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Reaching the Next Level with Private Equity
Franchising World, January 2007 “Look before you leap,” is often given as advice. In today’s world there is plenty of capital available for franchise systems. Venture capitalists and private-equity investors have grown comfortable with the predictable cash flow and exciting growth opportunities in franchising. As a franchise company exploring financing alternatives, it is important to understand all of the options before jumping into any arrangements. There are several reasons a franchise company may look for capital. Maybe there’s a need for growth capital. Perhaps it’s time to buy out partners or original investors. Creating liquidity for shareholders and management is also a common reason a franchise firm might pursue private equity. A variety of capital sources exist, including: • Senior Debt. Generally the least expensive option, but it usually requires principle payments to begin immediately. Thus, senior debt reduces cash available for growth. Current rates are 8 percent to 12 percent. • Mezzanine Debt without Equity. More expensive than senior debt, but it normally only requires interest to be paid currently. Principle is paid in one lump sum at the end of the term. Current rates range from 12 percent to 18 percent. • Mezzanine Debt with Equity. The current interest rate may be less than mezzanine debt without equity, so it lowers the drain on cash flow. It’s typically structured with a lump-sum principle payment at the end of the term, along with a requirement for the company to repurchase any stock held by the lender. Current total return for mezzanine debt with equity is 15 percent to 25 percent. • Equity. For the most part, equity does not require any current payments. However, it can result in new investors owning or having the ability to gain control of the board or directors, and it may require the company to repurchase the investors’ shares at some point in the future. Private-equity investors are seeking a minimum return of 22 percent, and generally want a return in the 25 percent to 35 percent range. Making a decision to pursue additional business capital is not an easy one. There are a variety of things to consider besides the best source of capital. It might be useful to enlist some outside assistance to help navigate the process.
Should an Investment Banker be Hired? Hiring the right financial advisor is just as important as finding the right equity partner. A good advisor will prepare its client to market the business. This includes developing materials and offering advice regarding the type of transaction that will best meet the client’s specific needs. The investment banker will also help screen potential investors, structure the transaction and keep things moving toward a successful completion. When Great Clips, Inc. completed a private-equity transaction several years ago, the company hired an investment banker. That transaction would have been very difficult to complete without the banker’s assistance, since the organization’s staff and leadership were not familiar with the process. Generally, the cost is minimal compared to the transaction size and therefore very worthwhile. One word of caution, in situations where shareholders and management have an overlap, it is important to be very clear regarding whom the investment banker represents. This helps ensure that all parties understand which side they are on in the event that conflicts arise.
What Do Investors Want? Conduct research and get focused on figuring out the priorities of potential investors. Finding the right fit before approaching a potential investor, rather than using the “shotgun” method, lends credibility to the organization. Investors appreciate being targeted with well thought-out opportunities that match their standard-investing patterns. The best partnerships occur when the objectives and priorities of the investors fit with the goals of the management team and other shareholders.
Typical Investor Expectations*
• A market leader is a brand that is well-positioned in the marketplace. *This list is strictly an example of what an investor might expect. Requirements will vary by situation.
Evaluating Options Think about the company’s long-range plans. Does the company and the investor plan to exit at the same time? If not, will the company be able to buy the investor out or will it be necessary to find another equity partner? Investors always plan their exit on the way in. Does the investor’s exit plan match the company’s goals? Another important question to consider is whether it’s acceptable to give up control of the company. How strong is the need for capital, and will the dollars be put to very good use? Spend as much time as possible with the potential investors. Are these people easy to work with and trustworthy?
Know the Real Cost Also, ask about initial and ongoing fee and dividend expectations. If the company relinquishes control, will the investors pay themselves large fees? Investors sometimes look for an early return of capital by collecting deal fees, ongoing management fees and dividends. Those could be fair, but the expectations should be spelled out in the agreements. Dividends can be paid as long as all shareholders get treated the same, and as long as certain income and balance sheet criteria are met.
Go the Extra Mile A good indicator of the way investors conduct business is how they handled problems in the past. When something does not go well, the business needs an investor that’s supportive, helpful and professional. Will the investors look for ways to solve problems or look for scapegoats?
Managing New Partners Early in the relationship, it may be helpful to have board meetings more often to build those relationships and help the new partners understand how things operate. Frequent phone calls between meetings can keep the lines of communication open and help ensure there are no surprises. It is always exciting to share good news, but just as important to share the bad. If there is bad news, get it on the table quickly and make sure the worse-case scenario is understood. If the partners know the worst and it ends up better, the company and its leadership look good. Sugar-coating issues and minimizing the possible negative effect look especially bad if things take a turn for the worst. Adding capital through private equity can help a business grow to the next level, but only through a full understanding of the process, along with a grasp of what potential investors need and how it will affect the business in the future. The more information known before jumping in, the better the results will be for all parties involved. Ray Barton is chief executive officer of Great Clips, Inc. He can be reached at 952-746-6401 or ray.barton@greatclips.com.
Investment bankers can be very helpful, especially for businesses raising capital for the first time. They can help evaluate business needs and determine which options are best. An investment banker can also help develop the information investors need to evaluate the business.
Selecting a partner for the next stage of growth is very important. Be sure the investor’s expectations are aligned with company goals. A big part of the selection process is gaining an understanding about what the private-equity partner is looking for in an investment opportunity.
• A solid, experienced management team with a proven track record in the industry.
• Current, predictable cash flow.
• Realistic growth plans based on history.
• Potential return on investment, currently the low- to mid-20 percent level at a minimum.
• An achievable exit strategy in four to six years.
• Complete control (or ability to take control) of the board if there are problems such as default on financial agreements.
When evaluating options, be sure to understand the true cost of each. It’s critical to know how the lenders or investors get what they need. Consider how much cash flow is available to service the debt. Make sure the plan for capital actually meets the goal, including leaving enough cash flow to fund your growth.
Most importantly, understand the real cost of this new capital. Do the math. The numbers get very big, very fast when investors expect a 25 percent internal rate of return. Is the company prepared to pay the price in five years? A $10 million investment with a 25 percent IRR means the investor will expect more than $30 million after just five years.
Once an investor has been selected, checking references shouldn’t be just a formality. Obtain a list of all the companies the investors has supported financially during the last four to five years. Make random calls in an effort to track down instances where there were problems.
Once the transaction is complete, the company has new partners. These partners can be very helpful during the growth process. New partners bring a new perspective. It’s a great way to look at the business from a different point of view. To maximize effectiveness and to build a strong relationship, openness and honesty are important in all communications.
