Is Private Equity for You?
Even though the calendar has turned to 2023, many of the obstacles franchisees faced in the challenging deal environment of 2022 are still present. Potential buyers continue to be discouraged by rising costs, restricted access to capital, and elevated interest rates. Franchisees considering a sale must seriously contemplate if this is the right time to sell their franchised units.
For companies that cannot wait for the macro-economic environment to improve, our advice is to get organized and proactive. Financial records, contracts, leases, and other financial documents must be in order. Know the challenges or weaknesses of the business and be prepared to offer options or solutions.
Valuations will be lower than in previous years, and a transaction’s momentum will suffer if the buyer encounters unexpected difficulties or surprises during due diligence. In some cases, a quality of earnings (QofE) report may be helpful, with most independent brand transactions requiring one. Proactively completing a QofE report before going to market will often mitigate a purchase price adjustment or re-trade and accelerate the deal timetable.
As part of the transaction, sellers should clearly outline planned and required future capital projects. For networks that have received deferrals or extensions on development or remodeling, the cost, timing, and scope of work should be detailed. In most cases, deferred maintenance and remodels that have not been completed will be a shared cost between buyer and seller. Projections that include proven sales increases have a greater likelihood of acceptance by a buyer.
Details on historical sales improvements will also provide the buyer comfort that they are sustainable and not a one-time occurrence. Positive sales and EBITDA momentum is essential when selling in a challenging economic environment. If you don’t have a definite logical buyer, hire an advisory firm to manage the sale, minimizing distractions with the process while adding value and allowing the seller to focus on maintaining the performance of the business.
Time kills deals
With rapidly changing costs, interest rate swings, global political developments, and government intervention in franchising, completing transactions on an accelerated timeline has never been more important. Uncertainty and the abovementioned factors are contributing to more situations for something to go wrong than at any time in recent memory.
To keep transactions on track, sellers should focus on preparation and relations with contracted parties. Solid relations and communication with landlords can save days or weeks in the closing process in terms of receiving timely consents and lease assignments. Open dialogue in terms of transaction timing can also minimize last-minute demands from landlords. Advanced communication with counsel to prepare initial forms of LOIs, purchase agreements, and other documents also can save sellers time.
A wide gap in valuation expectations persists between sellers and buyers. Many sellers, especially those in the QSR space with drive-thrus, experienced strong financial results in 2020 and 2021 and continue to think they can sell based on those results. Buyers, however, are factoring in an additional 6 months of margin compression because of increases in commodities and labor costs.
Thus, sellers contemplating deals today must be prepared to get creative to bridge the gap. With traditional capital sources constrained, to get deals done both buyers and sellers should review alternatives such as seller financing, non-bank lenders, earnouts, and rollover minority equity positions. We expect the valuation gap to remain unbalanced until margin pressures and interest rates are more predictable.
The private equity option
While private equity can be a solution for franchises, especially in larger, established tier-one brands, most PE firms concentrate on owning brands, not on being a franchisee.
PE firms, family offices, and other institutional capital will continue to selectively pursue new franchisee opportunities. In limited cases, turning to one of these investors may be the best option for franchisees, especially in growing, independent brands with scale. Family offices can be a better fit for franchisees as they often have a longer-term investment horizon with flexibility to invest in real estate as well as in operating businesses. PE firms generally have a defined investment horizon and are not interested in real estate.
However, many brands are not interested in PE investments in their system. Before embarking on a sale to a PE firm, it is best to understand your brand’s thoughts on institutional capital. Brands vary on this issue; some restrict PE investments while others are more open to the idea.
Selling to a PE firm or family office also can be an option for operators who may want to continue to be involved in the business without the pressure of full control. Often PE firms bring industry experience, back-office resources, and technology that can improve profitability. Synergies may be present in their existing portfolio, especially if the PE firm is a proven consolidator. Franchisees looking to partner with a PE firm must be prepared to have a laser focus on growth and investment returns.
Franchisees that are successful dealmakers must adapt to different and evolving criteria as deal conditions remain less certain and fluid. Be patient, flexible, and look for fair solutions that can satisfy both parties. The deal environment is expected to be unpredictable for the foreseeable future, so consider adjusting your expectations to improve your chances of success.
Carty Davis is a partner with C Squared Advisors, a boutique investment bank that has completed hundreds of transactions in the multi-unit franchise and restaurant space. Since 2004 he’s been an area developer for Sport Clips in North Carolina with more than 70 units. Contact him at 910-528-1931 or email@example.com.
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Multi-Unit Franchisee Magazine: Issue 2, 2023