New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

Due diligence is essential to all business purchase transactions. However, when the business transaction involves the lease or purchase of property that may be contaminated (such as a gas station, "quick lube" and car wash), your due diligence must expand to include the additional task of obtaining an environmental study.

So where do you start?

• Add an Environmental Contingency Clause to your Contracts - Make sure that your purchase agreements (such as your asset purchase agreement, lease agreement and/or real property purchase agreement) include an "environmental contingency" clause  permitting you to order and obtain an environmental assessment and study of the property.  If contamination is found, the contingency clause should be drafted in a way that permits you to back-out of the transaction and, importantly, get your deposit refunded.

• Obtain a Phase I Site Assessment - Obtaining an "environmental assessment" is not a complex process.  This assessment, performed by a licensed professional is typically known as a “Phase I Environmental Site Assessment”. This initial assessment will review the history of the property and provide you with preliminary findings as to possible contamination. Depending on the results of the “Phase I” study additional studies may be required.

Keep in mind that when purchasing a business such as a gas station, "quick lube" and even car wash, typically, you will be leasing land or purchasing property that may have a long history of "industrial type" activity that may be contaminated.   Once you purchase the business - even if you did not cause the contamination - you could be stuck with a big problem created long-ago. Environmental assessments are readily available, affordable (relative to the investment of your life savings) and should never be ignored.

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(Great, a lawyer answering a question about whether you need to hire a lawyer)

Answer? Yes - but not right away.  

The competent advice and guidance of a franchise lawyer will serve as a valuable tool (one of the many "tools" that are required) to be utilized on your road to entrepreneurship and the purchase of a franchise.  The advice provided by your franchise lawyer should be based on practical experience and involve a detailed review of the proposed franchise agreement and franchise disclosure document (FDD) and be followed by negotiatios with the franchisor.  However, while hiring a franchise lawyer is critical, it should not be your first step.

So what do I mean by "not right away"?  The process of buying a business is not a "sprint" (at least it should not be) but rather an "endurance event" that will require you to seriously evaluate your individual needs, business skills and expectations.  Once you have made this assessment, you will be faced with the challenging task of finding a business that is both profitable and right for who you are and your skill sets.  This is no easy task and will require that you do significant research (tons of resources available on the web), communicate with other business owners, communicate with existing franchisees (to do this, see "Contact Existing Franchisees before Signing a Franchise Agreement") and, possibly, seek out the advice of franchise professionals.  Don't just pick or get stuck on one particular franchise model or limit your research to the information provided to you by the franchisor's salesperson.  Remember, first and foremost, what matters most to a successful franchise investment are "profits" that will be  measured by your ability to take home money to your family each and every month.  So question everything.  If the franchise sells soup, then question how you will earn "profits" in the summer.  If the franchise sells ice cream, understand how "profits" are generated in the winter.  If the franchise appears to draw long lines or generate large revenues, then question what percentage of  those long lines and revenues are converted into "profits". 

Once you have completed your own internal analysis and "business review" , thats when the legal advice and analysis becomes critical.  The franchise agreement that you will sign will serve as the blueprint and road map for your business for many years to come.  As such, there are many, many critical issues that you must address with your franchise lawyer.  Some of the many issues that you must discuss and evaluate, include:

• The franchise fee that will be charged;
• The continuing royalty that you will be paying on a monthly or weekly basis;
• Advertising fund fees that you may or may not be required to contribute to;
• Approved vendors and suppliers of the supplies and products critical to your business;
• The protected territory that you may or may not be granted;
• Buildout and lease obligations that you will be required to undertake;
• Many, many other issues.

In many instances, (contrary to statements by a franchise sales person that their franchise agreement is "non-negotiable") your franchise lawyer will be able to negotiate and implement modifications to your franchise agreement that will have a substantive impact on your franchise investment and increase the odds for your success.  In today's economic climate, my experience has been that franchisor's are more willing than ever to negotiate with new franchisees.  Even things like deferring "royalties" for a number of months.  

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This is a question that I get often from my clients.  However, since lawyers are not the most qualified professionals to answer this question  (compared to a business appraiser or specialized consultant) I am not the most qualified to answer this question.  That said, business valuation is key and must be discussed with your lawyer prior to committing to a purchase agreement. While I am emphasizing the obvious, this issue comes up daily and in many transactions purchasers become "attached" to the idea of becoming a business owner and entrepreneur and let their guard down as to valuation.  So while your lawyer can not value your business, you must be taking every step to do so - preferably with the assistance of a qualified business account and certified business appraiser.  All of this should be coordinated with your business and franchise lawyer whose job is to ensure that you (and your contract deposit) are legally protected during this review period / due diligence.  

Some important factors that a prospective business / franchise purchaser should consider:

• Due Diligence is critical - always insure that you thoroughly review the finances (tax returns, royalty reports, purchase order receipts and register receipts) of the business that you are purchasing to verify the earning claims of the seller.

• Conduct on Site Due Diligence - Don't stop at a "paper review", spend time "on-site" interacting with customers and sampling/measuring daily sales.  This is not asking too much and the attorneys can structure confidentiality agreements to protect the seller and encourage him or her to provide you with access.

• Include a Due Diligence Contingency Clause - If your financial review/due diligence cannot be completed prior to signing the business purchase or franchise agreement , then ensure that your agreement includes a "due diligence contingency clause" enabling you to complete your review and back out of the agreement if necessary.

• Coordinate Communications - Ensure that your attorney, accountant/valuation professional speak and coordinate their activities. 

• Remember that Profits (not gross sales) are Key - This is an obvious point but one that should be emphasized again and again.  The most important factor to you will be how much money you get to take home to your family on a weekly or monthly basis and not the gross sales of your business and how much you paid the franchisor in royalties.  So don't get enamored with gross sales, pay attention to the recurring expenses of the business.

Essentially, leave no stone unturned.  By the way there are a multitude of valuable resources out their, always be circumspect, but check them out, i.e., www.franchisepick.com, www.thefranchiseking.com, www.unhappyfranchisee.com.

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In a recent decision of the United States Court of Appeals for the Second Circuit, In re American Express Merchants' Litig, 2009 WL 214525, *2, *5-*6 (2nd Cir. January 30, 2009), the Second Circuit rejected the enforcement of a "class-action waiver" clause contained in American Express's standard merchant agreement (the agreement between American Express and the restaurants and vendors that accept the American Express card).  Although the Court did not impose a per se prohibition, it held that "class action waiver clauses", may be invalidated where their implementation (i.e., prohibiting the plaintiff from joining together with others in a class action - and forcing the plaintiff to fight American Express on its own) would be to strip a plaintiff of its substantive statutory rights.  In the American Express decision, the plaintiff/vendor was one of many vendors claiming damages based upon American Express's alleged violation of federal law. The problem for this plaintiff was that, if forced to fight American Express alone (whether in court or an arbitration proceeding), it did not possess the resources to litigate against a corporate giant.

What does this mean for franchisees?  Right now, maybe not much.  But, down the line it could serve as a basis for expanding franchisee rights and possibly addressing onerous clauses in franchise agreements that undermine a franchisees "substantive rights".  For the time being, franchisees / individuals considering the purchase of a franchise, must recognize that as a small business owner and franchisee, the contractual rights and obligations specified in your franchise agreement will constitute one of your most important "business assets".  So, before buying a franchise, do your homework, read your franchise agreement, review the franchisor's disclosure document (FDD) and seek out the advice of an experienced accountant and attorney. Also, as discussed in a prior post, speak to existing franchisees. Definitely, ask questions.

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This weekend, driving back to New York from an an exceptional legal  conference in Virginia my partners and I came across one of my  childhood heroes (maybe not really a hero but a pretty cool guy):  "Bob's Big Boy". Meeting up with "Big Boy" reminded me, once again,  of the critical importance of trademarks and trade  dress to a franchise  system.  By the way "Bob's Big Boy" is a registered trademark of Big Boy Restaurants International, LLC.

For the prospective franchisor who would like to start a franchise or believes that franchised expansion may be in the future of his or her business, it is critical that you evaluate and protect your trademarks now.  Why is this so important?  Because trademarks and trade dress  are one of the most fundamental and critical assets of a franchise  system.  So, well before you start a franchise (where you will be  licensing your trademarks to franchisees) make sure that you consult    with a franchise lawyer or trademark lawyer (even if you are years  away from starting a franchise) and evaluate the following factors:

• Are your trademarks legally protectable?  Among many other factors,  your trademarks must go beyond "descriptive" terms and involve unique terms that have become associated with your business.

• Does your Trademark Actually Infringe on the Mark of a Third Party? It is quite possible that the mark you are using may actually infringe on the trademarks and intellectual property of a competitor.  Even if you never heard of the third-party competitor, depending on issues involving State and Federal trademark registration, your use of a trademark in one state, i.e., New Jersey, may actually infringe on the registered marks of an unknown competitor in California.

These points apply for any successful business - even if you never intend to start a franchise.The process for evaluating and registering your trademarks is not a complex process and may be accomplished cost effectively by a business and franchise lawyer.  Before you even contact a lawyer, you can conduct a basic and preliminary trademark search on your own by visiting the website of the United States Patent and Trademark Office (Click on the "Trademarks" Tab and then "3. Search TM Database").

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