Risk Shifting: Rep & Warranty Insurance in Franchise Transactions
Posted by Bret Lowell
Representations and Warranties Insurance (“RWI”) has become a mainstream tool that is used in most M&A transactions, including transactions in which franchisors change hands. This type of insurance is not new, but as deals get more competitive it has emerged as a regular way to shift risk from the seller to an insurer, and thereby smooth out the transaction process and to increase trust between the parties. According to an American Bar Association study, RWI usage more than doubled in the past five years. And, in the past two years, some insurance underwriters have reportedly asked sponsors to delay transactions while they catch up on writing policies.
So what is RWI and how can it be useful in franchisor buy and sell transactions?
RWI is basically a type of coverage aimed at breaches of contract; in the case of franchisor sales, the contract is typically a stock (or asset) purchase agreement (“SPA”). Typically in a franchisor M&A transaction, a seller will make representations and provide warranties about the condition of the franchise system they are selling. Buyers, in turn, agree to the transaction based on a combination of what the seller has represented the business as, what the seller has warranted, and their own due diligence. The parties usually agree to some type of indemnification around unforeseen liabilities and may set aside money in escrow to cover surprises. RWI comes alongside representations and warranties to provide insurance in the event that a “rep” or warranty proves to have been wrong or inaccurate, and causes a surprise in the deal.
The surprises we are talking about here are not usually enough to break a deal, but they could be annoying and have significant unforeseen costs. In the case of franchising, potential problems with a single franchisee unit or a number of units; or potentially some type of intellectual property issue could be covered. Coverage is also likely to exist for the typical reps that appear in SPAs for the sale of franchisors, such as reps that:
- The Franchise Agreements are legally, valid, binding, and enforceable,
- The franchisor has not received notice of material non-compliance from franchisees,
- The franchisor has disclosed all outstanding notices of material franchisee default,
- Consent to the transaction is not required to be obtained from franchisees,
- The Franchise Disclosure Document complies with all applicable franchise laws,
- There are no outstanding options, ROFRs, or rights to additional territory,
- All required state franchise registrations are in place, and
- There is no outstanding litigation other than that disclosed.
Without RWI, parties may spend a lot of time negotiating the right size of an escrow or how to indemnify against these surprises, because if a cost is high enough it can materially impact the economics of a deal. On the other hand, RWI to cover unforeseen circumstances enables the parties to avoid protracted or difficult and alienating negotiations, and to close the deal rapidly.
As a rule, insurers will take a close look at a potential transaction before agreeing to write a policy and once they do, that tends to create a level of trust for both sides.
Insurers will typically look at:
- The stock purchase agreement (SPA) terms and conditions, including “Schedules” that provide for exceptions,
- The scope of due diligence undertaken by the buyer,
- Due diligence memoranda from franchise (and other) counsel for the buyer, and
- Answers to questions presented to the buyers and buyer’s franchise (and other) counsel, and responses to interview questions presented to the buyer and such counsel.
RWI, as you might guess from its name, is designed to cover representations and warranties, but it is not all-encompassing. Even in the best deals, there are still things insurers won’t cover. Those include:
- Known issues – if due diligence memoranda and interviews reveal existing and adverse high risk conditions, insurers aren’t going to cover those conditions,
- High ticket items, like antitrust, FCPA, and environmental claims may be excluded,
- Broad-based labor issues like joint employer, misclassification, wage and hour, and union violations are likely to be excluded,
- The risk of purchase price adjustments will not be borne by insurers, and
- Forward-looking claims like future revenues or growth projections will not be insurable.
These policies are bespoke and tend to be expensive relative to other types of business insurance. Costs per policy will vary depending on the size and complexity of the transaction. Generally, premiums are 3-4% of the total cost of coverage with an upfront additional fee to cover the cost of the due diligence. Either the buyer or the seller can pay for the cost of the policy. If a seller pays, they may be able to lower the amount of escrow in a transaction which could improve their net profit. Some buyers offer to pay, which can enable them to offer more competitive deal terms.
In the event of a claim, RWI works like most other insurance. There’s a deductible (aka “retention”) that has to be met and the insurer has to agree to cover the claim. The deductibles tend to be pretty significant for these policies so it is sometimes the case that the cost of a surprise will have to be covered without help from the insurer. Parties can guard against some of this by using RWI as part of a constellation of insurance including environmental impairment liability policies, political risk policies, and policies that cover the failure to qualify for expected tax or regulatory treatment. There are pros and cons to using all of these policies but ultimately, they may be preferable to large escrows or longer closings.
For franchise sellers, working closely with legal counsel and insurance advisors can help you understand the costs and tradeoffs of these policies and whether it makes sense for you to pay or to look for a buyer offering one or more of these policies.
Franchisor Consolidations Post-Pandemic
October 13, 2020 | Posted by Bret Lowell
The wave of franchisor consolidations resulting in families of franchisors in the same or related industries will be different after COVID-19. The consolidation craze that existed pre-COVID-19 will continue in an opportunistic way, but will be moderated by a recognition that consolidation sometimes yields rewards that can be overtaken by risks.
I.The History of Consolidation
Franchise systems can be attractive targets. The most desirable have strong financials such as healthy and predictable revenue streams, cost controls, corresponding profitability, superior debt to equity potential, and great return on investment (ROI) (which could arise in either a “gold plated” deal, or a deal involving underperformance with superior turnaround). Franchise systems also typically come with positive drivers for expansion, including a proven business concept and model, a growing market, few or manageable regulatory hurdles, a strong trademark and a positive brand reputation, healthy relations with franchisees, untapped potential (such as new markets and technological efficiencies), and a good and stable management team. Attractive targets also sometimes provide “synergies” with other already owned businesses.
The acquirers of attractive franchise systems are commonly private equity (PE) firms. Other common acquirers are “strategic” buyers, who are looking to buy others in their industry. Both PE and strategic buyers may later acquire additional “add-on” companies in the same or a complimentary field.
II.Types of Consolidations.
Both types of acquirers – PE firms and strategic buyers – can eventually amass a “franchisor family,” and many have done so. The synergies that derive from such consolidations are a natural force that drives this result. The consolidations, however, are not all the same, and it is useful to distinguish among them. The four descriptions below indicate the different types of consolidations and the perceived potential to achieve greater profitability through synergies.
Acquisition of Direct Competitors. Some acquisitions are of franchisors that compete practically head-to-head – or at least in the same industry space. While management may draw appropriate distinctions among geographic footprints, customer bases, marketing strategies and more, the essence is that these are the same type of business and, therefore, perceived as being capable of deriving the most synergy from a consolidation. Think of affiliated car rental or real estate brokerage businesses operating under different brands. The synergy often derives from the efficiencies of eliminating or combining overlapping functions, such as the merger of two similar departments into one, or the enhanced purchasing power of buying for two systems instead of for just one.
Acquisition of Indirect Competitors. Some franchisor families compete only indirectly. They are arguably in the same industry segment (e.g., restaurants), but because of the different product offering (chicken vs pizza), delivery method (e.g., dine-in vs take-away), or other characteristics are most appropriately perceived as only indirectly competitive. In a market generally best defined broadly (e.g., as the restaurant industry, the automotive repair industry, or the hotel industry) these segmented businesses are only indirectly competitive as they provide different product or service offerings. Such businesses when consolidated offer synergies that can be significant, but not as potentially significant as those that compete directly.
Acquisition of Complimentary Franchisors. In consolidating franchisors, some acquirers have sought not to bring on direct or even indirect competitors but, rather, other types of franchisors that are only (or mostly) complimentary to the franchisors already in their portfolio. For example, the owner of a franchise system that services residences, would acquire franchise systems that can also service homeowners but in other segments of the residential service category. When consolidated, these businesses offer synergies that can be almost as synergistic as those that are indirectly competitive, especially when the systems are encouraged to collaborate.
Acquisition of Unrelated Franchisors. There are also many buyers of franchisors that do not seek the synergies associated with “add-ons” and “franchisor families.” These buyers are often opportunistic and see value even without maximizing synergies. While there can be some synergies as a result of owning multiple yet diverse types of unrelated franchisors, those synergies are likely to be less than those associated with the directly competitive, indirectly competitive, and complimentary types described above.
III.Reasons for Consolidation.
Increased or enhanced economies of scale, and greater synergy, can be achieved by
putting several franchisors under one roof. Doing so provides opportunities to pool resources. And, one of the main indicators of an ability to pool resources is the degree to which the combined franchisors are similar. The more similar the franchisors, the greater the ability to pool resources, the greater the economies of scale, and the greater the synergies.
IV. Consolidation Increases Risk.
Consolidation and the “synergies” it provides can be and often is a winning strategy. The desirability for synergistically positive results has led to unprecedented waves of consolidation, including through auctions that have been called a “feeding frenzy” and at which franchisors sell for very high multiples of EBITDA. But, along with the synergistic rewards comes risk.
These risks have come to the surface with COVID-19. Entire industries have been decimated, including many in which franchising is commonly used. The industries include restaurants and bars, hotels, amusement and entertainment venues, travel planners, car rental companies, personal service businesses, fitness clubs, and more.
Even franchise families that don’t compete directly, like restaurants and hotels, for example have suffered significant pandemic losses. Those portfolios typically have less diversification than franchisor families made up of complementary franchised businesses or unrelated businesses. During the initial wave of pandemic-related shutdowns, a portfolio of dine-in businesses or hotels dropped more or less in tandem. Whereas a portfolio that had within it complementary franchisors or franchisors in diverse industries might have had some of the losses mitigated. Of course, the mix matters, and exceptions exist, such as for a mix of franchisors of dine-in and take-out restaurants that might have had losses mitigated by the take-out restaurants that were already in place to respond to the abrupt change in demand.
IV.Lessons for the Post-Pandemic World.
The post-pandemic world will no doubt lead to many opportunities for greater consolidation of franchisors. There will be sales of failed franchisors, fallen franchisors, bankrupt franchisors, and insolvent franchisors. And, many of these transactions will be far different from those that took place pre-COVID. Processes that worked pre-pandemic will be adjusted. No longer will it mean simply hiring an investment banker, reviewing the Teaser and Confidential Information Memorandum, conducting due diligence, preparing a Buy-Sell Agreement, holding Management Meetings, conducting an auction, and picking a winner. These deals will likely be more complicated, and require more careful analysis to understand the full picture.
While each will be different, we can anticipate some upcoming transactions needing bankruptcy court approvals (which will allow, for example, the shedding of certain contracts, and transfers free of prior claims), sales of some assets (or territories) and not others, heavy lender and landlord negotiations, real estate sale-and-leasebacks, recapitalizations (debt or equity), infusions of working and growth capital, holdbacks and earn outs, complicated structures such as convertible arrangements, purchases of distressed debt, and more. How these transactions are structured can be as important as the stock or assets being acquired.
Those PE firms with “dry powder,” and strategic buyers with adequate cash, will be wanting to gain market share and greater synergies by buying up prior competition. The temptation to acquire industry competitors will be significant. And, especially so, at the right price.
But, COVID-19 has illuminated a risk that previously lurked in the dark. On top of all of the financial, industry, and system analyses, diversification and correlation concerns will move to the forefront. Sponsors will be looking across the portfolio to understand how a new acquisition might make investors especially vulnerable during a crisis – for example, investors with directly competitive franchisor portfolios might consider acquisition of unrelated franchisors in order to diversify and thereby mitigate risk at the cost of lower synergies. And, this vulnerability analysis is not just theoretical, as new crisis-like market conditions can be readily imagined, such as a second COVID-19 wave, another pandemic, or even industry-focused headwinds such as the effect on auto repair franchises due to the growth in electric vehicles.
Buyers should ask whether the extra reward that comes from the economies of scale and synergy of consolidating same or similar types of franchisors is going to be worthwhile when considering the increased risk. This analysis may also lead some owners of consolidated franchisors to not only conclude that further consolidation in a non-diversified manner is too risky, but also that the current portfolio is too risky and that some divestiture of same or similar businesses needs to take place.
The appetite for franchisors, and the synergies that they bring to the table, will clearly continue. This will likely mean a return to traditional M&A activity, but next time with a greater understanding of the need for diversification or at least the risks of running an industry-concentrated portfolio.
A fuller version of this article, written by the author, appeared in the Summer 2020 issue of the Franchise Law Journal.
Private equity acquisition of multiple-unit franchises: 8 likely negotiation points
February 6, 2019 | Posted by Bret Lowell
Private equity firms have historically been interested in owning franchisors. Due to the limited number of franchisors, and the high multiples at which franchisors have been selling, PE firms are increasingly acquiring multiple-unit franchises by transfer from existing franchisees.
Transfer provisions in franchise agreements usually require that a buyer:
- be approved by the franchisor (based on an existing track record, existing financial statements, and adequate equity ownership)
- execute the then-current form of franchise agreement
- provide a guarantor of payment and performance
- attend training and
- execute confidentiality and non-compete covenants.
Due to the structure and nature of PE firms, these requirements can present hurdles to buyers that are PE firms, and a franchisor may use the PE firm’s inability or refusal to fully satisfy these requirements as a basis to try to deny consent to transfer.
For example, the entity proposed by the PE firm to be the franchisee is likely to have no track record and no prior financial statements and to be highly leveraged. Also, it is unlikely that anyone at the PE firm will be ready to – as the then-current form of franchise agreement will probably require – provide a guarantee of the franchisee’s obligations under the franchise agreement, have (as to both the owner and potentially the manager) an unencumbered minimum equity stake, attend training, or personally sign confidentiality and non-compete covenants. However, after weighing the legal and practical consequences of such a denial, franchisors will often negotiate their traditional approaches to these provisions and be flexible about their policies in order to facilitate a transaction with a PE firm.
Legally, if a franchisor unreasonably withholds its consent, an existing franchisee may bring claims for breach of contract, breach of the covenant of good faith and fair dealing, or tortious interference. While the claims for breach would belong only to the selling franchisee, both sellers and buyers have sought to bring tortious interference claims.
Advantages and disadvantages of negotiating with a PE firm
From a practical perspective, and beyond the general desire to avoid litigation, there are often advantages and reasons why a franchisor should be willing to negotiate with a PE firm and thereby bend when it comes to its usual requirements and policies pertaining to transfer. There can also be disadvantages to providing this flexibility.
On the advantage side, PE firms have the potential to infuse significant capital into the franchisor’s system through the renovation of existing units and the construction of new units. In turn, such investment can enhance the brand in a way that leads to greater overall system revenue and royalties and higher resale values system-wide.
On the disadvantage side, there are a number of unfavorable aspects to private equity involvement. PE firms generally have a short-term strategy (about seven years) through which they seek to return investor money and earnings. And, because they are driven almost exclusively by financial returns, PE firms may close marginal units without regard to brand, development obligations or breaches of the franchise agreements.
Likely negotiation points
To overcome these differences, franchisors and PE firms typically need to negotiate and modify owner/operator, training, confidentiality, financing, non-competition, transfer, guarantee and cross-default requirements. Specifically, PE firms are likely to negotiate:
- Owner/operator requirements. As PE firms generally have a unique ownership structure not suitable for standard franchise agreements, they may need to modify owner/operator equity requirements.
- Training requirements. Private equity executives are unlikely to be willing to attend the training (or at least extensive training) typically required under standard franchise agreements.
- Confidentiality requirements. Confidentiality obligations may need to be tailored in a manner that allows private equity executives to oversee other portfolio companies that may operate in a same or similar field.
- Financing requirements. Provisions and policies requiring franchisor approval of franchisee financing arrangements likely will need to be changed so that, at most, the franchisor will receive notification of new franchisee financings.
- Non-competition requirements. PE firms are likely to want to do “bolt-on” acquisitions of businesses that they can add to their franchise portfolio (eg, other franchises from within the same system), and, more contentiously, may desire to acquire other businesses that operate in the same or a similar space.
- Transfer requirements. A “not unreasonably withheld consent” qualification on a franchisor’s approval rights may provide the PE firm with the comfort it needs to transfer the franchises according to its exit strategy, but even more unrestrained freedom to transfer may be requested. Of potentially greater concern to a PE firm would be provisions in the franchise agreement that restrict minority transfers, transfers of beneficial interests (ie, interests in the fund that owns the portfolio company franchisee) and provisions calling for franchisor approval of heirs and representatives of such persons upon death or disability.
- Guarantee requirements. In lieu of a guarantee from the PE firm of the portfolio company’s obligations to the franchisor, the franchisor may instead be willing to receive a letter of credit, or simply rely upon a strong balance sheet that remains above certain minimums.
- Other requirements. If multiple franchise agreements contain cross-default provisions, and it is the intent of the PE firm to shutter certain non-performing units, the PE firm may seek franchise agreement changes that allow for such closures without risking a default under franchise agreements other than the one that corresponds to the closure.
PE firm ownership: a trend likely to continue
In sum, PE firm ownership of multiple-unit franchises is a trend that is likely to continue at a significant pace. The process of acquiring such a franchise is similar to the transaction in which a PE firm acquires a franchisor (ie, entailing a bidding process; a Memorandum of Understanding; a purchase agreement, including representations, warranties and schedules; due diligence, including of franchise aspects; and a closing). Unlike such franchisor transactions, the acquisition of a multiple-unit franchise entails not just the assignment and assumption of existing franchise agreements but also the negotiation and entry into non-standard franchise agreements with the franchisor that reflect the special circumstances that PE firms present.
Learn more about this trend and its implications by contacting the author.
Bret Lowell delivered an earlier version of these comments at the American Bar Association’s 41st Annual Forum on Franchising.
FRANVOICE®: Getting Your House In Order: Pre-Sale Clean Up – An Interview with John Goldasich (M&A Advisor)
June 13, 2017 | Posted by Bret Lowell, Founder, and John Goldasich
Todays’ interview is with John Goldasich of Arlington Capital Advisors, an investment banking firm that works with franchisors. Here we explore the topic of pre-sale cleanup.
Bret: The competition for Franchisor deals seems to be getting more intense lately, what power to sellers bring to the transaction? Can you provide some color on what they should expect from today’s market?
John: For well-performing franchisors, this is a seller’s market. But even with that dynamic, sellers should hire an experienced M&A advisor who knows the franchise landscape, knows who the buyers are and knows how to drive the most favorable terms for the franchisor.
The dealmaking process has also shortened significantly. Several years ago, I would have said that the process usually lasts about 6-9 months. Now, it can take 4-6 months. The introduction of rep & warranties insurance and the competition in today’s market has cut time to close in most instances. Sellers need to initiate a process with clear objectives and work with their advisors closely before approaching the market to make sure that they are prepared for the accelerated timeline.
Bret: We often work with Franchisors who are selling their business for the first time. Can you tell us what to expect in the due diligence process and more specifically, how to avoid red flags cropping up? Where should Franchisors start when they are thinking of selling?
John: Many of our transactions are with first time sellers. We work closely with our clients on the front end of any transaction to understand their objectives and tailor a process for them. The main thing we educate our clients on is that buyers of franchisors are attracted to the royalty based revenue model and the high cash flow margins that are produced by that royalty base; therefore, the health of that recurring revenue stream is most important to a buyer.
A lot of operators get fixated on EBITDA or the size of their system or growth opportunities. But above all else, an acquirer or investor is going to look at the health of the franchisee base, because that is the underlying driver of the health of that business. It is the one factor that has the most impact on valuation in franchising.
The main thing that buyers are looking to diligence is what the strength of the franchisee base is. They want to know if the franchisees are happy – if they are making money, if they are committed to opening new units, or are they meeting their development schedules.
Bret: What makes a standout seller?
John: Providing visibility into franchisee health is critically important. We recommend that all emerging franchisors provide a fully disclosed Item 19. Item 19 is the section in the FDD that addresses franchisee profitability. We also encourage franchisors to require that their franchisees maintain a standard chart of accounts and that they submit unit-level profit and loss statements to the franchisor. That way the franchisor has visibility into the overall health of the system, can compare franchisee performance to others in the system and can provide that information during the sale process.
Acquirers also really want to see a healthy development schedule. It is very telling if you have a lot of franchisees that are behind on their development schedule. That shows that the franchisees are not willing to invest or grow with the franchisor.
The other thing we look for is does the franchisor have the infrastructure in place to support future growth? Often, franchisors operate on a shoestring budget and a buyer is going to look at that and say ‘well I have to add ten incremental people to the SG&A to support the business and future growth,’ so they may deduct that expense from the EBITDA. You also want to know if there are any unresolved issues up front. Those could be finance issues, legal issues, franchisee issues and so on.
Buyers also want to see if a franchisor has hit a critical mass and thereare some hurdles that are indicative of that. Every system is different, but one of them is $5 million in recurring revenue – that can come in the form of royalties, sales of products to franchisees, or rebates. We typically also see critical mass in the form of over 100 units or over 100 franchisees. High franchisee validation rates also factor in.
Without those items, the acquirer is going to have to look at other ways to gauge the health of the business and the franchisee base and those can be more difficult to execute. It could mean the acquirer takes a survey of the franchisee base or conducts one-on-one interviews. Those more difficult options can create confidentiality issues or lengthen the time to close because it is a less straightforward process.
Bret: If red flags do pop up in a process, what should sellers avoid doing if they don’t want to make things worse?
John: A lot of these issues can be handled right up front through the initial marketing process. For example, if financial statement quality is a concern, you can work with your advisor and a CPA firm and put together a sell-side quality of earnings diligence report that you can make available alongside the transaction marketing materials. If consumer efficacy is an issue, you can work with a consumer research firm to do a consumer survey and add the findings to your marketing materials.
Working with a good advisor that has seen red flags pop up before and worked through similar issues in the past can help mitigate red flags considerably. This is also why we advise emerging franchisors to develop and maintain relationships with highly qualified accounting, legal, consulting and M&A practitioners as the business grows.
Bret: When sellers are thinking about an exit strategy, what’s realistic? How do you find the right audience?
John: It really depends on the seller’s objectives. If a seller wants full liquidity, such as looking to retire, then the M&A advisor will look at marketing the business to a strategic acquirer or a dual track process with strategic bidders and private equity bidders. If strategic focused, that means they are positioning the business to a larger organization and pitching it as a new business line or as an incremental revenue stream with potential cost or revenue synergies associated with the acquisition. There’s a different buyer universe for strategic acquirers and they are sub-sector specific.
If the objective of a franchisor is to take partial liquidity or bring on a partner to facilitate additional growth, then you’re really looking to transact with private equity investors. Private equity might see the business as a platform investment or as an add-on acquisition to a franchisor within their existing portfolio. There’s no cookie-cutter process and we work with each client to tailor a process that is most impactful at meeting their transaction objectives.
FRANVOICE®: Finding Buyers – An Interview with Amy Forrestal (M&A Advisor)
Todays’ interview is with Amy Forrestal of Brookwood Associates, a middle-market investment banking firm that focuses on restaurant, franchisor, and franchisee transactions. This interview is an exploration of how investment bankers find buyers for franchisors.
Bret: Amy, how far in advance of a sale are you ideally engaged?
Amy: Typically, we like to know our clients many years before they start a sale process. Sometimes that happens, and other times we meet a potential client only months before we begin the process. The earlier we know and begin to work with a sell-side client, the more helpful we can be to properly position their business for a rewarding exit.
Bret: Once you are engaged, how do you prepare your client to be sold?
Amy: We have an extensive due diligence list that we review with the client which includes financial, operational, and legal issues. To begin, we typically spend a day or two on site to understand the business and its potential. We are obviously initially focusing on financial metrics like Average Unit Volume, same store sales, store level profitability, and cash-on-cash return of building new units. If a client has not done an audit, we suggest that early in the process. We also want to understand the infrastructure and the management team. We also look at lease terms, franchise agreement terms and expirations, and remodel requirements. Growth is another important area — we want to really understand the brand, its historical growth, and the potential for future growth.
Using the above information, we often make suggestions. For example, if there are items than can be improved, like obtaining another option on a lease, we make that suggestion. Also, most times, clients are focused on after tax proceeds from a transaction, so working with their attorney and accountant to consider best deal structure and estate planning issues are often critical early planning steps.
Based on all this gathered information, we then prepare a teaser and a Confidential Information Memorandum (“CIM”) which describes the company and explains the opportunity for potential buyers.
Bret: How do you find potential buyers?
Amy: We have an extensive network of buyers with whom we are constantly in discussion. The website, www.FranchisorPipeline.com, is also a great source of buyers.
Using such resources, we prepare a focused buyer list for our client’s approval. The scope of the list will depend on the client’s goals and objectives. Buyers can include strategic buyers, private equity groups and family offices. The type of buyer will depend on the owners’ objectives, such as whether they want to reinvest in the deal in a rollover scenario or would prefer instead to exit and retire.
With the list complete, we then contact the decision makers for the buyers to describe on a “no name” basis the situation, and deliver a teaser. If the prospective buyer is interested, we have a Non-Disclosure Agreement (“NDA”) signed before delivering the CIM and other information.
Bret: What is the process of narrowing down the field of potential buyers?
Amy: After distributing materials to potential buyers as described above, we ask for Indications of Interest (“IOIs”). These IOIs give a price range, source of financing, and identifies items that the buyer still wishes to receive and review. Based on these IOIs, we select the proposals that best fit our client’s objectives. We then set up face-to-face management meetings and open a data room to which will be downloaded a plethora of documents for the serious bidders to review. We also distribute to prospective buyers a draft Purchase Agreement at that time. Overall, we want the buyers to see the concept, meet management, and get all their questions answered. Once we have had those meetings and given time to finish up due diligence, we then ask for Final Bids from this group of buyers. Details and final price are then negotiated with the best fit. The “best fit” is usually the best price but also factors in comments on the Purchase Agreement, rollover equity requirements, escrows required, indemnification levels, and personality fit.
Bret: Once the field is narrowed, what comes next?
Amy: Once we have picked the winning bidder, we typically sign a Letter of Intent (“LOI”) which almost always includes an exclusivity clause. This exclusivity could last as short as 30 days to as long as 90 days. Exclusivity is a negotiated item and depends on how much data has been shared in the data room, whether or not the financials are audited, and whether a “Quality of Earnings” analysis has been done pre-sale. During this time, multiple tasks are undertaken:
- due diligence is being completed by having a third party confirm the numbers,
- legal due diligence is proceeding,
- insurance due diligence is ongoing,
- financing is being firmed up and finalized, and
- the Purchase Agreement is being negotiated.
Bret: How do you get to the finish line — a final Buy-Sell Agreement and a closing?
Amy: Once diligence is completed, various documents then need to be assembled. These documents include financing documents, lease assignments, liquor license assignments, Hart Scott Rodino antitrust filings (depending on the size of the transaction), environmental approvals, and more. And, unless the seller is the franchisor, approval from the franchisor may be necessary, including waiver of any applicable rights of first refusal and execution of new franchise agreements and other documents. A final flow of funds also needs to be prepared and confirmed, and working capital needs to be analyzed and projected. We work with the seller and its legal counsel and accountants to get all these documents, schedules, and other documents in order. And, when these pieces are fully assembled, the Purchase Agreement typically is then signed. Eventually, everything comes together and the closing can occur.
This sale process from launch to closing is at a minimum four months but is more typically a six to seven month process.
FranVoice®: Interview with Burt Yarkin (M&A Advisor)
An important player in many sales of franchisors is an “investment banker” — an intermediary whose role is to shepherd the transaction — from finding a buyer/investor — to seeing the transaction through to completion. Below is an interview with Burt Yarkin, Managing Director of The McLean Group, a leading investment banker for middle-market franchisors.
Bret Lowell: How does a franchisor know when it’s time to sell?
Burt Yarkin: Franchisors face numerous issues and challenges leading up to and during the sale process. A big question is: when is the preferred time to pursue a transaction? The decision involves three considerations: (a) company-specific variables, (b) existing market conditions, and (c) synergistic opportunities with potentially interested parties.
As to (a), at a certain point in a company’s growth, the management team is likely to desire growth capital or a strategic partner to accelerate growth. As to (b) — market conditions — it is important to evaluate the company’s recent performance and look at recent transactions of similar companies to gather an accurate picture of valuation. Market analysis of the state of private equity and availability of investable capital is also important. Regarding (c), franchisors should consider synergistic opportunities with other brands, such as access to new customers, a wider geographic footprint, and expanded product/service offerings.
Bret Lowell: What is the process to sell a franchisor (or partial equity in a franchisor)?
Burt Yarkin: A sell-side transaction is a multi-step process that typically takes 4-9 months. The process usually begins with the management team and a trusted advisor/investment banker working together to understand objectives, determine a preliminary range of value, and develop a tailored positioning strategy for strategic and financial buyers. A strong presentation of favorable performance trends and a clear articulation of growth strategy are critical to a successful exit for the franchisor, shareholders, and the franchise system. The ultimate goal is to generate multiple offers through an efficient and competitive auction involving a variety of motivated buyers.
When the company goes to market, the advisor distributes a confidential information memorandum (CIM) to buyers, answers follow-up questions, and solicits initial non-binding offers. After initial offers are received, a select group of potential buyers are typically invited to meet with management and gather more information. Shortly after management meetings are concluded, the seller will upload legal, financial, and other information to a data room so that buyers can determine an appropriate valuation and submit a final offer. Once a single acquirer is selected, the advisor will negotiate the details of the offer. At the end stage, financing is organized, legal documents are finalized, and the advisor arranges to have the transaction consummated.
Bret Lowell: Why are franchisors an attractive target?
Burt Yarkin: The franchisor/franchisee model stands out as a proven business concept that is a prime target for investors. Investors want differentiated concepts that have unique value propositions and sustainable competitive advantages. Concepts that are able to offer a distinctive service model or environment are particularly attractive to investors.
When analyzing the financial health of a franchisor, investors view unit-level economics as the best indicator of a company’s growth potential and sustainability. A common measure investors examine is year-over-year, same-store sales. And, while unit-economics are important, other factors such as number of closed units and number of troubled units are analyzed. Additionally, investors are attracted to the predictability of recurring royalties.
Bret Lowell: What is the state of the market; what multiples are you seeing — how are franchisors valued?
Burt Yarkin: Overall, the market to sell franchisors is very strong. Private equity firms have $1.34 trillion of capital available to invest, also known as “dry powder.” This figure has grown significantly within the past year and is putting pressure on private equity buyers to invest the cash or return the cash to their investors. Premiums are being paid — sometimes even double-digit multiples of EBITDA — for differentiated, on-trend concepts with strong unit economics, strong management teams, and significant growth opportunities.
Bret Lowell: How will life change post–transaction?
Burt Yarkin: Franchise and private equity relationships are collaborative and are oriented toward the long-term success of building the company. If a private equity firm invests in your company, they generally do not seek to be involved in day-to-day management, but rather to act as a strategic advisor and add value through their advice and experience building businesses. Through an extensive network of operational managers and advisors, private equity firms are often able to strengthen the management team. Typically, private equity firms want to meet with the management team quarterly to discuss financial and unit growth. These meetings are to evaluate the company and to identify areas for improvement.
Life will change post transaction. For it to be fulfilling, make sure you have run a good process and have selected the right investor or partner.
August 5, 2015 | Posted by Bret Lowell, Founder, and Jeremy Dorfman
You have listed on Franchisor Pipeline to find an acquirer of, or an investor in, your franchisor. In doing so, you have kept your company anonymous, and have now been contacted by a prospective buyer or investor. Early in your discussions you should present and have signed a Non-Disclosure Agreement or “NDA.”
Ideally, the NDA will be signed prior to the exchange of any confidential information. If discussions have begun, however, an agreement still can be drafted to apply to talks that have already taken place.
It is useful to prepare a template NDA. This template should reflect the franchisor’s unique business concerns and the specific types of information that it considers confidential. As such, your template NDA will be different from the template NDA prepared for other franchisors.
Also, the template may need to be conformed to reflect the parties to the transaction. For example, if the prospective buyer is a competitor (e.g., a strategic purchaser in your line of business) the concerns and provisions will be different from those that arise when the prospect is a financial buyer or investor (e.g., private equity). Most NDA templates are apt to be subject to some negotiation when presented to the other side.
Some of the differences that may exist (and be negotiated) from one template to another include:
Unilateral vs Mutual Protection
Is it only your information that needs protection, or is the other side likely to also share information with you that requires protection? This need for mutual protection is, of course, more likely when the prospect is a strategic purchaser.
Definitions of “Confidential Information”
There are typically two broad categories of confidential information to be protected.
The first, and potentially most important aspect to be protected, relates to the mere fact that you are even considering a possible sale of (or investment in) your business – that is, that negotiations are taking place. You likely do not wish to have your franchisees, your employees, or your suppliers know that you are contemplating a sale due to concern that they will react negatively. This could be due to their belief that a new owner will be less paternalistic, or more aggressive about enforcement of the franchise agreement, or simply due to fear of the unknown.
The second type of confidential information to be protected is that which is non-public and is exchanged between the parties. This may be generally described, or may be by reference to specific information such as development and marketing plans, organizational infrastructure, operating manuals, methods of franchisee support, the identity of customers, and sales and profits (of both the franchisor and its franchisees).
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While the terms “Non-Disclosure Agreement” and “NDA” are commonly used, most NDA’s cover more than just non-disclosure. NDA’s also typically require non-use and non-solicitation.
The recipient of the confidential information should promise to use it only for purposes of evaluating the possible transaction. You should also consider requiring the recipient to be responsible for its representative’s (e.g., a buy-side broker’s or advisor’s) use and improper disclosure of confidential information. You may even want to have the representative sign on to the NDA.
Especially if the recipient is a strategic buyer, you are likely to want protection from solicitation. You would not want to the prospect hiring away your key employees. You may also want to prohibit solicitation and purchasing of key products from vendors on which your franchise system’s reputation is based. And, while non-compete clauses in your franchise agreements may be helpful, you may also wish to prohibit solicitation of franchisees whose franchise agreements are due for renewal.
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The NDA should also address the duration of the non-disclosure, non-use, and non-solicitation obligations. Some information and activities may be appropriately protected and restricted in perpetuity, whereas other information and activities may be adequately and reasonably protected only for a few years.
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As a seller listed on Franchisor Pipeline, you should have a template NDA that fits your particular circumstances. Using this NDA, you will be able to rapidly begin discussions when you are contacted online by prospective purchasers and investors.
Staging Your “Franchise House” for Sale
A common approach to selling a home – for top dollar – is to “stage” it. Paint the walls, polish the floor, replace appliances, and bring in the props (the rental furniture and accessories) that make the home look “just right.”
Selling a franchisor – for top dollar – entails much of the same. Be sure that all the components of the franchise house are in place, all problems are cleaned up, and the props (i.e., lists, charts, and other documents) that will appear in the online dataroom that sellers will visit look “just right.”
In staging your home, it is each room that needs to look “just right.” In staging a franchisor, it is each department that must look “just right.”
And, if you are in charge of a department you need to assure that your department looks “just right.” You would not want to be responsible for a buyer’s cancellation of the transaction, reduction in the purchase price, or hold‑back of a portion of the proceeds because your department did not look “just right.”
Any buyer will do a thorough investigation of your “franchise house” before they make a bid to purchase. This investigation is known as “due diligence.” There can be many aspects to due diligence. For example, financial specialists will review financial statements, technology specialists will review software, intellectual property specialists will review trademark rights, and franchise specialists will review compliance with the franchise laws.
But, before the “other side” conducts its due diligence, the seller will want to conduct its own due diligence audit. This will assure that all the components are present, enable any problems to be fixed, and provide a basis for creation of the props (i.e., lists, charts, and other documents) that will appear in the dataroom. This sales planning process can and should begin even years before a sale.
For example, in the franchise arena, and well before a sale, the seller will want to assure that each of the following look “just right”:
- Agreements – franchise and ancillary agreements (such as confidentiality, non-compete, development, and international agreements) must exist, be signed, and be analyzed for any possible issues (g., missing provisions [such as for ad fund, social media, data protection, and alternate dispute resolution]; antitrust violations; state franchise law violations; royalties too-low or waived; vague, overlapping or overly large territories, etc.).
- Disclosure Documents and Registration – there must be timely and effective compliance with FTC, state and international requirements (along with receipts or other proof of delivery), and, for states in which it is required, approval of advertising materials and salespersons.
- System Materials – there must be in place all of the items promised by the franchise agreements, such as an operating manual, training programs, and supply arrangements, and each of these arrangements should be reviewed to assure no contractual, antitrust, or other violations.
- Advertising Fund – should be properly used, have decision-making authority clearly set forth (g., by the franchisor, an Advisory Counsel or an advertising committee), be reconcilable (e.g., regarding surpluses and shortfalls), and provide for effective and timely reporting.
- Other Important System Issues – also must be considered, such as terminations, non-renewals, non-competes, transfers, litigation (historical and pending), intellectual property rights, real estate (owned & leased), accounts receivable balances (royalties, ad fund, product purchases), franchise relations, and more.
If any of the required franchise components are missing, have been improperly or unlawfully dealt with, or will not lead to the creation of the lists (e.g., of agreements, of FDDs, of terminations and transfers), charts (e.g., of system growth), and other documents (e.g., of sources of revenue) that buyers often wish to see in the dataroom — the ability to sell the franchisor, and especially the price paid for the franchisor, will be in jeopardy. It is far better for the seller to identify these business shortfalls and legal liabilities before a buyer does, in order to fix what can be fixed, and to properly explain that which is not repairable. Only an early effort to audit and get your “franchise house” ready for sale will reveal these important components that require attention.
Seller’s Market Opens Myriad Options
November 2014 | Posted by: Jeremy Holland, The Riverside Company
Franchise industry entrepreneurs and management teams may never see a better market for selling all or part of their companies. I have worked in private equity for nearly 20 years and have never seen companies valued at such high multiples of their annual earnings. Many factors are fueling this trend, including competition among interested investors and low interest rates, but one thing is certain — this great seller’s market won’t last forever.
So what’s a business owner to do? As someone who seeks out deals for The Riverside Company, a global private-equity firm, it probably seems self-serving that I’d encourage you to sell now, but private equity offers many more options than simply selling. I’ve heard plenty of myths in the course of my work, and by dispelling some of them I hope to show how you might benefit from this incredibly strong market while doing exactly what you want with your business.
Read the full article here.
Franchisors Are Hot!
June 3, 2013 | Posted by Bret Lowell, Founder
Franchisors have long been sought after investment and acquisition targets. This is because, unlike a stand-alone business, the franchisor owns a proven, replicable business model and system. Also, the purchaser of a franchise system will gain the rights to the franchisor’s extremely valuable assets – intangibles consisting of contractual rights and IP (trademarks, trade secrets, goodwill, etc.), as well as established relationships with numerous customers, suppliers and other vendors. And, franchisors often have rising valuations due to the enhanced unit sales and brand recognition that comes from expanding systems.
Additional reasons why franchisors are “hot” acquisition targets:
1) Established brand – due to a collection of franchised (and company-owned) units, and the products or services sold to multitudes of customers by those units.
2) Recurring, predictable revenue and profitability – due to the statistical aspect of having a relatively constant number of replicated units and relatively constant margins.
3) Proven infrastructure – due to having developed proven methods for franchisee recruitment, store openings, training, product purchasing, customer service, operations, advertising, and more.
4) Non-capital intensive operations – due to the ability to downstream certain costs (e.g., operational, advertising, training, and more) to franchisees.
5) Experienced personnel – due to having in place the relatively small executive and management teams needed to run most franchise organizations.
6) Expansion opportunities – due to the relative ease of reaching new markets (domestic and international) through the use of franchise growth techniques.
7) Transparency – due to easy access to franchise disclosure documents that are revealing with regard to: (a) the franchisor (e.g., franchisee turnover and franchisee costs, sales, and profitability); and (b) other franchisors that compete with the target franchisor (including their otherwise hard-to-access financial statements).
This collection of desirable characteristics makes franchisors unique, and is the key reason why franchisors are “hot.” In fact, there are not enough franchisors for sale at any given time. Buyers expend enormous effort trying to locate and land “proprietary” deals before they come to market, and those that come to market often result in bidding wars.
THE Marketplace For Buying & Selling Franchisors is “red hot” – and it exists here on Franchisor Pipeline!
Please see Franchisors 4 Sale® for a listing of current franchisors for sale.