Private equity and franchise networks: the next growth phase?
What issues should private equity firms consider when looking to invest in a franchise network?
Australia is a franchise nation. For several years, Australia has held one of the highest levels of franchisors per capita in the world and since the global financial crisis the franchise sector has performed well and demonstrated strong growth.
The Franchising Australia 2016 survey conducted by Griffith University estimated the annual sales revenue generated by the franchise sector in Australia was $146 billion, up $2 billion from 2014. This is despite a domestic economy still characterised by moderate retail spending and weak consumer confidence. The results also predicted that as the sector matures we will see the number of franchisors lessen whilst individual franchise systems grow internally.
Over recent years there has been significant investment by private equity firms in all retail sectors as well as a number of successful private equity exits. Private equity firms tend to favour businesses with strong brands and leading positions in niche, fast growing markets. Many brands which have these characteristics use franchising to expand in a way that reduces their capital input requirements and ensures those operating the businesses are incentivised to grow it. This trend, combined with private equity’s continuing interest in the retail sector indicates that private equity investment in franchise networks will continue to grow.
This article outlines some headline issues private equity firms should be considering when looking to invest in a franchise network and outlines some key issues to consider when structuring a private equity buy-in which will facilitate an exit in the future.
A key consideration for private equity purchasers will be validity and sustainability of revenue flow of the franchise network (such as initial fees, royalties, rebates, product and service sales). If the nature of the business is seasonal then the timing of the acquisition is important. The potential purchaser should also determine whether franchisees are up to date with their payment obligations and if any have been granted royalty relief. Some franchisors derive the majority of their revenue from rebates rather than franchisee royalties, so identifying the revenue drivers early on will help guide the focus of a purchaser’s due diligence.
A good indicator of the health of a network is whether the majority of franchisees have positive cash flows and strong earnings. Similarly, relationships with franchisees are likely to be better where franchisees have enjoyed consistent business growth. However, if there are outstanding amounts owed to an outgoing franchisor, to protect relationships with franchisees, the outgoing franchisor should be restrained from making claims against franchisees post completion. Alternatively, this could be addressed by the purchaser taking on the outstanding debt. Of course, this may result in an increase to the purchase price.
Depending on the private equity firm’s plans for expansion, the factors affecting growth potential may differ. For example, if the purchaser is looking to buy back franchised stores to utilise in-house management resources to run company owned stores, relevant considerations will include:
- are there opportunities to acquire existing franchise rights?
- on expiration of franchise agreements, what obligations does the franchisor have to grant franchisees a renewal term?
- any rights of first refusal granted to franchisors in respect of the sale of a business by a franchisee.
- what ability does the franchisor have to control the premises that the business is operated from? Does it hold the lease directly with the landlord and sub-lease to the franchisee or does the franchisee lease the premises directly from the landlord?
- what is the level of management competency and leadership within the franchisor?
Whereas if the purchaser’s intention is to use franchising as a model to expand the network quickly, the purchaser may wish to focus on issues such as:
- are there any exclusivity rights granted to franchisees which would impact on the ability to grant new franchises?
- how many multi-site franchisees are there in the network and have they been successful?
- are many franchisees looking to exit the network?
- what rights does the franchisor have to purchase, merge, acquire or affiliate with other networks (including competitive networks) and require franchisees to re-brand?
- how many franchisee prospects does the franchisor have in the pipeline?
In addition to the usual due diligence conducted as part of an acquisition, there are a number of issues particular to franchise networks that purchasers should be mindful of, some of which are set out below.
Feasibility of the Franchise Model
A purchaser of a franchise network must understand that when completion occurs they will be in the business of franchising rather than just selling the particular product or service at retail level. Franchise businesses rely on revenue from royalties paid by franchisees and rebates from suppliers based on the purchases of products by franchisees. As such, the success of the overall franchise business is inextricably linked to the profitability and viability of each individual franchisee.
It is a fundamental consideration that a franchisee within the network can remain profitable after payment of royalties to the franchisor in addition to their key operating costs such as rent, cost of goods and employees. It is therefore necessary that an assessment is made of the profitability and sustainability of at least a cross section of, if not all, unit franchises. If there are significant numbers of franchisees that are not viable or only marginal in terms of profit it may be necessary post completion to terminate a number of unit franchises or even revise the royalties payable by franchisees. This will have a direct impact on the profit of the franchisor.
It is vitally important for the purchaser that the terms of the existing franchise agreements do not hinder the acquisition by preventing a change in control of the franchisor where there is a share purchase or not permitting an assignment or novation of the franchisor’s rights where there is an asset purchase.
Where consent of or notification to franchisees is required under franchise agreements, this can significantly increase the timeline and costs of a transaction, particularly if there are any disgruntled franchisees who may see it is an opportunity to try and negotiate a better deal.
As the majority of franchisors will develop their standard franchise agreement over time, it is difficult for a franchisor to verify whether each franchise agreement contains the same or similar terms without reviewing each agreement. Special attention should be paid by purchasers to franchise agreements for franchises in key or high value locations.
As part of this review, purchasers should cross check that there is a signed franchise agreement for every franchised business listed by the franchisor and the franchisee entities operating the businesses align with the parties to franchise agreements. It sometimes happens that a franchisee sells its business or transfers its business to a related party as part of a restructure, without informing the franchisor. This may mean that there is no written agreement with the franchisee operating the business.
Most franchise agreements will refer to an 'operations manual' or other policies and procedures that a franchisee must comply with when operating the franchised business. Potential purchasers should ensure that the terms of these do not conflict with the terms of the franchise agreements.
Potential purchasers of franchise networks should also be wary of the changes to unfair contract terms laws which came into effect on 12 November 2016. The drafting of these laws mean that most franchise agreements are caught and if terms of a franchise agreement are deemed ‘unfair’ then the clauses will be void. See our previous articles on the changes to the unfair contract laws at https://www.maddocks.com.au/grappling-b2b-unfair-contract-term-laws/. Purchasers of franchise networks should review the template franchise agreement to ensure it is compliant with these new laws.
The franchising sector is regulated by the Franchising Code of Conduct (Code). The Code contains a comprehensive framework around the contractual process between a franchisor and a franchisee and regulates the use of certain terms in franchise agreements. The ACCC can issue on the spot infringement notices of up to $8,500 or issue civil penalties of up to $51,000 for breaches of the Code.
As part of a purchaser’s due diligence, they should ensure that:
- franchise agreements comply with the Code requirements – the Code prohibits or restricts the inclusion of certain terms in franchise agreements, such as releases by franchisees or post term restraints of trade without appropriate compensation
- the franchisor has a current disclosure document that complies with the Code – a disclosure document sets out various information about a franchisor, the network and the terms of a franchise agreement. The Code prescribes the form of disclosure document that must be used by a franchisor, down to the headings and font size
- the franchisor has provided, collected, and retained copies of all certificates required under the Code – the contractual procedure set out in the Code requires that prior to entry into a franchise agreement, franchisors provide franchisees with the following (among other things):
- information statement – this must be provided when a prospective franchisee expresses an interest in acquiring a franchise and sets out information about the Code and the risks of franchising
- disclosure document, franchise agreement and the Code (at least 14 days prior to signing a franchise agreement)
- site and territory history form
- advice statements – a statement to be signed by a prospective franchisee that they have obtained, or been advised to obtain but elected not to, legal, business and accounting advice in relation to the franchise.
A franchisor should retain full records of the delivery, signature and return of these documents so that compliance with the Code can be easily established.
- the franchisor has followed the procedure set out in the Code for termination of a franchise agreement. The purchaser should review any terminations by the franchisor over the years preceding the purchase to ensure this procedure has been complied with
- the collection of marketing or advertising fees from franchisees is in compliance with the Code -- the Code requires that these funds be kept in a separate bank account, that such funds be audited each year (unless 75% of franchisees agree otherwise) and regulates how the fees can be spent. Often purchasers overlook the fact that as part of the network, they are acquiring the rights to the marketing fund which is generally treated as the franchisor’s asset but the franchisor is restricted in the manner in which it can be used.
As part of its due diligence, a purchaser should conduct a review of the relationships between the franchisor and its franchisees. If there are disputes or general grievances amongst the franchisees, this may assist the purchaser to negotiate a lower purchase price or alternatively avoid acquiring a risk-laden business. It is unlikely a franchisor will allow a purchaser to speak directly with franchisees as disclosing the potential sale to franchisees may be damaging to the relationship between the franchisor and franchisees and future operations of the network if the transaction does not proceed.
An option to address this is to work in conjunction with the franchisor and arrange for an independent consultant to conduct a survey of franchisees of the network which is presented as being conducted on behalf of the franchisor for internal purposes.
Trademarks and other intellectual property are central to the value of a franchise network. Purchasers need to carefully consider ownership of all intellectual property used in the network to ensure it obtains the rights necessary to operate the network. Often intellectual property is owned by a separate entity to the franchisor for asset protection purposes, so it is vital to ensure that the transaction documents facilitate the effective transfer of the intellectual property to the purchaser.
The structure of a franchise network lends itself to arrangements that are heavily regulated in Australia under the Competition and Consumer Act 2010 (Cth).
Often a franchisor will operate company owned businesses that compete for sales with its franchisees. Franchisees will also generally compete for sales with each other in particular geographic locations. In addition, the franchisor will often seek to regulate price between its outlets and force franchisees to buy products or services from specified suppliers at particular prices. Unless the agreements that regulate these relationships are carefully structured or complex exemptions apply, there are risks that some price fixing provisions of the Competition and Consumer Act will be offended.
When looking to acquire franchise networks, ensuring there are appropriate exit strategies in place will be integral for a private equity purchaser.
If the sale is completed by way of an asset sale, the purchaser can put in place the right corporate structure to facilitate an exit pre-purchase. However, if the sale is completed as a share purchase, the purchaser will be inheriting the franchisor’s corporate structure so changes may need to be made post completion. Again, it is important that private equity purchasers consider as part of their due diligence that the terms of the franchise agreements and other arrangements will not adversely impact a restructure post completion.
The structure set out below is one that is often used by more sophisticated franchise networks and enables a clean exit through the sale or IPO of Franchise Holdings Pty Ltd. As noted above, the intellectual property rights are often held in a separate entity for asset protection purposes, and for similar reasons the operations, leasing and franchising activities are often separated also. Ensuring the corporate structure is tax effective will also be a key consideration for private equity purchasers, however this is beyond the scope of this article. It is also becoming increasingly common for franchisors to ‘partner’ with franchisees via joint venture (whether corporate or commercial in nature) arrangements. While these arrangements can be mutually beneficial, they bring with them a separate set of considerations that should be worked through by those looking to invest in a network such a this.
The growth opportunities that are available through franchising make it likely that private equity interest in the sector will only continue to grow. Acquiring franchise networks allows private equity firms to align themselves with strong brands and solid cash flows. Where private equity firms have existing franchise networks, acquiring similar franchise networks will allow them to capitalise on synergies between the two and maximise investor value.
However, the regulated nature of franchising in Australia combined with the involvement of third party franchisees means that private equity firms should proceed with caution and ensure that all advisors for the transaction have experience in the sector so they are alert to franchising specific issues that can arise.
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