Why Companies Neglect Vetting Franchisee Opinions In Pre Acquisition Due Diligence

I have been on all three sides of franchise system acquisitions. Only once was I able, through aggression, to blow an acquisition out of the water – actually it was a leveraged management buy out and I blew up the financing on behalf of my franchisee clients who objected to an agenda that management was determined to pursue. I always wondered why it was that acquiring companies seemed not to give a tinker’s damn about franchisee attitudes, concerns and aspirations when vetting these acquisitions.

I think I now understand it better, and I’ll share this with you in the hope of instigating a dialogue about the subject. I am not suggesting that any acquirer vet for franchisee morale by any touchy, feely dialogue with franchisees pre closing. The reason for that is that I think that the current vetting techniques work just fine in almost every instance, and that it may be wise not to open a floodgate for the attempted imposition of franchisee agendas that, if given free rein, could be pernicious to a franchisor’s legitimate interests.

The three most important questions in acquiring a franchise system are its financial performance history; whether the brand and the substance of what the franchise has to offer have potential continued longevity considering market conditions and trends; and the strength of its portfolio of enforceable franchise contracts, measured by the consistency of the agreements over the history – their net compatibility – and the dispute resolution track record if any.

In its financial performance history one looks not only at cash flow, but also at the quality of the financial performance of its franchisees in terms of their reasonably prompt payment of what is due. If the footnotes to the financial statements show large, old receivables from franchisees, the value of a potential acquisition diminishes greatly. Disciplined franchise systems are valuable for that discipline.

Where the acquiror is not itself a large franchise system operator, but has for its purpose the hasty improvement of the performance of the system, looking to potential public offering exit strategy, serious changes over a very short term are inherent in the event. If one were to go to the franchisees and publicize the intended “improvements” as part of the vetting process, a negative response and the initializing of resistance would be the most predictable response. So why do it, especially if the changes are permitted in the extant franchise agreements? Moreover, where there are many renewals coming up in the near future with franchisees required to sign new agreements with different terms upon renewal, issues are easily resolved with simple draftsmanship.

While franchisees probably dislike the notions discussed here, If the system is generally profitable for them, they will accept, albeit grudgingly, the intended changes. Those that are marginal simply have to be culled. Sanguinity is based upon the history of franchisor post acquisition success and the fact that even in the absence of acquisition most of the intended changes have already been exonerated in major court decisions, especially those that involve alternative distribution channels.

Where does that leave franchisees that have issues with the new franchisor’s agendas? The answer depends upon the success history of the franchisees. The more successful franchisees will not go out on any limb to protect the less successful. That dichotomy has always been consistent in situations like this. There is a serious divergence of interests between these two groups. Since it is business issues that are in play, notions of fairness, charity, democracy, and all the other soft serve philosophical principles that are customarily invoked, really don’t apply and won’t be implemented. That has been the history, and history is a more reliable indicator of reality than wishful thinking.

This is what the reality of the situation has been and is likely to continue to be. One might expect the adoption of safety valve venting opportunities, but that will be more for appearance and deflection than for any serious consideration purposes.

The underlying principle on which this is based is that in commercial law and usage, the most valuable piece of paper in the world is an enforceable contract. We may rely upon courts to protect that principle, and we have seen that such is in fact the case. Courts are mandated not to insert into agreements provisions that were not put there by the parties before execution, and whenever courts have veered from that directive, they have been reversed or not been followed. Hard cases make bad law. The rules don’t get changed because in a few instances they may not work as “fairly” as one might wish.

Advantages are bargained for. The economic cost of advantages is that the franchisor would have to insist upon greater and faster returns in a less advantageous arrangement for it to be justified as something to invest in. Moreover, the other, non contract law, legal constructs support the protection of owner’s control rights. Illustratively, if an owner is not militant in its supervision of how its intellectual property is used, those rights will be lost under abandonment principles.

My purpose in writing this is to suggest that franchisee groups carefully think through the art of the possible before taking hostile, aggressive positions when their system is being acquired. The only immediate way for them to assume controlling prerogatives is to buy the system themselves.

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