Even with a certain amount of market volatility and uncertainty, the M&A market has seen a great deal of activity recently, including in the franchise industry. The changing market has brought significant opportunity to the buying and selling of franchises. Franchisors and strategic buyers have been consolidating in various areas of the franchise industry. Particularly in recent years, private equity funds have brought significant additional capital to the industry and have demonstrated a strong interest in franchising, investing behind multi-unit concepts of all varieties, including investments in franchise systems and multi-unit franchisees.
As with M&A generally, the past several years have brought to franchise M&A transactions a very seller-favorable market with high valuations and limited post-closing risk for sellers. The increasingly rapid and seller-friendly market lends towards more seller-favorable terms in transaction documents such as limited survival periods for representations and warranties, an increased use of representation and warranty insurance, accelerated transaction timelines and limited closing conditions (for transactions structured as a signing with a later closing).
This environment forces buyers to focus on the major risk areas during the due diligence process, including supply chain issues, regulatory compliance issues, joint employer liability and vicarious liability risks, and the impact of market volatility on the franchise system.
Franchise system acquisitions now require additional layers of consideration to deal with evolving issues in the changing market, including COVID-19, rapidly changing economics, and domestic and global events that impact franchise systems.
These market and franchise M&A trends seem likely to continue, so are worth considering when approaching a franchise system transaction.
Representations and warranties insurance
The use of representations and warranties insurance in private U.S. mergers and acquisitions has increased in recent years, including in franchise transactions. This is a trend that is expected to continue. Private equity buyers, in particular, tend to be very comfortable using representations and warranties insurance in their transactions, which can help make their offers more attractive to sellers.
While it comes at a cost, for which the Buyer is usually responsible for some or all, the use of representations and warranties insurance decreases the risk of post-closing indemnification claims against sellers and allows for less negotiation when it comes to representations and warranties in the purchase agreement.
In the franchise industry specifically, there has been a heightened focus in underwriting for these policies relative to the franchise agreement, controls, performance, and licensing matters.
As an alternative to representations and warranty insurance in franchise transactions, parties have also looked at using other types of insurance to add value or protect the parties:
- As credit support in respect of the franchisee’s ability to perform.
- To help a franchisee secure more favorable leverage to improve their returns.
- Using ‘reputational harm’ insurance to protect franchisors against loss in revenue as a result of a franchisee acting badly.
The use of insurance of various types can help move deals along, with less risk and negotiation but increased cost (to at least one of the parties).
Closing timelines & contingencies
In the franchise and M&A world, we have seen increased pressure to close transactions quickly and to have fewer contingencies (and potential roadblocks to closing). Generally, sellers are requiring accelerated timelines and are accepting only minimal conditions on buyers’ obligations to close transactions.
In particular, sellers seek to limit or eliminate conditions related to a material adverse change in the business that could include changes in financial conditions or industry conditions, in case there are significant changes based on overall economic conditions in the industry that are out of a seller’s control.
Conversely, a buyer wants to make sure that the initial deal struck at the letter of intent or purchase agreement stage still makes sense financially, and that its financing is secure.
Purchasing and supply chain issues
As we all know from the daily news about shortages of various products, businesses in nearly every industry have struggled to maintain needed supplies in recent years. Supply chain issues are a major threat to U.S. brands. A recent Brightpearl survey of retailers found that 80 per cent of those surveyed have been hit with supply problems in the last year, leading to stockouts, increased costs and low cash reserves.
For franchise systems dependent upon supplies to produce goods and services, the supply chain is increasingly important when it comes to a transaction, particularly from a buyer due diligence perspective.
On the buyer side, diligence efforts should include review of key supplier arrangements. The buyer will want to know if the business system or any particular franchise unit(s) are dependent on a sole source supplier, or if the business has experienced any issues with obtaining supplies. If affirmative, is it easy enough to find other suppliers and products essential to the system? What control, flexibility and benefits will the franchisor have related to suppliers used by franchisees?
These questions are all important in the diligence phase of a transaction, and could greatly impact the system financial performance after the closing.
Joint employer concerns
An important issue that has received a great deal of attention in the media and franchise industry is the potential that franchisors may be treated as “joint employers” with respect to the franchisees’ employees, and thus be subject to liability risks for acts and omissions of the franchisee. Therefore, when acquiring a franchise system, a buyer should look carefully at the level of control the franchisor actually, or potentially, can exercise over employment-related issues of its franchisees. Often, this analysis includes review of not only the franchise agreement and franchise disclosure document, but also operations manuals and any guidance the franchisor has provided to the franchisees regarding employment. Certain disclaimers should be included in the franchise documents to make clear that the franchisor is not the employer of franchisee’s employees.
The vicarious liability risk
A related issue that has become a hot topic in regulation of franchise systems and recent case law is that franchisors may be held vicariously liable for the actions of their franchisees. If the franchisor exercises enough control over the franchisee’s day-to-day operations, particularly in relation to an alleged harm, the franchisor will be held liable for the acts of the franchisee or its employees or agents.
When considering acquiring a franchise system, a buyer’s due diligence should include a review of the level and nature of franchisor’s control over franchisees’ day-to-day business operations – again, this includes looking at the franchise agreements, operations manuals, communications from the franchisor, and reviewing any existing vicarious liability claims.
The franchisor’s control should not go beyond brand protection. If the franchisor is controlling every detail of daily operations, there is a higher risk of the franchisor being held liable for a franchisee’s acts under the vicarious liability theory. Conversely, all control measures should tie back to brand protection.
COVID-19 considerations and economic uncertainty
Even after several years, the ongoing Covid-19 pandemic continues to impact franchise M&A transactions, particularly the parties’ valuation of the franchise system or franchise units, the due diligence process, and assessment of regulatory issues.
Relating to valuation, the parties to a transaction will need to consider the full picture of how Covid-related impacts (or other economic fluctuation impacts) on the business have affected revenues. As well as what the duration of the impact was or is likely to be, how a franchisor has reacted to such impacts, what have been or are the costs of necessary operational changes, and how permanent are any operational changes.
The parties must assess the level of uncertainty related to the business (i.e. does economic uncertainty have a significant impact on valuation)? Higher average EBITDA multiples returned after an initial dip in the early stages of the COVID-19 pandemic, but it is possible this trend could change along with market conditions.
In the diligence process, a buyer will want to review operational changes, treatment of employees, if there are contract defaults, waivers or deferrals under franchise agreements, and the substance of force majeure clauses. When considering purchasing a franchise system, to avoid risk of regulatory compliance issues, a buyer will also want to look at financial representations made by the franchisor in Item 19 of its franchise disclosure document and elsewhere (on its website) to make sure the representations are consistent and accurate.
Franchise system transactions present a variety of trends and issues – some common to all M&A deals, while others are new and present unique considerations for franchisors. In a rapid, active and unpredictable market, parties to a franchise M&A deal may consider these key trends to make sure they are focusing their energy on the main risk areas relative to the transaction, and maximizing their efforts in the due diligence and negotiation process.
The authors
Partner Alyssa Hirschfeld, who concentrates her practice on general corporate law transactions and mergers and acquisitions, and associate Rachel O’Connor, who counsels franchisors on transactional matters and acquisitions and sales of businesses, practice at Lathrop GPM.
