By Michael Seid, Managing Director, MSA Worldwide
New Franchisee, Old Franchisee – Who do you protect?
One of the most difficult business and relationship issues for franchisors to manage is the transfer of a franchised location between franchisees – especially when the seller is an existing operator and the buyer is looking to join the franchise system for the first time.
For the purpose of this discussion, let’s set the stage as follows:
- An existing franchisee has decided to exit the franchise system and has decided to sell their business to a new franchisee;
- The existing franchisee provides the potential buyer with access to their books and records and has prepared or worked with the buyer in the development of projections on the future performance of the business;
- You do not have a Financial Performance Representation in your disclosure document;
- The seller and the buyer have negotiated a price for the business;
- Per the terms of the seller’s franchise agreement, they have presented to you in writing the terms of the sale to meet your right of first refusal;
- You believe the selling price for the franchise is too high and you pass on the opportunity to purchase the franchisee’s business;
- In reviewing the transaction between the seller and the buyer, you determine that the cash flow that likely will be generated by the business is insufficient to carry the debt structure the buyer intends to have;
- You meet with the buyer, conduct your standard franchisee review, and approve them to become a franchisee; and,
- Other than approving the buyer and making your decision regarding your right of first refusal, you have not had any material involvement in the sale of the franchisee’s business.
What are the potential issues?
- Was there any violation of the disclosure rules, since the seller provided the buyer with both historic and projected financial information on the business?
- Do you have any obligations to disapprove the sale or notify the seller or buyer that the purchase price, in your opinion, may be too high?
Was There a Violation of the Franchise?
The FTC Rule governs the offering of a franchise opportunity by a franchisor to a potential franchisee. But the FTC Rule does not come into play in transactions between a seller and a buyer of a business, or with the ability of the seller to provide historic, projected or any other information they choose about their businesses to any buyer of that business. This is true even when one of the assets being sold includes the rights that flow from the seller transferring its franchise rights to a buyer, so long as the franchisor does not play a material role in the transaction.
Under the FTC Rule “A person who purchases an existing franchise directly from the franchisee who owns it, without significant contact with the franchisor, is not a prospective franchisee. A purchaser who purchases from an existing franchisee will not be deemed a prospective franchisee, therefore merely because the franchisor has, and exercises, a right to approve or disapprove the purchaser, unless the franchisor’s role in the transaction is otherwise significant.” 
Further, there is no prohibition under the FTC rule regarding a franchisee sharing financial information. “Prospective franchisees may be able to discuss earnings and other financial performance issues directly with current and former franchisees”.
Providing historic and anticipated financial projections is a routine and necessary part of the sale of any asset, including any independently-owned franchise business. Without such basic information the buyer would have little basis upon which to value the assets being purchased or to make a reasoned determination of whether or not to enter into the transaction. This is the reason that the FTC specifically provided for this type of sharing of information between a seller and a buyer of an existing franchise.
Since the franchisor had no material involvement or contact regarding the transaction, the buyer is not even considered a prospective franchisee under the FTC Rule. Therefore there was no violation under the rule, should the buyer have received financial information from the seller. Even though the rules are clear, most franchisors, out of an abundance of caution, have the new franchisee sign a series of representations at the time they enter into the franchise agreement, including a representation that they did not receive any ex-disclosure financial performance representations from the franchisor or anyone else prior to entering into the franchise agreement.
Typically these representations include acknowledgments by the new franchisee that:
“No oral, written or visual representation, promise, agreement, contract, commitment, understanding or otherwise which contradicted, expanded upon or was inconsistent with the Offering Circular of the Franchise Agreement was made to me by any person or entity.”
“No oral, written or visual claim or representations (including but not limited to charts, tables, spreadsheets or mathematical calculations) which stated or suggested any specific level of range of actual or potential sales, costs, income, expenses, profits, cash flow, tax effects or otherwise (or from which such items might be ascertained) was made to me by any person or entity.”
Most franchise agreements also contain a provision that:
“Franchisor does not make or endorse, nor does it allow, any marketing representative, broker or other individual to make or endorse any oral, written, visual or other claim of representation (including but not limited to charts, tables, spreadsheet or mathematical calculations) which stated or suggested any specific level or range of actual or potential sales, costs, income, expenses, profits, cash flow, tax effect or otherwise (or from which such items might be ascertained) with respect to this or any other Franchise, whether made on behalf of or for Franchisor, any Franchisee or other individual and expressly disclaims any such information, data or results.”
The courts have supported these types of representations by franchisees prior to entering into a franchise agreement. In Governara v 7-Eleven, Chief Judge Preska of the United States District Court, Southern District of New York opined:
“Plaintiffs’ arguments also contravene the basic principles of contract law, which are to “protect the expectations of the parties and provide certainty where the future would otherwise be uncertain.” Refusing to enforce non-reliance disclaimers would violate the sanctity of contracts and discourage their use. Ironically, this would undermine the goals of the NYFA, since non-reliance disclaimers help franchisors “root our dishonest sales personnel and avoid sales secured by fraud… by requesting franchisees to disclose whether a franchisor’s representatives made statements concerning the financial prospects for the franchise during the sales process. Accordingly, “the disclaimer must be given effect, and Plaintiffs cannot successfully allege the element of reasonable reliance.”
While possibly these representations by franchisees prior to signing a franchise agreement can arguably be considered unnecessary, franchisors include them so that claims to the contrary cannot be raised by the franchisee later on. Once made, the courts have found that the franchisor had the right to accept and rely on these material representations by the new franchisee.
What to do about the purchase price?
This is really one of the hardest decisions a franchisor may need to make.
- You can do nothing, and many franchisors and franchise lawyers will tell you this is the most prudent action. By not becoming involved in the review of the transaction, the franchisor cannot be faulted by either the buyer or the seller.
- The franchisor can inform the buyer and seller that in their opinion the price is too high. This has the potential of triggering a few reactions. The buyer might try to negotiate a lower price for the business, or they might walk away from the transaction altogether. Certainly the existing franchisee is not going to be pleased with your involvement, as you have either caused them to sell the business at a lower price or you might have killed the sale altogether.
- You could reject the sale based on your belief that the anticipated cash flow from the business is insufficient to service the debt, and require the buyer to increase their down payment sufficiently to bring the anticipated cash-flow to debt-service ratio into an acceptable level.
- You can just allow the transfer to go through, but if your analysis is correct, the business may run into financial difficulty and therefore could possibly fail.
This is one of those Gordian Knots that can keep you awake at night, since any choice you make could possibly trigger litigation from either the buyer or the seller. After all, just because you are trying to do the right thing, this is still the United States and there are plenty of lawyers that will convince their client that they should litigate.
There are proactive ways for you to deal with this type of situation in advance and hopefully lower your chances for litigation, improve your chances to win should litigation not be avoidable, and set and retain a positive relationship with your franchisees.
Your first action should be to review with your business advisors and lawyers your current franchise agreements, with a focus on your rights and obligations during a transfer of the business by an existing franchisee. If your agreements were well drafted, your attorney has already included a transfer precondition that required the selling franchisee to advise you of the terms of the transaction and allowed you to withhold consent if you believe the transfer price is excessive. But the issue is not really the purchase price, but rather the ability of the franchise to support the intended debt structure.
You should address the issue with your Franchisee Advisory Council and get their assistance and support in determining the proper projected cash flow to debt service ratio to use. Likely, existing franchisees are in the best position to determine what a proper ratio or formula should be for the system.
Once established, and with advice of your legal counsel, you should publish your recommended cash-flow to debt-service ratios in your operations manual or in some other format. By doing so in advance, in addition to providing yourself with an objective source upon which to evaluate whether or not to approve a transaction, you alert the franchisee in advance of your criteria for approving a sale. Doing so removes you from the transaction loop and avoids your need to comment on whether the selling price is too high, since your focus is instead on the viability of the location going forward.
Some franchisors go one step farther and require the buyer and seller to obtain a “comfort letter” from a CPA indicating that, based on their independent analysis, the projected cash flow of the business will support the new franchisee’s debt structure to system standards. This method removes the franchisor from any direct involvement in evaluating the financial aspect of the transaction.
As with everything in a franchise system, it is important that the franchisor be proactive, manage the business, include franchisees in significant decisions that impact them, and communicate clearly your system’s standards. Doing so may not guarantee that franchisees will love you or may still not sue, but at least you will know you acted appropriately to protect the franchise system, including the franchisees.
 Final Guides to the Franchising and Business Opportunity Ventures Trade Regulation Rule, 74 Fed. Reg. 49966, 49969 (August 24, 1979)
 16 CFR Parts 436 and 437, Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunities