As refranchising gains popularity internationally, it’s important that these transactions clearly identify challenges and complexities to ensure smooth transactions and provide solid foundations for long-lasting relationships.
By Rick Morey, CFE, and Tao Xu
Refranchising, or the franchisor’s sale of company-owned outlets to franchisees, is a trend that comes in and out of favor. Published reports indicate that many brands are actively engaging in refranchising transactions for their international markets, including Yum! Brands, McDonald’s, many hotel companies who are pursuing an “asset-lite” strategy, and even Coca-Cola. We will explore some of the reasons why these deals can be attractive for both franchisor/sellers and franchisee/buyers, and some of the issues that both sides should consider when analyzing an international refranchising transaction.
There are a number of reasons why franchisors are increasingly looking to refranchising transactions. First, international refranchising transactions often make sense for the same reasons that all franchising transactions make sense: realizing the efficiencies that typically accompany ownership of the brand by someone in the local market who understands the unique labor, real estate and governmental requirements of the country. Also, and perhaps most obviously, these deals generate cash for the franchisor.
Particularly in brands that have shown limited or stagnant growth in sales and outlets, refranchising transactions can generate significant cash to fund new initiatives or satisfy investors. Similarly, selling company-owned outlets also decreases the franchisor’s ongoing capital expenditure requirements by shifting the burden of developing new outlets and remodeling aged outlets to the franchisee. In some countries, franchisors may find exiting the market (at least in terms of company-owned operations) will result in a tax benefit, and also might reduce some of the uncertainty that brands might face in a shifting
geopolitical environment.
Significant Benefits for Buyers
Acquiring operational company-owned outlets from the franchisor also provides significant benefits to the international franchisee/buyer. Often buyers can obtain good prices for these transactions compared to the multiples that sellers of non-franchised assets charge. Franchised outlets typically trade at a lower multiple than non-franchised brands, which makes sense because the buyer is acquiring the outlets subject to a franchise agreement and other restrictions, and is not acquiring ownership of the brand and the resulting expansion rights.
Prices for these deals can also be attractive for buyers because, unlike many typical sellers, franchisor/sellers have considerations beyond just maximizing the price. A franchisor has a vested interest in ensuring that the buyer succeeds. This sometimes results in a franchisor being more forthcoming in the diligence process and willing to invest in the buyer’s success through mechanisms like seller financing. Buyers also may find that acquiring the infrastructure that goes along with the existing outlets, including the labor pool, real estate expertise, operating expertise and established supply chain, will be far easier than launching a new brand in a country and developing this infrastructure themselves.
More Complicated Than Domestic Deals
Many of the reasons why refranchising deals are attractive for sellers and buyers apply both to domestic and international transactions. But while domestic refranchising transactions can follow a standardized process, international refranchising deals are typically more complicated than domestic deals.
Due diligence is critical in every M&A transaction, as buyers need to understand the value and condition of the target’s assets, the recurring and potential future liabilities, and any landmines that might be lurking after the closing. But in international refranchising deals, diligence is even more critical. Sometimes franchisors sell high-performing international markets, but often franchisors are selling international outlets because they are underperforming and profitability can be increased by local ownership. In these deals, the buyer needs to understand why the market is underperforming and the investment needed to increase profitability.
Sometimes U.S.-based franchisors can miss some steps in terms of compliance with local laws and regulations, and off-shore ownership can result in inefficiencies in the supply chain and local management teams. It is critical for a franchisee/buyer to understand the scope of these issues impacting the acquired business. Open communication about the market’s shortcomings is also important for the franchisor/seller, as it not only increases the chances of the buyer’s succeeding in the system, but also generates the trust that is so critical in the franchisor-franchisee relationship.
One of the key terms in a refranchising transaction is the franchisee/buyer’s commitment to opening new outlets and remodeling aged outlets. The difficulties for the bidders are manifold, aside from their general aversion to commit contractually to a target that could be difficult to achieve. Often, the market is already mature, and further expansion could be difficult and yield lower marginal return.
Reaching consensus on the remodeling investment (both in terms of the overall amount and the deployment timeline) could be difficult, given the brand’s preference to update the aged outlets as soon as possible and the franchisee/buyer’s preference to space out the capital investment. For private equity buyers in particular, the investment horizon may not fully align with their holding/exit strategy. As such, it is critical for the parties to reach agreement on this issue early in the negotiation process.
A Higher Threshold
Subfranchising adds another layer of complexity to international refranchising transactions. In certain foreign markets, the U.S.-based franchisor operates both company-owned outlets and has franchisees operating franchised outlets. In a refranchising transaction, these franchised outlets will almost always become subfranchised outlets overseen by the franchisee/buyer. This places a higher threshold on the qualification of the franchisee/buyer, because it will be asked to play the roles of both franchisor and franchisee-operator.
Second, the three-party relationship between the franchisor, the franchisee and the subfranchisees will be a complex one to manage, especially if the franchisee/buyer was selected from the pool of the existing subfranchisees.
Finally, while the franchisor might seek to keep its revenue stream from these subfranchisees intact, the franchisee/buyer typically will want to get compensated for the services and supervision it provides to the subfranchisees. Given all these complications, it will come as no surprise that some franchisors try to buy out the local franchisees before proceeding with the
refranchising transaction.
Greater Legal Compliance
Compared to domestic refranchising transactions, international refranchising transactions often raise more legal compliance issues, given their size and complexity. Just looking at the profile of the franchisee/buyer alone, for example, buyers who have existing operations in the same industry could trigger antitrust issues and merger notification/approval requirements, private equity buyers might require off-shore holding structures depending on the market, buyers who are wealthy investors might want to introduce trust and other family arrangements into the mix, and buyers from outside of the market might invoke foreign investment restrictions requiring a local partner.
Of course, many foreign countries also have specific franchise laws, some of which require registration, disclosure or even modifications to the parties’ contractual arrangement. Because these regulations were not conceived to address complex transactions like international refranchising, sometimes they can introduce complications that do not exist in a non-franchise deals. For example, a few countries’ franchise laws give the franchisee a post-signing cooling-off period, which, if not addressed properly, can affect the transaction timing and even upset the closing risk allocation that the parties negotiated.
It is clear that refranchising transactions are picking up steam internationally, despite all of these and other challenges and complexities. Those who are managing these transactions must clearly identify these challenges and complexities to ensure a smooth transaction and, perhaps more importantly, a solid foundation for a long-lasting franchise relationship going forward.
Rick Morey, CFE, is a Partner at DLA Piper in its Chicago office. Tao Xu is a Partner at DLA Piper, specializing in international franchising, licensing and distribution transactions.