When Private Equity Knocks, Will You Be Ready to Answer?

An important area for consolidation and documentation is any policy or 'lore' of the franchise system that is accepted or acknowledged by the franchise community but is not reflected in the franchise agreement or system manuals. If payment dates, development schedules, and opening deadlines are routinely extended, then those practices should be documented. One of the most unpleasant surprises for a new management or ownership team is to discover post-closing a course of dealing contrary to the franchise agreements and system manuals that is adverse to the interests of the franchisor.

2) Spring clean the files. Diligence for your proposed transaction will involve review of your franchise regulatory and franchise contract files. The former will be extensive, the latter either extensive and complete or randomly deep, with emphasis on major franchise customers. Anticipate the review and resulting questions by performing your own internal diligence. Are there loose ends to be tied up? Dangling deliveries of documents, deeds, approvals, consents, amendments, responses that were somehow relegated to the bottom of the task list? In particular, are there franchisee-originated communications that have not received an appropriate reply, creating the prospect of an estoppel or waiver argument when action is to be taken? Comprehensive review of these files and completion of administrative tasks will allow you to demonstrate administrative efficiency, scalability, and perspicacity.

The franchise regulatory files should be organized to allow the reader to instantly verify compliance, registration and expiration dates, and advertising filing dates. Comment letters and responsive communications, including telephone conference notes and black-lined disclosure documents, will assure the reviewer that no regulatory issues linger. A summary of current registrations, amendment and renewal dates, and pending changes to disclosure agreed for the next cycle of amendment, if any, will confirm that compliance administration is not an issue about which the buyer should be concerned. These files should collect and present field instruction memoranda and historic franchise offering circulars, together with change summaries or explanations prepared at the time of amendment. Finally, any earnings claim/financial performance representation data that support the reasonable basis for a published earnings claim should be compiled and identified.

3) Protect the jewels. Uniqueness and non-duplicability create value in franchise system assets and concepts. These traits are protected by patents, copyrights, trademarks, service marks, and contractually protected trade secret status. An intellectual property protection audit with knowledgeable counsel will examine your methods of operation and identification and your creative works to recommend what should be formally protected. Business method patents are, for the time being, important means and opportunities to protect unique business methods not previously thought to be eligible for patent protection. Business methods were thought to be abstract ideas, but are now eligible for utility process patents, as long as the method produces a useful, concrete, tangible result and is novel, useful, and non-obvious. See State Street Bank & Trust v. Signature Financial Group, 149 F.3d 1368 (Fed. Cir. 1998) and AT&T Corp. v. Excel Communications, Inc., 179 F.3d 1352 (Fed. Cir. 1999). Accord, see eBay Inc. v. MercExchange LLC, 78 USPQ2d 1577 (U.S. 2006).

Likewise, original creative work should be evaluated for a copyright claim and registration. Manuals and the like that are proprietary are not likely to be good candidates, as the franchisor would lose control over the material under the first sale doctrine of copyright law, or subject the material to fair use for criticism, comment, news reporting, teaching, scholarship, or research. (See Copyright Act, Sections 107, 109; 17 USC ”107; 109.) Those cute and original words, phrases, logos, symbols, or devices that identify elements of the retail or wholesale franchise offering are protected from unauthorized use by trademark or service mark registration. While all franchisors aggressively register and protect their house marks, other valuable, distinctive identifiers that provide texture and nonfunctional distinction to the brand can often be ignored. The coined names for menu items, service programs, and other elements of the brand system and marketing offerings are ripe for protection.

The flip side of protection activities is unintended or undiscovered infringements. Part of the intellectual property review and audit are searches to determine if any aspect of the brand identity or know-how infringes third-party rights protected by law or contract. Elimination of downside surprises that would otherwise occur during private equity diligence will be beneficial to deal harmony and the selling price.

4) Police the map. Two mantras for private equity are location, location, location, and opportunity, opportunity, opportunity. A regional franchise yearning to break out nationally is the mother's milk of private equity. What does your map show? Are the potentially fertile undeveloped territories subject to unfulfilled commitments from area or unit franchisees? Has development been stymied by aggressive but unrealistic commitments that take large areas out of the sales mix with no or insufficient progress toward development? Are area development deals on schedule, or woefully behind with no chance of recovery? The thorough review of pending development transactions, followed by lawful, direct action to evaluate the likelihood of franchisee performance, and steps to recover territory for development or resale from defaulting franchisees will be a rewarding experience.

Few transactions in the franchisor's corporate history are fraught with more tales of fits and starts, or tales of woe, or best intentions gone awry, or unbridled optimism unchecked by rigorous realism than area development transactions. Yet unwinding or modifying these agreements can be expensive and difficult, as The Athlete's Foot found out. An area franchisee was awarded more than $1.5 million plus interest, for a total of $2 million, in an arbitration over termination of the area development agreement. That matter involved both the franchisor and its counsel (see Athletes Foot Marketing Associates Inc. v. Inner Reach Corporation, et al., Business Franchise Guide (CCH) ”12,303, 12,350). The area developer can obtain damages for lost profits, even if no store ever opened, if the franchise system is sufficiently mature to produce evidence of profitable operation by other franchisees (see No Ka Oi Corp. v. National 60 Minute Tune, Inc., et al., Business Franchise Guide (CCH) '10,548). The disputes serve to catalyze claims associated with the sales process of the deal gone bad, like misrepresentation, fraud, disclosure violations and the like, including claims of control person liability for officers associated with the original transaction. (See Athletes Foot Marketing Associates Inc. v. Inner Reach Corporation, et al., Business Franchise Guide (CCH) '12,349; Cherrington v. Noodles 1 LLC, et al., Business Franchise Guide (CCH) '13,373; but see Popeyes, Inc. v. Yuzo M. Tokita, et al.; FIMA & Associates, et al. v. America's Favorite Chicken Co, Business Franchise Guide (CCH) '10,384.)

Finally, to demonstrate how seeking attorneys' fees for the cost of an amendment can go horribly wrong, an ice cream shop's struggling franchisor terminated an area developer for failure to pay the franchisor's legal fees incurred for the amendment. The area developer counterclaimed, and was awarded more than $6 million in damages by a California jury. An appeals court reduced the award to slightly more than $200,000, representing the costs incurred by the developer for its failed deals. There was evidence that the franchisor never could operate a store profitably, and the receiver took on the case when the franchisor failed, although the president of the franchisor was also a defendant (Parlour Enterprises, Inc., et al., Plaintiffs-Respondents v. The Kirin Group, Inc., et al., Defendants-Appellants, Business Franchise Guide (CCH) '13,585). The clear implication from this case is that the franchisor improvidently sold area development rights before it could demonstrate the validity of the concept and the viability of its units.

Franchisors who are successful to a point but are subject to unsuccessful legacy transactions that are in need of reformation should approach these situations gingerly and carefully, and may need to consider liquidating the franchisee's investment.

Conclusion

Growth stage enterprises focus on the elements that fuel growth, often at the expense of other mundane aspects of their business and legal affairs. The priorities may shift at the time of owner monetization, when the buyer and source of takeout capital scrutinizes the neglected elements of the business. Addressing some of the issues likely to concern the putative buyer/investor will produce salutary effects for the business, even if no deal is ever consummated.

Joel R. Buckberg is of counsel to Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. in Nashville. He can be reached at 615-726-5639 or [email protected].

The wealth-building strategy for the executive team and investors in a franchisor traditionally focused on setting the stage for one of three scenarios: a private sale to a strategic buyer; going public through an initial public offering, with a secondary offering to partially liquidate the group's investment; or establishing an enterprise with significant cash flow available for salaries, bonuses, dividends, and other emoluments of financial success. An attractive option now available is the private equity option, which involves a sale of all or the controlling share of the equity of the business to a financial buyer. This approach reorients financial exit strategy to harvest simultaneously the gain in enterprise value while positioning existing management and possibly investors to participate in future value accretion. This approach usually allows, or even compels, existing management to participate in the equity of the business going forward.

The sellers' objective is always to maximize selling price, tempered by the reality of creating a tenable rollover equity position should the sellers desire to continue ownership at some level. As seller management considers this prospect, the books, records, and practices of the franchisor will come under intense scrutiny as part of the diligence process. The skeletons in closets will be identified and valued, and downside risk will be weighed. Several simple steps could enhance value and reduce downside risk. These steps could also cement the image of management as truly on top of the business and capable of managing the next phase of growth.

1) Codify inspiration and lore. Much of the genius of franchise systems derives from the instinctive management decisions made by the founders or early management. Some of the decisions are truly insightful and spontaneous, based on intuition as much as science or empirical data; others represent the application of experience and the culmination of research, development, testing, and evaluation. A major risk to a financial buyer is that the wrong people take the money and run, losing the benefit of the acumen and insights that have been important to the success of the business. To the extent possible, management should create written operating guidelines, standards, practices, and procedures that can be readily understood by diligence investigators and successor managers. The new writings will likely facilitate growth by enabling the training of more people to execute projection of system support and management.

An important area for consolidation and documentation is any policy or 'lore' of the franchise system that is accepted or acknowledged by the franchise community but is not reflected in the franchise agreement or system manuals. If payment dates, development schedules, and opening deadlines are routinely extended, then those practices should be documented. One of the most unpleasant surprises for a new management or ownership team is to discover post-closing a course of dealing contrary to the franchise agreements and system manuals that is adverse to the interests of the franchisor.

2) Spring clean the files. Diligence for your proposed transaction will involve review of your franchise regulatory and franchise contract files. The former will be extensive, the latter either extensive and complete or randomly deep, with emphasis on major franchise customers. Anticipate the review and resulting questions by performing your own internal diligence. Are there loose ends to be tied up? Dangling deliveries of documents, deeds, approvals, consents, amendments, responses that were somehow relegated to the bottom of the task list? In particular, are there franchisee-originated communications that have not received an appropriate reply, creating the prospect of an estoppel or waiver argument when action is to be taken? Comprehensive review of these files and completion of administrative tasks will allow you to demonstrate administrative efficiency, scalability, and perspicacity.

The franchise regulatory files should be organized to allow the reader to instantly verify compliance, registration and expiration dates, and advertising filing dates. Comment letters and responsive communications, including telephone conference notes and black-lined disclosure documents, will assure the reviewer that no regulatory issues linger. A summary of current registrations, amendment and renewal dates, and pending changes to disclosure agreed for the next cycle of amendment, if any, will confirm that compliance administration is not an issue about which the buyer should be concerned. These files should collect and present field instruction memoranda and historic franchise offering circulars, together with change summaries or explanations prepared at the time of amendment. Finally, any earnings claim/financial performance representation data that support the reasonable basis for a published earnings claim should be compiled and identified.

3) Protect the jewels. Uniqueness and non-duplicability create value in franchise system assets and concepts. These traits are protected by patents, copyrights, trademarks, service marks, and contractually protected trade secret status. An intellectual property protection audit with knowledgeable counsel will examine your methods of operation and identification and your creative works to recommend what should be formally protected. Business method patents are, for the time being, important means and opportunities to protect unique business methods not previously thought to be eligible for patent protection. Business methods were thought to be abstract ideas, but are now eligible for utility process patents, as long as the method produces a useful, concrete, tangible result and is novel, useful, and non-obvious. See State Street Bank & Trust v. Signature Financial Group, 149 F.3d 1368 (Fed. Cir. 1998) and AT&T Corp. v. Excel Communications, Inc., 179 F.3d 1352 (Fed. Cir. 1999). Accord, see eBay Inc. v. MercExchange LLC, 78 USPQ2d 1577 (U.S. 2006).

Likewise, original creative work should be evaluated for a copyright claim and registration. Manuals and the like that are proprietary are not likely to be good candidates, as the franchisor would lose control over the material under the first sale doctrine of copyright law, or subject the material to fair use for criticism, comment, news reporting, teaching, scholarship, or research. (See Copyright Act, Sections 107, 109; 17 USC ”107; 109.) Those cute and original words, phrases, logos, symbols, or devices that identify elements of the retail or wholesale franchise offering are protected from unauthorized use by trademark or service mark registration. While all franchisors aggressively register and protect their house marks, other valuable, distinctive identifiers that provide texture and nonfunctional distinction to the brand can often be ignored. The coined names for menu items, service programs, and other elements of the brand system and marketing offerings are ripe for protection.

The flip side of protection activities is unintended or undiscovered infringements. Part of the intellectual property review and audit are searches to determine if any aspect of the brand identity or know-how infringes third-party rights protected by law or contract. Elimination of downside surprises that would otherwise occur during private equity diligence will be beneficial to deal harmony and the selling price.

4) Police the map. Two mantras for private equity are location, location, location, and opportunity, opportunity, opportunity. A regional franchise yearning to break out nationally is the mother's milk of private equity. What does your map show? Are the potentially fertile undeveloped territories subject to unfulfilled commitments from area or unit franchisees? Has development been stymied by aggressive but unrealistic commitments that take large areas out of the sales mix with no or insufficient progress toward development? Are area development deals on schedule, or woefully behind with no chance of recovery? The thorough review of pending development transactions, followed by lawful, direct action to evaluate the likelihood of franchisee performance, and steps to recover territory for development or resale from defaulting franchisees will be a rewarding experience.

Few transactions in the franchisor's corporate history are fraught with more tales of fits and starts, or tales of woe, or best intentions gone awry, or unbridled optimism unchecked by rigorous realism than area development transactions. Yet unwinding or modifying these agreements can be expensive and difficult, as The Athlete's Foot found out. An area franchisee was awarded more than $1.5 million plus interest, for a total of $2 million, in an arbitration over termination of the area development agreement. That matter involved both the franchisor and its counsel (see Athletes Foot Marketing Associates Inc. v. Inner Reach Corporation, et al., Business Franchise Guide (CCH) ”12,303, 12,350). The area developer can obtain damages for lost profits, even if no store ever opened, if the franchise system is sufficiently mature to produce evidence of profitable operation by other franchisees (see No Ka Oi Corp. v. National 60 Minute Tune, Inc., et al., Business Franchise Guide (CCH) '10,548). The disputes serve to catalyze claims associated with the sales process of the deal gone bad, like misrepresentation, fraud, disclosure violations and the like, including claims of control person liability for officers associated with the original transaction. (See Athletes Foot Marketing Associates Inc. v. Inner Reach Corporation, et al., Business Franchise Guide (CCH) '12,349; Cherrington v. Noodles 1 LLC, et al., Business Franchise Guide (CCH) '13,373; but see Popeyes, Inc. v. Yuzo M. Tokita, et al.; FIMA & Associates, et al. v. America's Favorite Chicken Co, Business Franchise Guide (CCH) '10,384.)

Finally, to demonstrate how seeking attorneys' fees for the cost of an amendment can go horribly wrong, an ice cream shop's struggling franchisor terminated an area developer for failure to pay the franchisor's legal fees incurred for the amendment. The area developer counterclaimed, and was awarded more than $6 million in damages by a California jury. An appeals court reduced the award to slightly more than $200,000, representing the costs incurred by the developer for its failed deals. There was evidence that the franchisor never could operate a store profitably, and the receiver took on the case when the franchisor failed, although the president of the franchisor was also a defendant (Parlour Enterprises, Inc., et al., Plaintiffs-Respondents v. The Kirin Group, Inc., et al., Defendants-Appellants, Business Franchise Guide (CCH) '13,585). The clear implication from this case is that the franchisor improvidently sold area development rights before it could demonstrate the validity of the concept and the viability of its units.

Franchisors who are successful to a point but are subject to unsuccessful legacy transactions that are in need of reformation should approach these situations gingerly and carefully, and may need to consider liquidating the franchisee's investment.

Conclusion

Growth stage enterprises focus on the elements that fuel growth, often at the expense of other mundane aspects of their business and legal affairs. The priorities may shift at the time of owner monetization, when the buyer and source of takeout capital scrutinizes the neglected elements of the business. Addressing some of the issues likely to concern the putative buyer/investor will produce salutary effects for the business, even if no deal is ever consummated.

Joel R. Buckberg is of counsel to Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C. in Nashville. He can be reached at 615-726-5639 or [email protected].