“Investing in Franchise Businesses”		«BACK
	by Dennis L. Monroe
	from March 2004 Franchise Times

A franchise investment creates unique opportunities, but it also creates some unique issues every investor should consider. Let’s look at a few key issues:

INVESTING IN A FRANCHISOR

• a. The concept which may have certain intellectual property rights) is the primary asset. An investor needs to make sure the franchisor actively monitors and fully protects its intellectual property.
• b. Corporate owned stores. The investor needs to make sure the franchisor knows how to operate and run its corporate owned stores. There have been many discussions over the years that a franchisor should either be in the franchise business or in the store operating business but not both. Lately, the common wisdom is the combination seems to work best in terms of system development and return on investment.
• c. Geographic Store Concentration. A real issue may be the diversity in geographic store concentration. This may make it difficult for investors to monitor the business.
• d. Senior Debt. If the franchisor has substantial senior debt, the actual value of the corporate stores without real estate (if the stores are not performing well) is probably minimal and therefore, the equity value in these corporate stores may be nominal.

• e. Franchisee Royalty Stream. The real issue for the franchise investor becomes the investment in the franchisee royalty stream. The investor needs to review: (i) the individual performances of the franchisees on a unit level; (ii) the ability of the franchisor to keep the system current; and (iii) the ability of the franchisor to keep the franchisees (who, in effect, are the franchisor’s customers) happy and moving along in a defined and common direction.
• f. Obligations. The franchisor/franchisee relationship creates a number of expressed and implied legal obligations. An investor needs to be aware of these obligations and the various state and federal laws that govern these relationships.

INVESTING IN FRANCHISEES

Many equity investors prefer investing in franchisees, particularly investing in large multi-unit operators. Again, the cash flow nature of this business creates a viable investment for individuals or private equity funds. Most franchisors do not design their franchise programs to provide for private equity. Most franchise programs are based on the owner operated business model that carries with it all types of personal liability and other covenants which may not be appropriate for private equity. The investor must consider the following normal franchise constraints when investing in a franchisee:
a. The potential personal liability for the investor of being a franchisee;

b. The operational control that the franchisors are going to require of the operator which may, in effect, limit the investor’s day-to-day say in management or the investor’s say as to significant management decisions.

c. Limitations on the various classes of stock;

d. The concern regarding the ability to assign the investor’s interest;

e. Rights of first refusal on the disposition of a franchisee interest;

f. Ability to change management if things are not working out;

g. Ability to dispose of the assets;

h. Indemnification and subrogation rights by the operator because of his or her guaranty of the franchise;

i. Limitations on rights of forced sale by the investor;

j. Senior lender rights that may create a problem for the investor;

k. Non-competes which may apply to the investor as well as the franchisee operator; and

l. Post-termination covenants which may apply to the investors.

While this list looks ominous, many franchisors today are grappling with these issues and are coming up with new and innovative approaches. There are now a number of small and large franchisors moving toward providing investor friendly documents as well as techniques and procedures that hopefully will encourage the investor community to invest in their franchisee world.

Money seems to be flowing into the franchise industry and will continue as long as franchisors and franchisees work together to come up with new techniques that fit the investment world.