Due diligence is necessary when buying a resale

Posted: 13 Feb 2019
Estimated Read Time: in 17 minutes

Due diligence is crucial before investing in an established business, Jane Masih, head of franchising at Owen White Solicitors, says

Due diligence is necessary when buying a resale

As franchise networks expand and mature, the opportunities to acquire a franchise as a start-up in your preferred area become less likely because the territory may have already been granted to another franchisee.

Increasingly, acquiring an existing business is the solution for the new franchisee.

A resale transaction offers the advantage of buying a business already established in terms of customer base and local reputation. However, it’s important to gain a good understanding of what will be involved before committing to the investment.

Why is the franchise owner selling?

A franchisor may be keen to encourage a sale where the existing franchisee is seeking to exit in order to retire or where the franchisor feels the existing franchisee has lost enthusiasm to develop the franchise to its fullest extent.

Equally possible is that the sale is the conclusion of the franchise owner’s plan to build a capital asset and sell to fund their retirement or a new business venture. As the prospective purchaser, you should ensure you know why the franchisee is selling.

Make sure you know where the franchise business sits in relation to the other franchisees in the network. Buying a top performing franchise may seem attractive, but begs the question about how much value you can add to the profitability of the business.

Acquiring a franchise from a franchisee who has taken their eye off the ball could be a better option, as when you introduce changes and adopt the recommendations of the franchisor profi ts should increase.

Assets or shares?

Acquiring a business will involve either buying the assets of the business as a going concern or the purchase of the shares in the company that operates the franchise.

The selling franchisee is likely to act on the advice of their tax advisers regarding the most tax efficient way for them to realise their investment in the business.

A sale of assets will involve you as the purchaser (or a limited company you set up for the purpose) acquiring the assets (customer list, machinery, equipment, stock, etc) of the existing franchise business. In this case, the employees of the existing business transfer to you on their existing terms and conditions of employment.

If the business involves premises, you will need to acquire the selling franchisee’s interest in those premises by taking an assignment of their lease.

The due diligence - the enquiries you and your advisers carry out before the purchase - will focus on identifying the assets being acquired and will allow you to exclude certain liabilities from the sale.

It’s standard practice for the seller to retain responsibility to collect the debts of the business being sold up to the date of transfer and to be responsible for the liabilities incurred up to the date of sale. As the purchaser, you will be responsible only for the debts and liabilities that agree will transfer and those incurred under your period of ownership.

On acquisition of the shares from the existing shareholders, the franchise company continues to operate as before the sale of the shares with no break in continuity of trade or ownership of the business.

The employees remain employees of the franchise company, the lease of premises remains in the name of the franchise company and all debts and liabilities remain with the franchise company. As the new shareholder, you will inherit all the history and liabilities of the company.

When acquiring shares, you should carry out detailed due diligence to make sure you have full knowledge of the liabilities of the franchisee company before you buy them.

The share sale agreement will contain warranties to protect you as the new shareholder. Warranties, which are effectively contractual promises, are given by the selling shareholders and can give rise to a claim for compensation if the warranty is breached.

It’s usual for the selling shareholder to remain responsible for any tax liabilities of the company relating to the period prior to the date of sale.

It’s increasingly common for the sale share agreement to include a requirement for a balance sheet to be drawn up to confirm the net asset position of the company at the date of completion of the share purchase. These are referred to as completion accounts.

As the purchaser, you are likely to have agreed to buy the company on the condition that its finances reflect an agreed position, often debt free and cash free. This means the share sale agreement will contain a mechanism for the price you pay for the shares to be adjusted up or down, depending on the results of the completion accounts.

If liabilities exceed assets, the price is reduced and if assets exceed liabilities the price is increased, usually on a pound for pound basis.

Completion accounts are useful to reduce some of the risk that may otherwise arise when purchasing shares, as they provide a mechanism to allow the liabilities of the trading company to be reflected in the price you pay for the shares.

The franchisor may require the selling franchisee and the purchaser to use a form of sale agreement that has been approved by the franchisor. It’s increasingly common for the franchisor to be a party to the sale agreement to ensure the conditions in the franchise agreement governing a sale by a franchisee are satisfied.

Increasingly common

Resales are increasingly common as franchise networks mature. Provided you carry out proper investigations about the trading history of the franchise business being offered for sale, a resale can provide a springboard for your own success as a franchisee.

It’s advisable to engage accountants and solicitors to help you in the process who are experienced in advising on franchise resale transactions and able to guide you through the process with confidence.

Benefits of a resale

The price of a resale is likely to be higher than a start-up, but offers the benefit of acquiring a business that produces sales turnover from the day you complete the purchase, rather than having to fund the franchise business while it establishes itself.

However, you will need to check whether key equipment, vehicles or the premises from which the business operates need to be updated to bring the business in line with the franchisor’s requirements.

A resale will also involve payment to the franchisor of either an initial franchise fee or sometimes a training fee. You are advised to ensure you’re aware of all the costs you will have to pay the franchisor before agreeing a sale price with the departing franchisee.

Acquiring funding to finance your purchase can be easier with a resale, as the trading history of the existing business will give a lender confidence that the business can provide a revenue stream from the outset from which to repay a bank loan.

It’s important to analyse the financial performance of the business, but past performance is not a guarantee of future profits. Put simply, with a resale some of the pain and associated investment of getting the business started has been incurred by the seller.

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