Legal Aspects of Buying a Franchise

By Javad Heydary & W. Xavier Navarrete

Print Version

Buying a franchise involves a host of legal considerations, which a prospective purchaser should consider before entering into a franchise relationship.

What is a franchise?

A franchise is an arrangement established by contract in which one person, the "franchisor" grants a right to another person, the "franchisee" to use a trademark or trade name in connection with the supply of goods and services by the franchisee. Common examples of these types of arrangements are seen in many chain restaurants or coffee shops. Generally speaking, what distinguishes a franchise from a distribution agreement is the ongoing royalty payments by the franchisee and/or some level of control exerted by the franchisor over the business.

Different Types of Franchises

Product Franchising/Distribution Agreements

In product franchising or distribution arrangement, the franchisee is allowed through a license granted by the franchisor, to sell the franchisor's trade-marked goods within a stipulated geographic area. The franchisor offers limited assistance and imposes only minor control on the operation of the franchisee's business. Products such as soft drinks, which require a low degree of pre-sale and post-sale, are well suited to this method of distribution.

Business Format Franchising

Under the business format franchising model, the franchisor provides the franchisee with a license to sell goods or provide services that are identified with the franchisor's trade-mark. The franchisor also allows the franchisee to use a detailed business format, operating system, and a marketing plan and strategy. Usually the type of support provided by the franchisor under this arrangement is as follows:

• site analysis and selection;
• leasing and construction services;
• financing services;
• fixturing and stocking the outlet;
• training and opening assistance;
• training, operating assistance and other initial services;
• quality control and operating standards;
• volume purchasing and advertising; and
• advice and guidance and other continuing support.

Under this format, there is almost a full merging of the business identity of the two parties. Some common examples of businesses that adopt this type of arrangement are chain coffee shops and fast-food restaurants.

Purchasing a Franchise

Generally, buying any business requires a certain amount of pre-purchase investigations. The type of business being purchased will dictate, to a large degree, the type and extent of these investigations. If the business you are planning on buying is a franchised business, additional issues arise such as the term of the franchise agreement, royalty rate and the scope of the exclusive local territory (if applicable).

Two important issues to consider when purchasing or selling a franchise is the "fair dealing" and disclosure requirements of Ontario's franchise legislation.

Specifically, the Act requires franchisors to provide franchisees with relevant and meaningful information concerning the franchise to be purchased - information such as the background information on the individuals managing the franchise system. This information must be provided before the franchisee makes an investment in the franchise.

Disclosure obligations

A disclosure document must be delivered to the franchisee fourteen days before he/she enters into any agreement related to the purchase of the franchise or transfers any money related to the proposed purchase. Subject to limited exceptions, some important details that the disclosure document must include are:

• all material facts relating to the franchise operation;
• copies of all proposed franchise agreements;
• some statements that assist the prospective franchisee in making the decision of purchasing the franchise; and
• financial statements where applicable.

The information set out in the disclosure documents must be accurate, clear and concise. Timing of delivery of the disclosure document is very important as late delivery or non-delivery can give rise to very important legal consequences. For example, untimely disclosure may release the parties from their contractual obligations.

There is also an obligation on the franchisor to provide the franchisee with ongoing information and to highlight any material changes that occur between the delivery of the disclosure documents and the signing of the franchise agreement. This is called "Rolling Disclosure" or open ended disclosure. Failure to do this may lead to important legal consequences to the franchisor.

Directors and persons signing the disclosure document on behalf of the franchisor may also face personal liability in certain circumstances.

Buying an Existing Franchise

If buying an existing franchise, apart from obtaining proper disclosure from the franchisor, there are other important issues you should investigate before completing the transaction. The following is a general outline of such considerations.

Method of Purchase

An important consideration you must keep in mind when purchasing an existing franchise is whether you should buy the assets of the franchise or buy the shares of the corporation or partnership interests of the entity that runs the franchise. Your accountant and lawyer can help you make that decision. Although this article does not deal with the issue of whether to buy assets or shares, it is important for you to realize that how you structure the transaction will impact the investigations you should consider conducting.

Status of Seller

One of the first things you will want to do is determine the status of the seller. Is the seller a corporation, a partnership, or an individual operating as a sole proprietorship? Is the seller a resident or non-resident of Canada? Once you have determined the seller's status, various searches can be conducted to confirm the accuracy of the information provided by the seller.

Ownership

Having determined the seller's status, you should obtain information on the ownership structure and related details. If the seller is a partnership, who are the partners and what are the terms of the partnership agreement that might affect the proposed purchase? If the seller is a corporation, who are its shareholders, is there a shareholders' agreement and do other individuals who are not shareholders have options or rights of refusal on shares of the corporation? The answers to these questions will determine if you are or will be dealing with all the parties who have an interest in the franchise and who can affect the seller's decision to sell the franchise you want to buy.

Real Estate

If the franchised business you plan to purchase owns for example, real estate property, you will want to confirm that the seller is the registered owner of the property and that there are no charges or encumbrances outstanding against or affecting the property. If there are outstanding charges, you will want to confirm the amount owing and the duration of the charge and other terms and conditions that apply. If there are restrictions affecting the property, you will need to know what they are and how they might impact the operation of the franchise you want to buy, even though they may currently not appear to be affecting the franchise.

You will want to conduct searches to confirm that the seller is and has been in compliance with various governmental rules and regulations that may regulate the way the franchised business can properly be conducted. Again, compliance with some rules and regulations may not be an issue because of the nature of the business being purchased.

Leases

You will want to review copies of all leases of real property to confirm that the terms and conditions are the same as those represented to you by the seller and that the leases cover the property used in the franchise you are planning to purchase. Almost always, with franchised businesses, the franchisor holds the head lease and subleases the premises to the franchisee. As such, it is important that you review both the sublease and the underlying head lease. Additionally, you will have to determine if the sale of the franchise involves an assignment of the lease or the entering of a new lease between you and the franchisor.

Various other legal issues should also be considered. As an example, you will want to make certain that the holder of the Landlord's mortgage, if there is one, cannot force you out of the premises in which the business is carried on because of a default of the Landlord under the mortgage.

Machinery, Equipment, Vehicles and Other Tangible Personal Property

You will want to obtain a list of all machinery, equipment, vehicles and other tangible personal property, both owned and leased, used in the franchise you are planning to buy. You will want to review the terms of all leases or similar documents relating to the equipment used by the business; again, you will want to confirm that the terms of these documents are the same as the terms that have been represented to you by the seller.

You will also want to develop a list of all security interests, liens and encumbrances that affect the assets of the business you are about to buy. You want to do this for a number of reasons. As an example, you will want to confirm the accuracy of what the seller has told you in terms of tangible personal property used in the business. You will also want, for example, to confirm the lease payments that remain to be paid on the equipment or confirm which equipment can be sold, either because it is not under lease or because it is not encumbered by a lien.

In addition to compiling the list of security interests and encumbrances, you will want to conduct searches under the Bank Act to see if any bank has an interest in the assets of the business and under the Ontario Personal Property Security Act to determine if any other parties have interests in the tangible personal assets of the seller. Because some equipment may cease to be personal property by reason of being affixed to the real property of the business, you will want to see if notices of a third party's personal property security interest have been filed in the appropriate land registry office. Additionally, searches should be conducted under Ontario's Execution Act to see if there are any outstanding Writs of Execution in the hands of the Sheriff in the district or county where the Seller's franchise has assets.

Conclusion

When buying any business including a franchised business, there are a host of other matters that should be considered such as employee-related issues and tax considerations, a discussion of which is beyond the scope of this article. Specifically, the issues covered in this article are merely examples of the kind of investigations you should consider when purchasing a franchised business. Constraints, such as time and money, may prevent you from conducting every search you might otherwise like to conduct. Because of this, your lawyer can help you decide the appropriate investigations for the particular franchise you are planning to buy and help you cover off any remaining exposure in the legal documentation that will be used to implement the transaction.