In installment Number 1 of our series on Investing in a Franchise Business, we discussed some of the unique issues involved in the relationship between an equity investor or mezzanine lender investing in a franchise business and the franchisor of that business.  We specifically discussed the intercreditor relationship of the parties and ways to address various scenarios arising out of a default by the franchisee under either the investment documents or the franchise agreement.  A related issue that an investor must consider in evaluating an investment in a franchise business is its own exposure to the franchisor under the franchise agreement and related documents.  In this second installment, we discuss guaranty requirements and other franchise related issues.

LIABILITY FOR FRANCHISE OBLIGATIONS

 

Historically, most franchisors required that all franchise agreements, development agreements and related documents be signed in the name of the individual or individuals who would be operating the franchise business.  Most business owners incorporated their business or formed some type of legal entity, such as a limited liability company, to protect themselves and their personal assets from liability to creditors of the business. Franchisors typically required that the individuals, rather than the corporation or other legal entity under which they were operating, be personally liable for all obligations to the franchisor.  In other words, the individual, not the legal entity, was required to be the “franchisee”.  These franchisee obligations included franchise fees, royalty payments, advertising fees, development fees and other miscellaneous amounts that are detailed in the franchise agreement and related agreements between the franchisee and the franchisor.

Today, many franchisors permit a legal entity to be the “franchisee”, subject to qualification requirements for the individual owners or operators of the business.  However, in virtually all cases, the franchisor still requires the individuals to be personally liable for all obligations of the franchisee to the franchisor through the execution of a personal guaranty.

GUARANTY OF FRANCHISE OBLIGATIONS BY A PASSIVE INVESTOR

Most equity investors and mezzanine lenders take a relatively passive role in the actual operation of the franchise business.  While most investors hold some combination of subordinated debt, preferred stock, and warrants for common stock of the operating company, these investments usually do not represent a controlling position in terms of equity ownership.  Likewise, while many investors require a position on the board of the operating company, their board participation does not generally represent control.  Many franchisors do not distinguish between active and passive investors and require guarantees from all investors who own more than some threshold level of the franchisee company which is generally 10-20%.  As a passive investor, it is obviously not in your best interest to provide the franchisor with a full guaranty of all of the franchisee’s obligations when you are not in a position to control the day-to-day operations of the business.  There are several ways that you, as a passive investor, can approach this situation with the franchisor, including the following:

• Negotiate Limits on the Guaranteed Amount:  The franchisor always has recourse to both the franchisee entity (corporation, limited liability company, etc.) and its assets through its execution of the franchise documents.  In addition, the franchisor may have recourse to the individual operator or active owner of the business through his/her execution of a guaranty agreement.  Therefore, recourse to a passive equity investor or mezzanine lender should be viewed as a plus, even if limited to some negotiated amount.  For example, the guaranty could be limited to past-due franchise fees only, not to exceed some predetermined amount, such as the amount of the investment. 
• Negotiate Limits on the Applicability of the Guaranty:  Recourse to a passive equity investor or mezzanine lender should be viewed as a backup to the primary obligations of the franchisee and the principal owner or operator of the business.  It may be possible to negotiate a “springing guaranty” whereby the franchisor only has recourse to the investor in the event some specific action, such as replacing management of the franchisee entity or taking control of the board, is taken pursuant to the investment documents.
• Negotiate Limits on the Duration of the Guaranty:  Many franchisors will consider a “burn-off” provision whereby the guaranty is reduced or released in the event the franchisee remains current on all franchise related payments or meets certain predetermined financial thresholds, such as a minimum level of capital or a minimum fixed charge coverage ratio, for a defined period of time.  This provides the franchisor with some additional level of protection in the early stages of the business, but allows you as the investor to eliminate any contingent liability once the business demonstrates financial strength and stability.
• Negotiate the Collection Process with respect to the Guaranty:  Since the franchisee entity and the individual operator or active owner are both primarily liable for obligations to the franchisor, try to negotiate provisions in the guaranty which require the franchisor to provide you, as the passive investor, with notice of any default under the franchise documents and to exhaust all of its remedies against the franchisee entity and its assets, as well as the individual guarantor, before pursuing collection under the guaranty.

             

Watch for future KM Outlook articles where we will address other unique issues in connection with investing in a franchise business, including transfer of interests and replacement of management.