July 29, 2009

"Financeability" in Buying and Selling a Franchise System—Buyer Beware, Seller Opportunity or Win-Win?

Franchisors and their franchise systems are unique acquisition targets. Compared with most businesses, their direct dependence on the success of outside parties—franchisees—is far greater.

Experienced buyers of franchisors have traditionally focused their due diligence on identifying and confirming the strength and success of franchisor-franchisee relationships, strong financial performance at the unit level and franchisor revenue streams, branding expertise and compliance with legal requirements, along with the many other characteristics that define successful franchise systems. Availability of financing for franchisees and prospective franchisees—franchisee "financeability"—has long been among those key characteristics, but is an often-overlooked or under-emphasized issue to both buyers and sellers.

As part of acquisition due diligence and in preparing to sell, buyers and sellers must be acutely aware that the success of a franchise system largely depends on franchisee financeability. Existing franchisees must obtain financing to operate and grow, and prospective franchisees need financing to become franchisees in the first place or buy the businesses of existing franchisees seeking to exit.

Today's tight credit markets have severely restricted the availability of financing to franchisees and magnified the importance of evaluating financeability in the acquisition context. Yet, paradoxically, this environment can create unexpected opportunities in the franchise space for savvy and disciplined buyers that recognize this risk and properly evaluate and mitigate it, and for sellers that anticipate the needs of buyers and prepare their systems to confront those challenges. Buyers that fail to appreciate this risk can overpay or worse. Sellers that fail to anticipate it can find themselves with systems that they cannot sell at favorable prices or, in some instances, at any price.

Financeability Pre-Credit Crisis

Many franchise systems grew rapidly in recent years, in large part fueled by easy credit for businesses, consumers' personal income growth and appetite and tolerance for personal debt and high levels of consumer spending. As with many businesses, franchisees often found ample financing for their needs on favorable—or at least tolerable—terms, even if they lacked substantial collateral or successful track records.

The ability of franchisees to obtain financing was not a primary worry for many franchisors, and financeability created relatively few challenges in their relationships. The factors fueling the growth activity of recent years, especially the wide availability of credit and ever-increasing levels of consumer spending, however, were not sustainable.

Financeability Today

The era of relatively easy financing for franchisees is over; perhaps not likely ever to return to the levels of a few years ago. Limited availability of financing is—and is expected to continue to be—a challenge for franchisees and, therefore, for franchisors as they seek to grow their systems.

Starting in late 2007, and deepening in 2008 and 2009, credit has become scarce. Banks generally have lost interest in lending to anyone other than the safest credit risks, including as underwriting standards have become far more stringent. Even SBA loans are relatively hard to obtain. Consumer spending has decreased significantly, weakening many franchisees and franchise systems and highlighting the need for innovative changes. Additionally, lenders want franchisors to have more "skin in the game," as further noted below.

The result has been a difficult environment. More franchisees need financing to survive, much less grow; however, other than for the strongest ones, financing is largely unavailable. Prospects, even those with strong qualifications, often cannot obtain financing to become franchisees or buy existing franchisee businesses. Moreover, revenue and margins are declining at the unit level in many systems.

This fundamental change in the credit markets and the poor state of the economy generally are severely impacting many franchise systems. There are concerns regarding failure of an increasing number of franchisees, as well as lower revenue and profitability of many franchisees that survive. On top of all this, many systems are likely to experience increases in the number of more senior franchisees that seek to exit, but cannot due to the lack of financeable buyers.

All of these adverse developments could result in a growing number of frustrated, disgruntled and under-committed franchisees. The net effect for a franchise system can be decreased revenue, increased costs, greater management time devoted to attracting franchisees and dealing with distressed ones and a negative impact on the all-important franchisor-franchisee relationship. Alternatively, these developments can create opportunity for those that plan accordingly and wisely navigate through this storm.

What Should Buyers Consider?

Buyers of franchise systems can protect themselves with insightful due diligence on the likely effect of tight credit markets on their targets and the approach and risk tolerance lenders likely will have in the short term and post‑credit crisis. Also, many transition plans of successful buyers will include actions designed to expand post-closing access to credit for franchisees.

Rely on Conservative Financial Due Diligence and Modeling

Buyers should view target franchise systems through the prism of the tight credit market. Information should be as current as possible and include detailed analyses of trends, same-store year-to-year comparisons and franchisee financial statements. Buyers should carefully review any Item 19 financial performance disclosures in the seller's FDD and critically question how the seller decided what information to disclose, as well as what not to disclose. Assumptions for financial projections and modeling, including regarding new unit growth, that are based on historical data should be viewed with a careful and critical eye. When valuing a target franchise system, include an analysis of how the tight credit market may affect financial models. Likewise, look for sellers with systems that can operate successfully in a tight credit market, including at the unit level with respect to both unit revenue and new store openings.

Conduct Rigorous Due Diligence on "Financeability"

Buyers should emphasize due diligence on existing franchisees and their ability to finance operations going forward. Due diligence should explore the target franchise system's ability to attract and obtain financeable franchisee prospects. That due diligence should include analyses of the geographical locations and concentrations of franchisees to determine if local demographic and economic conditions, as well as the quantity and nature of local lenders, create concern or signal opportunity.

Appreciate Special Considerations as a Financial Buyer

Unlike many strategic buyers, some financial buyers are new to franchising and need to appreciate how borrowing by franchisees can vary compared to borrowing by their portfolio companies. Many franchisees and prospects rely heavily on community banks and SBA loans, lending sources with which many financial buyers do not typically have significant relationships or background. Therefore, financial buyers may be in unfamiliar territory, as they may not be able to leverage their longstanding relationships and institutional track records with large lenders in the same manner as they historically have done to help franchisees and prospects. Instead, they may need to find creative ways to leverage those existing relationships or develop new relationships.

Scrutinize the Number and Identity of Exiting Franchisees

In seeking to analyze the franchisor-franchisee relationships, buyers should also understand the proportion of franchisees seeking to exit now and those that will likely seek to exit in the near future. Buyers should view the likelihood of success of those exit strategies and, if not successful, understand the toll on those relationships, as well as the potentially negative impact on franchisees forced to retain their businesses.

Include Purchase Agreement Protections

In today's mergers and acquisitions environment, special mechanisms to establish the overall purchase price are becoming more common and are being used to benefit buyers and sellers. Parties often use these mechanisms when they want to close a transaction, but cannot reach full agreement on the value of a business. These take many forms. For example, so-called "earnouts" can bridge that valuation gap. In most earnouts, the buyer pays a portion of the price at closing. Then, contingent upon the success of the business in the buyer's hands (in theory, proving the seller was correct in seeking a higher value), the buyer makes additional payments after closing. The structure of those additional payments and related triggering events can take many forms, including as a percentage of post-acquisition revenue that exceeds negotiated thresholds or as a lump sum payment upon achieving certain milestones.

"Security" provisions may also be used in the purchase agreement. In many transactions, the buyer holds back a portion of the purchase price, or places that portion into escrow, for a period of time after closing as protection against negative events or misrepresentations. Buyers could make creative use of holdbacks and escrows to protect against financeability-related risks.

Take Post-Closing Actions to Address Financeability Issues

Buyers should analyze the seller's practices, if any, to enhance credit availability and opportunities for franchisees and prospects. They may also wish to consider adopting or expanding practices for these purposes after closing. Those practices could include:

  • Creating programs educating lenders on a specific system or franchising generally
  • Taking an active role in developing lender relationships and seeking to capitalize on the collective strength of industry associations
  • Providing franchisees with tools to educate lenders
  • Implementing franchisor "credit enhancement" programs, such as making a portion of franchise fees or royalties available for loans, as well as other means of showing lenders that the franchisor is also taking financial risk regarding its franchisees;
  • Waiving or financing initial franchise fees for new franchisees, delaying royalty commencement, providing other grace periods or graduating the onset of financial obligations;
  • Providing direct financing
  • Offering other incentives to attract new franchisees and reduce their need for traditional financing
  • Registering the system with "The Franchise Registry" program offered by the SBA and FRANdata

For the savvy buyer, the foregoing suggests a two-pronged approach. First, perform extensive due diligence on the financeability issue. Second, engage in careful planning to address the issue post-closing. Those steps can identify an excellent franchise system and result in a highly successful acquisition.

What Should Sellers Consider?

Sellers should recognize the fundamental changes in the credit markets and view their franchise systems through the eyes of a potential buyer. Sellers should understand what sophisticated buyers seek and take active steps to distinguish their systems to make them attractive acquisition targets.

Proactively Identify and Solve Anticipated Buyer Concerns

As with the sale of any business, sellers of franchise systems should actively identify and try to solve, or at least mitigate, situations that would concern buyers. For many sellers, the starting point in this process is "self-due diligence," in the form and with the intensity that experienced buyers perform and with due regard for financeability issues. Sellers should also consider how prospective buyers will view their Item 19 financial performance disclosures (or lack thereof) when they are considering whether to include such disclosures in their FDDs and what information to include.

Include Purchase Agreement Provisions to Give Comfort to Buyers

The pricing mechanisms, holdbacks and escrows described above might be seen as "buyer-friendly" concepts. Confident sellers, however, can make a portion of the price contingent on future performance to bridge a valuation gap and, if correct, obtain a higher price. Similarly, sellers can offer holdbacks and escrows as tools to convince skittish buyers to proceed with an acquisition. If any portion of the purchase price is contingent on post-closing performance, however, a wise seller will do its own due diligence on the buyer's ability to grow the business and make it more profitable, including in sustaining or expanding the financeability of franchisees and prospects.

Expand Franchisee Access to Credit or Reduce Need for It

Finally, sellers can create and implement programs such as those proposed above that will benefit a franchise system in the near and long term. If the system is sold, the seller will have benefited from the additional value it created and, presumably, received a higher purchase price. If not sold, the seller will have improved its system and the system's profitability and prospects.

Buyer Beware, Seller Opportunity or Win-Win?

Successful franchisors have long recognized the importance of franchisee financeability, first in building and operating a system and then when in the market to sell. Buyers and sellers that appreciate how the current and future lending environment will impact financeability can avoid unforeseen challenges, create opportunity and produce successful purchases and sales of franchise systems.

The authors would like to thank Darrell M. Johnson, President and Chief Executive Officer of FRANDATA Corporation, and Ronald A. Feldman, Chief Executive Officer of Siegel Financial Group LLC, for their insights and contributions.

2009 Trends Summer.pdff.pdf

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