Private equity and franchise netwrks: the next grwth phase? Intrductin Australia is a franchise natin. Fr several years, Australia has held ne f the highest levels f franchisrs per capita in the wrld and since the glbal financial crisis the franchise sectr has perfrmed well and demnstrated strng grwth. The Franchising Australia 2016 survey cnducted by Griffith University estimated the annual sales revenue generated by the franchise sectr in Australia was $146 billin, up $2 billin frm 2014. This is despite a dmestic ecnmy still characterised by mderate retail spending and weak cnsumer cnfidence. The results als predicted are that as the sectr matures we will see the number f franchisrs lessen whilst individual franchise systems grw internally. Over recent years there has been significant investment by private equity firms in all retail sectrs as well as a number f successful private equity exits. Private equity firms tend t favur businesses with strng brands and leading psitins in niche, fast grwing markets. Many brands which have these characteristics use franchising as a way t expand in a way that reduces their capital input requirements and ensures thse perating the businesses are incentivised t grw it. This trend, cmbined with private equity s cntinuing interest in the retail sectr indicates that private equity investment in franchise netwrks will cntinue t grw. This article utlines sme headline issues private equity firms shuld be cnsidering when lking t invest in a franchise netwrk and utlines sme key issues t cnsider when structuring a private equity buy-in which will facilitate an exit in the future. Key cnsideratins Financial A key cnsideratin fr private equity purchasers will be validity and sustainability f revenue flw f the franchise netwrk (such as, initial fees, ryalties, rebates, prduct and service sales). If the nature f the business is seasnal then the timing f the acquisitin is imprtant. The ptential purchaser shuld als determine whether franchisees are up t date with their payment bligatins and if any have been granted ryalty relief. Sme franchisrs derive the majrity f their revenue frm rebates rather than franchisee ryalties, s identifying the revenue drivers early n will help guide the fcus f a purchaser s due diligence. A gd indicatr f the health f a netwrk is whether the majrity f franchisees have psitive cash flws and strng earnings. Similarly, relatinships with franchisees are likely t be better where franchisees have enjyed cnsistent business grwth. Hwever, if there are utstanding amunts wed t an utging franchisr, t prtect relatinships with franchisees the utging franchisr shuld be restrained frm making claims against franchisees pst cmpletin. Alternatively, this culd be addressed by the purchaser taking n the utstanding debt, f curse this may result in an increase t the purchase price. Grwth prspects Depending n the private equity firm s plans fr expansin, the factrs affecting grwth ptential may differ. Fr example, if the purchaser is lking t buy back franchised stres t utilise in-huse management resurces t run cmpany wned stres, relevant cnsideratins will include: Are there pprtunities t acquire existing franchise rights? On expiratin f franchise agreements, what bligatins des the franchisr have t grant franchisees a renewal term? Any rights f first refusal granted t franchisrs in respect f the sale f a business by a franchisee. [COM: 15276485_1]
What ability des the franchisr have t cntrl the premises that the business is perated frm? Des it hld the lease directly with the landlrd and sub-lease t the franchisee r des the franchisee lease the premises directly frm the landlrd? What is the level f management cmpetency and leadership within the franchisr? Whereas if the purchaser s intentin is t use franchising as a mdel t expand the netwrk quickly, the purchaser may wish t fcus n issues such as: Are there any exclusivity rights granted t franchisees which wuld impact n the ability t grant new franchises? Hw many multi-site franchisees are there in the netwrk and have they been successful? Are many franchisees lking t exit the netwrk? What rights des the franchisr have t purchase, merge, acquire r affiliate with ther netwrks (including cmpetitive netwrks) and require franchisees t re-brand? Hw many franchisee prspects des the franchisr have in the pipeline? Due diligence In additin t the usual due diligence cnducted as part f an acquisitin, there are a number f issues particular t franchise netwrks that purchasers shuld be mindful f, sme f which are set ut belw. Feasibility f the Franchise Mdel A purchaser f a franchise netwrk must understand that when cmpletin ccurs they will be in the business f franchising rather than just selling the particular prduct r service at retail level. Franchise businesses rely n revenue frm ryalties paid by franchisees and rebates frm suppliers based n the purchases f prducts by franchisees. As such, the success f the verall franchise business is inextricably linked t the prfitability and viability f each individual franchisee. It is a fundamental cnsideratin that a franchisee within the netwrk can remain prfitable after payment f ryalties t the franchisr in additin t their key perating csts such as rent, cst f gds and emplyees. It is therefre necessary that an assessment is made f the prfitability and sustainability f at least a crss sectin f, if nt all, unit franchises. If there are significant numbers f franchisees that are nt viable r nly marginal in terms f prfit it may be necessary pst cmpletin t terminate a number f unit franchises r even revise the ryalties payable by franchisees. This will have a direct impact n the prfit f the franchisr. Franchise agreements It is vitally imprtant fr the purchaser that the terms f the existing franchise agreements d nt hinder the acquisitin by preventing a change in cntrl f the franchisr where there is a share purchase r nt permitting an assignment r nvatin f the franchisr s rights where there is an asset purchase. Where cnsent f r ntificatin t franchisees is required under franchise agreements, this can significantly increase the timeline and csts f a transactin, particularly if there are any disgruntled franchisees wh may see it is an pprtunity t try and negtiate a better deal. As the majrity f franchisrs will develp their standard franchise agreement ver time, it is difficult fr a franchisr t verify each franchise agreement cntains the same r similar terms withut reviewing each agreement. Special attentin shuld be paid by purchasers t franchise agreements fr franchises in key r high value lcatins. As part f this review, purchasers shuld crss check that there is a signed franchise agreement fr every franchised business listed by the franchisr and the franchisee entities perating the [COM: 15276485_1] page 2
businesses align with the parties t franchise agreements. It smetimes happens that a franchisee sells its business r transfers its business t a related party as part f a restructure, withut infrming the franchisr. This may mean that there is n written agreement with the franchisee perating the business. Mst franchise agreements will refer t an peratins manual r ther plicies and prcedures that a franchisee must cmply with when perating the franchised business. Ptential purchasers shuld ensure that the terms f these d nt cnflict with the terms f the franchise agreements. Ptential purchasers f franchise netwrks shuld als be wary f the changes t unfair cntract terms laws which came int effect n 12 Nvember 2016. The drafting f these laws mean that mst franchise agreements are caught and if terms f a franchise agreement are deemed unfair then the clauses will be vid. See ur previus articles n the changes t the unfair cntract laws at https://www.maddcks.cm.au/grappling-b2b-unfair-cntract-term-laws/. Purchasers f franchise netwrks shuld review the template franchise agreement t ensure it is cmpliant with these new laws. Cde cmpliance The franchising sectr is regulated by the Franchising Cde f Cnduct (Cde). The Cde cntains a cmprehensive framewrk arund the cntractual prcess between a franchisr and a franchisee and regulates the use f certain terms in franchise agreements. The ACCC can issue n the spt infringement ntices f up t $8,500 r issue civil penalties f up t $51,000 fr breaches f the Cde. As part f a purchaser s due diligence, they shuld ensure that: franchise agreements cmply with the Cde requirements the Cde prhibits r restricts the inclusin f certain terms in franchise agreements, such as releases by franchisees r pst term restraints f trade withut apprpriate cmpensatin; the franchisr has a current disclsure dcument that cmplies with the Cde a disclsure dcument sets ut varius infrmatin abut a franchisr, the netwrk and the terms f a franchise agreement. The Cde prescribes the frm f disclsure dcument that must be used by a franchisr, dwn t the headings and fnt size; the franchisr has prvided, cllected, and retained cpies f all certificates required under the Cde the cntractual prcedure set ut in the Cde requires that prir t entry int a franchise agreement, franchisrs prvide franchisees with the fllwing (amng ther things): infrmatin statement this must be prvided when a prspective franchisee expresses an interest in acquiring a franchise and sets ut infrmatin abut the Cde and the risks f franchising; disclsure dcument, franchise agreement and the Cde (at least 14 days prir t signing a franchise agreement); site and territry histry frm; and advice statements a statement t be signed by a prspective franchisee that they have btained, r been advised t btain but elected nt t, legal, business and accunting advice in relatin t the franchise. A franchisr shuld retain full recrds f the delivery, signature and return f these dcuments s that cmpliance with the Cde can be easily established. the franchisr has fllwed the prcedure set ut in the Cde fr terminatin f a franchise agreement. The purchaser shuld review any terminatins by the franchisr ver the years preceding the purchase t ensure this prcedure has been cmplied with; and [COM: 15276485_1] page 3
the cllectin f marketing r advertising fees frm franchisees is in cmpliance with the Cde -- the Cde requires that these funds be kept in a separate bank accunt, that such fund be audited each year (unless 75% f franchisees agree therwise) and regulates hw the fees can be spent. Often purchasers verlk the fact that as part f the netwrk, they are acquiring the rights t the marketing fund which is generally treated as the franchisr s asset but the franchisr is restricted in the manner in which it can be used. Franchisee relatins As part f its due diligence, a purchaser shuld cnduct a review f the relatinships between the franchisr and its franchisees. If there are disputes r general grievances amngst the franchisees, this may assist the purchaser t negtiate a lwer purchase price r alternatively avid acquiring a risk-laden business. It is unlikely a franchisr will allw a purchaser t speak directly with franchisees as disclsing the ptential sale t franchisees may be damaging t the relatinship between the franchisr and franchisees and future peratins f the netwrk if the transactin des nt prceed. An ptin t address this is t wrk in cnjunctin with the franchisr and arrange fr an independent cnsultant t cnduct a survey f franchisees f the netwrk which is presented as being cnducted n behalf f the franchisr fr internal purpses. Intellectual prperty Trademarks and ther intellectual prperty are central t the value f a franchise netwrk. Purchasers need t carefully cnsider wnership f all intellectual prperty used in the netwrk t ensure it btains the rights necessary t perate the netwrk. Often intellectual prperty is wned by a separate entity t the franchisr fr asset prtectin purpses, s it is vital t ensure that the transactin dcuments facilitate the effective transfer f the intellectual prperty t the purchaser. Cmpetitin Law The structure f a franchise netwrks lends itself t arrangements that are heavily regulated in Australia under the Cmpetitin and Cnsumer Act 2010 (Cth). Often a franchisr will perate cmpany wned businesses that cmpete fr sales with its franchisees. Franchisees will als generally cmpete fr sales with each ther in particular gegraphic lcatins. In additin, the franchisr will ften seek t regulate price between its utlets and frce franchisees t buy prducts r services frm specified suppliers at particular prices. Unless the agreements that regulate these relatinships are carefully structured r cmplex exemptins apply, there are risks that sme price fixing prvisins f the Cmpetitin and Cnsumer Act will be ffended. Exit When lking t acquire franchise netwrks, ensuring there are apprpriate exit strategies in place will be integral fr a private equity purchaser. If the sale is cmpleted by way f an asset sale, the purchaser can put in place the right crprate structure t facilitate an exit pre-purchase. Hwever, if the sale is cmpleted as a share purchase, the purchaser will be inheriting the franchisr s crprate structure s changes may need t be made pst cmpletin. Again, it is imprtant that private equity purchasers cnsider as part f their due diligence that the terms f the franchise agreements and ther arrangements will nt adversely impact a restructure pst cmpletin. The structure set ut belw is ne that is ften used by mre sphisticated franchise netwrks and enables a clean exit thrugh the sale r IPO f Franchise Hldings Pty Ltd. As nted abve, the [COM: 15276485_1] page 4
intellectual prperty rights are ften held in a separate entity fr asset prtectin purpses, and fr similar reasns the peratins, leasing and franchising activities are ften separated als. Ensuring the crprate structure is tax effective will als be a key cnsideratin fr private equity purchasers, hwever this is beynd the scpe f this article. It is als becming increasingly cmmn fr franchisrs t partner with franchisee via jint venture (whether crprate r cmmercial in nature arrangements. While these arrangements can be mutually beneficial, they bring with them a separate set f cnsideratins that shuld be wrked thrugh by thse lking t invest in a netwrk such a this. PE HldC Franchise Hldings Pty Ltd IP Pty Ltd (wns intellectual prperty) Operatins Pty Ltd (wns and perates franchisr businesses) Leasing Pty Ltd (hlds head leases) Franchising Pty Ltd (grants franchises, cllects ryalties etc) Cnclusin The grwth pprtunities that are available thrugh franchising make it likely that private equity interest in the sectr will nly cntinue t grw. Acquiring franchise netwrks allws private equity firms t align themselves with strng brands and slid cash flws. Where private equity firms have existing franchise netwrks, acquiring similar franchise netwrks will allw them t capitalise n synergies between the tw and maximise investr value. Hwever, the regulated nature f franchising in Australia cmbined with the invlvement f third party franchisees means that private equity firms shuld prceed with cautin and ensure that all advisrs fr the transactin have experience in the sectr s they are alert t franchising specific issues that can arise. [COM: 15276485_1] page 5