By Robert Zarco, Esq. – Founding Partner at Zarco Einhorn Salkowski, PA
Whether to buy into Franchisors and/or multi-unit Franchisees, Private Equity firms have been flexing their muscle for their investors to keep pace and exceed inflation by gobbling up and taking advantage of established businesses in the franchise world. The sale to these often enticing offers by equity partnerships may come with a variety of significant side-effects to the detriment of franchisees, franchisor, and related investors that would be wise to closely consider before diving in to the temptation. Never do so without first engaging experienced legal, financial, and business advisors to work hand in hand with you.
Private Equity Companies are seeking to buy scalable and steady revenue streams from growing businesses which lack the necessary capital and experienced management to continue their growth. With that in mind, they are after a proven business brand and model, and consider variables in the process of their due diligence such as: the Amount of Initial Investment, Time to Profitability, Time to Recoup Capital Investment, and Time to Achieve Steady and Optimized Earnings as part of their intended exit strategy. In other words, attaining profitability as soon as possible is often their ultimate goal, usually to either exit with a sale of the business in 4-7 years from entry, or to a lesser extent, to hold onto the business and its income stream for optimized return to its investors.
The temptation for franchise companies is to cash in their chips on an increased share value and enjoy the benefits of a quick burst of capital infusion, access to experienced management and leadership executives, and a network of contacts such as vendors and bankers in order to grow the business to a new level, or resuscitate the company. While this sounds ideal, the reality is that the investors and the acquired entity often find themselves with incompatible goals and management culture, increasingly leading to dissatisfaction, disagreements, and ultimately legal disputes and litigation.
Some examples of franchises that have traveled down this Private Equity path include Jamba Juice, Sonic Drive-In, Hooters, Whataburger, Dunkin Brands, Quizno’s, Papa Murphy’s, Hollywood Tan, Burger-Fi, and more. Many of the specific conflicts stem from tunnel vision and short-term thinking to achieve profitability by cutting expenses to increase income. Furthermore, imposing marketing promotion programs that raise revenue and royalties for the franchisor at the expense of sensible margins and profitability to the franchisees that fail to meet the company’s franchisee profile is short-sighted and counter-intuitive. Also, offering locations to inexperienced franchisees and locating in geographical areas and sites that do not translate well culturally or logistically for the products and services being sold, represent other revenue-growing strategies that are potentially harmful to the brand and business. Other conflicts center around slashing expenses and investments such as cutting marketing and promotions, staff providing service and support, training, limiting supplies, research, technology, quality of products and services, and product offerings all of which directly affects the execution and offering to the customer experience. This impact ultimately negatively affects the brand and long-term value of the franchise business. Additional risks centers around over-leveraging the balance sheet with extraordinary debt unsustainable in a sudden downturn, and outright conflicts of interest, such as requiring the use of certain vendors whose prices are high or quality is less than competitive, or beneficial to the franchisor at the expense of the franchisee.
Nevertheless, it is critical to conduct extensive research and due diligence. This includes expertly reading and interpreting the Franchise Disclosure Document (FDD), checking for leadership stability and experience, delving into red flags such as litigation, bankruptcy, instability of stores, and speaking with franchisees for references about the franchisor or vice versa. While the risks are always great, the rewards loom at the other end when successful, provided that the opportunities have been met with great preparation.
With all of these considerations in mind, and after thorough due diligence utilizing experienced professional guidance and protection, these equity partnerships with Private Equity could prove very valuable. This is quite possible when partnering with an experienced executive team whose goals are aligned for both the franchisor and the franchisees, where control and governance is shared or very well defined, and the leadership is stable, transparent, and the future objectives and goals are well intentioned to be mutually beneficial. As long as there is full disclosure and documentation, alignment of interests and goals, both short and long term, a complementary skill-set and professional competence, mutual respect and partnership, and a common culture that puts the health and stability of the brand, the franchise, and the clients first, then the relationship can be quite fruitful.