Buying an operating franchise can appear less risky than opening a new location. The business may already have customers, employees, equipment, revenue and a recognized brand. However, an existing California franchise can also carry contractual problems, unpaid liabilities, an expiring lease or costly obligations imposed by the franchisor.
The buyer is not simply purchasing a conventional independent business. The transaction normally involves at least three parties: the buyer, the selling franchisee and the franchisor. A landlord, lender and government licensing agencies may also need to approve or participate in the transfer.
Before signing a purchase agreement, the buyer should confirm what is being acquired, whether the franchisor will approve the transfer and whether the location can remain financially viable under the terms that will apply after closing.
Confirm Exactly What Is Being Sold
The first question is whether the buyer will acquire the assets of the franchise business or the legal entity that owns and operates it.
In an asset purchase, the buyer may acquire selected property such as equipment, inventory, customer information and contractual rights. The seller’s corporation or limited liability company generally remains with the seller.
In an entity purchase, the buyer acquires ownership interests in the corporation or LLC. The operating entity continues to own its assets and remain a party to its contracts, but it may also retain debts, tax problems, employment claims and other liabilities.
The purchase agreement should identify all property included in the sale. Important items can include:
- Equipment, furniture and fixtures
- Inventory and supplies
- Intellectual property owned by the local business
- Telephone numbers and approved social media accounts
- Customer or membership records
- Deposits and prepaid expenses
- Assignable permits and contracts
- Rights under the premises lease
- The remaining rights under the franchise agreement
The right to use the franchisor’s name, trademarks and operating system normally comes from the franchise agreement. The seller cannot necessarily transfer those rights without the franchisor’s written consent.
Review the Existing Franchise Agreement
A buyer should obtain and review the seller’s complete franchise agreement, including amendments, renewal documents, guarantees and related contracts.
The agreement may reveal restrictions and expenses that are not apparent from the business’s financial statements. Relevant provisions can address:
- The remaining franchise term
- Renewal rights and renewal conditions
- Royalty and advertising payments
- Technology and software charges
- Required suppliers
- Minimum operating hours
- Training requirements
- Transfer fees
- Mandatory renovations
- Personal guarantees
- Territorial protections
- Default and termination rights
- Dispute-resolution procedures
A location producing acceptable earnings under the seller’s current agreement might become less profitable if the buyer must sign the franchisor’s latest agreement with higher fees or different operating requirements.
The buyer should ask whether the existing agreement will be assigned or replaced. If a new agreement is required, that agreement—not the seller’s older version—will determine the buyer’s future rights and obligations.
Obtain the Franchisor’s Transfer Requirements Early
Most franchise agreements require the franchisor’s written approval before a franchise can be sold. The buyer may need to complete an application, demonstrate sufficient financial resources, undergo background checks, attend interviews and complete training.
The seller may also have to satisfy several conditions before approval, such as correcting defaults, paying outstanding royalties, completing required repairs or signing a release.
California law provides franchisees with important transfer protections. Under California Business and Professions Code Section 20028, a franchisor generally cannot prevent a transfer when the proposed buyer meets the franchisor’s then-existing standards for new or renewing franchisees and the parties comply with the transfer conditions in the franchise agreement.
This does not mean the buyer can take over automatically. Written consent may still be required, and a franchisor may disapprove a buyer who does not satisfy its standards or required transfer conditions.
Understand California’s Transfer Procedure
California Business and Professions Code Section 20029 establishes a procedure for notifying the franchisor about a proposed transfer.
The notice generally must identify the proposed buyer and include the agreements relating to the transfer, along with the buyer’s application and required financial information. If the franchisor’s application forms or approval standards are not readily available, the statute establishes deadlines for providing them.
After receiving all required information and documentation, the franchisor generally has 60 days to provide written approval or disapproval, unless a different period is established by written agreement. A disapproval must state the reasons for the decision.
The purchase agreement should account for this process. The buyer should not be required to close the transaction if franchisor approval, training or another essential condition has not been completed.
Check for a Right of First Refusal
The franchise agreement may give the franchisor a right of first refusal. This can allow the franchisor to purchase the business after the seller receives a bona fide offer from another buyer.
A right of first refusal can affect the timing and certainty of the transaction. The buyer might spend money on legal review, accounting, financing and inspections only for the franchisor to exercise its contractual right to purchase.
The purchase agreement should explain what happens to the buyer’s deposit and expenses if the franchisor exercises that right. It should also prevent the seller from changing material terms in an attempt to avoid or trigger the provision improperly.
Request the Current Franchise Disclosure Document
The buyer should ask for the franchisor’s current Franchise Disclosure Document, commonly called the FDD.
The Federal Trade Commission’s Franchise Rule requires franchisors to provide prospective franchisees with a disclosure document containing 23 categories of information. When the federal disclosure requirement applies, the FDD generally must be provided at least 14 calendar days before the prospective franchisee signs a binding agreement with, or pays money to, the franchisor or its affiliate in connection with the franchise sale.
The precise disclosure obligation can depend on how the resale is structured and the franchisor’s involvement. A buyer should not assume that receiving financial information from the seller replaces the need to review the franchisor’s current disclosures.
The FDD can provide information about:
- The franchisor’s history and management
- Litigation and bankruptcy
- Initial and continuing fees
- Estimated initial investment
- Purchasing restrictions
- Franchisor assistance and training
- Territory
- Renewal, termination and transfer
- Franchisee and outlet turnover
- Financial performance representations
- Franchisor financial statements
- The agreements the buyer may be required to sign
The FDD describes the franchise system. It does not establish that the particular location being sold is profitable or accurately valued.
Verify California Registration
The California Franchise Investment Law generally requires a franchisor to register before offering or selling franchises in California unless an exemption applies.
The buyer can review franchise information through the California Department of Financial Protection and Innovation. Registration does not mean the state guarantees the franchise, recommends the investment or confirms that the location will succeed.
The buyer should verify whether the franchisor is currently registered or relying on an exemption and whether the documents provided match the current California filing. Any inconsistency between the filed disclosure document and the documents supplied to the buyer deserves further investigation.
Compare the FDD With the Transfer Documents
The transfer package may require the buyer to sign contracts that differ from the agreement attached to the FDD.
The buyer should compare every document carefully, including the new franchise agreement, personal guarantee, software agreement, development schedule, confidentiality agreement and required vendor contracts.
Particular attention should be given to changes involving:
- Royalty or marketing percentages
- Technology fees
- Required remodels
- Territory boundaries
- Renewal rights
- Default provisions
- Mandatory purchasing
- Dispute venue
- Arbitration
- Transfer restrictions
- Post-termination obligations
A side letter or verbal statement should not be treated as modifying the franchise agreement unless the franchisor formally agrees in writing.
Investigate the Seller’s Defaults
A location may look healthy to customers while being in default under the franchise agreement.
The seller could owe royalties, advertising contributions, technology fees or supplier balances. There may also be unresolved audit findings, operating-standard violations or required upgrades.
The buyer should request written information about:
- Current and previous default notices
- Unpaid amounts owed to the franchisor
- Quality-control inspection results
- Customer complaints forwarded by the franchisor
- Required corrective work
- Pending termination or nonrenewal notices
- Audit disputes
- Approved or disputed sales reports
- Required remodel deadlines
- Any franchise-related litigation or arbitration
The franchisor’s approval letter should identify the defaults or conditions that must be resolved before closing. The agreement should specify whether the seller, buyer or purchase escrow will pay the associated costs.
Verify the Location’s Financial Performance
A buyer should independently verify the financial performance of the existing location instead of relying on the seller’s asking price or informal earnings claims.
Useful records may include several years of:
- Business tax returns
- Profit-and-loss statements
- Balance sheets
- Bank statements
- Point-of-sale reports
- Payroll records
- Sales tax filings
- Royalty reports
- Supplier invoices
- Delivery-platform statements
- Customer membership records
The records should be compared with one another. Sales shown in point-of-sale reports should reasonably correspond with bank deposits, sales tax returns and royalty reports submitted to the franchisor.
The buyer should separate recurring operating performance from unusual items. A recent increase in revenue might result from temporary circumstances, discounted pricing, unpaid owner labour or deferred maintenance.
Seller-prepared figures such as “owner benefit” or “seller’s discretionary earnings” may add back expenses that the buyer will still incur. The buyer should recalculate expected earnings using realistic wages, debt payments, rent, royalties and capital expenditures.
Examine Every Franchise Fee
The royalty is only one part of the cost of operating a franchise.
Other expenses may include national advertising contributions, local marketing requirements, technology fees, call-centre charges, software subscriptions, training costs, inspection fees and required purchases from designated suppliers.
The buyer should determine whether fees are calculated as a percentage of gross sales, a fixed amount or the greater of the two. Gross-sales definitions may include revenue the business never fully receives, such as amounts connected to promotions, gift cards or delivery services.
Future increases also matter. The agreement may permit the franchisor to introduce new technology, change required vendors or modify operating standards. Those changes can affect profit even when sales remain stable.
Determine Whether Renovations Are Required
Many franchise systems require locations to update their design, equipment, signage or technology periodically.
An existing business may be approaching a mandatory renovation deadline. The seller may be trying to complete the sale before becoming responsible for that expense.
The buyer should obtain written confirmation of:
- Required improvements
- The deadline for completing them
- Estimated costs
- Approved contractors or suppliers
- Whether the location may remain open during construction
- Consequences of missing the deadline
- Whether another renovation could be required during the buyer’s term
A purchase price that appears attractive can become expensive when a major renovation is required soon after closing.
Review the Remaining Franchise Term
The remaining term directly affects the value of the business.
A buyer should not pay for expected long-term income without confirming that the franchise can continue for a sufficient period. If the agreement expires shortly after closing, renewal may require new fees, renovations and acceptance of a substantially different contract.
Renewal is not always automatic. The franchisee may need to satisfy current operating standards, have no outstanding defaults, provide timely notice and sign the franchisor’s then-current form of agreement.
The buyer should distinguish between a contractual renewal right and the franchisor merely stating that it expects to offer a renewal.
Examine the Territory and Nearby Competition
The buyer should identify the exact territory, if any, granted by the franchise agreement.
Some franchise agreements provide an exclusive territory. Others allow the franchisor to open another location nearby, sell through online channels, operate in nontraditional locations or distribute branded products through third parties.
The buyer should also investigate planned locations, recently closed units and changes in customer traffic. A profitable store can lose value if the franchisor opens another outlet nearby or changes its online-order allocation system.
Statements about territorial protection should be compared with the actual contract and FDD.
Review the Premises Lease Separately
A strong franchise cannot succeed at a particular location without the right to occupy the premises.
The lease may require landlord consent before assignment or a change in control of the tenant. The landlord might require updated financial information, a transfer fee, a new guarantee or revised lease terms.
The buyer should review:
- Remaining lease term
- Extension options
- Base rent and scheduled increases
- Common-area and operating expenses
- Maintenance obligations
- Repair responsibility
- Permitted use
- Assignment restrictions
- Personal guarantees
- Relocation rights
- Default history
- Signage rights
- Exclusivity provisions
The lease term and franchise term should be compared. If one expires significantly earlier than the other, the buyer could lose the location while remaining subject to franchise obligations.
Closing should generally depend on receiving all necessary landlord and franchisor approvals.
Identify Personal Guarantees
A buyer may operate the franchise through a corporation or LLC but still be required to provide personal guarantees.
The franchisor, landlord, lender and equipment lessor may each request a separate guarantee. These documents can expose the owner’s personal assets if the business fails to meet its obligations.
A guarantee may continue after the franchise is sold unless the creditor provides a written release. The buyer should also confirm that the seller’s guarantees will be released without creating an obligation for the buyer beyond what was negotiated.
The scope, duration and termination requirements of every guarantee should be understood before signing.
Check Tax Liabilities Before Closing
Buying an existing business can create exposure to certain unpaid tax obligations if the transaction is not handled correctly.
California’s Employment Development Department advises a buyer to request a Certificate of Release of Buyer when a business with employees is sold. Until the certificate is issued, the buyer may need to withhold sufficient funds in escrow to cover amounts owed to the EDD, up to the purchase price.
The buyer should also address sales and use tax clearance with the California Department of Tax and Fee Administration. Relying only on the seller’s statement that taxes are current may not protect the buyer.
The purchase agreement should authorize the necessary tax-clearance requests and permit escrow to withhold funds until the relevant agencies respond.
Review Employees and Workplace Liabilities
An operating franchise may come with an established workforce, but employees are not assets that automatically transfer without legal consequences.
The buyer should review payroll, classifications, wage rates, accrued vacation, sick leave, schedules, meal and rest-period practices, workers’ compensation claims and pending workplace complaints.
California employment law can create significant liability for unpaid wages and misclassification. The transaction documents should specify which party is responsible for obligations arising before closing and how employees will be transitioned.
Indemnification from the seller can be useful, but it is only as valuable as the seller’s ability to pay a future claim. Due diligence remains necessary even when the contract assigns responsibility to the seller.
Confirm Licences and Permits
Business licences, seller’s permits, health permits, alcohol licences and professional or industry-specific approvals may be required. Some are not transferable.
California’s Office of the Small Business Advocate explains that requirements can exist at both state and local levels.
The buyer should identify every permit required to operate and determine whether it can be transferred, must be replaced or depends on an inspection. A closing date should allow enough time to obtain essential approvals.
Operating under the seller’s nontransferable permit can expose the buyer to penalties or interruption.
Investigate Equipment and Inventory
The buyer should inspect equipment rather than assuming that everything visible at the location is owned by the seller.
Some equipment may be leased, financed or provided by a vendor. Other property may be subject to liens. An asset list should identify ownership, condition, serial numbers and any associated payment obligations.
Inventory should be counted near closing and checked for expiration, damage and compliance with franchisor standards. The purchase agreement should explain how inventory will be valued and whether obsolete items are excluded.
A lien search and appropriate release documents may be needed to ensure that the buyer receives the purchased assets free of undisclosed security interests.
Speak With Current and Former Franchisees
The FDD generally contains information identifying current franchisees and certain former franchisees. Speaking with them can reveal practical issues that do not appear in sales presentations.
Questions may address:
- Actual startup and operating costs
- Reliability of franchisor support
- Frequency of required upgrades
- Vendor pricing
- Profit margins
- Territory disputes
- Renewal negotiations
- Reasons locations were transferred or closed
No single franchisee’s experience proves how the buyer’s location will perform. Repeated concerns across several conversations, however, may identify risks that deserve closer investigation.
Make the Purchase Agreement Conditional
The buyer should avoid becoming unconditionally obligated before essential approvals and investigations are complete.
Appropriate conditions may include:
- Franchisor approval
- Delivery and review of disclosure documents
- Landlord consent
- Financing approval
- Satisfactory due diligence
- Tax clearances
- Required licences
- Training completion
- Release of liens
- Resolution of franchise defaults
- Accuracy of the seller’s representations at closing
The agreement should also explain what happens to the deposit if a condition is not satisfied.
If the buyer forms an LLC or corporation for the acquisition, ownership and management documents should be prepared alongside the purchase. TCL’s guide on what happens when a business partner wants to leave an LLC illustrates why ownership-transfer and exit rules should be addressed before disagreements arise.
Verify the Seller’s Statements in Writing
A purchase agreement should contain representations from the seller about the condition of the business and the accuracy of the information provided.
Depending on the transaction, representations may address financial records, taxes, employees, contracts, litigation, franchise defaults, equipment ownership, customer liabilities and regulatory compliance.
The buyer should also negotiate appropriate remedies if a statement proves inaccurate. These may include indemnification, escrow holdbacks or adjustments to the purchase price.
Contract protections do not replace due diligence. They provide a possible remedy after a problem appears, while due diligence is intended to identify the problem before closing.
Coordinate Legal, Financial and Franchise Review
Buying an existing California franchise can involve franchise law, contracts, commercial leasing, employment rules, taxes and business-entity planning.
A franchise lawyer can review the FDD, franchise agreement, transfer requirements and purchase documents. An accountant can test the seller’s financial records and calculate realistic cash flow. Depending on the business, the buyer may also need assistance with employment, licensing, environmental or real-estate issues.
The advisers should review the same proposed transaction rather than working from inconsistent assumptions. The purchase price, financing, franchise term, lease term and required improvements all affect whether the acquisition is commercially sustainable.
Legal Note: This article provides general information about buying an existing franchise in California and does not constitute legal, tax or financial advice. Franchise-transfer requirements depend on the applicable agreements, transaction structure and current federal and California law. Prospective buyers should obtain advice based on the specific franchise and purchase documents.