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The franchise industry, which in the past had been ignored by institutional investors, has recently gained favor with private equity firms (PE firms) who are acquiring or making significant investments in franchise companies. PE firms raise funds from institutional investors, pension funds and high net-worth individuals to acquire companies in targeted industry sectors. Unlike venture capital firms which make significant minority investments in early stage companies, PE firms invest in companies with demonstrated track records with the view to acquiring all or a significant ownership stake, increasing the profitability of the target and selling the target typically within a five- to seven-year period. In instances where the founders remain in control of the franchisor, private equity is a source of expansion capital which potentially allows the founders to engage in two sale transactions, the first being the sale of the business to a private equity fund, which will typically want the franchisor’s management team to remain in place with a minority ownership stake until the PE firm is ready to flip the company. When the PE firm sells the company, management will then sell its minority interest which should have created additional value over and above the valuation associated with the initial investment by the PE firm. This article discusses the steps that a franchisor should take to attract private equity. PE firms routinely receive solicitations and franchisors would be mindful to create a good first impression if they hope to attract interest from their preferred firm or firms. As an initial step, a franchisor must ensure that it is presenting a “clean company” to prospective investors. Management should critically assess the company in terms of brand equity, operations, legal compliance and opportunities. Successful franchise systems are operated by persons who have expertise in dealing with independent owner-operators. The most successful franchise systems are those where the lines of communication between franchisor and franchisee remain open, where the franchisor continually seeks ways to upgrade the franchised system and promptly communicates suggested changes to the franchisee community. In reality, administering a franchise system is unlike operating a network of company-owned units. For this reason, PE firms typically require then-current management of the franchisor to retain a minority stake as the PE firm wants to realize the upstream increase in value, not run the day to day operations of a franchise system. Brand equity is arguably a franchisor’s greatest asset and will be perhaps the single most-critical item evaluated by a PE firm that considers investing in a franchise company. PE firms consider the extent to which the franchisor has created sufficient brand identification in its existing trading area to warrant its investment that will fuel growth outside of its present trading area. The stronger the brand, the greater the likelihood of exporting the concept to other trading areas. Conversely, if brand identification is considered less than robust, a PE firm will discount the valuation of the franchisor because of a perceived difficulty in exporting the franchisor’s concept to new markets. Whether the franchisor has sufficient brand identification in its existing market is a subjective question that should be considered in the most objective manner possible. Key issues that must be addressed in determining the extent of brand identification include the degree of public recognition of the prospective franchisor’s existing trademarks and service marks, the degree of public acceptance of the existing products or services sold by the prospective franchisor and the extent to which its present market and future markets are dominated by competitors having superior brand identification and economic resources. To position itself for a possible sale to a PE firm, a franchisor should evaluate its advertising to ensure that a consistent message is being delivered to the consuming public and should survey its targeted consumers to determine whether the company’s public image is consistent with its branding effort. A franchisor’s operations should be consistent across all operating units. The hallmark of franchising is consistent delivery of goods and services resulting in the ratification of consumer expectations. Consumers demand value for their money and build their purchase decisions around whether the vendor can deliver the requisite goods or services faster, better or cheaper than the competition. It is the rare consumer indeed who will knowingly purchase goods or services of an inferior quality. Therefore, to ensure success a business must critically examine the goods or services that it sells and determine whether such goods and services are of a sufficiently high level to distinguish them from the competition. PE firms recognize the need for a compelling story, and recognize that a business offering inferior or even average quality goods and services will have difficulty in franchising its concept because there is no incentive for the typical consumer to purchase such goods or services. While quality products or services are of paramount importance, they are not the sole component of a successful franchised business. The typical franchisor-franchisee relationship has a tension unlike that in other business relationships because both parties own and operate independent businesses, the success of which depends on the mutual cooperation and respect of the parties. If management of the franchisor is determined to regulate its franchise system in a dictatorial manner, treating franchised outlets in the same manner as company-owned outlets, the franchisor will often be at odds with its franchisees. To avoid the problems associated with franchise relations, a franchisor should endeavor to employ or train persons who are experienced in dealing with franchisees and with whom prospective franchisees will have good relations. PE firms will evaluate the quality of franchisee relations during the due diligence process in order to set price. The prototypical franchise system is grown by locating franchised units in areas contiguous to existing or planned company-owned units. A franchisor should avoid the temptation of franchising outlets in wholly unrelated geographic areas without having first considered whether such expansion will ultimately be beneficial to its long-term strategic plan. Expanding into contiguous geographic areas confers certain benefits upon the franchisor such as ease of administration and the ability of its franchisees to make use of the franchisor’s then-current sources of supply for goods and services. On the contrary, franchisees who are located in more remote regions may be served by suppliers who, while approved by the franchisor based on some empirical criteria, are unable to deliver the requisite goods or services on the same consistent basis as the franchisor’s normal vendors. PE firms critically evaluate a franchisor’s sales history to determine whether the franchisor will be able to grow its system. It is not sufficient to show large numbers of franchisees. Rather, the franchisor would do well to reach critical mass in one or more ADI’s or area of dominant influence. According to ASCAP, an ADI “is the geographic area or market reached by a radio or television station (and) (i)t is used by advertisers and rating companies to determine the potential audience of a station.” In short, a franchisor is better served to sell 50 franchises in an ADI, which should enable it to advertise on radio and TV thereby further strengthening the brand, and then selling 50 franchises without regard to location. A franchisor should formulate a careful screening process in order to select only the most qualified franchisees. To the start-up franchisor – on whom there is typically pressure to close any deal – a qualified franchisee may be a person with sufficient funds to invest in the franchised business. However, a franchisor who seeks to solicit interest from a PE firm should be mindful that a qualified franchisee is not simply a person who has sufficient capital but one who has a desire to work within the context of a franchise system. The ability to work within a franchise system is critical given that the success of a franchise system is dependent upon uniformity of appearance and consistency of the requisite product or service. Franchisors and by extension PE firms do not want to be in the position of frittering away valuable resources on recalcitrant franchisees. Finally, franchisors should have “clean” legal files. The UFOC should be up-to-date, with all regulatory filings having been made. The franchisor should also ensure that its principal trademarks are registered in all applicable jurisdictions so that expansion will not be disrupted on a post-closing basis. In short, a franchisor seeking to attract the interest of a PE should operate its business much as if it was preparing to engage in a typical M&A transaction to attract the right PE firm and the maximum valuation. EDWARD J. DEMARCO JR. is a partner in the business and finance department of Ballard Spahr Andrews & Ingersoll practicing in the franchise and distribution group.

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