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The past decade has seen an increasing number of M&A transactions, particularly in mature industries, as increased competition for gross revenues has fostered consolidation. The franchise industry has not been immune to this general trend toward M&A transactions, as the capital markets were generally not receptive to public offerings for franchise companies, particularly restaurant systems, in light of the tech boom. Certain factors should be considered in evaluating the acquisition of a franchise system from the perspective of both the buyer and the buyer’s lender. INTANGIBLES The purchase of a franchise system differs substantially from the purchase of any other business because the assets being acquired are intangible in nature and are embodied in the good will (especially consumer good will) of the target franchise system. Specifically, the key assets being acquired are intangible in nature: contract rights as embodied by the various franchise agreements, such as master franchise agreements; area development agreements and unit franchise agreements; and related items of intellectual property that brand the system and that enhance the value of the business, such as confidential operating systems. For purposes of this article, we have assumed that counsel possesses an adequate due diligence checklist for use in a typical M&A transaction. Accordingly, we focus on supplementing that checklist with certain general categories for examination to account for franchise and intellectual property issues. FRANCHISE DUE DILIGENCE As a precatory matter, counsel must focus the buyer’s (or lender’s) due diligence on the primary assets being acquired (franchise agreements and other intellectual property). The logical starting point for this review is the seller’s Uniform Franchise Offering Circular. The UFOC sets forth valuable summary information regarding the franchise system, including an identification of the franchisees, operating manuals, technology, relevant trademarks, patents and copyrights, and historical financial information. Counsel should review the UFOC to obtain a thorough understanding of the franchise system and the franchisor. Counsel’s goal should be twofold: � To obtain an understanding of the relationship between the franchisor and its franchisees. � To assess whether the franchisor has complied with applicable laws that regulate the offer and sale of franchises and the ongoing relationship between franchisor and franchisee. Counsel should obtain a historical list, together with copies of all executed franchise agreements, including, but not limited to, standard unit franchise agreements, nontraditional franchise agreements (for locations such as airports, highway rest stops and the like), area development agreements, subfranchise agreements and master franchise agreements. The resulting list should delineate whether the underlying franchised units are in operation by the original franchisees or have been transferred to new owners, terminated, reacquired or have otherwise left the franchise system. This information should correspond with the disclosures made in Item 20 of the UFOC. A careful review of the franchisor’s files with respect to each franchisee is warranted to ascertain the state of the relationship between the parties. For example, counsel should request accounts receivable aging reports from the franchisor setting forth each franchisee’s payment history with respect to initial franchise fees, royalties, advertising fees and other fees required to be paid to the franchisor or its affiliates under the franchise agreement. Counsel should evaluate these reports in conjunction with a review of the franchisor’s files to determine whether any aberrations are due to disputes with the franchisor, poor operating history of the franchisee, general or localized economic conditions or other factors. Specifically, counsel should pay heed to all correspondence and materials related to franchisees in default under franchise agreements, leases, loans or other contracts with the franchisor or its affiliates. FEDERAL AND STATE REGULATING It is important to note that the offer and sale of franchises is regulated by federal regulation and state statutes. Careful consideration should be given to the status of the franchisor’s offering materials on a current and a historical basis. Counsel should obtain a list on a state-by-state basis of all state franchise and business opportunity registrations and exemptions for unit franchises, including effective dates, expiration dates and lapse periods (if any) for the most recent five-year period. A careful review should be undertaken of all correspondence with state franchise and/or business opportunity law administrators. In addition, counsel should obtain copies for such five-year periods of all UFOCs, marked with dates of use and the jurisdictions in which such UFOCs were used. In addition, 17 states, Puerto Rico and the U.S. Virgin Islands have enacted legislation creating standards governing the franchise relationship, especially franchise terminations, transfers and nonrenewals. Franchise agreements and related files should be examined and scheduled for renewal rights, dates of renewal, and obligations on termination and nonrenewal of the franchise agreement. Franchise files also should be examined to evaluate whether the franchisor has complied with applicable default notice and opportunity-to-cure requirements, and prohibitions against unlawful franchise terminations. Counsel also should ascertain whether franchise sales advertising on a current and a historical basis complies with applicable law. Thus, counsel should review copies of all franchise sales copy, including advertisements, brochures and Web site materials used by the franchisor, and all applications filed with state franchise law administrators for approval of such materials. In connection with that review, counsel should obtain a list of all franchise salesmen and franchise brokers employed or hired by the franchisor, to determine whether such employees were properly registered with the appropriate state regulators, and whether such employees used only the approved advertising materials. Counsel should review the UFOC to determine the nature and extent to which the franchisor has protected its principal trademarks and other intellectual property rights. In addition, counsel should require that the franchisor furnish a schedule listing all trademarks, service marks, trademark registrations, trade names, brands, copyrights, patents, trade dress, Internet domain names and web pages, recipes and all other intellectual property rights that the franchisor owns or uses in the franchise system. Counsel should evaluate the resulting schedule and ascertain why some items are subject to registration, and should evaluate the chain of title with respect to such items to ensure that the franchisor has marketable title to each material item of intellectual property. In particular, counsel should ask to review materials concerning or relating to alleged infringements, conflicts or objections to use of the franchisor’s various copyrights, patents, marks, brands, trade dress, and names associated with the system. Counsel should require the franchisor to schedule all disputes, infringements or other actions regarding any trademarks, service marks, trademark registrations, trade names, brands, copyrights, patents, trade dress, Internet domain names and Web pages, recipes and all other intellectual property rights owned, licensed or used by the franchisor and its affiliates. Counsel should be primarily concerned with the state of the franchisor’s principal trademarks. Are they registered on the Principal Register of the U.S. Patent and Trademark Office? Have incontestable rights been conferred upon the franchisor’s marks? It is important to note that while registration on the Principal Register is not a prerequisite for protection, such registration confers a number of benefits that are of paramount importance to a franchisor. For example: � With respect to a registered mark, the filing date of the application is a constructive date of first use that provides the registrant with nationwide priority as to the ownership and use of the mark, subject to the rights of certain prior users. � A registrant has the right to bring suit for infringement in federal court and to recover lost profits, attorney fees and, in certain cases, treble damages. � A registration is considered to be prima facie evidence of a registrant’s ownership and exclusive right to use a mark. Sec. 8(a) of the Lanham Act requires the filing of an affidavit stating that a mark remains in use (� 8 Affidavit) as a prerequisite to maintaining an effective registration. If a mark is not in use in commerce, but the registrant desires to maintain the registration of such mark, the registrant must nonetheless file a � 8 Affidavit explaining the reasons that the mark is not being used and affirming that such nonuse is not an indication that the registrant intends to abandon the mark. In addition to filing a � 8 Affidavit, a registrant may file an affidavit of incontestability under � 15 of the Lanham Act (� 15 Affidavit) with respect to a mark, provided that the registrant has continuously used such mark for a period of five years. The filing of a � 15 Affidavit confers “incontestable” rights with respect to a mark. Thus, subject to certain exceptions, the registration in respect of a mark for which a � 15 Affidavit is filed is as follows: � Conclusive evidence of the registrant’s ownership and exclusive right to use the mark. � Immunity from attack on the basis of the prior use of the same mark by a third party. � Immunity from attack by a third party on the basis that the mark is descriptive. A franchisor may possess myriad works that are subject to copyright protection, such as the following: � Its operations manual, newsletters and software programs, all of which are literary works. � The music and lyrics to advertising jingles, which would be musical works. � Commercials for broadcast over television, which would be categorized as dramatic works. � Print advertisements and point-of-sale materials, which would be categorized as pictorial works. � Advertising jingles, as opposed to the narrative music and lyrics, which would be categorized as sound recordings. � Standard building plans, which meet the definition of the term “architectural work.” Counsel should determine the extent to which the franchisor has obtained the copyright in such works, given that the buyer will want to fully exploit them on a post-closing basis. The Copyright Act confers upon a copyright holder the exclusive rights to do and to authorize the following: � The reproduction of copies of copyrighted works. � The preparation of derivative works. � The distribution by sale, rental or lease of copies of copyrighted works. � The performance of copyrighted work publicly. � The public display of copyrighted works. The value in franchise systems is typically based on an amalgamation of several intangible assets. Adequate due diligence on these systems, therefore, is more subtle and requires a more thorough evaluation of difficult-to-measure intangibles, including franchise revenue streams, consumer good will associated with franchise system marks, and the effectiveness of proprietary operating systems. Counsel for potential buyers of, and lenders to, franchise systems must use the due diligence process to elicit the necessary information related to these intangibles, for the client to be in a position to evaluate the opportunity at hand. Benjamin A. Levin is the partner-in-charge of the franchise and distribution law group at Philadelphia-based Ballard Spahr Andrews & Ingersoll, www.ballardspahr.com. He is the founding chairman of the franchise law committee of the New Jersey State Bar Association and an editor of the American Bar Association’s Franchise Law Journal. Edward J. DeMarco Jr. is a partner in the business and finance department of Ballard Spahr and former chairman of the franchise law committee of the business law section of the Philadelphia Bar Association.

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