Franchise Mergers and Acquisitions
Edward (Ned) Levitt Dickinson Wright LLP
Mergers and acquisitions of franchise companies have been steadily increasing over the last decade. This trend is set to continue for some time, for a variety of reasons.
There is a lot of cash in the coffers of private equity companies, which must be deployed by acquisitions. With growing examples of private equity acquisitions of franchise systems and subsequent profitable divestitures, the private equity community has definitely discovered franchising. This includes larger multiunit and multi-brand franchisees as well. And the public markets are showing a similar appetite for franchise companies, allowing for some very successful IPO’s at attractive prices.
Contributing to this growth is the fact that investing in a quality franchise system has lower working capital requirements than other types of businesses and can generate a longterm and predictable revenue stream. Furthermore, an increase in revenue, and consequent increase in value, can be achieved with a reasonable effort from an acquirer and a modicum of growth capital. As the appetite for franchise acquisitions grows, the existing stock of attractive targets is growing at only a modest pace. The consequence is that the valuations for franchise systems are rapidly increasing, with multiples of EBITDA often reaching into double digits.
When it comes to a discussion of mergers and acquisitions in franchising, the world can be divided into several sectors; the small systems with under $2 million dollars of EBITDA, the typical middle sector of systems with $2 to $5 million dollars of EBITDA and the higher end sector above $5 million dollars. The most prized franchise systems are the ones whose EBITDA exceeds $10 million dollars. The principle at work here is that, regardless of how much EBITDA the system generates, it costs a similar amount for due diligence, executive time and professional fees to make an acquisition. Of course, franchise systems come in all shapes and sizes and the decision to buy has to be based upon many factors, including the system’s staying power, growth potential, franchisor/franchisee relationships, management team, brand value and much, much more.
The higher the EBITDA number, the larger and more sophisticated the buyer will likely be. Some private equity companies have several to many brands within their stable of franchise systems at any one time. For the franchise systems with lower EBITDA, the purchasers are more likely to be management, venture capital companies, suppliers, competitors, or other strategic buyers.
An important trend with the smaller franchise systems is emerging in parallel with the aging population. It is anticipated that there will be a significant increase in the retirement of the baby boomer owners of these systems for the next decade or two. While this may have a dampening effect on valuations, this trend will also support an increase in strategic acquisitions and consolidations, i.e. 1 and 1 may equal 3!
The size and sophistication of some of these franchise systems and the transactions that evolve are impressive and often rival traditional businesses as to scope and complexity. Certainly, many of the issues, challenges and approaches are the same in franchise and non-franchise M&A transactions. However, for a variety of important reasons, franchise M&A has an additional layer of complexity and risk.
M&A in franchising can be quite different if: the system is public or private, large or small, provides services or products, the franchisees have multiple units or multiple brands, the franchisor has expanded through master franchising or, perhaps, the seller is a large master franchisee itself within a broader system.
It is rare for a franchise system to have a lot of hard assets, such as real estate or valuable equipment, even if it has a high valuation. The value of the system resides primarily in its brand, franchise agreements with franchisees and the relationship between the franchisor and the franchisees. The correct value of the system and how the acquisition is executed needs to take into account the strength, durability and transferability of these assets. This leads to a unique set of due diligence issues and choices and, while proper due diligence is important in any acquisition, it is critical in a franchise acquisition.
Some of the typical areas for due diligence, relate to the financial performance of the franchisor and its franchisees, the content of all franchise agreements and leases, the status of any marketing fund, the condition of all accounting and computer systems and the status of all intellectual property. In addition, however, there are some very important, but less common due diligence areas an acquirer of a franchise system should consider. For example, what the relationship is like between key management personnel and the franchise community. If it is not a good one, then the acquirer will need to be able to readily replace such people. On
“When it comes to a discussion of mergers and acquisitions in franchising, the world can be divided into several sectors; the small systems with under $2 million dollars of EBITDA, the typical middle sector of systems with $2 to $5 million dollars of EBITDA and the higher end sector above $5 million dollars.”
the other hand, if the relationship is very good, then the acquirer will want to know what the likelihood is that they can be retained after the acquisition is completed. Another is the timing of franchise sales. If too many franchises are sold in too short a period of time, it may indicate trouble in the future because all franchisors have to be able to “service what they sell” and a quality franchise culture takes time to grow without the pressure of a constantly and rapidly expanding franchisee population. Conversely, if too many franchises are being resold by existing franchisees, there may be trouble lurking in the system. Also, a thorough analysis of what the franchisor spends on site selection, franchisee selection, initial franchisee training and support will be very revealing about the health and viability of the system. Franchise systems that grow quickly and without sufficient resources being deployed in these very crucial areas may present as very successful on the surface, when there is really a lot of rot at the core.
“Most importantly, there is the reality that the franchisor/franchisee relationship is at the heart of any successful franchise system and, in an acquisition of the system, preserving and, hopefully, enhancing that relationship is key.”
Conclusion
Much of the same considerations, requirements and issues in M&A transactions with businesses generally apply when an entire franchise system is acquired. Overlaid on all of that is the added franchise specific considerations, issues and challenges. Most importantly, there is the reality that the franchisor/ franchisee relationship is at the heart of any successful franchise system and, in an acquisition of the system, preserving and, hopefully, enhancing that relationship is key. This leads to the reality that how something is done is equally important as to what is done. Further, the ability to zero in on the true state of affairs in a targeted franchise system is more challenging than would be the case in the acquisition of another type of business. Finally, an acquirer has to struggle with the legal framework of the business being franchised and the laws which govern franchising specifically.
Edward (Ned) Levitt is a Certified Franchise Executive, a partner at Dickinson Wright LLP, Toronto, Canada, and provides legal services to Canadian and international clients on all aspects of Canadian franchise law. He was General Counsel to the Canadian Franchise Association (2000-2007) and is a member of the American Bar Association Forum on Franchising, the International Bar Association and the International Committee of the International Franchise Association. As a member of the Ontario Franchise Sector Working Team, Ned was instrumental in the creation of Ontario’s franchise legislation and has had significant input in the franchise legislative process throughout Canada. Among his many publications is the leading text, Canadian Franchise Legislation (2001, LexisNexis/Butterworths). Ned can be reached at 416.646.3842 or nlevitt@dickinsonwright.com.