Editor's Note: This is the first article in a two-part series on how to acquire a franchise system. To read the second article, click here.
During the years of the internet boom, you could count all the VC firms interested in acquiring franchise companies on one finger. Today, we live in a different world. Now that the internet bubble has burst, we are seeing more and more interest in the acquisition of franchise companies, both among professional investors and among individual acquirers.
In fact, as the power of franchising's organizational and financial leverage is finally being realized in the financial marketplace, franchise companies are often fetching premium valuations. Many franchise companies, already familiar with the franchise process, are acquiring complementary brands so they can leverage off of their skills in the areas of franchise sales, franchise support and franchisee relations. There are at least a half-dozen VC firms actively looking for franchise companies, with many more interested on a peripheral basis. In short, from an acquisition perspective, franchising has "arrived."
Franchising, as a means of business expansion, is largely geared toward helping companies leverage their growth. At its very essence, franchising is about helping companies with limited capital resources grow using "other people's money." Given this basic premise, it begs the question of "why should businesses buy a franchise company instead of just franchising a similar concept themselves?"--especially since the acquisition route requires the buyer to spend significantly more capital to get into the "franchise business."
The reasons companies choose to go the acquisition route are really quite simple. First, it is very difficult to create the original successful business model. Second, given the speed with which new franchisors can expand, the target franchisor may establish too much of a head start in the franchise marketplace. Finally, existing franchise companies are attractive acquisition candidates, because they have already demonstrated a market for the sale of their franchises.
On a regular basis, we hear from individuals who are eager to franchise--and yet they do not even have one profitable operating prototype. What we tell these companies is that without an operating prototype, it is virtually impossible (and certainly unadvisable) to franchise. More important, the development of a prototype that is successful enough to franchise is often the hardest part of franchising.
For a business model to be "franchisable," it needs to be more profitable than a business that is simply successful. A franchise company needs to be profitable enough to allow the franchisor to collect a royalty--and still provide an adequate return to their franchisees.
For a brand new concept (as opposed to an established franchisor), a potential buyer may face two choices: buy one of the pioneer franchisors or spend six months opening the unit, six months refining it and another six months preparing to franchise the business. For entrepreneurs intent on entering a new market, the dynamic nature of franchising itself often forces them to buy, because they realize that if they wait the year-and-a-half (or more) that it takes to test and prove a prototype and begin franchising, they may well have missed the boat if the market leaders have all sold 100 franchises or more.
And while some acquisitions are straightforward, many are made for strategic purposes. Existing franchisors acquire a new and perhaps competing brand. Manufacturers may want to acquire a franchise company in order to simultaneously acquire a channel of distribution for their own products. In some instances, the buyer may be looking to acquire a troubled franchise company or a sleepy, underdeveloped concept, raising an entirely different set of questions. But regardless of whether the acquisition is strategic in nature, the nature of the specific strategic goals (and specific challenges posed by that strategic relationship) must be understood and evaluated.
Let the buyer beware: Due diligence in the franchise acquisition process
Of course, finding the franchise company to buy is only half the process. Once you have settled on your acquisition target, determined that the company is for sale and negotiated a price, you must then determine if the franchise company is what the seller has claimed. But in doing this due diligence, the acquisition of a franchise is complicated by the fact that, by definition, there are multiple interested parties in the ultimate transaction: the franchisees.
From a business perspective, the biggest concern you face when acquiring a franchise company is that the business model is not (or will not remain) viable. This issue is closely followed in order of magnitude by the potential threat that the acquisition could spawn dormant or perhaps newfound litigation.
While secondary research on the market can provide some information in this regard, the best way to unearth both of these potential problems is to undertake a systematic survey of franchisees. With that in mind, the first order of business in acquisition due diligence involves a survey of franchisees to "take the pulse" of operators prior to an acquisition.
As a related step in gauging the effectiveness of a franchisor's business model, you should conduct unit-level due diligence (if this is an operation operating out of a fixed location) to assure that the franchise model and unit economics are viable. In conducting this analysis, someone with appropriate consumer-side expertise should visit a number of franchisees in a variety of different markets to examine factors such as brand and operational consistency, quality control and overall business model viability.
You should also gain insight and perspective as to how the seller measures up against its major franchised competitors. To conduct this analysis, the seller's legal documentation, business plans, marketing plans, historical sales and marketing performance data and other materials should be reviewed and compared. This documentation is publicly available on the seller's major competitors (Uniform Franchise Offering Circulars, SEC documentation, websites and articles, etc.).
You also need to compare franchisor performance to anticipated performance to try to uncover any areas of concern. In doing so, it is important to scrutinize all variances from the norm, as even "positive" deviations from the norm can be an indication of an underlying problem. For example, high close ratios in the franchise sales department may be an indicator of a great concept, great marketing and a strong sales force. Alternatively, these high ratios could also be an indication of a sales force run amok and potential disclosure issues that will surface years from now.
The single most important factor in the success of any franchise organization--perhaps even more important than the concept itself--will be the management team charged with its growth. To the extent that existing management will remain with the company being acquired, you should also conduct an assessment of their abilities to grow the franchise organization. It is imperative that you assess the franchisor's existing organizational structure, budget and personnel needs (if any), with an eye toward evaluating what additional tools the franchisor may need to achieve the seller's future goals.
As part of this process, you'll want to analyze staffing ratios versus those of direct competitors and franchisors in general. One serious problem that such an analysis might uncover, for example, involves the question of whether the organization has been intentionally understaffed (or under-resourced) in an effort to inflate earnings (and the selling price). In the case of a planned sale, a franchisor may use employee attrition or even terminations to affect this end, causing serious concerns relative to the question of whether the franchisor can maintain quality and continue to grow at the current pace without staff additions.
Of course, the business issues discussed above make up only a small part of the due diligence required in any franchise transaction. And while the issues discussed here represent only a fraction of the issues that go into a successful acquisition, this process will provide you with a better analysis of the opportunity and a fuller understanding of the risk involved in a particular purchase.
Ultimately, like all business decisions, the acquisition of a franchise company is an exercise in measuring risk versus return. The advantages of acquisition (proven concept, existing franchise operations, and speed to market) must be weighed against the risks (increased cost, existing problems with the franchisor, etc.) if the acquisition is to provide the desired results.