Guidelines For Investing In, or Acquiring, An Established Franchising System –

There appears to be a growing interest among private equity firms in established franchising systems. Recent deals have included: Riverside Company’s acquisition of the publicly traded multi-brand home services franchisor, The Dwyer Group; Sentinel Capital Partners’ acquisition of Cottman Transmission Systems; Roark Capital Group’s acquisition of Carvel Ice Cream; Apollo Capital’s backing of a management buyout of the K-12 division of Sylvan Learning Centers; American Securities Capital Partners investment in El Pollo Loco; and many other recent investment and acquisition transactions involving Chem-Dry, Meineke Car Care, Ruth’s Chris Steakhouse, Nutri-Magic and Money Mailer Systems. Franchises present some unique issues to investors, however, and private equity fund managers should be aware of the special challenges that a franchising system faces prior to making a time and capital commitment.

What is a Franchising System?

At its heart, a franchising system is a distribution channel; a licensing of brands and systems by the franchisor to a dedicated network of franchisees who pay initial and ongoing fees (typically expressed as a percentage of gross sales) to operate businesses under contractually prescribed systems and standards. From a strategic perspective, franchising is a popular method of leveraging a company’s intellectual capital by opening up new markets with a highly motivated owner-operator who will work harder than the average salaried manager to ensure the success of a particular location.

More than 6,000 U.S. companies in 100 different industries have selected franchising as a method of growth. The offer and sale of a franchise is regulated, however, at both the federal and state levels. A franchisor is required to provide a prospective franchisee with a Uniform Franchise Offering Circular (UFOC), which complies with federal law and which must be registered in advance of an offer and sale in 14 states.

Franchising is a capital efficient growth model. It provides the franchisor with the opportunity to leverage the capital invested and the equity of the local franchisee operator to build and strengthen the brands and systems of the franchisor. Brand and systems are indeed the keys to success of a profitable franchising operation. A franchisor with a strong management team that is experienced in building brands and developing and enforcing operational and IT systems can operate with relatively low overhead. When combined with the durable and predictable revenue stream provided by royalty payments, this cost structure can yield healthy profit margins. Franchisors also offer attractive platforms for revenue growth-ranging from product sales and franchisees, to international expansion opportunities and acquisitions of additional brands and franchising systems. In addition, franchisors typically require relatively low levels of working capital, especially after the software and operational systems have been put in place to support the network of franchisees.

In evaluating franchisor economics, investors and acquirors should pay particular attention to the franchisee unit margins, same-store sales growth, marketing budgets, litigation costs, research and development expenses and field support ratios relative to the number of operating units.

Key Due Diligence Issues When Acquiring or Investing In a Franchise System

With respect to each franchise program that currently exists, or which may have existed, the franchisor should provide the investor or acquirer with the following information and documents:

1) Federal Trade Commission or UFOC franchise disclosure documents, past and present;

2)Any registration approvals or exemptions obtained under any state franchise or business opportunities registration act, past and present;

3) Any registration applications pending under any state franchise or business opportunities registration act;.

4) Any registration applications in the process of being prepared for filing;

5) Any notice filed under any state franchise or business opportunity disclosure act regarding the sale of franchises or business opportunities, past or present;

6) Franchise registration or disclosure states where no registrations or notices of sale are effective or currently in process;

7) All versions of all franchise agreements;

8) All versions of any currently used operating manuals for franchisees;

9) A list of all former, existing or prospective franchisees;

10) List of any franchise consultants used, past or present;

11) Any orders, directives or inquiries received from the FTC or any state franchising, business opportunities, or other regulatory authority relating to franchising or business opportunities activity;

12) A list of all termination or non-renewal notices set to franchisees, either pending or implemented;

13) Information on all pending and concluded litigation involving franchisees;

14) Information on the status of royalty payments (up front fees or continuing, and advertising contributions);

15) A list of all franchisees in default with respect to any payments of fees or royalties;

16) A list of pending or proposed sales of existing franchises by franchisees, and the franchisor’s right of first refusal to purchase such franchises, if any;

17) A list of any disputes with franchisees, past or present;

18) Information on any franchisee advisory councils or franchisee associations, whether formed by the franchisees or by the franchisor.

Analysis of Franchise-Related Due Diligence Materials Should Focus on the Following:

1) The strength and registration status of the franchisor’s trademarks and other intellectual property;

2) The quality of the franchisor’s UFOC and franchise agreements as well as the strength of its overall relationships with its franchisees;

3) The status of any litigation or regulatory inquiries involving the franchise system;

4) The quality and integrity of the franchisor’s sales staff;

5) The durability of the financial payments to the franchisor, including the regularity of the franchisor’s cash flow from royalty obligations;

6) The strength of the franchisor’s training, operations, and field support programs, manuals, and personnel;

7) The status of any franchisee association and its relationship with the franchisor;

8) The strength and performance of the franchisor’s company-owned units (where applicable).

In order to successfully invest in franchise systems, private equity firms must be able to accurately assess brand strength, growth opportunities in new and existing markets, quality of existing franchisees, adequacy of the franchisor’s systems and procedures, and the performance and capabilities of the franchisor management team.

Andrew Sherman is a capital partner in the Washington D.C., office of law firm McDermott, Will & Emery. He also serves as chairman of the firm’s International Franchising, Licensing and Distribution Group. He can be contacted via email at Karen Dewis is a partner ifnMcDermott, Will & Emery’s Corporate Department in Washington,D.C.