International Franchise Association47th Annual Legal SymposiumMay4-6, 2014Chicago Marriott Downtown Magnificent MileChicago, IL

Looking Under the Hood:Conducting Due Diligence inFranchise Transactions

Gaylen KnackGray Plant MootyMinneapolis, Minnesota

Grayson BrownTBC CorporationPalm Beach Gardens, Florida

Jeremy HollandRiverside CompanySanta Monica, California

1A. Introduction

Over the past two years, players in the franchise mergers and acquisitions market havewitnessed an increased upward pressure on purchase price multiples for franchisecompanies. At the same time, the number of quality franchise systems on the markethas dropped. This recent market activity has increased the focus and pressure on thedue diligence process. This paper examines the key components of a sound duediligence strategy involving the sale of a franchise system and common limitationsplaced on the party conducting the due diligence. While both buyers and sellers offranchise systems will conduct due diligence in a proposed transaction, this paperfocuses primarily on due diligence that the buyer of a franchise system will or shouldconduct. For additional information on this topic, there have been a number of IFA andABA articles and presentations during the past several years.1

B. Due Diligence Goals

The goals of due diligence in a franchise transaction will vary depending on the natureof the transaction and the parties involved. From the perspective of the buyer, there arecertain goals that are common to nearly all transactions. These include:

1. Provide the buyer some assurance that the initial valuation of the targetedfranchise company (seller) is realistic;

2. Identify potential risks related to the transaction and determine thesignificance of those risks (e.g., risks that are quantifiable and can beaddressed versus risks that are potential deal-killers). The due diligenceprocess also may assist in outlining options to reduce or limit the potentialrisks; and

3. Uncover information that may be useful in the negotiation process,assuming that the due diligence process takes place at a stage wheninformation received can be used in negotiations or to reopen thenegotiation process.

From the sellers viewpoint, the due diligence process may be more limited in value butstill represents an important element in the potential sale of a franchise system. For aseller, the due diligence goals should include:

1. Provide a sense as to how likely and how quickly a proposed transactioncan be completed;

2. Indicate whether the buyer is a good fit for the franchise system and howthe franchisees may perceive the buyer; and

1 See, e.g., Mark Kirsch, Scott Pressley and Patrick Walls, A Sellers Guide to Preparing to Sell theFranchise System, IFA 42nd Annual Legal Symposium (May 2009); Victoria Blackwell and Kevin P. Hein,The Fundamentals of an M & A Transaction in a Franchise System, ABA 33rd Annual Forum onFranchising, Tab W18 (2010).

23. Indicate whether the buyer can and will assume various seller liabilitiestied to the franchise system.

C. Developing a Due Diligence Strategy and Factors Impacting that Strategy

Buyers considering acquiring a franchise system may approach the due diligenceprocess in one of several ways.

1. Factors Impacting Buyers Due Diligence Strategy

Determining the best approach for a particular transaction will depend on various factorsthat may or may not be present, including the following:

(a) Buyers Experience in Acquiring Franchise Systems. Certain buyers mayhave established minimum due diligence standards and, from a risk tolerancestandpoint, may be unwilling to deviate from those standards. These buyerssimply may refuse to move forward in acquiring a target franchise system if doingso would force the buyer to significantly alter its normal due diligencestandards.

(b) Number of Potential Suitors for the Target Franchise System. Franchisesystems that are highly desirable will likely garner interest from a significantnumber of potential buyers. In those situations, a potential buyer may find thatthe seller has less patience for a more thorough due diligence process or, inanticipation of such a reaction, scale back, bifurcate or otherwise modify itsprocess to increase its chances of successfully acquiring the target franchisesystem.

(c) Seller Limitations Placed on the Due Diligence Process. These limitationsmay be in the form of a condensed time period during which the buyer mayconduct due diligence, the amount of information that the seller makes availableto the buyer, and the stage in negotiations during which the seller may permitdue diligence. Seller limitations on the due diligence process appear to haveincreased during the last few years as potential interest in target franchisesystems has exceeded the supply of possible target systems. Sellers haveimposed severe limits on the length of the due diligence period in a number ofrecent acquisitions. The authors are aware of several transactions in which thedue diligence period was limited to two weeks or less. A sellers ability to imposesuch limits on buyers often depends on the number of interested buyers, thetarget price and the perceived challenges respecting the target franchise system.

(d) Buyers Familiarity with the Target Franchise System. A buyer that has anexisting stake in the target franchise system, such as the existing managementteam, a minority investor or a franchisee or group of franchisees within thesystem, will likely be willing to conduct more abbreviated due diligence thanwould a third party that does not have such experience. Buyers with insideknowledge often will have an advantage over other potential buyers, especially in

3potential transactions in which the seller imposes limitations on the due diligenceprocess.

Two related transactions in 2011 reflect the advantages an insider may have inacquiring a franchise system. In 2011, two separate groups of franchiseessuccessfully acquired the then-struggling A&W and Long John Silversfranchise systems from the franchisor, Yum! Brands. In each situation, theeventual buyers were longtime franchisees of the target franchise system, wereintimately familiar with many of the shortcomings of the franchise system andlikely felt it was unnecessary to conduct extensive due diligence. That approachwas in contrast to the demands of other potential buyers that were in need ofmore information to assess the risks associated with the two franchise systems.For Yum! Brands, the sale to a group of franchisees would involve a less rigorousdue diligence process, and less demanding representations and post-saleindemnification obligations, than a sale to outsiders. That was likely the reasonthat the group of franchisees was successful in acquiring the franchise systems.

(e) Reliability of the Information Sought or Received from the Seller. Thebuyers approach to due diligence will be impacted by the integrity of the sellersrecordkeeping information as well as the integrity of the seller. Buyers are oftensurprised by the poor recordkeeping practices of sellers, practices that oftenpresent an unclear picture of the health of the franchise system. Examples ofpoor recordkeeping include missing or incomplete franchise sales files (e.g.,certificates or other evidence of insurance, franchise disclosure document (FDD)receipt pages, FDD order letters and exemption filings, and related documentsand filings), poorly worded or undetermined protected territory descriptions infranchise agreements, and scattered franchise operations files. Poorrecordkeeping may increase litigation risks and ultimately diminish the value ofthe franchise system or increase demands for greater protection againstunforeseen problems. Greater concerns arise when the buyer senses that theseller is less than forthcoming in cooperating with the buyers due diligencedemands or purposefully restricts access to damaging or less than favorableinformation. This latter concern may impact not only the buyers approach to duediligence, it may result in the buyer terminating negotiations.

(f) Size of the Target Franchise System and the Buyers Due DiligenceBudget. If the target franchise system is large or the buyers budget allocated tothe due diligence process is relatively tight, the buyers approach to due diligencewill be impacted. The buyer likely will not have the resources to review everyfranchise agreement in detail in large franchise systems. In these situations, thebuyer must choose representative samples and attempt to project those findingson the balance of the franchise system. Selecting representative samples, aswell as projecting such findings, can be challenging and, if not handled correctly,can lead to faulty conclusions.

With these factors in mind, buyers will need to identify the specific due diligence goalsfor the transaction and a strategy to achieve those goals. At an early stage in

4negotiations, the buyer will need to assess the scope and focus of due diligence, thetiming of due diligence and the environment in which due diligence will occur.

2. Due Diligence Checklists

Buyers typically will develop a due diligence checklist to ensure that it gathersnecessary information on the sellers franchise system to satisfy its due diligence goals.In fact, the buyer may develop two due diligence checklists an internal checklist thatidentifies preliminary issues and a more complete checklist that is shared with the seller.An internal checklist, if developed, should include items necessary to determine whetherthe target system is worth pursuing. This checklist should address issues such as theability to take advantage of synergies between the target system and those of the buyer(e.g., parallel products or services as well as common or similar supply chains),potential territory conflict among the systems and the potential or perceived impact onthe buyers existing franchisee base. The buyers financial and legal departmentsshould assess information obtained through this internal due diligence process to helpdetermine if the buyer should place a bid on the target system or enter into the letter ofintent (LOI) stage with the seller.

Following the development and review of an internal due diligence checklist, counsel forthe buyer should prepare a list of relevant documents to request from the seller.Exhibit A to this paper is a sample due diligence checklist that buyers may work from ina franchise transaction. This checklist focuses only on franchise-related documents andshould be supplemented by items addressing general corporate matters as well asindustry or system specific matters. Because due diligence checklists typically areexhaustive and may overwhelm the seller, a buyer often will tailor the checklist to thespecific transaction. Alternatively, a buyer may deliver a more general checklist andforce the seller to react to such a checklist. In either situation, and as further describedbelow, the buyer should discuss the process with the seller and make some initialinquiries before providing the seller with the checklist.

3. Starting the Due Diligence Process

One of the first questions involving the due diligence process is one of timing whenshould it occur? The answer will depend on a number of factors, including whether thebuyer is involved in a bidding process with others, the buyers familiarity with thefranchise system, the sellers willingness to be transparent and the sellers projectedtimetable for closing. The buyer often will be inclined to conduct due diligence involvingkey legal and financial matters early in the negotiation process or in several stages.The first stage will likely occur before the parties reach a preliminary agreement, or LOIstage. The buyers finance and legal teams will assemble a short list of critical mattersto review (e.g., outstanding franchisee disputes, franchise sales activity, and royalty andother revenue source trends) to determine whether the target franchise system satisfiesthe buyers general criteria for a potential acquisition. Information gathered early duringthe due diligence process can play a role in negotiating price and other key terms withthe seller. More detailed legal and financial due diligence can take place after the

5parties reach a preliminary agreement, though generally before negotiation of thepurchase agreement.

Conversely, the seller may not want to permit the commencement of due diligence untilnegotiations are further down the road in an effort to limit the buyers efforts to leverageinformation received during the due diligence process in negotiations. Delaying duediligence may also give the seller some comfort that the buyer is committed to theprocess before the seller expends time and energy in participating in the due diligenceprocess. At an early stage, the seller should require some form of a non-disclosureagreement (NDA) to protect proprietary information that otherwise could be damaging tothe franchise system if made available to competitors or otherwise made public.

As part of, or following, this initial stage of due diligence, the buyer should develop amore comprehensive due diligence plan and timeline for due diligence. The buyershould also schedule a meeting or call between the seller and buyer to discuss thescope, timing and mechanics of the buyers due diligence. This initial meeting isespecially helpful in situations where the sellers management team lacks experience inresponding to due diligence requests in a franchise setting or where the buyer has littleknowledge of the target franchise system. During this meeting, the buyer can outline itsrequests for documents and discuss the mechanics for receiving such documents, aswell as a timeline for receiving them. The buyer also can gauge the level of cooperationit can expect from the seller and potential challenges in conducting due diligence.Sellers counsel, on the other hand, will likely need to balance cooperation with the needto reasonably limit overly broad requests expected from the buyer.

D. Addressing Key Areas of Concern Through Due Diligence

What aspects of the franchise system should a due diligence review cover? A strategicdue diligence review will cover a variety of subjects, some of which will vary dependingon the targeted franchise system and the buyers familiarity with the system. Duediligence conducted on a target franchise system typically will involve the following:

1. Assessing the Strength of the Franchise Systems Intellectual Property

The intellectual property of a franchise system its marks, logos, proprietary software,domain names, trade dress, copyrights, and proprietary manuals and other tradesecrets form the foundation of the franchise system. Assessing the vulnerability ofthose assets is a key aspect of a comprehensive due diligence plan. Each intellectualproperty asset should be assessed in terms of its inherent strength, protectability and itsvalue to the franchise system. This assessment should take into account the currentenvironment in which each asset exists, as well as the future environment in which itmay operate.

(a) Service Marks and Trademarks. The service marks and trademarks(including logos) that identify a franchise system obviously are critical assets ofthe target franchise system. The buyer must closely examine the primary marksto assess their distinctiveness and overall strength. To adequately determine the

6strength of the sellers marks, the buyer should analyze several factors. First,are there questions regarding the sellers ownership of its trademarks or otherissues relating to their legal validity? Are the primary marks distinctive or havethird parties registered similar marks in the same or related classes? To theextent the seller relies on a primary mark that is not distinctive to identify afranchise system, the buyer of such a system will likely face more challenges inprotecting the mark and avoiding confusion in the marketplace. Has the sellerregistered the primary marks in the form and classes of goods and services inwhich they are used in the franchise system? To what extent do third partieshave prior rights of use in key geographic areas? The seller should have a solidbase of information on any prior third party use of each key mark. Second, hasthe seller effectively protected and policed its trademarks both within thefranchise system and from potential infringing use by third parties? Mistakesoften occur in the policing and protection of key marks mistakes that can stiflefuture growth and possibly threaten ownership of the mark. Policing mistakesmay arise from an actual or perceived lack of resources to pursue third partyinfringers, including former franchisees, or from a failure to follow through oninitial enforcement measures to ensure that infringing activity has ceased.Finally, to the extent the targeted franchise system has been or potentially maybe exported to other countries, has the seller established a sound strategy forinternational protection of its primary marks and sought registration of thosemarks in key foreign markets? Franchisors without such a strategy may fail toact quickly enough to register key marks in foreign markets and find that a thirdparty has filed a prior application for the same or similar mark. In thosesituations, the buyer may find that the primary mark is unavailable in key foreignmarkets deemed important for future growth.

Finally, the buyer should ask whether the seller has registered all key domainnames relating to the marks and the targeted franchise system? The buyershould determine whether the seller has maintained control over key domainnames respecting the franchise system domestically and in foreign marketswhere the seller currently conducts activity or may plan to do so in the future.

(b) Proprietary Software. Proprietary software and other system specificintellectual property can distinguish a system from its competitors so long as theseller preserves clear ownership of, and has appropriately protected, theproperty. A number of franchise systems employ the use of proprietary software.To the extent proprietary software is employed in the target franchise system, itcan provide the system with a competitive edge in the marketplace and improvefranchisee operational performance. While proprietary software often serves asa valuable asset to the franchise system, the buyer should review certainattributes of the proprietary software to determine the actual value of that asset.First, the buyer will need to determine whether the seller or an affiliate owns thesoftware or if ownership rights reside with a third party, possibly a softwaredeveloper. If the seller or an affiliate owns the software, will that asset betransferred to the buyer at closing? To the extent a third party owns theproprietary software, what rights does the seller have to continue using and

7licensing the use of the software and what obligations must the seller satisfy tocontinue using the software (e.g., sale of a minimum number of softwarelicenses)? How does the software license agreement address future updatesand maintenance and who shoulders the burden of those expenses? Can thethird party owner license the same or similar software to others, including thesellers competitors? These inquiries will assist the buyer in determining thevalue of any proprietary software used in the targeted system.

(c) Operations Manuals, Confidential Information and Other IP Assets. Theoperations manual can serve as a key asset of a franchise system or as anindicator of underlying problems in a troubled franchise system. The operationsmanual should be regularly updated and reflect existing system standards andprocedures. The buyer should assess the content of the operations manual toensure that it is drafted to help shield the seller from potential liability. The buyeralso should determine to whether the seller maintains other valuable IP that canincrease the long-term value of the franchise system. The buyer should assessthe importance of secret recipes, customer and supplier lists and any otherconfidential information and steps taken by the seller to protect the confidentialityof that information. Similar assessments should be conducted respecting otherpotentially valuable IP, such as copyrights, patents and the sellers website.

2. Assessing the Strength of the Franchise (and Related) Agreements

Any purchase of an ongoing business requires the buyer to perform a significantamount of due diligence to understand the risks and liabilities the purchase entails.With the purchase of a franchise system, the due diligence often starts with a focus onthe franchise and related agreements, which serve, along with trademark rights, as theselling companys most valuable assets.

The buyer should review how many versions of the sellers franchise agreement exist,how they differ, which units they cover and when they expire. For most companies,lining up the versions by year will work best because franchisors usually make contractchanges when it annually updates its FDD. The buyer should request a summary of thenumber of franchisees operating under each version of the franchise agreements,especially versions with lower fees, longer terms, larger territory grants and othermaterial terms the seller later changed.

The buyer should review whether the franchise agreements give the seller flexibility inresponding to dynamic changes in the marketplace. If not, the buyer may facerestrictions in implementing changes in the system going forward. As discussed below,the scope of rights granted to franchisees and outdated technology provisions tend tobe two provisions that can restrict future system changes.

A thorough and useful contract review will summarize significant changes that haveoccurred over the years in royalty fees, marketing fees, technology and other fees,territorial rights and other key areas.

8(a) Assignability of Franchise and Other Key Agreements. Before advancingfar into a review of the targeted franchise systems franchise agreements, thebuyer must ensure that the franchise agreements, as well as other significantagreements, can be assigned upon sale of the system. Buyers generally findthat the systems franchise agreements include provisions permitting the seller toassign its interests in the agreements without the consent of the franchisees.The buyer will need to confirm that each version of the sellers franchiseagreements includes these provisions and that the seller has not modified theseprovisions for select (often pioneer or large multi-unit) franchisees. The buyeralso should review key vendor contracts, leases and other significant contracts todetermine what, if any, third-party consents must be obtained as part of theacquisition of the targeted system. To the extent a third party consent isnecessary, the buyer will need to discuss with the seller any challenges inobtaining third-party consents and who will be responsible buyer or seller inobtaining such consents.

(b) Scope of Grant/Reservation of Rights. The buyer should determine theexact nature of the license granted in the franchise agreement. How broad arethe rights granted and what rights has the seller reserved? Has the sellerconsistently defined the rights granted to franchisees and rights reserved to theseller or do earlier versions of the franchise agreement grant franchisees broaderor different rights? The buyer should determine whether the seller has reservedrights as to potential future markets such as internet sales, captive markets andnational accounts (if applicable). Rules should be established, either in thefranchise agreement or the operations manual, regarding the franchisors rightsto sell to customers in a franchisees territory and a franchisees right to sell inanother franchisees territory. Finally, did the disclosures in the FDD accuratelyreflect the rights granted to each franchisee? Surprisingly, inconsistenciesbetween the franchise agreement and the FDD arise and can blur rights grantedto franchisees.

(c) Addressing Territory Conflict. To the extent the buyer owns similar orcompeting franchise systems, or may do so in the future, it will need to assesswhether the rights granted to the sellers franchisees may conflict with the currentor future rights of franchisees in the buyers existing franchise systems. Do thetargeted franchise systems franchise agreements specifically permit the seller tooperate or franchise other or competing brands within the franchisees territory?If the targeted systems franchise agreements do not specifically reserve thisright to the seller, the buyer will need to assess the ability to proceed with thetransaction and the reaction of the targeted systems franchisees. Even if thetargeted systems franchise agreements specifically permit the seller to operateor franchise competing brands within the franchisees territory, the buyer willneed to determine the possible reaction of the sellers franchisees as well as thatof the buyers existing franchisees.

(d) Flexibility to Modify the System. The buyer should analyze whether thefranchise agreements are adaptable and give the seller flexibility in responding to

9dynamic changes in the marketplace. Can the seller update system technology,add new product lines, change suppliers, create value programs or add servicesthat could not have been anticipated when the franchise was first sold?

(e) Number of Negotiated Changes; Special Deals and Atypical Provisions.The buyer must evaluate whether the seller has followed a uniform contractprogram. In the interest of growing the system and completing sales, the sellermay have granted numerous concessions and made side offers favorable to thefranchisee. The buyer will need to search for and catalog these negotiated dealsand consider the implications of administering a non-uniform system. Did theseller comply with franchise sales laws in negotiating changes to the standardform franchise agreement? For example, negotiated changes to franchiseagreements involving California franchisees or franchises located in Californiarequire compliance with unique negotiated change rules in California. The buyershould also consider the implication of negotiated changes from a long-termperspective. When renewal time arrives, how successful can the buyer expect tobe with these one-off deals in imposing a standardized agreement as acondition to renewal of the franchise?

The buyer also will need to identify any unusual provisions that are atypical infranchise programs, which may create a material risk to the buyer as the newowner. For example, if a franchisee can easily terminate the franchiseagreement without cause or get a royalty reduction if certain sales levels are notachieved, the seller may face the loss of all or a portion of its revenue stream forthat contract. The buyer should factor this risk into the purchase agreement witha price reduction, hold-back or an indemnity.

(f) Existence of Promises or Oral Agreements Outside of the WrittenContract. The buyer should not limit its review to specific provisions of thetargeted systems franchise agreements in determining the sellers rights. Itshould also consider what expectations have been created by communicationswith the franchisee community - whether those communications take place one-to-one, with a select group of franchisees, or with franchisee council. Whatsafeguards, such as closing acknowledgments, has the seller implemented tolimit franchisee claims that are based on representations outside the franchiseagreement? Have the sellers practices led to lower franchise standards? If thefranchise agreement calls for the achievement of minimum sales, has the sellerenforced such provisions? In situations where the seller has not enforcedfranchise agreement provisions, has it instituted a new day program (i.e. Wevelet you slide in the past, but now were getting serious about compliance and willhold you accountable to our standards going forward) and with what successand ongoing implications to the enforceability of standards?

(g) Creating Flexibility through the Operations Manual. The sellers franchiseagreements should be complemented by a quality operations manual to createthe flexibility needed to modify system standards in the future. The buyer shouldreview the franchise agreements to determine if the seller has properly used this

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tool to create such flexibility. In addition, the buyer should carefully review theoperations manual, including the frequency and manner in which it has beenupdated. The seller should have a standard method for implementing systemchanges through the operations manual and for notifying franchisees of eachchange to the operations manual as it occurs. A thorough review of theoperations manual, however, goes far beyond understanding modifications ofsystem standards. An operations manual should assist a franchisor in limitingliability resulting from activities occurring at the franchisee unit level. Anoperations manual that is not carefully drafted can result in potential vicariousliability for a franchisor due to the level of control exercised or available to thefranchisor through the operations manual. The buyer should review theoperations manual for common mistakes, such as directives intended forcompany-owned units or excessive and detailed direction on employment orsafety-related unit standards.

3. Gauging Compliance with Franchise Sales and RelationshipLaws/Practices

Franchisors must comply with franchise and business opportunity laws regulating thesale of franchises, as well as the franchise relationship. Failure to comply with theselaws can lead to costly regulatory actions, legal claims by franchisees or challenges tothe future enforcement of franchise agreements. These claims or actions often arisemonths or years following the sale of the system and a buyer who steps into the shoesof the seller under franchise agreements often is left facing such claims or actions. Forthis reason, the buyer must review the target systems compliance with franchise saleslaws and franchise relationship laws.

(a) Franchise Disclosure Document. The buyer often will need to examine(preferably for at least 5 years) the FDD prepared by the seller for compliancewith applicable federal and state disclosure requirements. Key areas addressedin the FDD that deserve focus include the following:

(i) Consistent Disclosure of Franchise Agreement Provisions. TheFederal Trade Commission (FTC) Rule on Franchising2 (the FTC Rule)and state law requires a franchisor to disclose, in an FDD, informationabout the franchisor, the franchise system and terms of the franchisorsfranchise agreement. As previously discussed, the buyer shoulddetermine whether there are inconsistencies between the FDD and theterms of the franchise agreements. Although this may seem an unlikelymistake, the failure to align provisions does occur. For example, thefranchise agreement may state that the seller can increase fees up to acapped percentage or amount, but the FDD may use language that doesnot track uniformly with the franchise agreement, creating an ambiguity asto what fees can be charged. As another example, the franchise

2 16 C.F.R. 436.1, et seq. (formally titled Disclosure Requirements and Prohibitions ConcerningFranchising).

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agreement may permit the seller to offer a competing brand under adifferent trademark, while the FDD may state that the seller will not openor franchise another outlet within the franchisees territory, leaving itquestionable as to what is permitted or prohibited. The integrationprovision in the franchise agreement, if prepared under the FTC Rule, willlikely state that the provision is not intended to change any representationin the FDD, leaving the buyer with the task of dealing with this ambiguity.

(ii) Litigation. The disclosure of litigation in Item 3 of the FDD is animportant disclosure item for prospective franchisees and the failure tomake appropriate disclosures could lead to future claims. For additionalreasons, however, litigation - including any action subject to disputeresolution - deserves special attention when considering whether toacquire a franchise system. The buyer will need to understand whatlitigation exists and how it will be treated in negotiating the purchaseagreement. The buyer also must determine whether existing or pastregulatory actions or litigation may lead to similar claims in the future. Inaddition, the buyer should investigate the industry in which the systemoperates for recent litigation trends. For example, if the FTC or a stateattorney general has investigated a type of practice or product used in thesellers industry, other states may jump on board in pursing copy-catinvestigations or third parties may initiate class action or multi-partyclaims, often at great expense to the seller.

(iii) Financial Performance Representations. Financial performancerepresentations (FPR) merit detailed scrutiny as well. To the extent theseller has included an FPR in the FDD, the buyer will want assurance thatthe seller has strictly complied with FTC and applicable state franchise lawstandards for disclosure and that sales force activities have beenconsistent with Item 19 disclosures. Within the parameters of what isallowable for an FPR in Item 19, the buyer needs to understand that theseller has flexibility in selecting the categories of information to disclose inItem 19 and the manner of the presentation to make it look favorable. Forthis reason, the buyer should require the seller to provide detail todemonstrate that it has a reasonable basis for an FPR, together withwritten substantiation of the data to back up its representations. Thissubstantiating data separately may assist the buyer in understanding unitlevel sales and profitability (see Section D.4 on financial considerations).The buyers task in reviewing the sellers sales practices where no Item 19FPR exists is more challenging. The buyer will need to take steps todetermine whether the seller and its sales force has made any FPRsduring the franchise sales process. The buyer should obtain assurancesfrom the seller and review any supporting documentation (such as closingacknowledgments) to verify, to the extent possible, the sellerscompliance.

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(b) Franchise Sales Compliance. The buyer will need to determine if theseller has taken a disciplined approach to its franchise sales practices andongoing franchisee administration. The number of franchise files reviewed by thebuyer in the due diligence process will depend, in part, on the size of thefranchise system. A buyer of a large system normally will not want to devote theresources to review all FDDs and related franchise agreements. The buyer willneed to develop the parameters of the review, given the buyers budget, the timepressures of the deal and cooperation of the seller. The review usually wouldinclude the form FDDs, as well as FDDs that vary from the standard form for usein certain states, from each year of franchise sales going back a minimum of five(5) years.

(i) Scope of Review. When reviewing the FDD, the buyer shouldanalyze a number of questions to help flush out typical franchisecompliance violations. Was a receipt signed by the franchisee or a keyindividual of the franchisee entity? Does the date of the franchiseagreement, when compared to the date of the signed receipt and othercorrespondence, confirm compliance with FTC and individual statedisclosure waiting periods? To the extent the sale involved one or morefranchise registration states, did the seller have current registrations inthose states? Was the current version of FDD provided? In particular, ifthe FDD was renewed after the date of the franchisees receipt, was theupdated FDD provided and the waiting periods observed?

Further inquiries should reveal poor or improper franchise sales or poorrecordkeeping. For example, was the franchise agreement properlysigned by the party acting as the franchisee? Did all required owners of afranchisee entity sign the guaranty? Was each ancillary agreement andany state specific addendum signed and dated? Were the exhibitscompleted properly? Franchisors frequently forget to complete theterritory description upon signing the franchise agreement and may leavethe description blank or state TBD (to be determined). How manyfranchise agreements reflect negotiated changes as a percentage of thesystem? A high percentage of franchise agreements with negotiated termscould indicate weakness in the system and the sellers desire toemphasize sales over the need for uniformity within the system.

(ii) Reviewing State Orders and Correspondence. The buyer shouldrequest copies of state franchise registration orders, comment letters andrelated correspondence for prior years. This information will reveal theperiod during which the seller had an effective registration in eachapplicable state and help the buyer determine whether any franchiseswere sold in violation of state franchise registration laws. Comment lettersfrom state examiners also may suggest whether the FDD has beenprepared properly and completely.

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(iii) Franchise Sales Advertising Materials. The buyers due diligencealso should include a review of any advertising materials that the selleruses to identify prospects and sell franchises. The review should:(1) assess whether the seller has complied with registration requirementsfor such materials; and (2) determine whether the materials included anyinformation that was inconsistent with the FDD or franchise agreement. Inparticular, advertising materials may contain financial performancerepresentations that do not appear in, or are inconsistent with, Item 19.

4. Financial Considerations

One major goal for the buyer in completing its due diligence is to assess the financialstrengths and weaknesses of the targeted franchise system. The buyer will base theprice it is willing to pay for the system on the systems current value and its potentialupside The financial statements and reports, once vetted, form the backbone of thesystems valuation. In addition to effective working relationships, franchising at its coreis about good unit economics. A complete financial review means delving into theavailable financial statements of the seller and drilling down beyond seller revenues intokey components, such as the unit level financial performance and revenue derivedthrough the sellers distribution chain practices. Special attention should be given to thefollowing:

(a) Financial Due Diligence Overview.

(i) At the System or Enterprise Level. The FDD requires that the sellerdisclose audited financial statements. The buyers accountants normallywill conduct a financial review that may include, if time and money allows,a thorough quality of earnings analysis. The buyers legal and accountingadvisors should compare notes in the audited financial statements withdisclosures in the FDD. If the financial statements contain differentinformation than that found in the FDD, such as number of units orrevenues of the company-owned stores, the buyer should investigate thediscrepancies further. The buyer also should review year-to-dateunaudited interim statements, correspondence between management andthe accountants, outstanding contracts for capital expenditures in excessof a stated threshold, material write-downs or write offs, unit level salesand expense specifics, and marketing fund data detailing contributionsand expenditures.

(ii) At the Unit Level. Depending on the size of the target system andother factors, such as the age of the system, type of concept, andfranchisee compliance with financial reporting requirements, the dataavailable at the unit level for buyer review will vary greatly from system tosystem. Some of the information available from the unit levelinclude: (1) periodic (weekly or monthly) gross sales reports; (2) annualprofit and loss statements, as well as balance sheets; (3) periodicinventory reports; (4) periodic lead generation and follow-up reporting; and

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(5) periodic fee payment reports (royalties, marketing fund, technologyand fee-for-services). In addition, the seller will usually generatecompilation reports that indicate franchisee delinquencies, accountsreceivable aging reports, and franchisee product purchases from thefranchisor, its affiliates or third party suppliers. For a seller with goodmanagement skills, the compilation reports should result in actions plansdesigned to address system-wide and franchisee specific concerns.

(b) Income from Initial Franchise Fees. The buyer should scrutinize trendsrelated to recent spikes in revenue. In particular, the buyer should determine theincome attributable to initial franchise fees, which are non-recurring, versusroyalty income, which is recurring. Has the seller aggressively sold franchises toboost income in preparing for a sale of the business? If so, has the sellerfollowed acceptable accounting practices and recognized this revenue only uponthe opening of the outlet? The answers to these questions may determinewhether part or all of the income should be included in EBITDA.

(c) Analysis of Royalty Income. The buyer must understand not only theamount of the historic royalty stream but also the factors that may affect theprojected royalty stream in the future. For example, is the unit level performancewithin a consistent range across the system or do a few strong franchiseeoperators with multiple locations masque poor performance by other franchiseeswhen averaged together? Do the franchisees generally pay on time or is there ahigh delinquency rate? A high delinquency rate may signal a lax enforcementpolicy or signs of unit level challenges.

(d) Financial Performance Representations. The buyer should carefullyreview Item 19 of the sellers FDD. The FTC Rule requires that any FPR madeby the seller appear in Item 19 - and only in Item 19. Whether and how the sellerhas prepared Item 19 is important in assessing both the sellers overallcompliance with franchise laws and the systems financial strength at the unitlevel. If the seller has not prepared an FPR for inclusion in the FDD, why has theseller elected not to do so? If Item 19 discloses only company-owned data, whyis the FPR limited to this information? And if franchise store data is disclosed,what are the limitations and assumptions for this data? In analyzing theseissues, the buyer can gain significant insight on the financial picture of thefranchise system.

(e) Payback Period for the Franchisees Initial Investment. What is the timeperiod for the franchisee to reach a breakeven point and become profitable?Does this time period differ greatly across geographical regions or for otherreasons?

(f) Turnover Rate. A buyers review of the sellers future viability will not becomplete without evaluating the churn rate of franchise units. The buyer shoulddelve into the specifics of why franchises have closed. This point is discussed inthe franchisee relationship section in more detail but it also is important in

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analyzing the financial picture of the franchise system. The buyer should reviewcarefully the Item 20 tables to determine the turnover rate and contact formerfranchisees identified in the FDD to determine why these former franchisees areno longer in the franchise system. Typically, former franchisees are willing todiscuss their concerns and complaints involving the system and the seller.Buyers should note if one or more franchisees are unwilling to discuss theirexperience within the franchise system as it may result from a settlementrestricting the former franchisee from disclosing any information.

(g) Competitive Dynamics of the Market. As with any potential target, thebuyer must investigate the size, growth potential and competitive dynamics of themarket in which the franchise system operates. What is the reputation of thebrand in the eyes of the consumer? What outside forces might threaten the futureviability of the system? For example, will the car oil change/repair industry facenew environmental waste disposal laws that impact the expense structure forfranchise units? Will the profitability of a restaurant franchise be affected bycompliance with menu disclosure laws? To what extent will changes in theminimum wage, overtime laws and Obama-care health initiatives affect thebottom line of a franchise system? To project the future growth of a franchisesystem, the buyer will need to further examine these issues.

(h) Aging in the Franchisee Ownership Ranks. A buyer should consider theage of the franchise owners. Will the system experience high turnover in thenear future due to the high level of long time owners in the system? Has theseller developed a strategy to address these potential transitions? Franchisorsthat have been proactive in developing succession planning strategies for theirfranchisees can avoid or limit the impact of this potential issue. The buyer shouldassess both the potential for and ease of turnover for franchised businesses inthe system.

(i) Marketing/Advertising Fund Treatment. The buyer should review thetreatment of the marketing (or advertising) contributions in the financialstatements and in practice. Most marketing contributions are funds that arerestricted in that they can be used only for certain marketing-related uses asdescribed in the sellers franchise agreements. The system franchiseagreements may require the seller to segregate the funds by holding them in aseparate account. The buyer also should be alert to intentional or inadvertentcommunications or provisions in the franchise agreements that subject the sellerto serve as a fiduciary respecting the funds, an extremely high standard thatcreates a greater risk in the use of those funds. Has the seller segregated themarketing fund from other revenue? Has the seller maintained good records ofthe amount and type of expenditures made from the marketing fund? Havefunds been used for questionable purposes that do not satisfy the sellerscontractual obligations in the franchise agreements? Because the sellers use ofthe marketing fund is often scrutinized and subject to criticism by franchisees,both the relevant provisions in the franchise agreements and the sellersrecordkeeping are important in avoiding or limiting disputes.

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In older franchise systems, franchise agreements containing outdated marketingprovisions may further limit the use of marketing funds. In the case of olderfranchise agreements predating the internet era, the description of the marketingactivities in the franchise agreement for which funds can be used may overlyrestrict the seller. For example, language permitting only traditional uses such asthe purchase of print or TV ads will prohibit the seller from using funds for manysocial media and marketing purposes. Franchise agreements also may notexpressly permit or otherwise may cap in-house expenses incurred inadministering the marketing fund. The buyer of a system with franchiseagreements containing these provisions will likely find it difficult to amend thefranchise agreements to address these restrictions prior to renewal.

(j) Technology Considerations. The buyer should evaluate the POS systemand back office computer system capabilities. As discussed earlier, does theseller own proprietary software that gives franchisees a competitive advantage?If the seller uses proprietary software owned by a third party vendor, the buyerwill need to understand the terms under which the seller has access to thesoftware and identify terms that could restrict further growth or modifications tothe POS system. How does the sellers technology compare with that of itscompetitors? Does the computer system allow the seller to easily accessfranchisee revenues and other financial information? Assessing scalability anduser friendliness also are key factors to consider, as is gaining an understandingof what data the systems can capture and whether the seller owns or can accessthe data. Finally, do technology provisions in the system franchise agreementsprovide sufficient flexibility for the buyer to easily modify or replace the existingPOS system and recoup the cost of such changes. Franchise agreements and,to some extent, FDDs, can restrict the seller (and the buyer) from institutingchanges or imposing/increasing technology fees to cover the cost of system widetechnology modifications.

5. Measuring the Franchise Systems Growth Potential

The ability to expand or develop new revenue generators within an acquired franchisesystem is central for any buyer. Is there room for geographic expansion, both in theU.S. and internationally? Has the franchise system been tested outside the U.S.? Tothe extent the franchise system has the potential to expand outside existing markets,either within the U.S. or in foreign markets, what factors must be considered indetermining whether the system can thrive in those new markets? Can the buyermodify or expand the system to increase revenue, such as adding complementaryproducts or services? The buyer also may consider co-branding opportunities and otherrevenue-generating synergies involving existing systems the buyer may operate.Potential expansion, whether geographical or product/service based, often will not be afactor in determining enterprise value unless the seller has a track record on which tobase likely success of such expansion. The buyer will need to consider these and otherfactors, which could contribute to or potentially impede future growth.

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6. Understanding Purchasing and Supply Chain Issues

Depending on the franchise system involved, purchasing and supply chain issues mayplay an incidental or significant role in assessing the value of the system. For nearly allfranchise systems, the buyer will need to conduct due diligence as to purchasing-relatedissues. What key goods or services must each franchisee acquire and how has theseller structured acquisition of, and control over the purchase of, these goods orservices? For franchisees in certain franchise systems, purchasing focuses simply ongoods and services necessary to conduct the franchised business. For franchisees inretail and many food-based systems, however, the supply chain becomes a much morecentral aspect of the franchise system. What role does the seller or its affiliates play inthe supply chain? In many franchise systems, the seller (or its affiliates) may supplygoods or services directly to franchisees. In those situations, to what extent does theseller profit from sales of these goods or services and is the sellers pricing structurecompetitive with that of third parties? In other franchise systems, the seller may imposerestrictions on the type of goods/services or the vendors from whom the franchiseesmust purchase. The buyer should review these restrictions to ensure they areconsistent with antitrust regulations and satisfy systemwide objectives.

In conducting due diligence involving purchasing and supply chain issues, the buyer willneed to review franchise agreement provisions and operational standards established tomonitor or control franchisee purchases and the system supply chain. The buyer alsomust examine agreements and relationships with key third party vendors to determinethe nature and strength of those vendor relationships. Are these relationships properlydocumented or more informal in nature? Do they result in favorable pricing tofranchisees in comparison to alternative vendors? How much control do key vendorshave respecting the system and what options does the seller have to change vendors?What rebates or commissions does the seller receive from third party vendors? Finally,has the seller properly disclosed in the FDD (Item 8) its role in the supply chain andrevenues it or an affiliate receives from franchisee purchases of products and services?

E. How the Due Diligence Process can Impact the Transaction

In determining how the due diligence process may impact a transaction, the partiesshould revisit their initial goals in conducting due diligence. What questions wereanswered or assumptions confirmed? Which ones were not answered? Moreimportantly, what surprises did the buyer (or seller) encounter during the process? Theparties often enter the due diligence phase with an expectation as to what they willencounter and anticipate that the due diligence process will serve to confirm thoseexpectations. While that most often may be the case, the most valuable aspect of duediligence in some situations is the discovery of the unexpected financial informationthat was not consistent with initial representations, potential legal risks tied tooverlooked provisions in the franchise agreement or an undisciplined franchise salesprocess. As a result, due diligence must be conducted in a manner that does notobscure potential surprises. Assuming the parties have implemented a deliberate duediligence process, information gathered through the process can impact the proposedtransaction in a number of ways.

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1. Impact on Purchase Price

The most obvious impact due diligence may have on a transaction involves thepurchase price for the target system. The parties initial agreement on the purchaseprice often referenced in the LOI is usually based on certain assumptions as to thecondition of the target system and its key assets. The buyer will conduct due diligenceto reaffirm those assumptions. If the process uncovers serious questions involving thetarget system and the assets, the buyer may find that the proposed purchase price doesnot reflect reality and use such information to renegotiate the purchase price to moreaccurately reflect the current condition of the target system. The challenge in thisapproach is that the seller may not fully appreciate the issues raised and be reluctant toaccept less than the amount originally agreed to. Further, the seller may have chosento move forward with the buyer and set aside offers from other parties. Efforts toreopen negotiations over price may lead the seller to revisit offers from other parties.

To avoid such a situation, the buyer should establish a due diligence process to gatheras much information as possible in advance of the LOI stage. In doing so, the buyermay be able to impact the price or structure of the transaction (see below) before theseller has become entrenched as to its demands on price or structure. Theeffectiveness of this strategy will depend on the circumstances surrounding the potentialsale of the system, the number of potential buyers and the sales process established bythe seller.

2. Modifying the Structure of the Transaction

Should the buyer uncover information during the due diligence process that increasesrisks associated with the transaction, it may approach the seller with a modifiedstructure to the transaction to reduce those risks as an alternative to directly impactingthe purchase price. While a modified structure ultimately may impact the purchaseprice through contingencies or earn-outs, the response is less drastic than a suggesteddecrease in the purchase price. A contingent payment may also bridge disagreementsas to the perceived level of risk associated with an issue discovered during the duediligence process. For example, in situations where franchise sales violations may haveoccurred, the parties may restructure indemnification and hold-back provisions or delaytransfer of certain agreements or other assets until the perceived risk is addressed.

3. Obtaining Further Information from the Franchisees

The due diligence process may uncover issues that question the health of thefranchisor-franchisee relationship. Because the health of this relationship is crucial invaluing the underlying assets the franchise agreements and royalty stream derivedfrom them the buyer should discuss with the seller the need for direct or indirectcommunications between the buyer and the franchise system (or at least key individualswithin the system). To the extent a franchisee association exists in the target franchisesystem, the buyer will want to understand the role of the association and its viewpointtoward the seller. Buyers frequently conduct, with the consent of the seller, indirectmethods to gauge the health of the franchise relationship and the existing sentiment of

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franchisees and any franchisee association. Direct communications with franchisees orwith an existing franchisee association can be more problematic as few sellers arewilling to disclose the possible sale of the system until there is a binding agreement inplace or, better yet, a closing is imminent and the transaction cannot be unwound.

4. Pursuing Other Options

The buyers most drastic reaction to information uncovered during the due diligenceprocess is the decision to walk away from a potential transaction. This decision often isa difficult one to make as the parties will have invested significant time and effort in theprocess and may become emotionally tied to the transaction. Before negotiations breakdown, however, each party may re-examine the risks associated with the transaction aswell as the economics (price). This re-examination may involve further due diligence.At the end of the day, decisions must be made and the due diligence process will servesome role - good or bad - in determining whether the transaction is completed.

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EXHIBIT A

SAMPLE

FRANCHISE DUE DILIGENCE CHECKLIST

[NAME OF POTENTIAL FRANCHISOR SELLER]

Date: ____________, 2012

For purposes of this document, the term Company collectively refers to__________________ [FRANCHISOR SELLER] and all of its affiliates, parentcompanies, subsidiaries and any predecessors that have sold franchises during thepast 10 years.

The term franchisee is intended to refer to Companys domestic and foreignfranchisees, area franchisees, area developers, area representatives, subfranchisors,master franchisees, and licensees, as applicable. In addition, the term subfranchiseeis intended to refer to the domestic and foreign subfranchisees and sublicensees, asapplicable, of Companys franchisees.

The term Disclosure Document refers to and includes any franchise or businessopportunity disclosure document (including Uniform Franchise Offering Circulars orUFOCs, and Franchise Disclosure Documents or FDDs) prepared by or for Companyfor use in: (i) the United States, including any of its states, jurisdictions, districts,territories or possessions; (ii) Canada, including any of its provinces, jurisdictions,territories or possessions; (iii) ____________________, [LIST ANY OTHERCOUNTRIES IN WHICH COMPANY MAY BE SPECIFICALLY INVOLVED] includingany of its states, jurisdictions, districts, autonomous regions, territories or possessions;or (vi) any other foreign country or jurisdiction.

Please provide to us the information described below. [Identify format in whichall requested information is to be received.]

Section A. Disclosure Documents and Registration/Notice Filings

1. All Disclosure Documents for the past five years approved, used, orpending in any state, province, jurisdiction, district, autonomous region, territory orpossession of the United States (including Puerto Rico), Canada,____________________ [LIST ANY OTHER COUNTRIES IN WHICH COMPANYMAY BE SPECIFICALLY INVOLVED] or any other foreign country. Provide a cleancopy of each different version of each Disclosure Document, as well as blacklinedcopies showing changes between the different versions of each Disclosure Document.Also provide an electronic clean copy of each different version of each DisclosureDocument in Microsoft Word format.

2. All files relating to franchise registration/notice filings, exemption filingsand business opportunity notice filings made by or on behalf of Company during the

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past five years, including all comment letters, approvals and other correspondence withapplicable franchise regulators and governmental agencies.

3. All franchise registration applications (including initial, amendment orrenewal applications) pending, or in the process of being prepared for filing.

4. A list of all states having franchise registration/notice laws or businessopportunity laws where no required registrations or notices of sale are effective orcurrently in process.

5. A chart indicating all applicable effective dates, amendment dates,expiration dates and renewal dates for all required franchise registration/notice filings,exemption filings and business opportunity notice filings in each jurisdiction in whichCompany has offered or sold franchises since 20__.

6. A copy of all questionnaires provided to counsel to assist in preparationand updating of Disclosure Documents during the past five years.

7. A copy of all advertising and marketing materials used by Company topromote and sell franchises during the past five years, and all related registration filingssubmitted by or on behalf of Company to franchise regulators or governmental agenciesduring the same period.

8. A copy of all sales representative disclosure forms submitted by or onbehalf of Company to franchise regulators and governmental agencies during the pastfive years.

9. A copy of all correspondence with the Federal Trade Commission (FTC),state franchise regulators and governmental agencies about franchise or businessopportunity sales, consumer marketing activities, or franchisee comments orcomplaints.

Section B. Franchise Agreements and Other Agreements

1. Executed copies of all U.S. and foreign franchise agreements, masterfranchise agreements, development agreements, option agreements, area franchiseagreements, area representative agreements, license agreements, subfranchiseagreements, sublicense agreements and like agreements currently in effect thatCompany or its franchisees, as applicable, have entered into with franchisees orsubfranchisees (collectively the Franchise Agreements). For each FranchiseAgreement, include a copy of: (i) all addenda, exhibits and ancillary documentspertaining to that Franchise Agreement; (ii) the signed and dated receipt for theDisclosure Document, if any, associated with that Franchise Agreement; and (iii) anyother material in Companys files evidencing compliance with all applicable waitingperiods and disclosure procedures with respect to any Franchise Agreements signedduring the past five years.

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2. A list of any franchisees or subfranchisees that executed non-standardforms of Franchise Agreements or that negotiated material changes to their FranchiseAgreements (whether prior or subsequent to execution of the Franchise Agreements),together with a brief summary of all terms that are materially different from the termscontained within the standard form of Franchise Agreement utilized at that time. Limitthis request to current franchisees and subfranchisees, and current and formerfranchisees and subfranchisees whose Franchise Agreements expired or wereterminated within the past five years.

3. A list of any franchisees or subfranchisees that have been granted anoption, right of first refusal or other similar right to establish one or more additionalfranchises.

4. A clean copy of each different form of each Franchise AgreementCompany has used during the past 10 years, as well as blacklined copies showingchanges between each different form of each Franchise Agreement. Also provide anelectronic clean copy of each different form of each Franchise Agreement in MicrosoftWord format.

5. Executed copies of any lease or sublease Company has signed orguaranteed on behalf of any franchisee or subfranchisee, and in the case of anysubleases, an executed copy of the underlying lease. Limit this request to currentfranchisees and subfranchisees, and current and former franchisees andsubfranchisees whose Franchise Agreements expired or were terminated within thepast five years.

6. Executed copies of any agreements Company has signed for anyCompany-owned franchises, licenses or locations.

Section C. Franchisee Matters/Franchise Sales Matters

1. A list of all current franchisees and subfranchisees. For each suchfranchisee/subfranchisee, provide: (i) its name, address and telephone number; (ii) theeffective date of each of its current Franchise Agreements; (iii) the location or locationsit has been granted the right establish, and/or the territory it has been given the right todevelop, under each current Franchise Agreement; (vi) the name and address of itsguarantors, if any, for each Franchise Agreement; and (v) the respective exclusiveterritory, if any, granted to it under each current Franchise Agreement.

2. A list of all current and former franchisees and subfranchisees who hadthe term of their Franchise Agreements end as the result of expiration, termination ornon-renewal during the past five years. For each such current or formerfranchisee/subfranchisee, provide: (i) its name and last known address and phonenumber; (ii) the effective date of each of its prior Franchise Agreements; (iii) the locationor locations it had been granted the right establish, and/or the territory it had been giventhe right to develop, under each of its prior Franchise Agreements; and (iv) the date andreason the term of each of its prior Franchise Agreements ended.

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3. A list of prospective franchisees and subfranchisees (including name,address and telephone number) who have been approached or contacted aboutbecoming a franchisee/subfranchisee. Indicate which of these prospective franchiseesor subfranchisees, if any, Company or its franchisee, as applicable, expects will signFranchise Agreements during the next 90 days. Provide copies of all agreements,letters of intent or similar expressions of interest, binding or nonbinding, with prospectivefranchisees or subfranchisees.

4. Access to Companys franchise files, including those containing:(i) Disclosure Documents and registration, notice and exemption filings; (ii) executedFranchise Agreements; (iii) correspondence between Company and former, current andprospective franchisees and subfranchisees; and (iv) inspection reports, internalcompliance reports, and checklists for all franchisees and subfranchisees.

5. All correspondence, notices, agreements, consents and similar materialrelated to any transfer proposed by a franchisee or subfranchisee during the past fiveyears, as well as a description of any pending or proposed sales of existing franchisesor subfranchises by franchisees or subfranchisees, and Companys rights of first refusalto purchase such franchises or subfranchises, if any.

6. A list of all franchisees and subfranchisees currently in default of theirFranchise Agreements, indicating the cause, the date of the default, the date and typeof notice sent to the franchisee or subfranchisee, if any, the cure date, whether any cureplan has been agreed upon, and Companys assessment of the probability of cure. Wemay request the full franchise file on any listed franchisee or subfranchisee.

7. All termination or nonrenewal notices to franchisees or subfranchisees,either pending or implemented in the past five years, together with a basic summary ofthe status or outcome.

8. A list of any current or former franchisee or subfranchisee who is currentlyviolating, or who has violated during the past five years, any post-term noncompeteprovision contained in its expired or terminated Franchise Agreement.

9. A list of any prospective or current franchisee or subfranchisee who hasbeen promised a waiver or reduction of any of the fees described in the current formFranchise Agreements.

10. Describe any policy relating to delays by franchisees or subfranchisees instarting or completing pre-opening activities beyond the performance dates in theFranchise Agreements.

11. State whether franchisees are required to obtain additional insuredendorsements in favor of Company for franchisee insurance policies, and describeprocedures for monitoring compliance.

12. A copy of the bylaws, minutes and other documents relating to anyfranchisee advisory council or other representative body and any franchisee

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association, including any documents that create obligations on the part of Company toobtain franchisee approval of standards or policy changes.

13. A description of all financing arrangements offered by Company tofranchisees or subfranchisees, amounts outstanding under such arrangements,amounts past due or in default and reserves established for doubtful accounts undersuch arrangements. Include copies of loan proposals, loan commitments, reports andcorrespondence relating to this activity. Also, include sample copies all notes, financingdocuments, UCCs, and disclosures, if any, required by law in connection with suchfinancing.

14. A description of all instances where Company has consented to acollateral assignment of any Franchise Agreement to secure any franchisee orsubfranchisee loan obligations.

15. A list of all contingent liabilities of Company relating to its franchisees orany guarantees of franchisee obligations.

16. All material system-wide communications with franchisees or franchiseegroups since 20__.

17. A copy of Companys current franchise application form, as well as anyother forms of franchise application Company has use over the past five years.

18. Copies of all form letters, notices and memoranda (i.e., form defaultnotices, form termination letters, and form transfer and consent to transfer agreements).

19. A list of all brokers or sales agents used by Company to sell franchises inthe past five years, and copies of any agreements Company entered into with them.

20. A list of any franchise consultants used by Company in the past five years,and copies of any agreements Company entered into with them.

21. A list of all franchise sales shows, events and commitments including thedate, a description of the event, the persons scheduled to attend and the financialcommitment.

Section D. Disputes, Litigation and Regulators

1. All orders, directives, or inquiries received from the FTC or any state orforeign franchising, business opportunities, or other regulatory authority, related to thefranchise system. All correspondence with any federal, state or foreign regulatorpertaining to the franchise system including, franchisee or subfranchisee comments orcomplaints or alleged violations of applicable law.

2. Describe in detail the current status or results of, as applicable, allpending, threatened and concluded litigation, arbitration or mediation proceedingsbrought against Company, or any of its officers, directors or employees, during the past

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10 years (even if not considered material for purposes of inclusion in the DisclosureDocuments), which involve or relate to franchisees or subfranchisees, or the franchisesystem. Provide a copy of all pleadings and notices in these cases. Provide a list of allvicarious liability claims and cases, indicating which claims are uninsured orunderinsured, describing the nature of the claims. Disclose any policy relating to suitsagainst franchisees or subfranchisees, including any policy about cases that should notbe filed or defended. Describe Companys collection policy for delinquent fees fromfranchisees and subfranchisees. Provide copies of pleading files for all Company-initiated litigation, arbitration and mediation proceedings brought against franchisees orsubfranchisees during the past five years.

3. Copies of all notices or correspondence from third parties within the pastfive years alleging violations by Company of the FTC Franchise Rule, any state orforeign franchise disclosure, registration or relationship, any federal, state or foreigndeceptive trade practices act (or comparable laws), any federal, state or foreignbusiness opportunities law or any other federal, state or foreign law specificallyregulating franchises, business opportunities or similar arrangements.

4. A description of all litigation in the past five years involving or affecting anyof Companys intellectual property rights.

5. Copies of all correspondence threatening litigation against Companywithin the past five years.

6. Copies of all termination, settlement, release, or estoppel agreements withcurrent or former franchisees executed within the past five years.

Section E. Supply and Distribution

1. Copies of all agreements, if any, between Company and/or Companysaffiliates, parent companies or subsidiaries relating to the manufacture, supply and/ordistribution of products and services to franchisees or subfranchisees.

2. Copies of all manufacturing, supply and distribution agreements, if any,between Company and any manufacturers, suppliers or distributors of products andservices to franchisees or subfranchisees.

3. Copies of all manufacturing, supply and distribution agreements, if any,between Company and franchisees or subfranchisees.

4. A list of all manufacturers, suppliers and distributors designated byCompany as an approved source, or as the only or one of the only approved sources,from whom franchisees or subfranchisees may or must purchase products and services.Identify any manufacturer, supplier or distributor who falls within the definition ofCompany.

5. Describe any commissions, rebates, discounts, or other considerationCompany receives from third-party manufacturers, suppliers and/or distributors as the

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result of the sale of products and services to franchisees. Provide the specific dollaramount Company received from third-party manufacturers, suppliers and distributors foreach of the past three fiscal years. Provide the specific dollar amount Companyreceived as the result of its direct sale of products and services to franchisees andsubfranchisees for each of the past three fiscal years.

6. Copies of all documents concerning Companys approval or disapproval ofmanufacturers, suppliers and distributors since 20__, including all relatedcorrespondence.

Section F. Advertising (Marketing) Fund

1. A description of the national advertising fund Company administers, aswell as any other local, regional, national or international advertising programsCompany administers or controls to which franchisees or subfranchisees contribute.Include copies of all relevant articles, bylaws, or other governing documents.

2. A description of how contributions to any local, regional, national andinternational advertising programs Company administers or controls have been spentfrom the beginning of 20__ to the present. Include copies of financial statements for thepast three fiscal years, and an accounting of advertising fees Company has collected in20__.

3. List of franchisees and subfranchisees who are more than 60 days behindin advertising fee payments.

Section G. Franchise System

1. Provide a clean copy of all current (i) manuals distributed to franchisees,and (ii) internal policy manuals or other materials prescribing policies relating tofranchise sales and administration. In addition, provide any different versions of thesemanuals Company has used over the past five years, with a description of the changesbetween the different versions.

2. A description of all training programs provided to franchisees orsubfranchisees during the past three years, including copies of all written materialsprovided to franchisees and subfranchisees, and instructions from Company to thetraining staff. Provide a schedule of all training activities for the next 12 months,including classes at home office and training programs in the field and at franchisedlocations.

3. Copies of all quality assurance reports written by Company pertaining tofranchisees and subfranchisees during the past three calendar years including thecurrent year.

4. Describe any proprietary component of the franchise system that islicensed to Company by a third party or otherwise not owned and controlled exclusivelyby Company.

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5. Printouts of all content currently published by Company on any internet orintranet or other computer network accessible by current or prospective franchisees orsubfranchisees, or the general public.

6. A copy of all written policies and public statements, press releases,announcements by any officer, director or representative of Company that affect theenforcement or interpretation of any of the Franchise Agreements, including terminationrights, calculation of quantitative measures and metrics, impact/encroachment policies,and quality assurance/standards policies.

7. Provide a copy of all audit reports generated during the last 3 years fromaudits of franchisees and subfranchisees and any related correspondence, billing,collection and contract modification activity relating to audits.

8. Copies or descriptions of all earnings claims/financial performancerepresentations, including supplemental earnings claims/financial performancerepresentations, made or provided to prospective franchisees or subfranchisees (bothwithin or outside of the Disclosure Documents), and all related substantiating data.

9. Instructions to franchise sales staff or franchise brokers regarding themaking of earnings claims/financial performance representations to prospectivefranchisees.

10. Description of any required computer hardware or software.

Section H. Intellectual Property

1. Identify, describe and give the status of any and all U.S. and foreignintellectual property (collectively Intellectual Property) owned, licensed or used byCompany, including but not limited to patents, patent applications and any and all otherpatent rights, trademarks, trade names, service marks, trade dress, brand names,logos, other trade designations (including unregistered names and marks), trademarkapplications, trademark registrations, service mark applications, service markregistrations, copyrights, copyright applications, inventions, inventors notes, moralrights, formulations, processes, methods, Internet domain names, Internet websites,URLs, trade secrets, software, computer programs, computer source codes, know-how,customer information, supplier information, proprietary development information, anddrawings and designs.

2. Provide copies of all (i) agreements, including without limitation alllicensing agreements (other than franchise agreements), assignment agreements,security agreements, maintenance agreements, confidentiality agreements (includingthose with members, managers, officers, directors, employees, and agents of Companyor other entities) advertising agreements, marketing agreements, and development,manufacturing, distribution, dealer, sales agency, sales representative, or other likeagreements, (ii) applications, (iii) registrations, (iv) correspondence and (v) otherdocuments relating to the ownership, use, or exploitation of any Intellectual Property.

3. A description of any royalty arrangements involving the IntellectualProperty, together with a statement of royalties paid out or received.

4. A list of all known pre-existing uses of the Intellectual Propertytrademarks and service marks), and to the extent possible, identify the(particularlyA-9

user(s). Additionally, provide a list of areas within the U.S. and any foreign countrywhere Company is prohibited from using its Intellectual Property (particularlytrademarks and service marks).

5. A description of all infringement actions, oppositions, proceedings,or challenges to ownership, (whether pending or threatened, verbal or written) filed byor against Company, in the U.S. or internationally, with respect to any IntellectualProperty or other right belonging to Company, and copies of all executed settlementagreements and related documents, and other material agreements, correspondenceand documents, concerning any such infringement actions, oppositions, proceedings, orchallenges.

6. List all software owned or licensed by Company and, for each itemof software, describe whether it is off the shelf software readily available for purchaseor license, or software specifically developed for Company by employees of Companyor by outside parties. If any software development occurred, provide copies ofapplicable agreements relating to that development.

7. A list of all copyrighted works material to the franchise system forwhich no application to register has been filed. Any works owned by third parties shouldbe separately identified.

8. Copies of Companys current policies, guidelines, and actualpractices with respect to the protection of its Intellectual Property.

9. A description, along with copies of all related documentation,regarding what actions, if any, have been taken to protect Companys IntellectualProperty in each of countries in which it has, directly or indirectly, conducted business.

10. A summary description of all litigation in the past five yearsinvolving or affecting any of Companys Intellectual Property rights.

11. Describe any proprietary component of the franchise system that islicensed to Company by a third party or otherwise not owned and controlled exclusivelyby Company.

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