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5 keys to successfully sell your franchise system
Though it doesn’t happen often, some franchisors start a franchise system with the goal of selling it in the short or medium term. However, the quality of the infrastructure required to build a viable franchise system and the amount of resources (financial or other) that need to be invested over time is likely to lead such franchisors to reconsider their initial goal and either develop a strategic partnership or simply cave in and sell their franchise system to a competitor. Given that a potential partner or buyer will likely carry out due diligence to substantiate the business opportunity, it is preferable to determine what issues may compromise or interrupt negotiations and try to resolve them in advance. Identifying issues in the relationship with franchisees and making the necessary adjustments Before thinking of selling all or part of your franchise system, you should assess the quality of your franchisees and your relationship with them. If you have conflicts with some of them, it is high time to resolve them. Unless faced with an isolated case that you have already taken steps to resolve, your potential partner or buyer may react negatively upon learning that some franchisees in your system are critical of the franchisor and may fear the impact that claims could have on the franchisor’s image, concept and brand. The most frequent criticisms against franchisors are related to a lack of support and collaboration, a lack of transparency in the use of national advertising funds, a concept and/or operations that aren’t viable, and the belief that the franchisor does too little for its franchisees. To learn if your system harbours any such criticisms, you should not visit your franchisees only to assess the quality of their operations. You should give them the opportunity to openly discuss the challenges and situations they face with your management team. It is always better to get franchisees to confide directly in their franchisor rather than letting dissatisfied franchisees discuss their points of contention between themselves. A better understanding of the state of your franchise system will make it possible for you to be more transparent in disclosing the issues underlying a potential transaction to your prospective buyer. Even if such transparency may lead to a lower sale price, it avoids the financial consequences of incomplete or inaccurate representations that you may make to the future buyer and helps to maintain trust. Reviewing and structuring documentation As part of its due diligence, the buyer and its lawyers and financial advisors will review all key aspects of the franchisor’s system, including contracts (franchises, leases, suppliers, etc.), intellectual property and accounting. Missing or incomplete documentation will likely discourage the buyer and justify a reduction in the sale price, or, even worse, withdrawal from the proposed transaction. It is therefore essential, before the buyer’s due diligence begins, that you instruct your resources to verify that your documentation is compliant and reliable, correct any deficiencies and obtain missing information, if any, even if it means hiring external consultants. Compiling your system’s financial information A potential buyer will undoubtedly want to analyze your financial statements and tax returns. It is also very likely that it will want to consult accounting records and verify some key performance indicators. Thus, your system’s monthly sales (compared to those of previous years), geographic trends, how profitable franchisees’ operations are and how frequently they pay their royalties will certainly be of interest to a buyer. In addition, a diligent buyer will pay close attention to a franchisor’s contractual obligations towards third parties, such as lessors and suppliers, and any warranties that it may have made to third parties. In short, full and structured disclosure of the financial information underlying your system will make it easy to demonstrate future profitability. Negotiating an advantageous Earn-out clause Negotiating the sale price of a franchise system can be done in different ways. In addition to the traditional EBITDA valuation of the business, it is not unusual for a franchisor (whose management will ensure an operational transition after the sale) to negotiate an upward adjustment to the sale price should the franchisor achieve, after a determined post-transaction period, better financial results than those on which the buyer based its valuation of the sale price (the “Earn-out”). For example, the sales agreement could provide that a sum equal to the increase in EBITDA that the franchisor achieves during the Earn-out period, multiplied by the EBITDA multiple applied to the transaction, be paid in addition to the sale price. Limiting the chances of your transaction failing by choosing a suitable buyer Make no mistake: a transaction isn’t concluded upon signing a letter of intent. There’s still a long way to go. A multitude of conditions in favour of the buyer generally need to be fulfilled in order for the transaction to proceed. Stipulated time limits often need to be extended by mutual agreement for the parties involved to cover all bases and close the sale. This doesn’t mean that you must consent to all the buyer’s requests to extend time limits. While delays in a transaction are usually well-founded, sometimes a buyer tries to buy time in order to exert pressure on the seller, or it will do so to finish due diligence that it deliberately made more complicated in order to find arguments justifying a decrease in the sale price./p> To avoid such an unfortunate situation, it is in your interest to be well informed about your potential buyer and how it handled past transactions. To assist you and make the best of your business model, feel free to contact a professional of our team!
The 5 key factors to consider before becoming a franchisor
Our team is frequently consulted by entrepreneurs asking the following question: we want to franchise our business concept, so where do we start? One of the most common scenarios involves a very enthusiastic customer approaching the owner of a new business concept with some local success (such as a restaurant) and offering to buy a franchise. It is quite common for the business owner to quickly accept this offer in hopes of becoming the next Subway. Unfortunately, many entrepreneurs do not realize that successfully running one or two locations requires very different skills and abilities than those required to develop a franchise network. So, rather than becoming the next Fred Deluca, they are soon faced with challenges resulting from the poor choice of franchisees, inefficient locations, an ineffective supply system and the inability to maintain a uniform concept with the few franchisees they have managed to recruit. As a result, one or more franchisees will most likely stop paying their royalties, close their doors and, guess what – blame the franchisor for the losses incurred. Having represented several franchisors over the past 15 years, we recommend that entrepreneurs pursue the franchise business model only if they are able to meet the following criteria: 1. The concept is viable and the business model is profitable The fact that one location is generating a profit does not guarantee that the concept is viable or that the business model is profitable. In order to be able to draw such conclusions, we strongly recommend that entrepreneurs run at least two, or ideally three, corporate branches (regardless of concept type) in different markets for a period of at least 18 months. Like any entrepreneur, a franchisee normally assumes some business risks related to the choice of location of the franchise and the quality of its operations. However, the franchisee should not share, or suffer from, business risks related to assessments that the franchisor should carry out before granting the franchise.Like any entrepreneur, a franchisee normally assumes some business risks related to the choice of location of the franchise and the quality of its operations. However, the franchisee should not share, or suffer from, business risks related to assessments that the franchisor should carry out before granting the franchise. 2. The concept and business model can be replicated Ideal demographics and geographic locations, supply costs (or sources), elements that may be difficult to replicate and even the unique expertise or charisma of the founder are all factors that influence the success of a business concept and should be taken into consideration before developing a franchise network. The franchisor must have a business concept that a qualified franchisee can operate without being in the same shoes as the franchisor. New franchisees, who will have different business experience than the founder in most cases and whose franchises will be located in different markets than the original, must still be able to easily replicate the franchisor’s concept with the same success by following the system that the franchisor carefully laid out in advance. 3. Recruiting franchisees is actually possible Wanting to sell franchises is an admirable goal, but there must also be a sufficient pool of candidates who meet the franchisor’s selection criteria. For example, franchising a shoe repair shop might seem like a good idea, in order to standardize customer service and modernize the environment in which this type of service is offered. Nevertheless, using the same example, it is important to determine whether there are enough candidates in the trade to consider developing a franchise network in the industry and to ensure that some shoemakers are ready and willing to convert their current businesses to franchises and continue operating under the branding of a third party. 4. The franchisor’s team has sufficient resources to properly train and support the franchisees Our team was recently called upon to resolve a franchisor-franchisee dispute that perfectly illustrates the issues that can arise from a lack of experience or resources on the part of the franchisor. The franchisor fell victim to the enthusiasm of many prospective franchisees for its seemingly viable concept and profitable business model and collapsed shortly after starting its franchising operations. After franchising some 20 businesses in a short period of time, the lack of support from the franchisor in choosing locations and layout, a poor understanding of key industry performance indicators, a flawed supply system and incomplete initial training of franchisees led to the collapse of the network. Even if it means slowing down the pace of development, franchisors must ensure that they have sufficient infrastructure in place to support the growth of the network. Poor choices made while developing a franchise network can have negative effects for several years, not to mention the impact these choices can have on the future success of the franchisor. 5. The franchisor has sufficient financial resources Developing a franchise network in accordance with the above recommendations requires excellent capitalization. The initial franchise fees and royalty payments from the first franchisees are not enough for the franchisor to cover the development of sufficient infrastructure to ensure the viability of the network. The vast majority of franchisors who have challenged this basic rule are now facing serious difficulties.
Franchisors’ duty to act in good faith and related implicit obligations: Dunkin’ Donuts ordered to pay nearly $18M to some of its franchisees
The Court of Appeal of Quebec has issued an important judgment pertaining to a franchisor’s implicit obligations towards its franchisees. In June 2012, the Superior Court of Quebec ordered Dunkin’ Donuts Brands Canada Ltd. (“Dunkin’ Donuts”) to pay an amount of $16.4M (plus interests and costs) to 21 of its franchisees in Quebec on the basis that the franchisor had breached its fundamental obligation under the franchise agreements he had entered into with its franchises to adequately protect and enhance the Dunkin’ Donuts brand in Quebec. In a unanimous decision released on April 15, 2015, the Court of Appeal of Quebec confirmed the trial judgment, finding no errors of law in the trial judge’s analysis of the franchise agreements nor any palpable and overriding errors of fact in his findings of fault or respecting the causal link between the breaches of contract by Dunkin’ Donuts and the franchisees’ losses. However, the Court of Appeal reduced the award to $10.9M (plus interests and costs) to take into consideration errors in calculation and unpaid royalties, which were due by the franchisees despite Dunkin Donuts’ contractual fault. Summary of the Facts In less than a decade, more than 200 Dunkin’ Donuts stores in Quebec closed, and Dunkin’ Donuts’ market share in Quebec plummeted from 12.5% in 1995 to 4.6% in 2003. Expanding from 60 stores in 1995 to 308 by 2005, Tim Hortons captured the lion’s share of growth in the coffee and donut fast food market, thus materially contributing to the collapse of Dunkin’ Donuts in Quebec during this period. Despite the franchisees’ numerous alerts, the franchisor failed to meet its duty of good faith towards its franchisees by neglecting to take reasonable measures to support and protect the Dunkin’ Donuts brand in Quebec. The Court of Appeal Decision The Court of Appeal came to the conclusion that the franchise agreements between Dunkin’ Donuts and its franchisees explicitly imposed on Dunkin’ Donuts an obligation of means to take reasonable measures to protect and enhance its brand. The Court of Appeal further confirmed that the nature of a franchise agreement is one of a long term collaborative agreement. Accordingly, it imposes on the franchisor an implicit obligation to provide franchisees with the continuous collaboration and support that they legitimately expect in order to protect and enhance the brand, maintain high and uniform standards within the franchise system and, generally, preserve the integrity of the franchise system as a whole. While rejecting Dunkin’ Donuts’ arguments, the Court of Appeal reaffirmed that the intensity of a franchisor’s obligation towards its franchisee is one of means, and not one of result. A franchisor does not have an obligation of result requiring it to outperform the competition or to guarantee the profitability of its franchisees. However, franchisors are bound by a duty of good faith, from which flows an obligation to take positive actions to protect franchisees from market challenges. In other words, had Dunkin’ Donuts taken reasonable measures to counter Tim Hortons’ or another competitor’s expansion, the franchisees would have had no basis for complaint. Comments The Dunkin’ Donuts decision does not create new obligations for franchisors in Quebec and is the logical continuation of the 1997 Court of Appeal decision in the Provigo case1 which is recognized as the leading authority in franchise law in Quebec. It is nevertheless an important decision insofar as the Court of Appeal clarifies the extent of the implicit obligations of a franchisor. Since 1994, the Civil code of Quebec imposes on franchisors a duty to act in good faith which was interpreted in Provigo as an obligation for a franchisor to assist and support the franchisee in its operations. While a franchisor is justified to impose on its franchisees important restrictions as to how to operate and administer their franchise business for the purpose of maintaining uniform standards of quality and a strong brand across the franchise system, the franchisor must, in exchange, provide its franchisees with the appropriate infrastructure to sustain the execution of such requirements. Accordingly, the franchisor’s obligation to take reasonable measures in order to protect and enhance the brand constitutes an implicit obligation of franchise agreements and form part thereof. In light of the clarifications made by the Court of Appeal as to the concept of assistance and support to which referred the Provigo decision, we can reasonable expect that other components of the infrastructure generally required from a franchisor, such as an adequate protection of trademarks, the qualification and initial training of franchisees, the efficiency of the supply chain and ongoing operational support, will be challenged in the future. Lessons for Franchisors While a franchisor is not bound by an obligation of result towards its franchisees, it must take positive measures (i) to protect the integrity of its franchise system, namely the notoriety of its trademarks and concept, and (ii) maintain an infrastructure that will sustain the viability of the franchise system. As to any explicit obligation, a franchisor should review the performance covenants provided in its franchise agreement and make sure that it can live up to the standards which it imposed on himself. _________________________________________ 1 Provigo Distribution inc. v. Supermarché A.R.G. inc., 1997 CanLII 10209.