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While “franchise diligence” creates additional burdens from the standpoint of buyers and sellers, if it’s done right, the result will be better outcomes that can drive future system-wide improvements.

• CenterOak Partners acquired Wetzel’s Pretzels;
• Jimmy John’s sold a majority stake to Roark Capital; 
• Driven Brands acquired Lube Stop and Express Lube;
• Dwyer Group acquired Cumberland County Glass and Window Genie; and,
• GPS Hospitality bought 194 Burger Kings. 

1. Purchasing Programs. Item 8 of a franchisor’s FDD and related procurement documents typically address the franchisor’s purchasing arrangements. This includes mandatory or required product purchases, use of approved and sole supplier arrangements, and adherence to product specifications and standards. It also includes revenue the franchisor derives from product purchases, whether from products purchased directly from the franchisor or from fees added to the purchase price by the franchisor or a supplier who then passes on all or some part of the added fees to the franchisor. These add-on fees are often referred to as commissions, mark-ups or rebates. In general, when a significant percentage of a franchisor’s revenue is derived from required franchisee purchases, franchisees are more likely to question whether the price they are paying for products is fair or competitive. The frequency and volume of complaints by franchisees about purchasing requirements can be a red flag. Ultimately, a lack of franchisee acceptance of purchasing programs casts doubt on the buyer’s reliance on the purchasing revenue continuing, or at least continuing as forecasted, in the future. Areas for review include whether the price paid by franchisees compares reasonably with pricing for similar products in the market, whether franchisees could realistically purchase the products or obtain comparable pricing in the market, and whether the price includes valuable services or other benefits. Buyers should also consider the degree to which the products are proprietary to the franchisor or otherwise tied to the franchisor’s trademarks and brand standards.
    
2. Joint Employer Liability. This issue has faded in the eyes of some franchisors in light of the current political environment. Nevertheless, it continues to be a key consideration given overall uncertainty in this area. Although there is ongoing disagreement about what constitutes “joint employment,” the touchstone of any inquiry is control. The central issue is whether a franchisor directly or indirectly exercises control, or under recently articulated standards, reserves the right to exercise control, over the essential terms and conditions of an employee’s employment. Any assessment of joint employer liability should include not only the franchise agreement terms, but also review of the training programs, the franchisor’s current operations manual, POS software, and any requirements related to the franchisees’ employee hiring, discipline, supervision, scheduling, and direction.
    
3. Growth and “Churning.”  Many franchise systems exhibit similar life cycles, even where the systems sell different products in different industries. The early period may be marked by rapid growth and dramatically increasing revenue. Extreme growth, or high turnover, calls out for further investigation. For example, the number of transfers can, and often does, signify that the franchisor is providing a strong exit strategy for its franchisees. On the other hand, a high percentage of transfers, relative to the total number of units, could be an indicator of system-wide instability. Similarly, a large number of unopened units, or closed units, could be an indicator that the system has grown too quickly. The key intangible asset is the franchisor’s ability to service and support its existing franchisees. The need for “smart growth,” in a geographic sense, is also critically important. The cost of supporting a single franchise unit in a far-flung state may outweigh any benefit to be gained from awarding that franchise in the first place. Information about system-wide growth, transfers and closures is readily available in Item 20 of the FDD, and should be analyzed alongside other information resources available during due diligence.
    
4. Non-Traditional Location Ag-reements. Many franchisors grant franchisees the right to operate in non-traditional venues, such as malls, stadiums, and airports. Typically, these franchise units involve a relationship between the franchisor, a concessionaire and a facility owner. The concessionaire, who is the franchisor’s licensee, has an agreement or lease with the facility owner. In this setup, the stability of the system depends on the concessionaire’s ability to continuously operate in the facility. For this reason, the facility owner exercises significant control over the franchisor and franchisee, both before and after the deal is consummated. This arrangement impacts any evaluation of the reliability of revenues flowing to the franchisor.
    
5. Item 19. Last but not least, buyers should consider the franchisor’s Item 19 disclosures in light of financial information provided separately in the course of due diligence. Unlike prospective franchisees, buyers typically have access to a much wider universe of financial data related to the franchise system under consideration. While this data typically drives valuations, it can also be used to assess the overall credibility of the financial performance representations. In this regard, buyers can evaluate whether current Item 19 disclosures meet and exceed applicable business, legal and regulatory needs. A robust, verifiable Item 19 can drive future sales and attract the most sophisticated franchisees.