Franchisors expect franchisees to remain in their system. The franchise relationship is built through significant effort by both franchisors and franchisees over a long period of time. Franchise relationships often last 30+ years. However, at some point, that relationship has to end in some fashion. The franchised business can close, the system can shut down, the relationship could be terminated, etc. One common ending is when the franchisee exits via transfer.

There are any number of reasons a franchisee may wish to transfer their business. They could have viewed the franchise from the beginning as an asset to build and sell. They could be experiencing a life or career change. They could need to cash out. The relationship between the franchisor and the franchisee could have fractured and a new franchisee needs to be put in. As a result, both franchisors and franchisees need to fully understand their legal rights, options and duties concerning transfers.

First, the parties should look to the franchise agreement. A well drafted franchise agreement should set forth specific steps and conditions for the franchisee to transfer. These can include things like:

  • Notice. Who gives notice and when? What must the notice include?
  • Buyer’s information. The franchisor should ensure that the transferee meets all of its financial and business qualifications.
  • Transfer fee payment. Sometimes the franchisee has to pay a deposit at the time it sends the notice.
  • Unless they are already a franchisee in the system, the transferee will probably need to be trained. When would this happen?
  • The agreement might require that the business be upgraded. Whose responsibility is this? When does it need to be completed? What is needed to upgrade?

In addition to what is listed in the franchise agreement, there are other important considerations that might not be as obvious:

  • Many states have laws governing transfers. Sometimes the franchisor cannot unreasonably block a transfer. Sometimes the franchisor might only be able to block a transfer under very specific conditions. An analysis of what state law says about transfers should be made.
  • Everyone should ask what is best for the business. Sometimes a new lease will need to be signed, financing will need to be obtained, etc. The parties should inform one another of what business and legal steps need to be taken.
  • The franchisor should ask what is best for the system. Sometimes turnover is needed to remove a franchisee who is viewed as a poison pill from a franchise system. Franchisors will typically face less scrutiny and litigation if that business is sold than if it is terminated. Plus, the franchisee can usually cash out instead of being left fighting over whether the termination was proper. This is often the best “win-win” situation 2 parties who aren’t getting along can reach.


Right of First Refusal

Many franchise agreements give the franchisor the right of first refusal (ROFR) on the franchised business when the franchisee decides to sell. Whether a franchisor should execute the ROFR is an important decision.


Involvement in the Sale

Franchisors should take great care with the role you play in the transaction. Most franchisors act as a bystander to the sale, only requiring that they approve the new franchisee and collecting any fees they are owed. Unless you have a good reason to get involved in the transaction, franchisors should only be involved in approving the deal and having the parties sign any paperwork required. The most obvious reason for doing so is that it minimizes your chances of being sued (or, more accurately, of a court allowing a lawsuit against you to stand) if one of the parties later becomes unhappy with the terms of the sale. If you didn’t help negotiate or draft the terms of the sale, it’d be hard for someone to argue you acted in bad faith, committed fraud, etc. We’ll get into more below, but state laws may also come into play if you are too involved in the sale.


Disclosure of New Franchisee

As a condition of approving the franchise sale, most franchisors choose to have the new franchisee sign a new franchise agreement. But, as a new franchisee, do they need to be disclosed with your FDD? Federal law says they don’t. Well, sort of – under the federal rule, all prospective franchisees must be disclosed. But their compliance guide states that someone buying an existing franchise directly from the franchisee who owns it is not considered a prospective franchisee, so long as they don’t have “any significant contact with the franchisor.” Great! But what is “significant contact”? While exercising the right to approve the sale won’t be considered significant contact, they don’t provide us much else. This is rather unfortunate, because a big part of approving the sale is, typically, evaluating whether the buyer would make a good franchisee.

Additionally, some states have their own disclosure requirements, and out of those states, only a few provide a specific disclosure exemption regarding a franchisee selling its existing business. And, similar to the federal rules, those exemptions will only apply as long as the franchisor is not involved in the sale.

Given the lack of exemptions in registration state laws and clarity provided by the federal rules, the safest practice is to always furnish the prospective buyer with your disclosure documents. If you find yourself in a situation where there is no time for proper disclosures, then you should speak to a franchise attorney before moving forward.


Will I Need State Registration?

Sorry, I know that question likely made your stomach do a backflip. The short answer is maybe – if you have a franchisee selling its business in a registration state, you may need active registration in order for that sale to happen. Thankfully, many states have specific exemptions from registration for situations where a franchisee sells its business to a third-party buyer. However, like the federal rules, those exemptions are again contingent on the franchisor not being involved in the sale (many states use headache-inducing phrase, “whether the sale is effected by or through the franchisor”).

While each state provides its own guidance and examples of what is too much franchisor involvement, most end up at approximately the same place. The examples they provide typically outline actions that franchisors are allowed to take without being required to register, as opposed to ones that will require registrations. Some examples of permitted behavior are listed below, but as you can see, they are fraught with exceptions:

  • Exercising the right to approve the sale/new franchisee – Washington requires that it is done in a reasonable manner.
  • Charging a transfer fee –some states require that the transfer fee must be reasonable, and in Wisconsin it can only be the franchisor’s actual expenses.
  • Requiring the new franchisee to sign a new franchise agreement – again, some states require that the new franchise agreement cannot be materially different from the old agreement.

Remember that the examples above are only related to registration. You are certainly allowed to be more involved in the sale if you want – you just might have to be registered in order to do so. Of course, if you are already registered, it won’t be an issue. Of course, there are several other financial and business decisions to be made when you have a franchisee selling its business, but from a legal perspective, these are the big components that could potentially land you in hot water if you don’t take them into account.