Assume that you are a large multi-unit franchisee and you have the opportunity to sell your business to either an existing franchisee or to someone who wants to become a multi-unit franchisee in your system. You read your Franchise Agreements (perhaps for the first time) and discover that you may not transfer without the franchisor’s permission and the franchisor has a “rights of first refusal” that prevents you from selling at all unless you allow the franchisor the first shot at buying “on the same terms and conditions.” What do you do? Well, here are seven things you should do and/or consider.
7 Things to Consider for Rights of First Refusal
1) Think Back In Time and Regret That Your Franchisor Has a Rights of First Refusal at All? Had Dady & Gardner reviewed your Franchise Agreement in the first place, we would have suggested that you try to avoid the right of first refusal (“ROFR”) altogether. ROFRs generally depress the potential sale price by at least the amount of attorneys’ fees that the buyer will need to incur to reach the ROFR stage. For example, if your buyer would have paid $1,000,000 without a ROFR, the buyer now might only offer $950,000 if there is a good chance that the franchisor will exercise the ROFR. The buyer will waste all of its time and money documenting a transaction that will, at the end of the day, benefit the buyer not at all. You will find very few buyers willing to graciously throw away their own time and money so that the franchisor can acquire your businesses.
2) Read the “Rights of First Refusal” Paragraph and the Consent to Transfer Paragraph. The language in most Franchise Agreements regarding transfer rights follows the same format, but that is not always the case. One franchisor permits any transfer at all, so long as the transfer is equal to or less than 49% of your interest in the business. Some franchisors permit transfers freely among current owners, or among close relatives. Maybe your transaction doesn’t need to be approved at all? Similarly, with ROFR issues, there are sometimes exceptions that say there is no ROFR on certain exempt transactions (family transfers, transfers on death, minority shareholder transfers). You never know, you may be able to structure the transaction in such a way that the franchisor has no ROFR, or, possibly, no rights at all.
3) Get the Clock Ticking. The Rights of First Refusal language generally sets forth how long the franchisor has to exercise its ROFR. The typical period selected is 30, 60 or 90 days. But one very important question is “30 to 90 days from when?” If it runs from the date when the franchisor receives a non-binding Letter of Intent, get that Letter of Intent formally submitted. If it runs from the date the franchisor gets a signed Asset Purchase Agreement, get that Asset Purchase Agreement formally submitted. If it runs from the date that the franchisor gets “all documents and other information necessary to make an informed decision,” make a strong written record with the franchisor establishing that the franchisor has all of the information the franchisor could ever want. Try to get a letter from the franchisor stating that “we will make a decision no later than [insert date].”
4) If the Franchisor Is Likely to Exercise the Rights of First Refusal, Try to Make the Buyer Pay 100% Cash. Many newer ROFR paragraphs in franchise agreements state that the franchisor “may substitute cash for non-cash consideration.” Franchisees often get far too clever and decide that the best course of action is to substitute non-cash consideration for cash. So, instead of $1,000,000, the franchisee will receive $500,000 plus the right to 25% of the company’s profits going forward. It has been our experience that a well-prepared franchisor will quickly state “the value of that 25% is either nothing or next to nothing, and it is certainly much less than $500,000.” What the franchisee has now accomplished is to give the franchisor a chance to drive down the sale price. If the business is worth $1,000,000 and the franchisee wants to get out and pocket $1,000,000, then ask for a $1,000,000 cash offer. Why buy a dispute with the franchisor (who almost always has far deeper pockets and can afford a long protracted fight)? If the issue of whether a ROFR has been properly exercised has to go to litigation or arbitration, the parties 95% of the time will compromise. This means that if the franchisor says the ROFR price is $500,000 and you as a franchisee say it is $1,000,000, the settlement figure will be well below $1,000,000. Why not just make it a cash deal and get the full $1,000,000? While the courts have questioned the “good faith” of non-cash consideration (for example, buyer has to wash my car every week) and chosen not to require such consideration if it is provided in bad faith, the general rule of law is the opposite on cash. When the contracting parties say “$40,000,000 in cash,” it does not matter that the amount is absurdly high, to exercise the ROFR, the franchisor must pay the $40,000,000.
5) Be Careful That Your Sale Doesn’t Get Rejected. Suppose you have done steps 1-4 and submitted a $3,000,000 cash offer for your units that are worth $1,000,000. Your franchisor is unlikely to take a $2,000,000 hit just to exercise the Rights of First Refusal. But, your franchisor has another weapon in its bag—it may reject the sale altogether. Almost all franchise agreements allow the franchisor to consider the financial status of the buyer and reject the sale if the financial status of the buyer would be insufficient to cover the debt incurred to pay for the franchise(s). Some franchise agreements specifically allow the franchisor to reject a sale for an excessive price. Do not be confused—the ROFR and the right to approve or reject the sale are not the same thing. They are two different “arrows” in the franchisor’s quiver.
6) Review Your Statutory and Common Law Rights. While most franchisees do not have statutory protection to void Rights of First Refusal efforts, some statutes involving car dealers or equipment dealers at least require a manufacturer or supplier who exercises a ROFR to pay the buyer’s attorneys’ fees and costs. If you have such rights, your buyer may be willing to present a 100% offer, knowing that it will at least not lose anything if the sale doesn’t go through. In some states, the “common law” (judge-made law) states that if the buyer promised to pay a broker fee, the franchisor exercising a ROFR also has to pay the same broker fee, but to the selling franchisee. This is the case even though the broker never gets paid! You need to know whether this is the law in your state as well.
7) Hire Competent Franchise Counsel and Work With the Buyer Early On. The analysis set forth above assumes that the selling franchisee is represented by competent counsel or has a good grasp of the concepts set forth above. We have recently seen franchisees in a major system lose out on trying to sell to existing franchisee friends because the deal used too much non-cash when the buyer actually had cash it could have offered. The seller ended up selling to a franchisor it didn’t care for, and the franchisor actually made the seller take a lower price. The buyer ended up holding the proverbial bag, left with nothing but a $50,000 bill for attorneys’ fees, while the franchisor stepped in and took the business at issue for less than the buyer thought it was worth. The buyers out there also need to realize that, in almost all states, they have virtually no legal rights and must work through the seller’s rights. For example, if the franchisee wants to sell for $1,000,000 in cash and $500,000 in non-cash, and the franchisor declares the non-cash to be worth $250,000, most courts will not question the ability of the seller to accept that $750,000 proposal. The general rule of law is that, once the Rights of First Refusal is exercised, the initial offer disappears. The buyer basically becomes a non-entity in the transaction. It is only the seller, in most states, who can complain about the ROFR and who can complain about a refusal to approve a sale transaction. If the buyer badly wants the franchised opportunity, it needs to work very closely with the seller and convince the seller that fighting the ROFR issue is in the seller’s best interest. After all, all money spends the same, so a seller who can get $1,000,000 from a buyer or $980,000 from the franchisor has a disincentive to fight if the fight will cost $20,000 or more.
Over the past several years, Dady & Gardner has fought several Rights of First Refusal and transfer approval fights on behalf of franchisees. We believe that we should be your preferred attorneys when these issues arise—whether you are the potential buyer or the potential seller.