BY BLAIR A. REBANE AND ERIC C. LITTLE, BORDEN LADNER GERVAIS

Over the last decade there has been an increas­ing level of interest by private equity firms in acquiring or investing in franchised businesses. This has been particularly notable among larger, well-established franchise systems with significant multi-unit franchisees, master franchisees, or area developers. In many ways, this has been a welcome development for large multi-unit franchisees who wish to sell their busi­ness, because previously the pool of potential buyers was often fairly small. Now, private equity is one of the most likely suitors who may come forward in these cir­cumstances. They may do so on a solicited basis (such as in response to a listing or sale process) or unsolicited basis (such as approaching the franchisee directly in the absence of a listing or sale process).

Franchised businesses are an attractive investment for private equity firms for a number of reasons. A mature franchise concept offers significant brand recognition, an established business model, and a well-developed network of supplier relationships, which collectively help to reduce the relative degree of risk associated with a prospective investment. A portfolio of established unit franchises can also provide fairly consistent and pre­dictable revenue and operating costs. Provided the fran­chisor is receptive, private equity firms who acquire or invest in franchised businesses may also have significant opportunities to scale their investment and drive unit and brand growth for the franchise system.

For franchisors, there can be many advantages to permitting private equity investment at the franchi­see level. Among other things, private equity firms are generally sophisticated, are well-capitalized, and have ready access to resources. Some have significant opera­tional expertise and experience as well. Private equity firms are also growth-oriented and focused on maximiz­ing sales and financial returns, which typically aligns well with the franchisor’s own objectives. That said, franchisors can also encounter challenges in dealing with private equity investment at the franchisee level. Deciding whether this is the right move for a particu­lar franchise system requires careful consideration of a number of issues. This article discusses some of the fac­tors franchisors should consider if they are evaluating a prospective private equity investment in one or more of their franchised businesses.

Considerations for franchisors

For many franchisors, a private equity firm or private equity-backed candidate will be very different than their typical franchisee candidate. Among other things, private equity firms are typically sophisticated, well-resourced and experienced negotiators, and in most cases they are invested in many different kinds of businesses, some of which might even compete in the same industry, market sector, or product or service category as the franchi­sor. Some of these factors may lead to the private equity candidate attempting to negotiate certain aspects of the franchisor’s standard franchise terms, which would typi­cally be off limits for negotiation.

For example, it is very common for franchisors to require the principals of a prospective franchisee candi­date to provide a personal guarantee with respect to the franchisee’s obligations under the franchise agreement and all associated agreements. Where the prospective franchisee candidate is a private equity firm (or is owned by a private equity firm), there often is no one individual who has a significant ownership interest in the private equity firm, which is typically owned by a large group of investors. Given this, there often is no one individual who will provide a personal guarantee, as no one has a large equity ownership interest in the private equity firm. There are ways that franchisors can address this issue. For example, the private equity franchisee candi­date may be able to provide a corporate guarantee from a parent or affiliated entity which has sufficient assets to give the franchisor the comfort it would usually obtain through a personal guarantee. Alternatively, the franchi­see candidate may be able to obtain a letter of credit from a bank or other institutional lender, which would provide the franchisor with some assurance that the franchisee will be able to satisfy its financial obligations under the franchise agreement and associated agreements. While either of these approaches can work in a particular case, they will likely constitute a significant departure from the franchisor’s typical practice. Determining the appropri­ate or desirable solution will require careful consider­ation and investigation of the available options, as well as negotiation with the prospective candidate.

Another area where a private equity franchisee can­didate may seek to depart from a franchisor’s standard franchise terms is with respect to the provision of non-competition or non-solicitation covenants, which fran­chisors commonly require from their franchisees. These types of covenants are often problematic for private equity franchisee candidates. If the private equity firm already owns an interest in a competing business, pro­viding a non-competition or non-solicitation covenant will likely be a non-starter, or the non-competition or non-solicitation covenant will have to be significantly reduced in scope. Even if the private equity firm is not currently invested in a competing business, they may nonetheless resist providing a non-competition or non-solicitation covenant due to concerns that it could create hurdles for future investment opportunities. Franchisors who are confronted with this position will need to con­sider whether the potential upside of permitting the pro­spective acquisition or investment outweighs the risks of foregoing these important aspects of their standard franchise terms.

The inclination to try to negotiate more aspects of the franchise system may also increase if, upon entry into the system, the private equity candidate is permitted to open additional franchises and gain further leverage within the system. For example, they may seek to take advan­tage of purchasing power and supplier relationships they may have through their other business investments in order to realize cost savings and improve profitability for their franchises. They may also push to use their own preferred technology platforms, solutions or service pro­viders in connection with their franchises. While these changes might be appealing at the unit level, they can be problematic for franchisors if they create issues with the consistency of product or service offerings in the fran­chise system, or if they create controversy or concerns about inconsistent treatment among other franchisees. Striking the right balance between these concerns can be challenging, and franchisors may find it difficult to fig­ure out an arrangement that adequately addresses their interests and those of the private equity franchisee.

Another common challenge with private equity fran­chisees is the separation between the ownership of the franchisee and the management of the franchised business. Historically, a typical franchisee was a small business where the owners or principals are directly involved in the day-to-day management of the franchise. On the other hand, a private equity franchisee is usually owned by a firm or fund which owns interests in many different businesses and the principals of the firm or fund may not be directly involved in any of them. Most often, the firm or fund will work through one or more separate operating entities to manage its various busi­nesses. From the franchisor’s perspective, this means that it may not have a direct line of contact to the owners of the franchised business, the way it might usually have with its other franchisees. One approach that franchi­sors may take to address this is to identify a designated general manager or operating partner for each fran­chised business that the private equity firm owns. This person would be selected by mutual agreement between the franchisor and the private equity firm and would have primary responsibility for overseeing the day-to-day operations of the franchised business and would be the franchisor’s primary point of contact for the fran­chisee. Depending on the nature and circumstances of the franchisee, the franchisor may consider specifying that the general manager or operating partner maintain a minimum ownership interest in the franchisee or its ownership group. In the right circumstances, this can help to ensure that a connection is maintained between the ownership of the franchisee and the day-to-day oper­ation of the franchised business.

Where a private equity franchisee owns interests in other brands, some of which may even be competitive with the franchisor’s brand, the franchisor must con­sider the possibility that some of its valuable proprietary information and know-how may make its way into the hands of one of those other brands. Most franchisors have confidentiality and intellectual property provi­sions in their standard form of franchise agreement that would protect against blatant misappropriation of their intellectual property or trade secrets. However, practi­cally speaking, if a franchisee is permitted to operate in more than one brand, it is often difficult to prevent them from using the knowledge they have acquired about one brand’s business, systems, and operating procedures in connection with their involvement in one or more of the other brands, or otherwise sharing that information with such other brands, perhaps even unintentionally. Fran­chisors who allow their franchisees to operate in more than one brand must accept that this is likely to happen to some extent.

In some cases, there can be an issue of compatibility between the franchisor’s objectives for the franchise system and the objectives of a private equity franchisee. As previously noted, private equity investors tend to be focused on growth and scaling their investment, with a view to achieving optimal returns. While most (if not all) franchisors are also growth-oriented, they might have dif­ferent ideas about what constitutes sustainable growth for the franchise system or what rate and type of growth aligns best with their strategic and long-term objectives. This is one area where a franchisor’s priorities and those of a private equity franchisee may diverge. Franchisors generally aim to balance system growth with long-term viability, and for this reason they often focus their fran­chise development efforts on recruiting strong operators with long-term potential. Private equity investors, on the other hand, tend to be more focused on recouping their investment and maximizing their return in a shorter term. In most cases, the basic approach is to invest in a busi­ness, grow it, and then sell it for a profit, with the typical investment timeframe being in the range of five to seven years. Developing a growth strategy that addresses the private equity firm’s objectives and aligns with the fran­chisor’s business goals and the best interests of the fran­chise system can be tricky. Among other things, the fran­chisor will want to ensure that the rate of growth and the specific markets that will be targeted are viable, sustain­able, and not overly aggressive, with a view to promot­ing the long-term health of the franchise system. These concerns go well beyond the typical lifespan of a private equity investment and therefore are unlikely to be on the private equity firm’s radar when determining their growth strategy. This is not to say that the respective goals of franchisors and private equity franchisees are incom­patible—they are not. Rather, the point is that in light of the specific motivations of private equity franchisees and their owners, if a franchisor is approached regard­ing a prospective acquisition or investment, it will need to consider questions such as whether this is the right fit for the system or whether the system is in the right place for such an investment to make sense at that particular point in time.

Key takeaways

Private equity investment at the franchisee level can offer many benefits for franchisors and franchise systems. The sophistication, access to resources, and operational expertise of many private equity firms can make them an attractive candidate as a prospective multi-unit operator, and their typical inclination towards growth and optimiz­ing the financial performance of the businesses in which they invest also generally plays well from the perspec­tive of franchisors. At the same time, private equity fran­chisees can raise certain challenges in comparison to traditional franchisee candidates. Determining the best way to address these challenges and find an arrange­ment that serves the respective business objectives of the franchisor and the private equity franchisee—which can sometimes diverge significantly—may not be easy. If approached regarding a prospective private equity acquisition or investment at the franchisee level, franchi­sors will need to carefully consider issues such as those discussed in this article and evaluate the relative pros and cons of the particular prospective acquisition or investment.

ABOUT THE AUTHORS

Blair A. Rebane is a partner at Borden Ladner Gervais LLP (BLG) and the National Leader of the firm’s Franchise and Distribution Group. Eric C. Little is a partner in the Corporate and Capital Markets Group at BLG, who practices corporate commercial law with an emphasis on franchising, licensing, and distribution.