms and conditions for retaining it post-acquisition).
If the investor is a competitor of the target franchisor, it should use the due diligence exercise to assess the feasibility of its future plans in terms of territorial expansion, new product or service lines and the extent of any post-acquisition changes it wishes to implement in its own network or the target. It may seek to factor into the purchase price the costs related to termination of some franchisees that it does not wish to retain – although the seller may legitimately refuse any reduction to the price for such changes which are linked purely to the buyer's strategy.
Do any restrictions affect the continuation of the franchise agreements?
A common misconception is that franchise agreements are entered into in consideration of the franchisee and not that of the franchisor. However, French courts often remind litigants that the assignment of a franchise agreement by the franchisor (through whatever means, including by way of merger or spin-off of the franchisor to another company) requires the prior consent of the franchisees, unless a specific clause in the franchise agreement provides for its free assignment or novation by the franchisor. This also applies when the agreement is transferred as a result of a change of control of the company owning the trademark (which may be a different entity from the franchisor); this is because the brand is an essential component to a franchise agreement.
Accordingly, the structure of an acquisition should be tailored to address or avoid the need to get the approval of each and every franchisee. Therefore, it is generally more advisable to choose a share deal over an asset deal, as it is rare to find clauses regarding the franchisor's change of control in a franchise or master franchise agreement. However, this is based on the assumption that the purchaser wishes to keep the franchise agreements as they are; that may not be the case (see below).
Can the buyer implement system changes to the target franchise network?
The basic principle is that existing franchise agreements must be performed in accordance with their terms and in good faith, regardless of the new owner of the franchise system. Therefore, existing franchisees may not be forced to accept changes to their ongoing agreements or enter into new agreements as a result of a change in the ownership of the franchisor.
If the acquired franchised network retains its identity post-acquisition, or the target's franchisees are offered the right to extend their business to other brands belonging to the buyer's group or to convert to a new brand with minimal conversion costs, no serious problem should arise between the new owner and the target's franchisees.
However, if the franchise agreements allow for no variance to the concept, methods, products or marketing and the new owner intends to implement some system changes, it may be very difficult to impose such changes on the franchisees unless they perceive a real benefit from it.
This is particularly relevant if the new owner is a competitor of the target franchisor via its own integrated sale outlets or franchise system. To the extent that the target's franchisees benefit from territorial exclusivity under their agreements, they must continue to benefit from such protection until the term of their contracts expires. Therefore, a new owner should make sure that it does not directly or indirectly encroach on the target's franchisees.
The new owner of a franchise system must not unduly favour its own system against that of the target. For example, in litigation following Quick's takeover of Free Time, the Supreme Court held Quick liable for failing to comply with the franchisor's obligations under the franchise agreements. This was because after the acquisition, Quick stopped investing in marketing to promote the Free Time brand. Although this resulted in lower royalties being charged to the Free Time franchisees, the court considered that this did not mean the franchisees had agreed with the changes imposed by Quick in relation to the overall economics of the agreements. Further, after the takeover, Quick set up a new fast-food restaurant in the neighbourhood of the plaintiff Free Time franchisee, encroaching on its contractual rights.
To balance this somewhat rigorous approach, French courts generally acknowledge the need for franchisors to adapt to consumer demand and market conditions. Therefore, when the new owner of a franchisor holds several brands and intends to organise some kind of market segmentation between them (eg, high, mid and low end), this will not necessarily be forbidden or restricted. For instance, in a January 7 2014 decision relating to the takeover of Budget by Avis, the plaintiff franchisee complained about the franchisor's new commercial policy (implemented post-takeover) targeted at key accounts at national level, resulting in a reduction of the car rental outlets operating under the Budget brand in France. The franchisee also sought compensation from the franchisor for downgrsding the Budget brand to a low-cost range. However, the Supreme Court refused to hold the franchisor liable on the grounds that a franchise network develops over time and the franchisor has no obligation to its existing franchisees to maintain the network in the same state or extend it.
In any event, anticipation and good communication with the franchisees are two basic guidelines that a purchaser of any franchise system should bear in mind, both ahead of the acquisition and once it has been completed.
For further information on this topic please contact Raphael Mellerio at Aramis Law Firm by telephone (+33 1 53 30 7700) or email (firstname.lastname@example.org). The Aramis Law Firm website can be accessed at www.aramis-law.com.
This update was first published in the May 2015 newsletter of the IBA International Franchising Committee – www.ibanet.org/LPD/Intl_Sales_Franchng_Prod_Law/Intl_Franchising/Default.aspx.
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