DUE DILIGENCE MINEFIELD – PART 2

What information do business lawyers need to dig up in any transaction involving a franchise company? Where will they find it? What troubles await the unwary in the due diligence minefield?

Start with the last question, since the things that can go wrong in the purchase of a franchise company are plentiful. Imagine the buyer of a franchise company who sells expansion rights to a new and promising territory to one franchisee only to discover that the seller has already sold them to another. Imagine the buyer who learns that some franchisees pay lower fees than others for, say, the advertising, marketing, or training assistance that the new franchisor is obligated to provide. Imagine the buyer who learns too late that the seller has violated the franchise laws of one state or another, generating fines that are now the legal obligation of the buyer. Last but not least, imagine the buyer who discovers 30 days after the closing that the seller failed to disclose pending sanctions by state regulators that could make it impossible to sign up new franchisees in their state for, say, one to three years.

Now, not every problem is a deal killer. If both buyer and seller are anxious to do a deal, they can find ways to shape their transaction to accommodate nearly any problem short of disaster – so long as the problem is visible to both as they negotiate their deal. It is the unknown that can kill a deal or make it go bad down the road, and it is the job of the lawyer who undertakes to guide a buyer through the due diligence incident to a franchise deal to make sure that what might otherwise remain hidden does not pop up later on as an unpleasant surprise.

The crucial document in any franchise operation is the uniform franchise disclosure document, or FDD, and the legal due diligence process begins with a careful inspection of the FDDs used by the franchisor in each state where it has done business over the last four years. Loosely akin to a prospectus for a stock offering, the FDD details the financial and legal elements of the franchisor-franchisee relationship and includes information about the financial investment and other commitments required of franchisees, the services to be offered by the franchisor – for example, training services and marketing help – and the business and professional background of the franchisor and its senior executive team, including any bankruptcies and securities violations, among other items.

In 13 states – California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin –franchisors must file their FDDs with the state attorney general or some other state official. Six states – Florida, Michigan, Texas and Utah, Nebraska and Kentucky – permit franchisors to file one-page “exemption filings” exempting the franchisor from the states’ business opportunity laws. Nebraska and Kentucky also require the filing of a copy of the FDD. The rest generally impose no filing requirements on franchisors so long as they meet the filing requirements of one of the 13 states requiring registration or comply with the FTC Franchise Rule, which imposes six important requirements on franchisors

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