During the past year, the franchising industry has been a bright spot for private equity firms on an otherwise bleak landscape. Looking ahead to 2004, it is expected that private equity firms’ interest will only increase. In 2003, private equity firms led buyouts of several leading franchisors including the Chem-Dry, Dwyer Group, Meineke Car Care and Money Mailer systems. The marriage between private equity and franchising is mutually beneficial. It gives franchisor owners an attractive option to monetize the value they have created over many years, while providing private equity firms with an opportunity to deploy capital in an industry with ideal criteria for a buyout.
Franchising is an Attractive Business
Franchisor Business Model
Franchising is, in many respects, simply a method to finance the growth of a business. Rather than providing all the growth financing and owning everything, a franchisor partners with other parties who provide the growth capital. In return, the franchisor receives up-front fees and future royalties. This partnership arrangement allows the franchisor to grow rapidly yet avoid being burdened with heavy financing costs. As a result, a typical franchisor is a good business to leverage in a buyout.
Steady, Predictable And Diversified Revenue
Most franchisors derive the majority of their revenue from a highly diversified franchise royalty stream. These mandatory payments provide a great deal of comfort to both the private equity investor and the lenders that provide the debt financing for the transaction. Private equity firms are able to obtain relatively more senior and subordinated debt financing, which can lead to a higher valuation for the franchise owner.
High Profit Margins
As a service business, the franchisor is not manufacturing a product nor does it have a large amount of employees relative to its revenue. Although a good franchisor incurs costs to provide services to its franchisees such as training and business support, a well run franchising business should generate high profit margins.
Large Free Cash Flow
Unlike a manufacturing business, a franchisor has modest capital expenditure requirements with information systems and office furniture for the headquarters being the most common. Also, many franchisors have low or even negative working capital, because they can collect payments from franchisees on a weekly basis while paying normal bills on a monthly basis. This provides an unusual ability to grow the business via adding more franchisees without investing materially in working capital. The combination of low capital expenditures and modest working capital provides a typical franchisor with high free cash flow.
Opportunity for Growth
Another attractive feature of franchising businesses is the opportunity to accelerate growth by adding new franchisees. Many franchisors even successfully expand internationally. Of course, the ability to capitalize on this opportunity depends on many factors such as the strength of the franchisor’s brand, the attractiveness of the system to potential franchisees, and the capability of the franchisor’s management team to execute a growth strategy.
Features of the “Best in Class”
Strong Executive Leadership
To paraphrase the real estate industry, the most important area for a private equity firm to analyze in a franchising business is management, management and management. Many small to mid-size franchisors are owned and operated by the individual who developed the original idea and founded the company. Before seeking an exit or a liquidity event with a private equity firm, it is critical that a management transition plan be successfully implemented if the owner/operator wants to leave the business. This helps to ensure that a strong management team is in place to lead the company’s future growth.
Franchisee Unit Economics
Ultimately, the success of a franchisor depends on the success of the franchisees. If the franchisor has developed a blueprint for a potential franchisee to make a decent profit, chances are good that the franchisor will grow a successful business. Before considering a transaction with a private equity firm, a franchise owner will need to have specifics on the economics of the business for the franchisees. The average cash-on-cash return for a franchisee is a good metric for this analysis. This ratio is the annual profit for a mature franchisee divided by the cash cost to open the business. Obviously, a high cash-on-cash return makes the system attractive to potential franchisees. It is also a good indicator that the franchisor will be able to continue to find qualified and motivated franchisees to fuel system growth.
A critical indicator of the health of a franchise system is same store-sales growth. When comparing the revenue of units opened at least one year to the revenue of the same units for the prior year, one is able to develop a sense of the relative strength of the system. Flat or declining same-store sales are an obvious indication of trouble from either loss of market share or a general industry downturn. These red flags can be masked by overall revenue growth from the addition of new units. Further analysis by geographical region and even individual locations can highlight the best and weakest markets within the system.
Private equity firms have taken notice of the franchising industry. That interest will remain for the foreseeable future, because the qualities that make the industry so attractive for leveraged buyouts, such as predictable revenue streams and high free cash flow, are not likely to change. Partnering with an experienced private equity firm may provide franchise owners with an ideal alternative to monetize some hard-earned equity in their business.
Paul Murphy is a principal with Sentinel Capital Partners, a New York-based private equity firm that specializes in investing in the franchise industry. More detailed information on Sentinel Capital Partners is available at