Founder & Managing Director of Emergent Growth Advisors, a strategic advisory firm at the intersection of franchising and private equity.
It has been said that private equity is attracted to complexity and makes money harnessing that complexity. But conversely, private equity loves franchising because franchising is a straightforward, proven business model with predictable value creation levers. Franchise growth curves are also predictable, as are common inflection points as brands grow. No doubt as you are considering options to start your own business, you also see the benefits of the franchise business model.
But no matter what type of business private equity buys, PE makes a good start by attempting to make smart purchase decisions upfront. Let’s walk through PE’s investing mindset and compare it to where you’re sitting in your own franchise due diligence process and approach. How are you “showing up” mentally to the franchise search? Are you pressure testing your thinking and assumptions? Are you checking in with others who can help you? You can adopt PE’s due diligence mindset to make better decisions when investigating franchise concepts.
Private equity investors have one goal that drives their activity, which is to make money for themselves and their investors. They strive for category leading returns for their fund investors, which in turn helps to raise their next fund. In contrast, as a franchisee, your motivations are likely multi-layered and personal. PE is clinical in their assessment of franchise systems and has clear financial objectives. Individual franchisees have more complex motivations and, unfortunately, many never put their personal goals or even their financial objectives in writing.
Using the following questions as a guide, reflect on your financial and exit objectives for your franchise business:
1. What are my financial and personal goals for this business? Have I discussed my goals with my CPA and family financial advisor?
2. What income do I need to pull out of the business to make it worthwhile?
3. What cash return do I require for my investment? Am I screening franchises with this in mind?
4. What are my exit requirements? What do I need to sell the business for when I’m ready to leave the franchise system, and is that realistic based on how units in that system are trading now?
5. What type of franchisee does a particular system attract? Does the brand attract experienced multi-unit operators of other concepts, or does the system tend to attract first-time franchisees?
6. What buyers of resales are in the system now? Is PE active at the unit level buying resales?
7. Do I want to run a franchise full-time or as a part-time side hustle?
8. Is there enough margin to pay market wages for the help I need? If operating at the system average, will my unit create the working lifestyle and income I’m looking for?
9. Do I have an accountability partner to keep me on track in this decision?
10. Am I prepared to walk away if the complete package isn’t what I need?
PE Insight: PE ruthlessly screens out companies that won’t meet their return-on-investment threshold. This is usually a minimum of 3x MOIC (multiple of cash invested) and 8% growth hurdle at sale, within an average hold period (5 years), which of course is shorter than the average 10-year franchise agreement. How does this compare with exits in the system you are investigating? Will the business repay your initial investment within 18 months or fewer? With a full staff, can you pull out the living wage you need to be satisfied with your business? Can business cash flow easily cover any debt service?
Do I have enough emotional distance to make this decision based on facts? Many franchisees come to this big decision with a fair amount of emotion, and often even some anxiety. How do I feel about taking this leap into business ownership? Am I tapping a professional advisor (attorney, CPA, etc., with franchise experience) to hold me accountable for making a data-based decision? Are the financial inputs backed by what is disclosed in the Franchise Disclosure Document (FDD)? You may have a strong personal affinity to a franchise concept or to the franchisor team. Don’t work backwards from emotion to justify a buying decision. Let the facts come together to guide you.
PE Insight: PE stops their due diligence and moves on when the business case is proving weak or if they find a deal-killer. They don’t try to talk themselves into anything. In contrast, prospective franchisees often make the mistake of continuing discussions with a brand with which they are enamored (emotions at play) even when warning signs are present.
Unless designed to be a part-time side hustle, does the business case support replacing myself within six months of opening? Can I stretch and hire that manager upfront to allow me to focus more on growing the business instead of running it? What percentage of the franchise system operates with managers versus owners in key roles? Are there signs of owner stress?
PE Insight: Because they aren’t buying themselves a job, PE only buys into models that throw off enough cash to afford hiring competent managers. Are franchisees trying to “save” money by doing some of that work themselves? That’s a red flag unless the model is designed to be part-time.
What is my exit plan, timing and who are buyers in this system? There are some franchise businesses out there with very little or no terminal value because they are essentially a “job” and not kicking off enough cash to attract anyone other than another job seeker. Find out what resales in the system have sold for. Don’t assume that no resale transactions signals happy franchisees. They may wish to sell but are unable to secure enough to release themselves from their contract and lease.
PE Insights: Who is buying these outlets from retiring franchisees? Is there any PE activity at the outlet level? The better the underlying economic model, the more likely your franchise system is to attract consolidators.
It isn’t always easy to separate your emotions from your franchise purchase decision. But to achieve the best return on your money and time, it helps to adopt the mindset of professional investors.
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