“A New Game - Franchisor Equity Participation”		«BACK
	by Dennis L. Monroe
	from Franchise Times, August 2002 Issue

Given all of these factors, a proactive franchisor should consider certain techniques to spur development of its concept. These approaches have been developed and used by franchisors we have worked with and, in many cases, result in a fundamental shift in how the franchisor views the franchise community. Many franchisors may claim these techniques are exactly what they were trying to avoid when they decided to franchise. Franchisors may say that if they had had the money to do corporate store development, they may not have decided to become a franchisor. But many franchisors, who now have a successful track record, have accumulated sufficient resources to do some type of participatory development. The technique discussed recognizes the franchisee community provides a large amount of leverage for the franchisor to both build its concept and develop new units. Keeping all of this mind, what are some of these techniques?

1. Seed a Market. Market seeding has been a common approach over the years when franchisors want to develop a new geographic area but have not been able to attract a franchisee willing to take on all of the risk of this new area. Under this approach, the franchisor uses its own funds and opens a few units. It can then test the market and provide a potential franchisee with a clear indication of both the viability of the market and likelihood for success. The franchisor then seeks a franchisee who is able to develop the market to critical mass and thus, ends up with a strong, viable market. Many large, multi-unit franchisees are not interested in taking the risk of securing name recognition for a concept in a new area. They would rather leave that task to someone else and do what they really do well - to operate and open stores. Market seeding by the franchisor is a key way to bring a talented franchisee to the table and take away some of its perceived risk. This approach has been used by a number of franchisors, most notably the quick-serve restaurant and quick-lube concepts.

2. Team up with an Investor/Sponsor Equity Fund. There are a number of equity investors and funds that are interested in multi-unit retail, particularly in the franchise industry. These funds see the proven cash flow in the franchise sector and want to share in the bounty. Investors normally have appropriate capital, but need the operating expertise of a franchise partner to help develop a business. Under this approach, the franchisor pairs a key operational partner with an investor/sponsor fund and assists in the development process. The franchisor does not necessarily have to provide site location or market analysis but can certainly recommend worthy development territories.

This approach requires the franchisor review its normal franchise arrangement and oftentimes, develop a new, looser kind of entity franchise approach. The franchisor may have to accept the fact that an investor will normally not guaranty a franchise. In addition, the franchisor may need to evaluate any prohibition of a franchisee IPO; the state of the current equity instrument requirements; the flexibility of various exit strategies; and the overall capitalization structure normally required by the franchisor.

3. Develop Equity Participation. If a franchisor has sufficient capital, it should consider becoming an equity investor in strong operating franchisees. This approach is a joint venture. The franchisor has control of the concept and has a capital base. The franchisee is a hands-on operator who has a proven track record and thus, is a good investment for the franchisor. This approach can take many forms: a participating loan; a joint venture partnership where profits are split; a preferred investment where the franchisor gets its investment out first; or even a participating lease arrangement. This technique creates a symbiotic relationship providing the franchisee with an equity base to prevent over-leveraging, while providing the franchisor with a significantly higher return on investment than from a mere royalty stream. Equity participation creates a method to jumpstart development; obtains a good return on equity investment for the franchisor; and in general, lets the franchise community know the franchisor is interested in assisting sound franchisees.

4. Special Funding Arrangements. Another technique is the use of private placements to raise money for specific corporate store development. This can be very appealing because the investor is not just investing in a mere royalty stream but is investing in actual, hard assets that have been developed - a business where the investor can "kick the tires." The investor has the safety of knowing the franchisor cannot let these stores fail, and this makes it a more attractive option than investing at the franchisee level. This approach has been done by a number of medium-sized franchisors that are able to effectively operate corporate stores. Again, the franchisor has three sources of revenue from this approach: normal royalty stream; potential management fees; and equity return. The ownership split in this type of arrangement should provide the equity investor a return in the 30+ percent range.

5. Joint Ventures with Other Concepts. We would be extremely remiss not to discuss the joint ventures between different franchisors that now proliferate the marketplace. We have seen some of the major franchisors take an active role in developing smaller franchisors. Franchisors are beginning to look at each of their franchise sites as retail opportunities, and as a result, are looking for other concepts. The franchisor-to-franchisor arrangement can provide one of the most successful ways to accelerate the development of a concept. The small to middle-sized franchisor should look at how its concept can fit in with larger franchisors and how it can successfully approach co-branding or a common site approach. Everyone is trying to reduce the cost of development, and these collaborative arrangements are the wave of the future. The best example of this approach is the recent McDonald's/Fazoli's joint venture. This joint venture approach may lead to an actual acquisition (i.e., the Wendy's/Baja Fresh acquisition). This shows how a franchisor can use its capital and equity base to develop another franchisor's concept in conjunction with its existing concepts.

In the last few years we have recommended the above approaches to spur development for our franchisor clients. Obviously there are other ways of providing financing for the franchisee but unless the financing is below market, franchisees by and large have learned their lesson about being over-leveraged. The franchisor must look for ways to keep its franchise community moving forward, to prevent over-leveraging and, in effect, to develop a new type of franchisee-franchisor relationship.