Draw the Law: Buying a Business or into a Franchise

Last post I discussed raising capital through governmental loans and programs.  Today’s topic is about deciding to buy a business or its assets and franchise agreements.

A hermit crab is a good analogy for a business and its assets. The shell is the business entity (limited liability, remember?) and the crab is all of the assets in the business.

Say you come to the realization that you don’t mind owning a business that someone else has built up.  The culture, the image, the stuff walls and tiles – all of it looks great!  You probably would then explore buying the business or if it is a part of a chain entering into a franchise agreement.

Buying a Business: Why Start from Scratch?

Exchanging Information: Getting to Know Each Other

Let’s say you want to buy the mom and pop store that makes shave ice down the road.  The first thing you will always need, and it remains true of all business transactions, is information.   The information you will need is your credit worthiness, financials, and the like – why?  Because the seller of the business wants to know if you can afford the business and in exchange you will ask for the books from the shave ice store.  Just because the business is always crowded with tourists does not necessarily make it the moneymaker you are expecting.  You want to know if they own the space they are in or leasing, is all the equipment paid up or are there liens on them, what are the terms of the current employees’ contracts, etc . . .  The only way you as the buyer of the business know it is worth it for you is to see if you are getting what you bargained for, and that means you will need to prove to the seller that you can pay them the price you will settle on.

Buy the Business or the Assets?

If you just want the stuff that makes the business run you can buy its assets and leave the seller the corporate shell.

Do you want the body or the guts?  That is one of the most basic questions you want to know.  Do you just want the stuff that makes up the business, which includes equipment, facilities, and intangible property like trademarks?  Or has the business been successful over the years because of the contracts it has in place (as it is the business entity that signed all those agreements)?

An anemone is like the contracts attached to the shell/business entity. If the buyer wants those contracts they will have purchase the whole business.

You will have to decide which is more beneficial.  Just buying the assets is like removing the hermit crab from its shell; you leave behind the corporate entity and anything attached to it similar to how an anemone is left on the shell when the crab moves.  Similarly, any contracts, lawsuits, and such liabilities are left with the corporation.

The Process: Start to Close

In general, the process is a lot of review, negotiating, and the finalizing of details.  Are the sellers telling you everything?  Can you get a look at the records and books?  How will you pay for the business?  If it is in monthly installments how will they accept payment?  Operationally, how will the transfer work out?  Like the transfer of accounts, titles, etc. . . .  Finally, when all that is reduced to writing you can sign the contract.  Of course, this does not happen overnight and you will probably need to work with a group of experts, such as a business broker, an accountant, your banker, an attorney, and the seller’s people to get this to all happen.

Non-compete Agreement and Warranties

Non-competes and warranties are things you will agree to before the deal is completed, but care about what happens after the business is in your hands.  The business you just bought or its assets are not worth much if the seller goes and starts the same exact business.   Therefore, you get assurances from the seller that they will not be your competition by placing a non-compete clause in the sales agreement or draft a completely separate document.  Either way, there are some restrictions on how much you can limit or prevent the seller from starting a similar business. Oft times, a buyer will actually retain the seller on as an employee or consultant to ease the transition, and thus is another way to prevent competition from the former business owner.

The customers got injured from the business when the old owner was in control, but they will suit the business. A warranty allows the new owner to go after the old owner because the old owner WARRANTS against undisclosed claims.

A warranty gives you, the buyer a right to go after the seller if an undisclosed liability comes up after the transaction is complete.  Let’s say you buy the shave ice store, but the former owners forgot to tell you that some of their customers had gotten stomachaches from food poisoning.  Those customers then sue you, as you have become the new owner of the business.  If you had a proper warranty clause you would be able to go after the former owners for what the customers are suing you for.

Franchising: What Comes with the Name?

When you buy a franchise you are buying a business.  Generally, it is a business with brand recognition and with that recognition comes all the inner workings of that brand from its trademark to its secret recipes you get it all.  It even includes how the storefront will look.  Typically, especially if it is one of the national brands, you will be paying a lot of money, and why not?  You would be paying for a brand name that has a proven track record (but like any business, you should realize that does not always mean success).

The franchisees get name recognition, access to supplies, and expertise help, but they lose a lot of control and must pay royalties for use of the name. Franchisor's like this arrangement because it helps build a distribution network while keeping a consistent image and earning money of that image.

Pros

  • Experience – the franchisor (the entity you are buying the franchise from) will help you with all their experience and knowledge get started.  If you are new, this is definitely something that will help you get up to speed.
  • Advertising – you are now apart of the franchises chain of distribution, therefore it is in their interest to coordinate marketing and advertising with you.  National sales campaign?  You will probably be sent all the material and have it all set-up for you.
  • Established – all the time spent creating a name and image has paid off for the company, and you are paying a fee or royalties so you can use that name and everything associated with it.
  • Lower operational costs – because you are getting all your products and supplies from the franchisor it is usually at a reduced cost and therefore, it is less costly for you to operate than if you had to buy all that stuff on your own.

Cons

  • Lost of control – the strength of a brand name and image comes from consistency.  When you enter a famous fast food chain in another state or even country you expect the same products and services you would expect locally.  To accomplish this feat, the franchisor restricts what you can do with the storefront.
  • Favoring the Franchisor – the franchisor is in the business of making money, naturally, the agreement they are going to have you sign favors them.  Some factors that favor them are the following:
    • Royalty fees – usually, paid on monthly gross sales and not profit, therefore you pay even if you aren’t making money
    • Restriction on transfer – you may not be able to sell the franchise and it may only be back to the franchisor
    • Termination at their discretion – the franchisor may end the agreement when they feel you are not cooperating leaving you high and dry
    • Competition – the franchisor can sell as many franchises as they wish, which includes your neighbor who also wants to buy into the franchise
    • Trapped – you might be forced to only buy supplies and products from the franchisor and be unable to go to outside supplies
    • Paperwork – the franchise wants to see you are making the most of your relationship with them, and thus would like to see reports from you, on a monthly, even weekly basis.

Just as a heads up the next several draw the posts will concern itself selecting a location for your business and the people involved with your business (employees, vendors, and customers).  Don’t forget if you enjoy this series or any of the other series on my blawg feel free to subscribe in the right-hand corner of this page to receive e-mail updates on posts.  If you are on Facebook be sure to “Like” “Ryan K. Hew” to get updates there as well.

See you on the next draw!

*Disclaimer:  This post discusses general legal issues, but does not constitute legal advice in any respect.   No reader should act or refrain from acting based on information contained herein without seeking the advice of counsel in the relevant jurisdiction.   Ryan K. Hew, Attorney At Law, LLLC expressly disclaims all liability in respect to any actions taken or not taken based on the contents of this post.

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3 thoughts on “Draw the Law: Buying a Business or into a Franchise

  1. Pingback: Draw the Law: People Issues, Part III: Non-Compete Agreements « The Blawg of Ryan K. Hew, Attorney At Law

  2. Pingback: Non-Compete Agreements: Draw the Law | Aloha StartUps

  3. Pingback: Draw the Law: People Issues, Part III: Non-Compete Agreements

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