Franchise systems are natural acquisition targets for private equity. Steady, contract-based long term cash flow plus limited physical assets and a limited number of skilled employees make it a natural fit for many private equity charters. In addition, mid-sized franchisors that have managed to break through to sustainable cash flow from their royalty streams can have very high gross margins.
The incremental cost of adding and supporting additional units is nominal, making future growth extremely profitable. Franchisors are natural candidates to scale, possibly even exponentially. As the groundwork has been laid, the model has been proven and a fresh capital injection can kick the program into overdrive.
However, it’s not a complete remedy, and there are many risks for the private equity acquirer, the acquired and the franchisees. Many franchisors, understandably, need to keep the deal, and the fact that they are for sale, completely confidential until the deal is closed. However, and understandably, this can contradict the desire of the buyer to learn as much as possible about the health of the system. This includes both what is on the balance sheet and what is in the hearts and minds of the franchisees.
Additionally, there is typically a myriad of different agreements that have been signed, handshake agreements that franchisees expect to be honored and other “promises” that are the bedrock of the franchisor/franchisee relationship. Even if the acquiring company is not legally bound to follow the past, there is no faster way to torpedo a good system than by losing the trust of the franchisees. Pitfalls and risks lie at every corner, and you need to really understand “what” you are buying and how healthy the system really is.
If you are a franchisor considering an exit strategy or a private equity firm, family investment office or other high net worth investor looking to get into franchising, you need experienced franchise attorneys to help you navigate these often choppy and unpredictable waters.
Franchising can give the buyer tremendous returns, as evidenced by the multiples that are currently being paid for strong systems that have made even the most optimistic investment bankers blush. But potential high returns come with a heightened level of risk. The key is to determine how healthy and scalable the system really is.
We prefer to work with franchisors years in advance of their exit strategy to get their legal house in order and to shore up latent defects in their contracts and issues with the franchisees that private equity may use to lower the final price, or worse, pull out of the deal at the 11th hour because these latent defects may not be uncovered until a deep due diligence dive is near completion. For private equity firms, you are essentially “buying” the contracts and the existing relationships. It’s a much more complicated transaction that a wholly owned company with steady cash flow and transactional clients and vendors. A deeper level of due diligence needs to be done, and your attorney shouldn’t be learning franchising on your deal.
Our senior partners have represented buyers, sellers and groups of franchisees in these transactions in addition to being in house at systems that have changed hands in private equity transactions. We understand these deals inside and out and would welcome a confidential initial conversation about your project.