PURCHASING a DISTRESSED FRANCHISE

Buying and selling a franchise is rarely, if ever, a simply task - as there are all too often a multitude of complexities, hurdles and pressures bearing down upon the parties involved.

Contact Neufeld Legal PC for franchising legal matters at 403-400-4092 / 905-616-8864 or Chris@NeufeldLegal.com

Purchasing a distressed franchise is a potentially high-risk, high-reward opportunity. Such an acquisition often comes with a lower purchase price but requires significant expertise and capital to turn the particular franchise location around (especially if the prior franchise owner has caused significant local reputational damage). As such, you need to take a very serious approach when contemplating the purchasing of a distressed franchise.

A. Initial Assessment and Research

• Determine the Cause of Distress: The most crucial first step is understanding why the franchise is failing. Is it a location problem, poor management by the current owner, local competition, or a fundamental flaw in the franchisor's overall system?

  • Fixable Problems (Higher Potential): Poor local management, lack of capital, or a fixable operational issue.

  • Systemic Problems (Higher Risk): A declining brand, outdated business model, or an over-leveraged franchisor.

• Evaluate the Franchisor: Research the parent company's health, reputation, and support systems. If the franchisor is struggling, it poses a much greater risk.

  • Review the Franchise Disclosure Document (FDD), particularly Item 20 (statistical information on outlets, closures, and transfers). A high rate of failures is a red flag.

• Assess the Market: Is there demand for the product or service in the franchise's territory? Is the location viable?

B. Due Diligence (The Deep Dive)

Due diligence for a distressed franchise is more intensive than for a healthy business.

• Financials: Don't just look at profit and loss (P&L) statements; look at the books for the last 3-5 years.

  • Quality of Earnings: Determine if the stated financials accurately reflect the underlying business. Be wary of hidden liabilities or accounting tricks.

  • Debt and Liens: Use may look to use the D.O.V. Method (Debt, Ownership, Value) to uncover all existing debt, liens (e.g., bank loans, IRS, landlord), and creditor claims tied to the assets or the business entity. You do not want to inherit unexpected obligations.

  • Capital Needs: Calculate how much capital will be required after the purchase to stabilize and grow the business.

• Legal Review:

  • Franchise Agreement: Review the existing agreement and the franchisor's transfer requirements, fees, and approval process. You will likely sign a new franchise agreement.

  • Contracts and Leases: Scrutinize all contracts, especially the lease agreement. A bad lease (too expensive, unfavorable terms) can sink the best turnaround effort.

• Operations:

  • Key Employees: Identify and plan to retain key employees. Transition risk is high.

  • Supplier Relations: Check on the status of accounts payable to suppliers; a distressed business may have strained vendor relationships.

• Talk to Others: Speak with other franchisees in the system (not just the references provided by the seller or franchisor) to get an honest assessment of the franchisor's support and system health.

C. Structuring the Deal

• Asset vs. Share Purchase: In a distressed situation, an asset purchase is often safer. It allows you to select which assets (equipment, inventory) and which liabilities (which to assume or negotiate away) you acquire, generally insulating you from the seller's past debt, unlike a share/entity purchase.

• Valuation: The value of a distressed business is often closer to its liquidation value (what the assets would sell for) or a highly discounted going-concern value based on a conservative projection of a successful turnaround.

• Contingencies: Negotiate strong representations and warranties from the seller, though these are often less valuable if the seller is financially insolvent.

D. Professional Guidance

Given the complexities and risks associated with distressed franchises, it is essential to involve professionals. Resuscitating a distressed franchise is rarely, if ever, an easy or straightforward process, given the considerable damage that the prior franchise owners have previously caused to the business, with experienced often capable of discerning even more of the problems and lingering issues that the new franchise owner will need to overcome. Even more significant is when those experienced professionals advise against acquiring the distressed franchise, as their own professional assessment suggest that serious concerns, both known and not fully perceptible, that makes the particular franchise acquisition a dangerous proposition.

Christopher Neufeld is a business lawyer knowledgeable in the rigors and challenges of the franchise business, together with the legal constructs that are critical to their effective operation. For experienced legal representation in starting, acquiring / selling, operating and managing a franchise, contact franchisee lawyer Christopher Neufeld at strong>403-400-4092 [Alberta], 905-616-8864 [Ontario] or Chris@NeufeldLegal.com.