While the U.S. M&A market largely has slowed since the 2021 acquisition boom, the franchise business model – which features an ongoing, predictable revenue stream, paired with low capital expenditure risk – continues to attract private equity investors. Despite the heavy focus on franchise M&A activity, investment banking insiders report a growing disconnect between the respective price expectations of buyers and sellers. Sellers are still expecting 2019 or 2021 multiples. However, with the exhaustion of COVID-era free government money, raising interest rates and overarching uncertainty regarding whether the U.S. will fall or has already fallen into a recession, private equity investors have become more risk adverse, often requiring longer and more rigorous due diligence periods.
To manage this process, it is important that counsel understand the intricacies of franchising. This process should include table stakes queries, such as whether the brand has any history of bankruptcy, litigation or adverse regulatory actions; whether the brand has an experienced management team in place; and whether the brand has complied with the complex federal and state framework of franchise laws, such as those laws and regulations related to the preparation of a compliant franchise disclosure document, pre-sale registration and disclosure, state franchise solicitation materials, and state relationship laws. This process should also include, however, certain hot topics and emerging issues in franchising, such as with respect to SNO counts, supply chain, restrictive covenants and intellectual property, joint employment standards and data privacy.
- SNO Count. Review of Item 20 of a franchisor’s franchise disclosure document to determine whether the system is expanding or contracting is a standard and basic element of franchise diligence. Because so many brands now primarily offer large scale multi-unit development opportunities, rather than single unit franchise sales, brands commonly publicize a tremendous amount of units “under development”. This term, however, may only represent the number of franchise rights sold pursuant to those development deals, rather than the number of franchised outlets actually in the process of opening – otherwise known as the brand’s SNO pipeline (i.e., pipeline of outlets sold not open). On the one hand, having a large number of SNO’d outlets may represent an economic opportunity for an investor, as it theoretically represents a definitive amount additional revenue not yet captured in the brand’s EBIDTA that the investor can expect to earn. On the other hand, however, if that SNO funnel has remained steady or has been quietly reduced year over year without any corresponding increase in outlets actually opened, it may represent a problem in need of further investigation. Are those outlets not opening because there is a temporary problem in the economy or because there is a deeper problem in the franchise system?
- Supply Chain. Since the onset of COVID-19, business across almost every industry have experienced some degree of supply chain disruption. Between product shortages, long lead times, and increased logistical costs, managing a franchise network supply chain has proved increasingly difficult. For some brands (e.g., service based franchise concepts), their inventory of products or supplies is incidental to their services. For other franchise brands (e.g., restaurant franchise concepts), however, their inventory of products and supplies is a crucial element of operations (e.g., the proprietary ingredients for menu items). Particularly with respect to franchise concepts falling into the latter category, conducting thorough diligence into the brand’s supply chain systems and management thereof is imperative. An evaluation should be conducted into how many suppliers the brand uses, whether those supply arrangements have been reduced to formal written contracts, whether those written contracts are freely assignable, whether the brand has a single designated supplier for any key products, whether and to what extent the franchisor profits from those supply arrangements, and whether the pricing of those arrangements is competitive. Diligence should also be conducted into whether franchise agreement allows franchisor to mandate use of certain suppliers and/or earn a profit from its strategic supply arrangements, whether the franchisor has established operational standards to monitor compliance with supplier mandates, and whether these supply relationships have been properly disclosed in the brand’s franchise disclosure document.
- Non-Compete Agreements and IP Protection. Restrictive covenants have historically been highly scrutinized, with many states and courts disfavoring them on public policy grounds unless they are narrowly tailored in temporal and geographic scope and a legitimate business interest in enforcement can be demonstrated. This scrutinization is becoming more pronounced in the United States. The Federal Trade Commission (“FTC”) recently proposed a new rule that would ban employers from imposing non-compete restrictions on their employees. While this proposal currently excludes franchising, the FTC requested public comment in March of 2023 on whether the proposed ban should also apply to non-compete clauses between franchisors and franchisees. With restrictive covenants becoming more difficult to enforce, it is vital that brands take adequate steps to strengthen their protection of intellectual property, including their trademarks, trademarks, trade secrets, software systems, domain names, social media accounts, trade dress, operations manuals, proprietary products, ingredients and recipes. Have the necessary trademark or copyright registrations been perfected and maintained in each jurisdiction in which the brand currently operates or may operate in the future? Does the brand’s franchise agreement include comprehensive and strong provisions in this regard? Has the brand actively monitored the use of such intellectual property and enforced its rights and remedies against infringers?
- Applicable Joint Employer Standards. Joint employer liability continues to be a hot button issue in franchising. In 2022, the National Labor Relations Board (the “NLRB”) proposed expanding the standard to determine the existence of a joint employment relationship, to include indirect, reserved and unexercised control over the terms and conditions of a job (i.e., even if a putative employer does not actually or directly control the worker’s job conditions, if it has the right, indirectly or otherwise to do to so, that could constitute an employment relationship). This has caused great concern for franchisors. Franchise agreements often include broad rights reserved in the franchisor to control a franchisee’s methods of operations in order to promote uniformity of brand experience. These broad reserved rights may indirectly affect a franchisee’s employee’s working conditions, by setting the baseline of requirements with which a franchisee must comply, that the franchisee may then delegate to its employees. Thus, under this new standard, franchisors may face employment liabilities that have traditionally been borne exclusively to their franchisees. These new employment standards are not just coming from the top. States are increasingly proposing new pro-employee laws and regulations that affect the franchise model. As such, an investor should consider the states in which the brand has the greatest concentration of outlets and/or targeted future growth and whether those states are more or less employee friendly and likely to impose similar legislation. A due diligence process should also consider the level of direct or indirect control the franchisor does, or has the right to, exercise over its franchisee’s employment matters. This should include a review of the reservation of rights in the franchisor’s form of franchise agreement, and any day-to-day control over the operational or employment standards set forth in the franchisor’s operations manual. Franchisors also often provide their franchisees with template employee handbooks, contracts and other employment related documents. Providing these sorts of templates bears inherent risk, but even more so when the templates are not tailored to the franchisee’s operations (e.g., if the templates still refer to the franchisor as the employer, or does not include certain disclaimers, etc.).
- Data Privacy. Between information transmitted in connection with purchases, loyalty programs, gift card programs, contests and sweepstakes, and the numerous third party technology platforms used by brands to manage the foregoing along with management of employee shifts and other systems, the amount of data transmitted by and through any given franchise system is vast. Data protection issues are currently addressed by a patch-work of applicable federal, state and local regulations – all of which continue to rapidly evolve. Many brands, particularly those smaller emerging brands, are simply not equipped to keep up. Any due diligence process should therefore include a data mapping, to understand the type of data that the franchisor is currently obtaining, transmitting, processing and controlling, and the type of data for which it has claimed ownership of in its franchise and other agreements. With the help of that data map, diligence should also be conducted into whether the brand is compliant with applicable data protection laws or alternatively its potential liability exposure associated with any non-compliance. The investor should also consider the compliance requirements and indemnification obligations, if any, imposed on a franchisor’s franchisees in the franchise agreement and the franchisor’s monitoring and/or enforcement of same.