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Economically, nothing is more important to a business owner than maximizing the value of his or her business interest. The ultimate value of the company is generally not realized until the business is either sold or merged with another company. However, by the time a business owner has decided to exit the business (either through a sale or merger) or has decided it is time to plan an exit strategy; it is often too late to bring optimum value to the company.
In today’s post dot.com world, people are focusing on real cash flow and the value of hard assets rather than speculative values. Such values are often difficult to develop in the short-term. In fact, attempts to maximize value in the short run not only tend to be very problematic from an operational standpoint; they also have a tendency to lower the long-term value of the business. Therefore, it is crucial from the beginning of a business to arrange the company’s affairs so over time value can be maximized.
How can value be maximized for both franchisors and franchisees? This article will address the issue of value maximization from both perspectives. In the end, the reader will find that the principles of maximizing value are consistent for both franchisees and franchisors.
Maximizing Value for the Franchisor .
In order to maximize the value of its business in the long term, franchisors need to concentrate on three major areas: (a) a flexible legal structure, (b) a clearly defined capital structure; and (c) and an efficient operational structure.
a. Legal Structure
Because the goal is to maximize long-term value, a franchisor should legally structure its franchise system in a manner attractive to potential buyers. This can generally be accomplished if the structure meets two equally important criteria: (i) the structure chosen affords potential buyers with a large amount of latitude in their selection of the form of the asset or equity purchase mechanism that best suits their individual situation; and (ii) the structure of the franchise system allows the franchisor to freely transfer all of the franchisor’s rights and obligations under its franchise agreements. As to (i), the type of entity selected should be determined in light of the potential or prospective purchaser. For example, the use of a flow through entity (i.e. a partnership, limited liability company or a Sub-Chapter S corporation) may allow the owner to maximize after-tax value in the short-term; however, such entities may not provide the type of flexibility that is attractive to potential buyers. As to (ii), while almost all UFOCs allow the franchisor to transfer their interests without franchisee approval or consent, a franchisor does not have free-reign over the selection of a transferee. In fact, a franchisor has the legal obligation to make a sound business judgment as to any transfer and to make sure the new franchisor is an organization that can effectively perform the obligations of a franchisor under the franchise agreement. In general, the franchisor needs to provide for franchise documents that are industry effective for any sales situation.
b. Operational Structure and Efficiency.
It is also vital for the franchisor to build a strong and efficient operational infrastructure. Potential purchasers are interested in buying a strong infrastructure that can provide for ease in business continuity after the acquisition. Therefore, the more efficient the operational franchise system, the higher the premium the successor franchisor will be willing to pay for the franchise.
Franchise systems should also be designed so they can be integrated with other franchise systems and allow for multi-concept development, appropriate types of compatible concepts and flexibility as to corporate store development. All of these items are designed to clearly address competition and allow for maximization of value. Again, the concept is maximizing operational flexibility in order to attract the largest number of potential buyers.
c. Capital Structure
As to the franchisor’s capital structure, there are two fundamental issues:
1. Senior Debt. The senior debt should be arranged so that it can be paid off without excessive prepayment penalties at a time when the ownership thinks the exit strategy is most likely. While a company may be able to get lower interest rates by having lock-outs or agreeing to pay significant prepayment penalties, this approach may not be in the best interest of the company as it relates to the timing of a reasonable exist strategy. Lately we have seen prepayment penalties in the neighborhood of 20% to 30% because of low market interest rates.
2. Equity. The franchisor’s balance sheet should also be structured to provide predetermined buyout formulas for passive equity players and define terms that outline the general buyout rights and obligations as to equity holders. Consider the following techniques:
a. Provide for active owners of the franchisor to have a right to force passive equity holders to sell their shares to the active owners at a predetermined price.
b. Provide equity owners with the right to force the company to be sold once certain thresholds are met.
c. Limit super-majority rights and thereby limit the veto powers of minority equity owners with respect to potential market value mergers and consolidations.
d. Provide for mandatory conversions of preferred stock into common stock upon the company attaining a predetermined valuation threshold.
The above are all techniques that can be used by the active owners of a franchisor. Some of the terms we frequently use in this type of planning are concepts such as “drag along rights” and “tag along rights” and “rights of forced sale.” All of these should be explored at the time of arranging the capital structure of the company.
Maximizing Value for the Franchisee.
Similar to franchisors, franchisees can maximize value through the use of a flexible legal structure, a clearly defined capital structure and an efficient operational structure, as further described below:
1. Legal Structure. While it is important for a franchisee to be legally structured in a way that enables potential buyers to have a wide range of available acquisition mechanisms, most potential buyers would rather structure the acquisition as an asset acquisition rather than as a stock or equity acquisition. Consequently, the legal form of the entity may be a less significant issue for franchisees than franchisors. However, due to a variety of income tax reasons, franchisees will generally select to do business in a flow-through entity.
The following items should be closely considered in the selection of an entity structure and in the negotiation of the franchise agreement:
a. Whether or not the franchisor has the right of first refusal.
b. Whether or not the franchisor has the right to approve any sale or transfer.
c. Whether or not the franchisee remains liable, even after the sale, for a period of time under the franchise agreement.
- d. Whether or not the franchisee, in order to sell, faces significant transfer fees or has to pay off certain trade payables.
- e. Whether or not you can negotiate your franchise agreement so that any potential buyer may be an equity investor who is not personally liable.
- d. Whether or not applicable development rights (particularly in concentrated arrangements) create a valuable market for a potential franchisee-to-franchisee sale.
f. Whether the acquisition of development rights are more desirable to the franchisor than a franchisee buyer.
g. Whether the franchisee has obtained market rate leases, rather than leases that are front-end beneficial but have high escalators on the back-end.
h. Whether the real estate upon which operations are located is owned versus leased. While having market rate leases that have assignability provisions allow for optimum flexibility, a franchisee should consider the importance of fee real estate ownership. Ownership of real estate may increase the value of the enterprise by as much as one to two times. Therefore, when thinking about exit strategies, do not be shortsighted and ignore fee real estate ownership. Ownership of real estate may not be feasible but take that into account when you are looking at your exit strategy.
2. Capital Structure. The issues of capital structure for franchisees are similar to the issues faced by franchisors discussed above (i) with respect to equity, avoiding various constraints from outside equity holders and (ii) with respect to debt structure, avoiding prepayments (where applicable) or factor them into the valuation. Because franchisees are more likely than franchisors to be involved with friends and family as equity holders (and possibly even lenders), they may be able to obtain (i) more favorable pay off terms and (ii) less restrictive transfer limitations (although these arrangements add an additional emotional element that does not exist with third party lenders and non-related equity holders). However, no matter from whom the financing is received, the key to maximizing value remains the same: the franchisee owner must control the selling process.
3. Operations
Operations and profitability are always key issues with respect to maximizing the value of the franchisee. To make yourself attractive to buyers, profitability should be measured not only with respect to your own operations, but also as to how your operations compare with those of your peers. As a franchisee, you want to make sure your profitability is some of the best in the system.
With respect to operations, three elements are given heightened significance: (i) general and administrative expenses (“G&A”); (ii) management retention; and (iii) stated profitability on the balance sheet. With respect to G&A, it is very important that your actual G&A is kept reasonably low. Although in the past it was customary to review G&A on a proforma basis, today purchasers are considering only the actual G&A associated with operating the business. It is also important to assure potential purchasers that good management is in existence and will remain with the business after the sale. Nothing will undermine the purchase price as quickly as the concern that the existing management staff will leave immediately after the sale and that profitability will decline as a result. Finally, balance sheets of franchisees should, in almost all cases, reflect positive net worth. Even though the concept may be generating significant cash flow, unless the company has been able to retain net earnings for future growth and down turns, many potential buyers will be concerned about the long-term stability of the company and the purchase price will suffer as a result.
Summary
As soon as you buy and finance assets, you need to be thinking about valuations and exit strategies. Hopefully this article has laid out some of the balance sheet, franchise and operational issues you should consider.
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