Franchise resales involve the transfer of an existing franchise from the current franchisee to a new franchisee. This process can be complex and involve a number of legal considerations that are critical for ensuring a smooth transition.
Unlike a direct franchise sale scenario, where the franchisor is, among other things, required by law to provide a franchise disclosure document and is actively involved in the sale, franchise resales operate differently.
Understanding these differences and how best to navigate them is important for franchisors, current franchisees looking to sell and prospective franchisees wanting to invest in an established business. This article discusses the key considerations and responsibilities for both franchisors and prospective franchisees when approaching franchise resale transactions.
Why franchisees decide to sell
While there are many benefits associated with being a franchisee, owning a franchise does not need to be a lifetime commitment.
Sometimes, the franchisor-franchisee relationship comes to an end due to the termination or non-renewal of the franchise agreement by mutual decision or because there has been a relationship breakdown between the franchisor and franchisee. In other cases, the franchisee may choose to sell the franchised business.
There are a wide range of different reasons why a franchisee may want to sell their franchise. For example, if there has been an increase in the franchise's value, the franchisee may want to sell the franchise to capitalize on that appreciation and realize profits. Conversely, if the franchised business is operating at a loss, for whatever reason, the franchisee may be looking to sell in order to recoup on their initial investment. In certain situations, the franchisee may be motivated to sell because of their own personal and professional reasons and wish to pursue other business interests. Other times, the decision to sell may simply be motivated by family and/or exit strategy planning, and the franchisee's desire to retire.
Regardless of the motivation, buying or selling a franchise is not as simple as buying and selling a business, and there are many things to keep in mind when embarking on the sale of a franchise.
Direct franchise sales
When acquiring a franchise opportunity from a franchisor directly, before the parties enter into an agreement, the franchisor is required to provide disclosure documents to the prospective franchisee, known as a franchise disclosure document (or "FDD"). These documents contain detailed information about the franchise, such as background and history of the franchisor, litigation history, franchisee fees, franchisee obligations, projected franchise earnings and more.
The FDD is intended to help the prospective franchisee make an informed business decision, and in provinces with specific franchise legislation (currently: British Columbia, Alberta, Manitoba, Ontario, New Brunswick, PEI and soon to be Saskatchewan), the delivery of an FDD by a franchisor to a franchisee before entering into the franchise arrangement is required by law.
Franchise resales
On the other hand, when acquiring a franchise from an existing franchisee, there are often (at least) three parties involved in the sale – typically, the current franchisee (the seller), the prospective franchisee (the buyer) and the franchisor.
Where franchisors are required by law to provide an FDD as part of a direct franchise sale, under the same legislation, a franchisor may be exempt from providing such disclosure to a franchisee in a franchise resale (commonly known as the "resale disclosure exemption").
More specifically, Manitoba franchise legislation states that so long as "the grant of the franchise is not effected by or through the franchisor," the obligation to disclose as part of such resale does not apply.
This exemption results in reduced disclosure obligations for the franchisor, which may simplify the selling process. However, it may also increase the risk for prospective franchisees, who must conduct thorough due diligence to mitigate this risk.
Thus, one of the key differences between direct franchise sales and franchise resales are the obligation for franchisors to provide disclosure, as well as the level of involvement of the franchisor in the sale generally.
When evaluating a potential franchise opportunity by way of resale, franchisors as well as prospective franchisee should be aware of these differences and how they may impact their respective responsibilities, as further discussed below.
Key takeaways for franchisors
For franchisors, the priority in any franchise sale is the success of the franchise system as a whole and protection of the franchise brand. The natural extension of this priority is wanting to ensure that a new franchisee can successfully operate the business.
Franchisors must be aware of their disclosure obligations under franchise legislation in all sale scenarios, including how their involvement in a resale effected between franchisees can impact these requirements.
If a franchisor intends to rely on the resale disclosure exemption, they must be careful that their involvement in a resale does not rise to the level of constituting the grant of the franchise being "effected by or through" them. Canadian courts tend to interpret exemptions to a franchisor's obligations narrowly, to the extent that almost any degree of franchisor involvement in the resale may bar the availability of such exemption.
Whether or not the conduct of a franchisor will rise to the level of involvement of being seen to "effect" the resale is a question of fact. While by no means an exhaustive list, franchisors should be mindful of being involved in the following ways, as taking one or more of the actions noted below have been considered, in the circumstances, as the franchisor "effecting" the sale:
- directing a prospective buyer to a franchisee (for example, finding and introducing a prospective buyer to the selling franchisee or providing information about the selling franchisee's business to the prospective buyer in order to facilitate the sale)
- actively participating in the resale negotiations
- requiring the prospective franchisee to sign new documents or imposing additional requirements as a condition of the sale (such as requiring the buyer to sign a new franchise agreement instead of assigning the exiting agreement to the new franchisee, or requiring the buyer's spouse to sign a personal guarantee that was not specified in the original franchise agreement);
- requiring the selling franchisee to comply with a guided transfer process
- actively facilitating or managing the transaction (for example, holding meetings at the franchisor's office, drafting contracts, providing the bill of sale and sublease, etc.)
- changing the material terms of the franchise agreement (for example, increasing royalties, shortening the term or reducing any exclusive territory)
If a franchise resale is effected by or through the franchisor, and the franchisor does not provide the new franchisee party with an FDD, the franchisee would be entitled to the associated remedies under franchise legislation for such failure to disclose, including the ability to rescind the franchise agreement and be compensated for any losses sustained.
It is important to note that, practically speaking, a certain level of franchisor involvement is always necessary as part of a franchise resale process.
The vast majority of franchise agreements will provide certain conditions and requirements on a franchisee's ability to transfer the franchised business, including (most often) the consent of the franchisor to the process and candidate. The simple approval of the franchise resale and collection of any associated transfer fee provided for in the franchise agreement will generally not be found to constitute a franchisor "effecting" the sale.
As the risks associated with a narrowly-construed and available exemption are quite high from a franchisor's perspective, in our view, it is general best practice for a franchisor to provide an updated FDD to prospective franchisees regardless of the potential application of the resale disclosure exemption. If there is any doubt regarding the franchisor's level of involvement in the resale, it is recommended that franchisors err on the side of caution and provide compliant disclosure in accordance with applicable franchise legislation.
Key takeaways for prospective franchisees
When compared to a direct sale of a franchised business from the franchisor, a franchise resale can be an attractive option to prospective franchisees for a number of reasons.
- Due to the existing infrastructure and often established customer base of an existing franchise operation, a new franchisee may be able to bypass much of the time and effort typically required for the initial construction, development or set-up of the business.
- Additionally, transfer fees may be lower than when buying the franchise directly from the franchisor (or, at least, open for negotiation) and, if the franchisor takes the position that the resale disclosure exemption applies to it, the entire transfer could proceed more quickly.
It is important to remember that, despite the potential upside, there remains a number of critical matters a prospective franchisees should consider before entering into an agreement to purchase a franchised business:
1. Due diligence:
It is always important for a prospective franchisee to conduct proper due diligence in purchasing any franchised business. However, this becomes even more critical in the franchise resale context where the franchisor may be exempt from providing a new FDD.
Conducting due diligence can minimize the related risks of purchasing an already operating franchised business and helps to ensure that franchisees make an informed decision. While it may not be entitled to rely on it the same way, a prospective franchisee can request copies of the current agreements and the disclosure materials that were provided to the selling franchisee by the franchisor.
Among other things, this process should involve looking into the current franchisee/franchised business's financial statements, litigation history and operations, as well as conducting market research in order to make a comprehensive assessment of the franchise.
2. Understanding the reason for the resale:
As previously mentioned, a franchisee may elect to sell their franchised business for many reasons. As part of carrying out due diligence, prospective franchisees should make sure they understand why the current franchisee is selling.
- Was the business failing? For what reason?
- Was the relationship with the franchisor strained?
- How was their experience with the franchisor navigating conflict and the sales process?
Understanding the motivation to sell and the context behind it can be an important tool to develop transition processes, identify room for improvement and potential synergies for the franchised business going forward. Prospective franchisees can also avoid taking on a sinking ship!
3. Transfer fees:
It is important that prospective franchisees are aware of (and settle on the expectations around) transfer fees. This is typically a fee that is charged by the franchisor when a franchisee sells their franchised business as part of an approved transfer under the franchise agreement. Generally, who pays the transfer fee, either the selling franchisee or the prospective franchisee, is part of the negotiation process.
4. Leases and other contracts:
Depending on the nature of the franchised business and/or any associated leasing arrangement, when a franchised business is transferred to a new franchisee, so too must the subject premises and by extension – the lease.
- Typically, this will involve the requirement to comply with the conditions for transfer set out in the lease agreement, which may include obtaining the landlord's approval for the transfer and payment of associated fees.
- There may also need to be certain adjustments made between the new franchisee and the seller franchisee on account of certain prepaid amounts or deposits.
These should all be discussed between the participants in the resale process as part of doing due diligence.
- In addition to any applicable lease, prospective franchisees should have received and satisfied themselves that they understand any other contracts being taken on as part of buying the franchised business (including those required by the franchisor).
5. Refurbishment:
In some cases, the franchisor may require certain updates be made to the franchised premises or business as a condition of its approval of the resale, including renovations or system upgrades. This can have a material impact on the purchase price since, depending on the franchise agreement, the refurbishment costs may be incurred by either the selling franchisee or the prospective franchisee.
These matters should be discussed and fully understood between the parties to the resale process before signing off on any resale or transfer agreement. Prospective franchisees will want to be aware of refurbishment or renovation clauses and requirements in the franchise agreement (and any other associated costs with the transfer) when negotiating the purchase price.
Ensure success with knowledgeable assistance
Buying or selling a franchise can be an intimidating and nuanced venture for all participants. However, it can be made smoother with enhanced results with the guidance of experienced advisers.
The considerations discussed in this article are not intended to be advice or exhaustive – as such, we strongly recommend consulting professionals with franchise knowledge to assist you with your franchising needs.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.