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Caveat Emptor: Here are five points for you to consider

before buying a company-owned restaurant franchise.

By Douglas McKenzie and Mike Vallorosi

Call it a sign of economic strength or simply thriving entrepreneurship, but franchisors are in the throes of another initiative to re-franchise stores. In recent years, large publicly owned chains have put hundreds of company-owned stores on the market after buying them back from troubled franchisees during the depths of the recession. Meanwhile, new stores in emerging concepts are popping up everywhere, giving smaller, aspiring franchisees a foothold for future growth.

From the vantage point of smaller operators looking to grow, it may be a good time to consider adding new stores. Added scale helps franchisees spread some of their fixed costs, such as marketing and management, and strengthen their operating margins. Because they’re already in the system, existing franchisees are privy to costs and other financial information that an outsider won’t have at their disposal. A franchisee may also want to remain the lead franchisee in a given geographic area. 

It’s true that some large nationwide franchisors prefer to work with a select group of bigger regional franchisees, which typically have been able to access capital more readily. But, at some point, large chains risk losing negotiating power if the franchisees in their system become concentrated and start resisting system-wide initiatives such as store remodels. Smaller franchisees may also have advantages when running stores in suburban and rural areas because they reside in the local community or region and can more deeply engage with the community, such as by sponsoring youth athletic activities. Finally, emerging brands often have less of an ability to be selective about their franchisee partners, and could be more open to a franchisee with multi-store experience on a smaller scale. 

When thinking about acquiring a company-owned store, franchisees need to keep a few things in mind. Most of these considerations amount to adjustments that should be made before the ink hits the paper. If the franchisee doesn’t account for them up front, they may cause your financing to be rejected or alter the economics of the deal when it’s too late to do anything about them. A buyer of a company-owned store should do a deep dive into five specific areas: royalties, real estate, purchase type, staffing and cost structure.

No. 1 – Royalties

Corporate entities don’t always charge themselves royalties, so this element likely represents the most significant pro forma cost adjustment to the P&L for any buyer. Franchisees need to layer in this cost when estimating their expected profit and loss statement.

Historically speaking, royalties are set at between 4 and 6 percent of sales, but that number has crept up to the higher end of the range in recent years along with inflation. A franchisee already in the system might discover that the new royalty structure differs from the one that governs their existing stores. For a system averaging $2 million in sales volume, one percentage point eats up $20,000. That difference can have a large impact on a franchisee’s ability to hit earnings and cash flow targets.

No. 2 – Real Estate

The whole premise of opening a franchise is gaining the right to operate and generate cash flow from that store for a long period of time. But if the operating lease (and corresponding option periods) governing the real estate the store sits on expires before the franchise agreement is up, it will jeopardize the whole operation. Before signing anything, make sure there’s enough remaining term on the lease and/or option rights to extend. If there isn’t, that’s a major sticking point that needs to be addressed during the sale process and negotiation.

You also want to have a firm understanding of the entire lease agreement including rent structure, future rent increases, events of default and non-disturbance rights. You would also hopefully know the corporate identity of the landlord, so you’d know what entity you could work directly with if there are complications with the lease or rent payments.

You may be considering a store acquisition in which the franchisor is the primary lessee and wants to sublease the property to you. A big corporation is an attractive lessee for a landlord, and may be able to secure better terms on the lease than a small franchisee could on their own. In some cases, the franchisor passes along some of those savings to the franchisee, but it’s wise not to count on it. In fact, the only benefit that might accrue to the franchisee in those cases is access to the land the store sits on, particularly if it’s in a prominent location.

No. 3 – Asset vs. Share Purchase

Another key factor to consider is whether you’re conducting an asset purchase or a share purchase, in large part because of the potential for different tax treatments. In the former transaction, the franchisee agrees to acquire all the assets of the business, but not the liabilities, and does so through the formation of a new corporate entity. In those cases, the purchase triggers a reset on the value of those assets and enables the franchisee to depreciate them on a go-forward basis, which can be a significant contributor to their cash flows.

You’ll want to be sure, though, that the seller doesn’t have a lot of deferred maintenance in the store. If that last remodel was years ago, that’s a cost you’ll need to directly adjust for in your purchase price.

With a share purchase, the buyer is acquiring the actual shares of the operating company that owns the franchise, which potentially generates some small business capital gains tax exemptions for the seller. It’s important to note that, with a share purchase, the buyer takes on all the liabilities of the business, which can include direct and contingent liabilities of the business. This liability transfer is another risk a buyer should be aware of and does not take place with an asset purchase.

Specifically, a share purchase means the buyer inherits the employees, all accounts receivable and payable, and all supply contracts, among other items. But the franchisee does not have any leeway on asset depreciation – in an extreme case, the previous franchisee may have depreciated all the assets down to zero, leaving nothing for the new owner left to claim unless they make capital upgrades. Given this, share purchase transactions typically come with lower price tags, but it’s important to understand whether those savings will make up for any lost depreciation.

No. 4 – Staffing

Staffing is another area where being close to the store can benefit a franchisee. Speaking generally, franchisors are sometimes less efficient at scheduling and managing workers. Franchisees, by comparison, as direct owners of the store, are personally invested in making effective staffing decisions and having an efficiently operating store. 

At the same time, manager pay may increase. More stores mean more oversight. Unless you want to be driving all the time between locations, you’ll need a regional operations manager you can trust. To attract the best, franchisees often adopt bonus structures that tie compensation to same-store sales or earnings before interest, taxes, depreciation and amortization (EBITDA). That’s a cost you will need to account for as part of your deal due diligence. It’s also important to note that in a share purchase agreement you agree to take on existing staff and bear the cost if you have to terminate any of them at a later date.

No. 5 – Cost Structure

Because they’re able to run a tighter ship, franchisees are generally able to keep a store’s cost of goods sold lower than a franchisor can. This can translate into operating margin gains of two or three percentage points, depending on how inefficiently  –in areas such as staffing, inventory, etc. – the store has been run.

While increases in sales can obviously improve margins even more, buyers shouldn’t bake in aggressive expectations for same-store sales growth. Rather, look at the most recent 12-month period, whether it’s rolling or fiscal year-end, along with comparatives – i.e., prior year – as a basis for your purchase price. View any sales gains you achieve above that run rate as a bonus.

Buying a company-owned store is like buying anything else. You’re getting the asset “caveat emptor,” or as is. If you’re moving from one or two stores to a handful, it can amount to a big leap. You have to understand what you’re buying – and that takes a certain amount of homework. Any of these five factors above can make or break an acquisition. It’s better to identify any red flags – and either avoid them or address them – before sealing the deal.

Douglas McKenzie leads the mid-cap practice and Mike Vallorosi leads the large-cap practice at CIT Franchise Finance, which provides restaurant franchise financing solutions for franchisors and franchisees.

 

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