Companies with strong brands, like franchise companies, are often seen as excellent investment vehicles. Because these brands have recurring revenue and can be “asset-light,” the revenue stream is considered an annuity.
Their v alue is assessed as a multiple of the revenue stream, adjusted and normalized for usual operations (Adjusted EBITDA). Once the revenue stream is normalized, the target company for investment or acquisition can be valued as a multiple of cash flow. This is compared to the value of other similar companies or investments, and then a negotiated price can be ascertained. The assessment of trademark, music, or patent portfolio values involves their own algorithms that predict how licenses will generate revenue over time. Franchise companies are different because they are capable of infinite expansion. The value of future expansion makes their valuation different from a mere annuity for both the buyers and sellers.
When acquiring or investing in a franchisee, we need to look not only at the strength of the franchisee’s operations but also at the strength of the franchisor’s brand. Will the brand promote and support expansion? Will the franchisor, as the consumer face of the brand, use social influencers and branding consistent with growth and your values? After investment, if the franchisee becomes stronger than the franchisor, will that create issues in growth or control dynamics, and how can that be addressed pre-acquisition? How receptive will the franchisor be to your ideas about expansion and alternative social media and marketing?
When acquiring or investing in a franchisor, we need to assess the strength of the trademarks, marketing, regulatory compliance, the ability to sustain operations with the current number of franchisees, the ability to expand by awarding new franchises, and the ability of management to lead with growth and transition the business to the new investor, management, or owner.
- Assessing and Guiding Culture
The culture of the system, like the character of a person, can predict the future of the system. If the system has an outstanding culture, with alignment in goals and values, then the system can sustain transitions in management, investors and ownership. Franchisees will not slip away and may reinvest and expand in a culture which sets the table for expansion. But culture must be assessed carefully.
On the sell side, what do franchisees say about the franchisor when the franchisor is not present? If you are selling your franchise company, or even your franchised business, perhaps you have feedback from franchisees or employees that trickles up. Companies should have informal surveys or other systems in place to assess satisfaction in order to head off unnecessary confrontations, and should be listening to these constituents. When franchise candidates contact existing franchisees to assess the system, what do they hear, and are those comments valid? Proactive listening and surveying will improve your business, help prepare it for sale, and if done correctly, will not turn into a gripe session. If you are a franchisor and do not have a franchisor-organized committee of franchisees controlled and appointed by the franchisor, called a Franchise Advisory Council (FAC), consider appointing and supporting one that can address issues as they bubble up and can be used as a sounding board for new franchisor initiatives. A FAC can be your most important sales tool as it is a spokesperson for the franchisee community. Establishing a FAC can avoid the establishment of an independent franchise association without franchisor controls or input that will have its own narrative.
If you do not have a FAC or an independent franchisee association, and you want to assess how franchisees think of you, you can hire third parties to conduct pretextual interviews with existing franchisees as if they were intending to buy into the system. Also helpful are third-party validating companies that will survey the franchisees, promising anonymity, which may help elicit feedback about what franchisees will say. Sometimes you can gauge the temperature of franchisees by how many cooperate with the validators.
On the buy side, you do not often have a window into the culture due to a non-disclosure agreement. During diligence, you will want the ability to talk with franchisees, but the franchisor may not allow that access. You could hire a third party to make a pretextual call as if they were a franchisee candidate and ask existing franchisees about the company. This would be important information for negotiating the deal and deciding whether to keep management or replace them. If you are not allowed to talk with franchisees during diligence, perhaps a third-party validation survey could be permitted by the selling franchisor to anonymously assess these issues. Just as importantly, it could also help assess franchisee attitudes regarding whether the earnings and direction of the company are sustainable.
- Quality of Earning and Legal Risk Assessment
Your target purchase price is based on an accounting estimate using the existing revenue stream, adjusted for extraordinary items and non-recurring income, normalized, and then multiplied by an industry multiple. Analysts may be experts at this, but cannot substitute for experienced business judgment for assessing the true state of the business. Take the example of a burger chain that had extraordinary revenues and income at the franchisor level, artificially inflated for sale by concentrated advertising and sales at cost at the franchisee level of brand-eroding couponing. How can this be assessed if you cannot directly inquire under your non-disclosure agreement whether the franchisees see this as erosion of brand equity and culture?
Both sellers and buyers could engage in quality of earnings assessment for their own Adjusted EBIDTA comparators. Quality of Earnings (QoE) is an analysis conducted during due diligence to assess the sustainability and reliability of a target company’s earnings. A QoE report is intended to provide an objective view of a company’s true financial health by normalizing earnings, identifying risks, and validating financial data, which helps buyers make informed decisions, negotiate a fair price, and avoid overpaying.
Buyers benefit from QoE as it guides decisions and provides confidence, helping them avoid overpaying based on inflated revenues or artificially suppressed costs, and identifies warning signs before the deal closes. Sellers benefit from QoE because it gives them confidence for a fair price, identifies potential future issues that can speed up the sales process, avoids delays, and prevents misunderstandings. A formal QoE can be offered to the buyer as an incentive to accept the asking price.
In a franchise transaction , the QoE analysis is performed by a specialize accounting or advisory firm, but there are certain risks which must be assessed by lawyers during diligence. Lawyers should perform diligence on whether the franchisor has complied with franchise regulations in the offer and sale of franchises, including the review of the current and past Franchise Disclosure Documents (FDDs) and check them against the trademark registrations and maintenance. Lawyers should assess the enforceability of each franchise agreement, their territories granted and renewal rights, and are often called upon to review management and supplier contracts.
Franchise lawyer teams work with merger and acquisition specialists to provide a bespoke strategy, pricing methodology and investment structure. Involve them at the outset so you can have confidence for a smooth and final closing.