FRANCHISE-SPECIFIC ISSUES RELATED TO THIRD-PARTY DEBT FINANCING OF FRANCHISORS AND FRANCHISEES
By Kenneth A. Freed
This chapter highlights the key franchise-specific issues involved in the origination of third-party debt financing of franchisors and franchisees. The term “debt financing” is very broad, and includes not only conventional senior debt financing, such as secured term loans and revolving credit facilities, but also real estate sale-leaseback financing, equipment loans and capital leases, subordinated or mezzanine debt, securitizations, construction loans, and unsecured lines of credit. Most of the issues addressed in this chapter arise in the context of conventional senior debt financing, although some of the same issues may arise in connection with the due diligence, representations and covenants in venture capital, or private equity finance transactions. The emphasis here is only franchise-specific issues; it is assumed that the reader is familiar with the typical UCC, due diligence, and documentation issues involved in commercial debt financing transactions generally.
The focus of this chapter is on finance origination, due diligence, and documentation; the issues involved in the workout, restructure, or foreclosure of any franchise-related financing are not addressed, except to the extent applicable to the negotiation of an intercreditor agreement at the time of origination of a loan. There is some discussion of regulatory and disclosure issues related to franchisor financing in connection with loan documentation and due diligence, but Franchise Disclosure Document (FDD) issues related to franchisor-secured financing and Item 10 disclosure issues related to franchisee financing are not addressed. Franchisor direct loans and leases to franchisees are also not covered, since most of the issues involved in third-party lending to franchisees are not applicable to franchisor direct loans. Historically, most franchisor direct loans have been limited to initial franchise fees and workouts of past-due amounts owed, although this has changed somewhat in the current market environment, and some franchisors have begun to provide financing for leasehold improvements and equipment.
This chapter is divided into two parts: (1) structuring, due diligence, and documentation issues involved in franchisor financing, and (2) lender, franchisor, and franchisee issues involved in franchisee-financing transactions.
II. FRANCHISOR-FINANCING TRANSACTIONS
While some franchise companies have substantial company-owned operations, the issues involved in financing those tangible asset operations are not the focus of this chapter. The primary assets of the franchise operations consist of contract rights and intellectual property, and essentially no tangible assets. In this regard, a franchise company is similar to any other company that owns intangible assets, although there are important differences. As with any such company, the assets’ value can be difficult to assess, and it can be difficult to identify and assess the value of some of the associated liabilities as well. In the case of a franchise company, however, the possibility of noncompliance with franchise laws can be a significant contingent liability that is not reflected on the franchisor’s balance sheet. Understanding the relationship between the franchisor and its franchisees is also crucial. All other things being equal (i.e., assuming identical financial statements), a franchisor with satisfied and successful franchisees has greater value than a franchisor with struggling and dissatisfied franchisees.
In a finance transaction, the primary purpose of representations, due diligence, and legal opinions is to try to identify major problems and issues affecting the franchise system. Few issues are necessarily deal killers provided they are disclosed early in the process and adequately addressed. Given the constraints in time and budget, it is generally not possible for lender’s counsel to uncover all potential problems through its own due diligence. Well-crafted representations and legal opinions can help to shift some of the due diligence burden to the franchisor and its counsel, who are in a better position to know about problems and issues. While the loan documents may provide for indemnity for misrepresentation, there is little value to the indemnity unless it is supported by some sort of financially meaningful guaranty. Therefore, since the purpose is to flush out potential issues, the representations should be written broadly and exceptions should be set forth in detailed schedules.
The purpose of covenants in a finance transaction is to ensure that going forward the franchisor takes all necessary action to protect the system and avoid taking certain actions which will harm the system. Covenants should be designed to keep the lender informed of system developments and to make sure that the lender is involved in major decisions affecting the franchise system without impeding the day-to-day functioning of the franchisor’s business.
Due diligence and representations are addressed separately since the burden for their performance affects the parties quite differently. While the burden falls on the franchisor and its counsel to provide much of the documentation for the lender’s due diligence, it is up to the lender and its counsel to request the information needed and review it. Conversely, while the lender’s counsel provides the language of the representations, it is up to the franchisor and its counsel to confirm that the representations are correct and to provide the detailed schedules necessary to complete them. In each case, however, it is crucial that the lender know what to request and how to review the information and responses.
B. TRANSACTION STRUCTURE AND SECURITY
While some franchise companies have company-owned operations as part of the same company, it is not uncommon to find that the franchise operations are a subsidiary of the company-owned operation, or a sister company of the company-owned operation, owned by the same parent-holding company. Sometimes the intellectual property is held in a separate sister or subsidiary entity as well. It is important to understand which entity is the borrower, which entity will get the benefit of the proceeds, which entities are guarantors, which entities have the valuable assets, and which entities will pledge their assets as security.
In some cases, the franchisor entity is not the borrower, but it guarantees the loan for its parent or sister entity and pledges its assets as security for the guarantee. While any such structure increases the lender’s risk of defenses based on lack of consideration and fraudulent conveyance, it is also possible that it could cause an unintended impact on the franchisor’s business as well. The guarantee of the parent or sister company debt will result in the inclusion of a footnote for the contingent liability in the franchisor’s audited financial statements. The franchisor will have a new contingent liability but it will not have received any of the proceeds of the loan. As a result, it is possible that state franchise regulators could impose an escrow requirement on the initial franchise fees and it is also possible that there could be an impact on franchise sales if prospective franchisees are concerned about the contingent liability. Depending on the size of the loan and the franchisor’s financial condition (and the likelihood that state regulators or prospective franchisees pay attention to the footnotes in the financial statements) this risk may or may not be small. Because of this risk, however, some franchisors will negotiate not to require a guarantee by the franchisor or a pledge of the franchisor’s assets. Instead, they will request that the lender accept a negative pledge, where the parent entity agrees not to cause or permit the franchisor to transfer or hypothecate its assets. Whether a lender will agree to do so, however, depends on its analysis of the likelihood of the risk and its potential impact, as well as its willingness to risk not having a perfected security interest in the franchisor’s assets.
C. FRANCHISE-SPECIFIC DUE DILIGENCE
Franchise due diligence falls into two categories: business and accounting issues, and legal issues. Typically, business and accounting issues are analyzed as part of a lender’s underwriting analysis and legal issues are analyzed by lender’s counsel. But there can be substantial overlap. Legal issues and risks must be quantified and business issues may need to be addressed in covenants. It is important that lender’s counsel understand the issues of concern to the underwriting team and it is important that the lender understand the legal issues so that it can quantify the risks.
At the outset of any due-diligence investigation, the lender and its counsel should engage in a dialogue with the franchisor’s sales and compliance personnel and counsel to get a general feel for the health of the franchise system and the level of franchise compliance. This will lead to a greater understanding of the franchise business and will also help focus the due-diligence investigation toward those areas of greatest concern. The following is a list of some of the areas of inquiry.
The lender needs to understand the unit economics. This is an analysis of the franchise model separate from franchisor’s business as a whole. Are a significant number of the franchisees making money? What is the likelihood that the franchisees will open the units that they have purchased? How many of these units have been purchased simply to lock out competition for a period of time? Can the franchisor sustain itself from recurring royalties, or is the franchisor dependent on the continued growth of upfront franchise fees? What is the impact of the economy on the franchisor’s ability to sell franchises? What is the impact of the economy on the revenues and earnings of the franchisor’s franchisees?
2. FRANCHISEE SATISFACTION
The lender’s due diligence should try to determine the franchisees’ satisfaction with the franchise system. This can be difficult to do directly since it is unlikely that the lender will be willing or able to speak with some of the franchisees (or former franchisees) or with the representative of the franchisee association(s). The lender may find it useful, however, to speak with senior executives who are not owners, particularly franchise and finance executives. There may also be survey that can be reviewed. To a large degree, franchisees’ satisfaction will be tied to their financial success, but it is not necessarily the case that franchisees are satisfied simply because they seem to be profitable. For example, they may be frustrated by franchisor policies or perceive themselves to be less successful than in the past or compared to franchisees of competing systems.
3. OBSTACLES TO FUTURE GROWTH
Due diligence should try to ascertain whether there are any obstacles to future growth of the system. For example, have any franchisees been granted large exclusive territories that cannot be terminated or reduced even if development does not occur? Do any of the current forms of franchise agreement in effect restrict the franchisor’s ability to market its goods or services through alternate channels of distribution (e.g., grocery stores, Internet, etc.)? Are there any limitations on international growth such as international trademark issues? Are certain markets “tapped out” by competitors? Supplier agreements need to be reviewed to ascertain that they do not restrict future growth or jeopardize the operation of the system in the event of a default or financial difficulty of the supplier.
4. FINANCIAL AND ACCOUNTING
In addition to the usual financial statement analysis, the lender should examine carefully a franchisor’s accounts receivable from franchisees. Large accounts receivable from franchisees can be a major alert that there are problems with the franchise system. It suggests either franchisee dissatisfaction, financial difficulty, or both. Either one has the potential to result in a dispute or litigation and consequently a reduction in revenue. It is also useful to examine the financial statements of the advertising fund to confirm that the franchisor does not appear to be managing the fund improperly. Finally, it is also important for the lender to understand Financial Accounting Standards Board (FASB) franchise income recognition issues. Under accounting rules, franchisors do not recognize initial franchise fees as income until the franchise unit is open. In the early years of a franchise system, when units are being sold faster than they are being opened, this can result in a disconnect between cash and financial statement income—frequently the cash is received (and used) before the income is generated. As the system matures, there may be income without cash, unless franchise sales continue at the same pace.
5. INTELLECTUAL PROPERTY
It is crucial to understand all issues relating to the status of the intellectual property of the franchisor, including the trademarks and any patents or copyrights. A trademark search should be conducted to determine that each mark is registered (and current) with the United States Patent and Trademark Office. A search will also help identify any infringing users as well as prior users whose rights may be superior. The lender should review the actions taken in response to any known infringements. Have the trademarks been properly registered and maintained as current in other countries? Other than the franchise agreements, have any licenses been granted with respect to the trademarks or other intellectual property? If the loan is to be secured, appropriate filings need to be made to perfect a security interest in the intellectual property. If the intellectual property is held in an affiliated company, the lender needs to ascertain that it can obtain an effective security interest in the assets of that company. As noted above, secured guarantees from affiliates provided without adequate consideration can pose fraudulent conveyance and other risks.
6. REGULATORY COMPLIANCE
The offer and sale of franchises is regulated at both the federal and state level. A discussion of the requirements of these laws and regulations is beyond the scope of this chapter, but one of the primary purposes of due diligence is to try to determine whether there has been a violation of these laws and regulations within an applicable statute of limitations period. Federal regulation is pursuant to the Federal Trade Commission Disclosure Requirements and Prohibitions Concerning Franchise and Business Opportunities (FTC Rule, 16 C.F.R. § 436). In addition, fourteen states require registration or notice filings before a franchisor may offer or sell franchises, and a number of other states have business opportunity laws that require franchisors to meet certain requirements and/or file for exemption from those laws before offering or selling franchises. The statute of limitation under these laws is generally three to five years but can be longer under certain circumstances. A violation of these laws and regulations can result in civil and criminal penalties as well as rescission and damages. The purpose of due diligence is to determine whether the franchisor has met all state registration or notice requirements, that there has been no lapse in registration, that there are no stop orders or violation notices, and that all advertising has been filed. To do this thoroughly, the various state registrations need to be reviewed. It can also be instructive to review comment letters from state regulators from prior years. It should be noted that under state registration and disclosure laws, principal officers and directors can be jointly and separately liable for violations. While few senior lenders would want to appoint a member to the board of directors (at least before a foreclosure) some mezzanine lenders might wish to do so. They may be well advised merely to plan to have board observation rights. The risk of liability may also make it more difficult to have an independent director for a special purpose entity.
7. DISCLOSURE COMPLIANCE
State and federal law requires that a prospective franchisee receive a disclosure document a specified number of days before execution of the franchise agreement or payment of any monies. The disclosure document must be in the proper form and contain all the appropriate disclosures. Not only should the lender’s counsel review the disclosure document, it may also want to review the due diligence questionnaires (if any) completed by the franchisor at the request of its counsel in connection with the preparation of the disclosure document. The object of due diligence is to understand the franchisor’s sales procedures, to confirm not only that the franchisor has properly followed these disclosure requirements, but also that the franchisor has maintained records that can demonstrate compliance. With a small franchise system it may be feasible to examine a substantial percentage of the franchisee files. With larger systems this is not practical. In these cases, lender’s counsel needs to review the files of large franchisees and to review a random sample of other franchisee files to try to ascertain the level of compliance. The review should examine, among other things, whether: disclosure document acknowledgements of receipt were timely signed, the franchise agreements were properly signed, guarantees were properly signed, the franchisor routinely obtains a general release from a franchisee whenever a consent is requested, and there have been undisclosed material amendments to the franchise agreements. It is also useful to review the form questionnaire/disclaimer of representations that franchisees are required to sign before the purchase of a franchise. A review of the correspondence in these files will also help to identify issues currently or repeatedly raised by franchisees.
8. FRANCHISE AGREEMENTS AND OPERATIONS MANUALS
Typically, the form of franchise agreement used by the franchisor evolves over time. That means that there may be a number of different forms of agreement in effect at any given time with differing rights and obligations for the franchisor and its various franchisees. The lender needs to understand how the franchise agreements have changed over the years, whether older franchise agreements have provisions that could hamper the franchisor’s current business plans, and whether the form of agreement requires that the franchisees sign the current form of agreement on renewal. The franchise agreement should also be reviewed to confirm that it grants the franchisor flexibility to change the marks or the look of the system, and the products or services offered, and that it requires franchisees to purchase only from approved suppliers. There are a number of provisions that are frequently found in franchise agreements that make it harder for franchisees to continue to compete after they break away or do not renew. Some examples of these provisions are a requirement to assign the lease of the premises on termination or expiration, and a franchisor’s right to purchase the assets on termination or expiration, liquidated damages, etc. These sorts of provisions may make it more difficult to sell a franchise, but they can provide the franchisor with substantial leverage upon termination or expiration. Lender’s counsel also needs to confirm that the FDDs and past uniform franchise offering circulars (UFOC) properly reflect the terms of the franchise agreement. It is also wise to review the franchisor’s operations manual to confirm that it is well drafted and up to date.
It is important to understand the franchisor’s current procedures for enforcing the terms of its franchise agreements as well as its past enforcement history. For example, what procedures does a franchisor follow when a franchisee is in default? Has the franchisor established a system for dealing with defaults that provides appropriate notice and opportunity to cure, both under the terms of the franchise agreement and under applicable state relationship laws? Does the franchisor confirm that former franchisees are not continuing to use the franchisor’s marks following termination? Does it promptly seek injunctions to restrain the continued use when necessary? The failure to do so may impair the trademarks. Does the franchisor bring actions for damages against terminated franchisees? Doing so may help minimize future defaults by other franchisees. Does the franchisor attempt to enforce post-term covenants not to compete? The failure to do so may encourage other franchisees to break away. Does the franchisor obtain general releases from its franchisees whenever consents are requested? Doing so may help minimize franchisor liability for franchise law violations.
Many state relationship laws impose restrictions on the franchisor’s ability to terminate or not renew a franchise agreement. The lender should review the files of terminated/nonrenewed franchisees to confirm that the franchisor has complied with its franchise agreements and with applicable state relationship laws in connection with the termination/nonrenewal. This can provide even more useful information than a review of existing franchisee files. Among other things, the correspondence in these files may show a pattern of (at least alleged) franchise law violations as well as recurring or ongoing issues that may or may not have been addressed. It is also useful to understand the franchisor renewal experiences. A low renewal rate can indicate serious systemic problems.
11. FRANCHISE LITIGATION
This falls into two categories: reviewing litigation history and assessing future litigation risk. In any finance transaction, ongoing litigation needs to be reviewed to quantify the contingent liability. But in a franchise finance transaction, a review of litigation will also show whether the franchisor has complied with the obligation to disclose its litigation history properly in the FDD, and it can be a telling indicator of the status of the relationships between the franchisor and its franchisees, and the risk of future litigation. Multiple lawsuits, whether brought by the franchisor or franchisees, raise red flags. This is especially true in cases in which the lawsuits focus on similar issues or practices. Franchise agreements are drafted by franchisor counsel in a way that strongly favors the franchisor with mandatory arbitration and jury trial waivers, shortened limitations periods, detailed integration clauses and disclaimers of reliance on representations, and punitive damage waivers. When these are enforced, they can help limit a franchisor’s exposure substantially. But litigation is still common. As noted above, disclosure violations can result in claims for damages and rescission. If a misrepresentation is contained in the disclosure document, it could result in multiple claims. For example, Item 19 of the disclosure document contains the franchisor’s financial performance representation. Some franchisors choose not to make a financial performance representation but others do. Either way, if a franchise salesperson makes promises or statements to prospective franchisees that are inconsistent with the information contained in Item 19, this will often result in fraud claims if those franchisees are not successful. The risk is magnified when the franchisor uses franchise brokers or salespersons that are compensated by commission.
12. ANTITRUST ISSUES