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The selling price of franchise businesses has significantly
increased. Nearly every week someone asks us
if it is time to sell. Even though it may be
an appropriate time to sell in terms of the market,
it may not be the appropriate time to sell in terms
of your business cycle or being prepared for selling
(both of which can give you a significantly lower price
than the market data would indicate).
Let’s
look at five areas of planning for a franchisee operator preparing to sell:
(1) Unit economics; (2) Financial statements and reporting; (3) Legal structure;
(4) Tax planning; and (5) Financing issues.
- Unit economics. It is important that
each store in your franchise business be reasonably
profitable. If you have a large number of stores,
it is unlikely that all of the stores are profitable;
in fact, you may have a group of stores that are
dragging down a higher overall profitability of your
company. It is important to deal with the unprofitable
stores prior to marketing the business for sale. There
are two common approaches:
- Drop the unprofitable stores into a separate
entity. This will segregate these stores
from the overall business and allow the good stores
to be sold under either an asset or stock sale. More
importantly, the unprofitable stores will have
separate books and records; thus, not confusing
the buyer.
- Bite the bullet and deal with these troubled
stores by closing or reletting. If you own
the real estate, sell the real estate.
Buyers may love your business but they do not want
your troubled assets. If the unit economics are
merely a result of a short-term problem (such as road
closures or population growth, which are inevitable),
then it may be important to tell that story in conjunction
with the unprofitable stores. The bottom line
is that the troubled stores need to culled out and
dealt with prior to a sale. This will give you
an overall higher price for your profitable stores
and the possibility to make some money off the troubled
stores through a separate sale of assets.
- Financial Statements and Reporting. One
misconception sellers have is that they can restate
their financial statements when they get ready to
sell. When I say “restate” I am
not talking about restating from a GAAP standpoint
but restating from a normalization of profits or
EBITDA. Sellers normally take out items they
believe are not necessary to the business from their
profit and loss statements (such as excess owner
salary, personal expenditures, and lifestyle items
(such as off-site housing, boats, planes, etc.))
and then restate their financials with a number of
these items removed (particularly items the seller
believes are excessive general administrative expenses). While
this is a valuable exercise, most buyers are somewhat
suspect of restated financial statements as they
do not believe they can operate the stores with less
expense than the seller. The key is to clean
up your P&Ls for at least a year before marketing
your stores.
In addition to P&L clean up, there may be Balance
Sheet issues such as unrelated business assets on the
financials. Any time the Balance Sheet contains
assets that do not pertain to the business, there is
a certain suspicion that may develop in the buyer. The
buyer will be concerned that there are other items
in the financials that are inappropriate or not correctly
reported. Prior to the sale it is important that
assets which are not part of the business be taken
out of the business. Additionally, the seller
should deal with related party receivables, payables
and notes that have no value to the buyer. Again,
clean up the Balance Sheet for at least one year prior
to a sale.
In summary, any time you are being encouraged to restate
your financials (or what we call “normalize” your
earnings), look at that request with some degree of
skepticism. While buyers who are anxious and
may be at first willing to accept the explanations,
it is much easier if there has been a reasonable reporting
period with clean financial statements.
- Legal Structure. Another roadblock
to a sale is an overly complicated legal structure
for the selling business. This particularly
occurs when each store is in a separate entity. There
can also be problems as it relates to use of management
and separate real estate holding companies. All
of these are good tax planning ideas (which will
be discussed below) but they do create complications
for a buyer in understanding what they are buying. Therefore,
do whatever you can in terms of trying to consolidate
entities, look at various holding company ideas (which
will create consolidated financial statements) and
in general, try to provide for a structure that is
easily understandable. If you know there are
certain assets that will be sold and other assets
that will be retained, it may be a good idea from
a structural standpoint to drop those down into a
separate entity. In general, the structure
needs to be looked at and the simpler, the better.
- Tax Planning. Most often tax structure
is dealt with when the seller gets an offer. This
is unfortunate because many things can be done prior
to a sale. Look at the following issues:
- Overall type of entity. If the selling
entity is a C corporation, double taxation can
occur. Even if a sale is pending within the
next year, it may be wise to make an S election
for the corporation now. There is a 10 year
rule that says that if assets are disposed of within
10 years, appreciation at the time the election
was made is subject to some degree of double taxation. If
there is the period of time from the time of the
election (many times you can go back one full year),
then the appreciation in the value of the assets
from the time of the election is not double taxed.
- Allocation. Think about allocation
prior to going to market. Most often buyers
want to allocate to assets that are rapidly depreciable,
such as fixtures, furniture and equipment (“FF&E”). We
all know these used assets do not have a high market
value. Therefore, make it clear to a potential
buyer that you are looking at a true market value
allocation for the FF&E assets. The balance
can then go to intangibles (i.e., franchise rights). Franchise
rights are amortizable over 15 years and create
a long-term tax savings for the buyer.
- Loans to shareholders. Look at assets
or liabilities on the Balance Sheet that may carry
adverse tax consequences, such as loans to shareholders. Loans
to shareholders need to be repaid or need to be
distributed out so you do not have debt forgiveness
and can plan the timing of any tax consequences. Additionally, loans made by the shareholder to the company may
be a way of getting money out of the company without
additional tax, particularly in the case of a C
corporation.
- Net operating losses. Look at the
use of any net operating losses prior to the sale. When
using flow-through entities it is preferable to
have the net operating losses offset by ordinary
income versus capital gains income that may come
from the sale of assets or stock.
- Stock or membership sale. Consider
the use of a stock or membership sale versus an
asset sale. You will have to make certain
price adjustments to offset the company debt, but
it still may be overall advantageous even at a
lower sale price because of a lower tax structure
and higher after tax dollars.
- Financing Issues. In almost every
case the buyer will need to obtain some type of outside
financing to acquire the assets or business. Some
of the key components relating to financing are:
- Do the leases the franchise business operates
under allow the successor tenant to provide to
the lender a leasehold mortgage?
- Are there assets under the equipment leases that
require a substantial prepayment penalty? Prepayment
penalties make it costly to refinance.
- Are the titles to personal property and real
property in good shape? Always look at the
title, environmental and liens issues prior to
a planned sale so you know what you have to deal
with. We recommend our clients do all appropriate
lien searches prior to starting the sales process
to make sure there is nothing on record that they
are unaware of.
- Conduct an in-depth review of your franchise
and development agreements.
- Can the franchise and development agreements
be transferred without being subject to the franchisor’s
approval?
- Make sure these rights (particularly development
rights) can inure to the benefit of the successor.
- Look at the termination dates for the franchises
and leases. Make sure these agreements
have a long enough period of time for the buyer
to realize the full value of the assets or businesses
being bought.
In general, do your own due diligence prior to putting
the business up for sale. This would be the same
type of due diligence the buyer will do. Have
everything in order so any issues can be answered. Issues
that often come up are employee claims, employment
agreements that need to be terminated, vacation compensation,
EEOC claims, and immigration issues. All of these
issues can be planned for prior to a sale.
In summary, if you are going to look at a sale, it
is best to spruce up the business and deal with the
tough issues such as poorly performing stores, lien
concerns, and inefficient tax structures prior to putting
the property on the market. Today’s buyer
is very sophisticated and will not see your business
through rose-colored glasses.
Next month’s article: “The 10 Best
Financing Ideas of 2006”
Dennis L. Monroe is a partner and the chairman
of Krass Monroe, P.A., a law firm specializing in
multi-unit franchise finance, mergers and acquisitions,
and taxation. Krass Monroe, P.A. is located
at 8000 Norman Center Drive, Suite 1000, Minneapolis,
MN 55437-1178; (952) 885-5999. For previously
published articles, and other Krass Monroe information,
please refer to our Web site at www.krassmonroe.com
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