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."
Why buy?
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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.
Mark Siebert is the "Franchising Your Business"
coach at Entrepreneur.com and the founder and CEO of
iFranchise
Group Inc., a consulting company that helps businesses assess
their franchising potential and develop and improve existing
franchise systems.