Exit Planning: Strategies for Franchise Owners

Finance

Proper planning to meet financial goals can create confidence, direction and lower stress.

By Adam Goddard

Franchising is in the midst of a significant transition, and franchisees, especially multi-unit owners, should take notice. Transferring ownership of one’s business is something that many franchisees delay considering until near retirement. 
 
Many reasons for exiting include a better work/life balance, opportunities for “Act II” post retirement, and growing valuations which make an exit more attractive. Developing a plan three or more years before exiting is wise. Many franchisees wrongly assume this is a simple process. However, a multi-dimensional plan is required and can be complex to develop and implement.
 
A better way to prepare for exit is to create a personal financial plan that includes a comprehensive succession plan. Succession planning is becoming prominent in franchising as some 80 million baby boomers approach retirement, the impact of which is felt by franchisors and franchisees. 
 
Most franchisees are not prepared, says Georgetown University Franchise Management Program Director Dr. Ben Litalien, CFE. “The research clearly indicates that franchise owners are way behind the curve in preparing for succession. Given the global demographic shift and the rapidly increasing value of franchised businesses this needs to be a top priority.” 

Franchisee Financial and Succession Planning

Effective succession planning is a custom-designed approach that maps how the owner intends to transfer his business. These could be to family members, another franchise owner, a third-party acquirer or private equity group or, the franchisor.
 
There are variables to developing a plan’s priorities. Establishing and ranking variables is important to the appropriate exit and succession strategy.  A resource allocation approach called the “5 Buckets” is useful for this process.

The "5 Buckets”

In planning to allocate your resources and holdings between these five buckets, consider a financial plan, which prioritizes the retirement bucket in most cases. 

This includes a scenario analysis — “Monte Carlo Simulation” — which compares different sequences of market returns to determine the probability that your plan will work. We analyze such variables as:
  1. Retirement age,
  2. Retirement Income needed and,
  3. Number of units needed to own to reach retirement goals.
Impact of the Plan’s Probability

That last factor is important. There are two elements: to determine after-tax income from the sale, i.e., optimizing retirement goals for your business, then determine how many franchise units are required to accomplish these goals. This helps the franchisee create a clear model and strategy for retirement goals.
 
Almost 70 percent of businesses don’t survive to the second generation, per a 2012 Harvard Business School study. Of those, only 12 percent reach the third generation. Among the primary causes is failure to create and execute a management succession plan. Other factors include inadequate estate and liquidity planning.
 
In succession planning for your family, estate planning is key. For example, a multi-unit owner with 50 units valued at $500,000 per unit equals $25 million. But, once your estate’s value exceeds a certain threshold, you may be taxed 40 percent to 50 percent of the excess over that value. 

Tax Consequences with Family Succession

When combining estate taxes with potentially significant income taxes paid at sale, the taxation can be onerous. Attorneys and CPAs that specialize in tax and estate concerns can identify tax efficiencies, especially regarding estate taxes. They should provide an analysis of best exit options for your situation.  

Transferring Ownership

Franchisee effect: Includes the ability to negotiate an agreement that aligns your business goals with personal financial goals. Good financial planning analyzes variables such as number of units owned, valuation per unit, transfer taxation and sale.

Franchisor effect: Compels the franchisor to ensure new owners will run the multiple units in a high-quality fashion as the seller. Remember, many franchisors have a right of first refusal to purchase franchisees’ businesses at point of proposed transfer. Certain factors, such as sale outside the system, can hinder transferability. Check the franchise agreement.

Exit Options Available

Various exit or succession options include:
  1. Transitioning to family members (family succession), 
  2. Selling via business broker or reseller (usually smaller/medium sales),
  3. Selling to another franchisee (or back to franchisor),  
  4. Selling to a private equity group or working with investment bank and private equity recapitalization (medium/larger sales).
Each option has strengths and limitations plus unique tax aspects, depending on the situation. For smaller operators, succession planning is often less complex given the transaction size. Potentially, an estate tax may not apply. In larger multi-unit transactions, succession planning is more complex due to more parties involved, potential taxation and the ability to agree on the sale’s structure.

Transferring to Family Member

This can be effective if less liquidity from your franchise value is required (i.e. having other portfolio assets that diminish liquidity needed from the business). Transfers to family members provide opportunity for in-depth tax planning, especially for estate and gift planning. An owner can also use charitable trust planning (Charity Bucket) in this situation to create estate tax efficiencies on transfer as well as deriving income tax benefits through charitable trusts.
 
Complexity can exist when one child wants to be involved in the business and one doesn’t. In those situations, use of insurance as part of the succession plan may help to equalize values between children.

Selling Through Business Broker or Reseller

Another option is to use a firm specializing in franchise re-sales, such as a business broker. Ellen Hui, managing director of mergers and acquisitions for National Federal Sales says: “As a former multi-unit franchisee, I’ve seen up close how the reseller can help speed the process of qualifying and matching possible prospects. In many cases, like a real estate agent that knows the neighborhood, a good reseller may have sold many units in your brand already.” 
 
A reseller may structure a sale more beneficial in ways that a private equity firm or banker can’t (typically smaller or medium-size transactions).

Assets vs. Stock Sales

A key sale structuring factor is taxation. There are two sales categories from a taxation perspective: assets and stock.
 
Stock sales are treated as a capital gain to the owner while an asset sale can be treated as ordinary income. Ordinary income rates may be higher. The difference can be substantial, potentially by 20 percent. Thus, a stock sale may help the owner, while the buyer may have advantages with an asset sale, including not having to assume company liabilities and a potential depreciation increase.
 
Beyond taxation, but also regarding increased returns expected on sale, franchise valuations tend to be rising, in some cases a five-to-eight profit multiple.
 
Selling to Another Franchise Holder

This is typically structured (in a multi-unit setting) using a business broker or a small/medium-sized investment banking firm, but is not typically done between franchise systems.

Sale to Private Equity Firm (Using a Banking Intermediary)

An investment banking firm, often a private equity group, can be a key to vetting the right purchaser. Private equity groups, on average, handle larger sales over $3 million EBITDA within a franchise system.
 
Investment banks conduct extensive due diligence by reviewing industry benchmarks and working with other consultants to optimize the sale’s structure. These firms look to add scale to brand ownership, creating a potentially larger opportunity as the brand ownership scale is developed.
 
The McLean Group Managing Director Burt Yarkin says: “We've worked with a variety of large multi-unit owners on private equity transactions. A smart transaction allows the multi-unit owner to take money off the table for retirement liquidity and work with a private equity partner on additional franchise opportunities that may present themselves.”  
 
Why plan? Your original goal for acquiring a franchise was probably to get more financial and time independence and gain work-life balance. For many, this may have been out of balance for years as they focused on their business. Now you can start the process to meet those goals.
 
Doing the proper planning towards meeting your life’s financial goals can create confidence and direction and lower stress. The “Five Buckets” approach can be highly effective. By creating a plan and refining it, a complex situation can be simplified and put you on the path to achieve your goals. 
 
Adam Goddard, CPA, PFS, is a Financial Advisor and Managing Director with The Capitol Bay Group, a financial advisory practice of Ameriprise Financial Services, Inc.

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This information is being provided only as a general source of information and is not intended to be the primary basis for decisions. It should not be construed as advice designed to meet the particular needs of an individual. Please seek the advice of a financial advisor regarding your particular financial concerns. 
Ameriprise Financial and its affiliates do not offer tax or legal advice. Consumers should consult with their tax advisor or attorney regarding their specific situation.
 
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