Private equity (PE) firms are increasingly investing in franchise brands. While that fact is no secret, the idea of partnering with PE investors can lead to many questions. The right PE partnerships can serve as an accelerant. The challenge, of course, is figuring out what the “right” PE partnership looks like.
This exercise should start with strategy and knowledge of the marketplace. It is important to thoughtfully prepare for any potential transaction, which requires an analysis of your current and future state of operations. It is even more critical now because although PE firms are still actively investing in franchises, the speed with which these deals are finalized has slowed.
In today’s transaction environment, many PE firms are taking a cautious attitude, asking more questions, and digging deeper into metrics than before to ensure an investment is based on accurate data and forecasts. This shouldn’t deter a franchisee from considering a transaction, but it heightens the need to be prepared.
Take a proactive approach to transaction readiness
If PE firms are being more cautious, so should franchisees. A smooth transition is more likely when franchisees are primed for PE participation. Better yet, being prepared may also result in a higher investment amount or purchase price.
Think about it as if you were selling a home. Potential buyers who find even one minor problem somewhere—a leaky roof, for example—often ramp up their skepticism and scrutiny. That’s why, when selling a house, sellers seek out issues and address them preemptively. Likewise, the more confidently a franchisee can express their business story, exhibit best in class processes, and show strong financial history, the more collaborative the transaction process may be.
To that end, franchisees may want to consider these six key questions to begin evaluating their PE options.
Question #1: What is your business story—and where is it going?
Franchisees should perfect their business story prior to engaging an investment banker or PE investors. That means being able to explain why things are the way they are in the business. What does a normalized profit look like—and if it’s different, why? And what if any factors exist that may have slowed or prevented growth.
In addition, your business story should focus as much on the future as the present. What have you put in place to ensure your company is poised for future growth?
Question #2: What are you trying to achieve?
Crystalize what you want from PE involvement. Do you need an exit strategy or succession plan? Capital for growth? Operational support? The answer to this question may change the partnership opportunities available. If you don’t yet have a definitive end goal, you probably aren’t quite ready to pursue a transaction.
While PE often comes to mind for franchisees looking to exit the business, a growing number of PE firms offer capital in exchange for a minority ownership in the business or non-traditional financing. This could be a desirable option for franchisees who wish to remain an active part of the business. In addition, PE firms may be able to “professionalize” the business by streamlining access to outsourced accounting, supply-chain efficiencies, IT, staffing, or other core expertise.
Question #3: What is the goal of the private equity firm?
Nearly all PE firms have the same fundamental investment strategy: invest in a business, grow it, and ultimately exit in another transaction. Still, franchisees should be aware of a firm’s preferred holding period; some PE organizations are interested in longer-term investments than others.
Other firms may be looking to build out so-called “platform companies.” In these cases, PE firms bring similar companies together under a shared corporate structure. Each individual company then benefits from greater buying power, shared overhead costs, and easier access to professional services.
Partnering with a PE firm whose goals align with your own is crucial. Misalignment can lead to issues such as conflicts over business decisions, culture clashes that jeopardize staff satisfaction and productivity, or tension with customers and key stakeholders. Conversely, well-aligned partnerships can result in better decision-making, efficiency, and performance.
Question #4: Does your business have an optimal tax structure for a PE sale?
Franchisees may find that they need to review and sometimes change their company’s tax structure prior to a transaction. Much depends on the business’s existing tax structure, the size of the investment opportunity, and applicable tax laws. Given the complexity, it’s a good idea to seek the advice of experienced tax professionals at least six to twelve months before the sale process begins.
When evaluating structuring options, you will want to take into account the tax impact to both buyer and seller. The buyer will want a structure that provides them a step-up in the tax basis of the assets that can be depreciated/amortized, and the seller will want a structure that has most if not all of the gain taxed at long-term capital gain rates and a tax-deferred rollover on the portion not sold.
Additionally, in connection with a sale to PE, key members of management may be asked to “rollover” a portion of their current equity in the franchisee. Franchisees with tiered entity structures often find it more challenging to implement rollover in a sale to PE. Proper structuring of rollover equity interests is critical to ensuring that the rollover is tax-efficient for the members of management and the rest of the shareholders selling to PE.
Question #5: Does your brand already have private equity within the franchise system?
Getting franchisor approval for PE investment may be easier and faster if the franchisor is familiar with the process. However, if the franchisor has never dealt with PE, you should be ready to invest more time and answer more questions. Educating them on the process, advantages, potential impacts on the franchise system, and goals will be beneficial.
This factor may also influence your choice of PE partnership. PE firms that often work with franchise businesses may be able to lend support for franchisor education.
Question #6: Is your internal team ready for the private equity sale process?
Determining whether your team is transaction-ready is arguably one of the most crucial questions to ask yourself in a PE investment scenario. It encompasses many different facets. Therefore, franchisees should take the time to consider factors such as:
- Have team members experienced PE investment or a company sale before? Team members who know what to expect may find it easier to support the due diligence, scrutiny, and changes that accompany many investment or sale scenarios. Be aware if any team members harbor preconceptions based on past experiences that were difficult.
- How comfortably do team members embrace change? Franchisees typically benefit when staff are dedicated to their roles and excited about the new challenges and opportunities.
- How coachable are your team members? Franchisees may need to train and develop internal staff members to help get them ready for a transaction. If staff find it difficult to alter their perspectives and workflows, franchisees may need to modify the team before embarking on a transaction. Franchisees who don’t want to replace their teams may want to augment them instead, using resources who’ve been through the PE transaction process to coach the team along the journey.
Preparation: A cornerstone for successful PE partnerships
The decision to seek a transaction through PE investment can open up exciting prospects for franchisees. Still, it is vital to take the time to prepare for it. Don’t be caught short in terms of strategy and time to accomplish your goals.
Franchisees should be able to tell PE firms their business story and paint a picture of its future success. By asking key questions upfront, franchisees are more likely to find the right PE partnerships to bring that picture to life.
About Lisa Plonka:
Lisa Plonka, CPA, CFE, leads the franchise and consumer goods and services practice at Plante Moran, one of the nation’s largest accounting, tax, consulting, and wealth management firms. She is a Certified Franchise Executive and a member of the International Franchise Association (IFA), the AICPA, and the MICPA. She continually educates herself on issues impacting the franchise industry, then transfers that expertise along with creative strategies to help power clients’ growth.
Reach Lisa at lisa.plonka@plantemoran.com or visit https://www.plantemoran.com/get-to-know/people/lisa-plonka