New Franchisee – Old Franchisee – Who Do You Protect?

By Michael Seid, Managing Director, MSA Worldwide

Likely one of the most challenging decisions a franchisor has to make is whether to get between the seller and the buyer of one of their franchises. After all, where does a franchisor’s loyalty lie?

Picture this real-life scenario. One of your long-time franchisees has decided to retire. They found a buyer and negotiated a price that both the seller and the buyer agree is fair. You have a right of first refusal to purchase the location, but based on your analysis, the price is considerably higher than it’s worth and you decide to take a pass. In addition, since same-store sales have been in decline, you are concerned that if you let the sale go through at the agreed-upon price, based on your projected cash flow the new franchisee will have trouble keeping the location viable.

But you also realize that with transfer pricing falling for the past two years, this higher price will set a benchmark, and in a down market would be of considerable benefit to other franchisees looking to sell. It might also help you in new franchise sales when your existing franchisees talk to prospective franchisees about the strength of your opportunity. This is a transfer of an existing agreement, so other than approving the buyer, you really don’t have any legal obligation to get involved in the sales transaction, if you don’t want to.

What should you do?

• You can do nothing. Many franchisors and franchise lawyers will tell you this is the most prudent action. By not becoming involved in the review of the transaction, you can’t be faulted by either party and the chance you will be sued is low.
• You can tell the buyer and seller the price is too high. However, a few things are likely to happen: The buyer could negotiate a lower price or walk away from the purchase altogether. They might investigate the purchase of another franchise at a lower price, or they might even choose to invest in a new franchised location.
• You could reject the sale based on the ratio of anticipated cash flow to debt-service ratio. If the buyer is able, they might be willing to increase their down payment and bring the anticipated cash flow to debt service ratio into acceptable levels.
• You can review the transaction and again do nothing. You can allow the transfer to go through. But if your analysis was right, the new franchisee may run into difficulty and could soon fail.

This is one of those Gordian Knots that can keep you awake at night.

If you cause the sale not to go through or have the selling price reduced, this will certainly anger your current franchisee and they might sue you. If you allow the sale to go through and the new franchisee fails, they might sue you. But even if you block the sale, based on some litigation history, believe it or not, the buyer might still sue you. After all, this is the United States.

But you can be proactive, lower the chance for litigation and improve your defenses should that occur, retain a positive relationship with your franchisees, and still smile at the person in the mirror each morning.

It is important to put aside the issue of supporting an artificially high market price for the resale of your franchisee’s locations. If you allow an inflated price for transferred locations, current franchisees may be happy, but franchisees in difficulty because they overpaid likely will not be. Over time, you will increase the turnover rate in your system, and that will depress future franchise sales. We know how well that worked in the housing market. Letting your units sell at unsupportable prices is not a good long-term strategy for your franchise system or for your franchisees.

Many franchisors—and their lawyers—support a do-nothing strategy. While it is arguable that the franchisor does not have a fiduciary responsibility or a duty of loyalty to the current franchisee or the future franchisee, the franchisor does have one overriding responsibility: They are responsible to their own brand. A preventable unit failure is always in the best interest of the franchise system. Even without a fiduciary responsibility to either the current or future franchisee, there really is no argument that the franchisor has a fiduciary responsibility of sorts to themselves. The do-nothing strategy is akin to closing your eyes, clicking your heels and repeating, “There’s no place like home—I hope it goes well.”

But how do you really know if the price is too high? It’s never an easy call even in the best of times. Couple this with a period in which there may not be any recent transfers to use as a guide, and no way to really judge if recent same-store sales are a predictor for the future. Sometimes the only method is to simply make a judgment call, and paraphrasing Justice Potter Stewart, you’ll know it when you see it. Without any other basis, that is likely a defensible position for a franchisor to take.

But there are better and more proactive ways to deal with transfers than waiting for the situation where a single transaction seems too high to be sustainable.

Review with your business advisors and lawyers your current franchise agreements and the transfer provisions provided. If your agreements were well drafted, your attorney 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. If your existing agreements do not have this provision, make certain that future agreements do.

The issue, though, may not necessarily be the price, but instead the ability of the location’s cash flow to support the intended debt structure. That is the real issue with transfers. Based on projected cash flow, can the franchisee meet their financial obligations?

One solution is to publish minimum cash-flow to debt-service ratios in your manuals. The deal then needs to meet the pre-determined ratios for approval. This method somewhat removes the franchisor from the transaction loop, because it is not focused on any one specific transaction. It also avoids the issue of whether the selling price is too high, and instead focuses on unit viability going forward.

Some franchisors will go one step farther and will require the buyer and seller to obtain a “comfort letter” from a CPA indicating that based on their independent analysis, the projected cash flow will support the new franchisee’s debt structure. This likely provides the franchisor with another level of litigation protection and it separates any direct franchisor involvement in ascertaining what will likely be the future cash flows from the location. It also distances the issue of whether conducting the review of potential cash flow by the franchisor is akin to making a Financial Performance Representation, or whether it elevates the chance for a claim of guaranteed performance by the incoming franchisee.

Setting up a proactive strategy

1. Understand the unit economics of your franchisees’ businesses.
2. Meet with your outside business advisors and franchise lawyers and formulate an appropriate transfer strategy for your system. It would be also wise to include your Franchisee Advisory Counsel in this discussion, as this policy will impact all franchisees.
3. For those willing to take off the blindfolds and remove the gag, determine the set of ratios appropriate for your system. Review the ratio periodically to ensure it continues to make sense. Cash-flow to debt-service may not be the only ratio your business and legal advisors recommend.
4. Ask your lawyer whether you should include transfer-approval language in your agreements. Ensure it provides protection for using your judgment in approving or disapproving a transfer. In some cases where specific language is not provided, the current language regarding transfers when coupled with changes to the operations manual may be sufficient.
5. Discuss with your lawyer having a comfort-level report prepared by the seller and/or buyer.

Does having a proactive approach guarantee franchisees will continue to love you or that someone might not still sue you? No. But it will be a clear communication to the franchise system that unit viability is as important to you as it is to them. It will also make it easier for franchisees to know, during their negotiations, what terms will be acceptable to you.