Franchise funding key points

Level of control

Lenders will consider the level of control the franchisor has over the franchisee, particularly in relation to non-assignment and change of control clauses.

A non-assignment clause typically prohibits the franchisee from assigning or transferring any part of the agreement to a third party. Similarly, a change of control clause prevents the franchisee from selling, transferring, or otherwise dealing with the controlling share in its franchise business. In some instances, these clauses may be drafted with the caveat that any such act may only be permitted with express prior written consent from the franchisor.

Depending on the intended structure of the lending arrangement, the inclusion of these clauses may mean the loan itself breaches both or either of these provisions. For example, if the loan grants the lender a share of more than 51% of the franchisee’s business as security, this would amount to a change of control resulting in a breach of the franchise agreement.

The question then arises, if these clauses are common in franchise agreements, how can such breaches be avoided. There are three options, which have varying levels of enforceability. These include; entering into a binding side letter amending the terms of the franchise agreement, securing formal consent from the franchisor (if applicable), or the issuing of a comfort letter from the franchisor  setting out the potential breaches and stating its rights are waived in respect of the same (although this carries limited legal weight).

Termination rights and the value of the franchisee's business

Lenders will also consider the franchisor’s termination rights under the franchise agreement. These are typically wide ranging and permit the franchisor to end its relationship with the franchisee for a host of reasons, including breach of the non-assignment or change of control clauses above.

The franchisor’s rights in this regard can often be sorted into hair-triggers and termination grounds following remedial periods. Hair-triggers permit the franchisor to terminate immediately, often without notice, should a specific act, event or circumstance arise. In contrast, other termination provisions will permit the franchisee a period of time to remedy a breach, and if not met the franchisor’s termination rights then arise.

Lenders will also review whether the franchise agreement includes a first right of purchase or cross-default termination provision. Where the franchisee operates more than one franchise business, cross-default provisions entitle the franchisor to terminate all agreements if the franchisee is in breach of the terms under any one franchise agreement. Although not included in all franchise agreements, a first right of purchase grants the franchisor the right to purchase the franchise business from the franchisee in the event of termination.

From the perspective of a lender, the culmination of the franchisor’s rights in this regard often dictate the structure of the debenture. For example, if the franchisor can terminate for breach of the change of control clause, the lender may seek to avoid shares as a form of security. Similarly, if the lender is considering shares as security but the franchisor has the first right of purchase, there is a chance the business could be sold to the franchisor below market value and the lender may not recoup the full loan amount. Ultimately, the decision in this regard will be determined by the risk appetite of the lender. Lenders are therefore keen to understand the value the franchisee will receive for its business, whatever the ground for termination may be.

Liability and indemnities

Liability relates to the level of legal responsibility the franchisee agrees to take on under the terms of the franchise agreement. Typically, the provision will be widely worded and there will be no maximum amount capping the liability of the franchisee. Linked to this, indemnities are a legal promise by the franchisee to pay on a pound for pound basis the amount of any losses experienced by the franchisor. As with liability, the indemnity clause will be widely worded, and will usually include both the direct and indirect losses of the franchisor.

These provisions will be considered by a lender because if the franchisee becomes liable to the franchisor and its liability is uncapped, this can have a significant effect on the franchisee’s ability to repay the loan.

Other provisions

The above is not an exhaustive list, and lenders will often consider other franchise agreement terms prior to granting franchise funding. This can include confirming whether the franchisor owns the intellectual property and franchise brand, and whether the territory granted is exclusive therefore protecting the viability of the franchise business.

How can Blake Morgan help with franchise funding?

Blake Morgan has a number of experienced lawyers able to deliver succinct and pragmatic advice to franchisees, franchisors and lenders in respect of funding arrangements and wider franchising matters.

If you are concerned about whether your franchise agreement will withstand lender due diligence, or require franchising advice generally, please contact our team. You can also read more about the franchising services we offer here.