“When Private Equity Buys Your Franchisor”

A Sneak Peak at an Upcoming Program at the 2019 AAFD Franchisee Leadership Summit in September

Within the last decade, private equity firms have purchased many established franchisors, and have significantly changed the landscape of franchising. Indeed, some of the most established brands have changed hands from legacy owners to private investors. This movement reflects, on the one hand, a desire of legacy owners to move on to retirement or other ventures after many years at the helm and, on the other, the fact that franchising is a good business and a good investment.

New ownership by private equity has created tensions and problems on an unprecedented scale in many systems, often with the result that franchisees would rather leave the system than stay. Frequently, the heart of these problems lies in the history of the system under old ownership and the interests and perspective of the new ownership. Legacy owners often started their systems with little to sell except a great idea, and frequently cut special deals just to get franchisees to sign up. Just as often, as the system grew and became successful, legacy owners treated their franchisees as family with franchise agreements that focused on a collaborative approach to developing the system and excusing mistakes in favor of system harmony and long-term growth. Even as legacy owners evolved a more sophisticated management, franchise agreements tended to remain the same, with royalties and ad fees at originally offered and accepted rates, and an absence of the expansion of new kinds of fees or charges. Above all, legacy owners tended to be devoted to the long term growth and success of the core franchise system business—delivering quality branded products and services, focusing on innovation and improvement, and ensuring high-quality customer experience.

Private equity firms, on the other hand, are in a different business—the business of maximizing profits, often with a short term goal of flipping the brand to a new owner. In taking over a franchise system, the focus is often on increasing the franchisor’s bottom line so that at the end of a three to five-year cycle, the private equity firm can either sell to yet another owner or do an IPO. Thus, when private equity takes over a franchisor, it often implements changes that effectively shift profits from franchisees to the franchisor.

In our experience, we have seen some private equity firms implement the following strategies shortly after their takeovers:

• New franchise agreements are published for all new and renewing franchisees that contain an array of new fees and that shift expenses from the franchisor to franchisees. For example, we have seen proposals for franchisees to share in the franchisor’s costs of developing technology or websites,
  even though franchisees have no ownership stake.
• In systems that used area developers or sub-franchisors, private equity has taken steps to eliminate these “middle men” in an effort to take a larger share of profits for the private equity owners (often sacrificing customary and expected franchisee support).
• The franchisor’s management team may be pared down or replaced, sometimes with inexperienced, but cheaper personnel.
• In some systems, private equity has sought to “roll up” or buy out franchisees in order to have a system that is completely company-owned.

What can franchisees do when faced with the prospect of a takeover by private equity?

An independent franchise association is a must in dealing with private equity. Strategies that we have used with success include:

• Reach out to new owners early. If possible, prior to acquisition, the association should reach out to the prospective acquiring firm and invite discussion. The contact can be friendly or it can be assertive, even to the point of bringing suit. The object should be to make the acquiring firm recognize that franchisees are stakeholders and need to be reckoned with and respected. While there is a good chance that any franchisee overtures will be ignored, at the least a record can be created that may be used in the future. In some instances, we have been able to derail an acquisition and force renegotiation to include franchisee interests; in another case, because we had advised the potential acquirers of deficiencies in the franchise offerings, the directors of the private equity firm were held liable for perpetuating a fraud.
• Take a ‘legal inventory.’ Before or after the acquisition, it is a good idea to take a ‘legal inventory’ of the franchise agreement and FDD. Are there provisions that have not been enforced historically that new owners could tighten up on? Do renewal clauses protect existing rights, or can the new owner force a completely new franchise agreement on franchisees? What opportunities are there to maintain existing rights? In one case, when the franchisor presented franchisees with a new and harsh agreement, we brought suit to maintain the old agreement and succeeded in bringing the franchise owner to the table to negotiate the new agreement.
• Understand the new owner. It is likely that private equity’s agenda is to increase fees, sell more franchises, take more rebates and kickbacks from suppliers, increase the bottom line and then sell the system to yet another buyer for an inflated price. But there may be other objectives and issues as well, such as merging with another system or rolling up the system. It’s critical to understand where private equity is going in order to formulate a strategy for both the short term and the long term.
• Get your toolbox together: What are your legal rights and obligations? What can you do in terms of publicity or news stories? How about political pressure?
• Contact the new owners directly with your grievances. Make it clear that a franchise system cannot succeed unless it has happy and profitable franchisees. Use as many avenues of communication (FAC, lawyers, individual franchisees who may have relationships) as possible.

Within this framework, each franchise association must define its own strategy, tailored to the players, the system and the franchisees’ objectives.

With the right strategy, and persistent, thoughtful effort, franchise associations can not only make their voice heard, but get a seat at the table to work with the franchisor and its private equity owners.