By Ron Gardner
Over the last fifteen years, private equity investors have acquired both controlling and beneficial interests in a tremendous number of franchisors, with some PE firms simultaneously owning literally dozens of franchise brand in multiple industries.
Much has been written and spoken about this evolution. Early on, there was great concern by everyone that this would hurt franchising. But the money was too great for many franchisors to resist. And to be sure, the results have been, by and large, and not unexpectedly, mixed. Like any other type of owner, some PE firms have turned out to be great for the health of the brands that they own, while others, who may not understand franchising or may not be particularly good at management or operations, have hurt the growth and stability of the brands that they acquire. There is no magic bullet here.
What has been interesting in the last few years, however, is how these same franchisors (many of whom are owned or controlled by PE firms) have reacted to the idea of PE as owners of franchisees. As a franchisee lawyer, I have watched with amusement and interest as franchisors that are owned by private equity have struggled to determine whether or not they would accept PE ownership amongst their franchisees.
Indeed, I have seen provisions in franchise agreements that were inserted to expressly prohibit private equity ownership, provisions indicating that private equity ownership requires security far and above that required of far less capitalized mom-and-pop operations, and provisions that restrict PE franchisees from growing more aggressively than franchisees that are not owned by private equity.
These more robust restrictions often show up in non-disclosed “Relationship Agreements.” I have often wondered how franchisors get away with some very fundamental changes to the agreement that is in their FDD in “offering” (read: requiring) PE buyers to agree to terms that limit or restrict what the “general public” is being told about the franchise offering.
This has me thinking about both the irony and contradiction of it all.
Fundamentally, franchising has always been about franchisors using other people’s money to expand their brands. You could think, on its face, that would mean franchisors would love the idea of well-capitalized groups coming into their system, particularly those looking to grow the system to obtain a larger and quicker return on their investments.
However, this drive by private equity franchisee owners often conflicts with franchisors’ other desires — for example, a desire to keep often iron-fisted control over not only the operations of their units, but their franchisees. Far too frequently, franchisees operate in what has been colloquially called the “North Korean model,” with franchisors that are convinced they know what’s best in every situation and in every market. These unenlightened franchisors, I believe, are fearful of new ideas that are well funded and that, typically, come from highly educated operators.
So, the trade-off is a real one. But I think this is just a transitionary phase.
My crystal ball, which is often foggy and cracked, suggests that, just as it took a while for PE on the franchisor side to take hold, we are moving toward a day where PE on the franchisee side will become much more common. This will create a more sophisticated marketplace than has historically existed in franchising, but will also create its own challenges.
For instance, franchise sales have long relied on small entrepreneurs, chasing their American dream, who are ready to walk away from corporate America and invest their savings into opening one, two, or three units. As private equity-backed franchisees become more common, one wonders how the sales process will shift when it comes to bringing new franchisees into a system. (My anecdotal view is that currently most PE on the franchisee side comes in through acquisition of existing franchisee units — sometimes in a roll up — and that they are much less frequently “new franchisees” buying into a system and building from scratch.)
If my crystal ball is right, it also raises interesting issues about how disclosure might change. Currently, both the FTC and many states have “sophisticated franchisee exemptions,” removing many of the disclosures that franchisors are required to make to sophisticated buyers — with a “sophisticated buyer” being defined by their financial wherewithal rather than by their experience or understanding of franchising. One wonders if the initial purchaser is a PE firm, with no understanding of the amount of control or the franchisor’s operation, who buys without proper disclosure might be a recipe for looming disaster. That is something to consider in this era of modifying and simplifying disclosure requirements on franchisors that remain helpful for franchisees.
To be sure, I understand and advocate for franchisors’ control of their systems and their brands. But I am also a big champion of making sure that franchisees aren’t seen just as owners (and funders) of a branch office type of operation. There needs to be some autonomy, and if that franchisee happens to be well capitalized, we should all be working toward an understanding of how that best works for everyone.
The opportunity here is real, and as the evolution continues, and those of us who can help shape it think about these concepts, there is certainly room for debate, variation, and, perhaps most importantly, improvement.