David W. Koch

A major source of fuel for the recent franchise explosion is private equity.  Although private equity firms do not typically fund startup franchise concepts, they increasingly serve as the catalyst that pushes a franchise concept beyond the 50-to-100 unit range — where many otherwise plateau — as the "white knight" that rides in to rescue a struggling brand or as the deep-pocketed successor that allows the business owner to cash in and retire. 

The current flood of private equity money not only nourishes mid-stage and mature franchise concepts but also tempts entrepreneurs to launch new concepts with the thought of tapping in downstream. A decade ago, only a handful of private equity firms had any real understanding of franchising.  Today, literally dozens of private equity firms have awakened to the franchise business model. 

While most private equity deals have involved investments in a brand owner  — the franchisor — some have involved investments in multi-unit franchisees with prospects for growth within a concept.  Which side of the franchise relationship the target company is on does not fundamentally affect the basic business issues facing the private equity investor and the target.  Let's take a closer look at those issues from the business owner's point of view.

Objectives. For the franchisor or multi-unit franchisee, the first private equity transaction is generally a breakthrough event.  But the decision to pursue private equity sets in motion a process that has its own momentum, and the interests and objectives of the existing business owners will inherently differ from those of a new capital source.  Unfortunately, owners often defer consideration of their objectives until they are sitting at the table with a private equity source.  As a result, the private equity players — who do this for a living — may dominate the deliberations to an unreasonable extent.  The best time for the owners to discuss their objectives is before meeting with equity sources.

Valuation.  Valuation is not everything, but it is the most important element in any equity transaction.  The valuation of the business determines how much of the company the franchisor or multi-unit franchisee must hand over in order to get the capital to pursue its business plan.  To put it starkly, if a business is valued at $10 million, and the new equity is $5 million, the new investor will expect to own 1/3 of the company post-closing.  If the business is worth $5 million, the same equity investor will expect to own half of the business post-closing.

The existing owners should get the valuation set in stone as early as possible after negotiations with private equity begin.  Equity sources may explain that valuation is subject to on-going due diligence.  That's fine, provided that the owners do not handcuff themselves to the particular equity source before the final determination of value.  The franchisor or multi-unit franchisee should avoid foreclosing other possibilities during the due diligence phase.

Control. The current owners must ask themselves:  Am I willing to give up some or all of the day-to-day control of the business?  Some private equity is passive — preferring to allow the existing management to stay intact.  Other investors play a more active role, and may have specific plans for revising or redirecting the business plan. 

Private equity is "smart money" in that it enters a business with clear objectives and knows how to achieve them.  If the new equity does not have voting control of the business, the investor may insist on specialized provisions in the articles/certificate of incorporation, the bylaws or a shareholders agreement. There is nearly an infinite variety of special voting/control mechanisms, but they include: "reserved" seats on the board of directors, supermajority vote requirements (at shareholder and board level) for certain transactions, cash-out rights triggered by certain events or dates to permit an equityholder to liquidate its invesment, and "tag-along" or "drag-along" rights that permit the minority shareholder to participate in stock sales and public offerings of stock. Private equity sources require these specialized clauses to protect their investment but they can also be seen as means to protect the original owners.

Dilution and "ratchet." Absent agreement to the contrary, new equity dilutes the interests of the existing equity holders.  Private equity sources will protect themselves with anti-dilution provisions that allow them to preserve their relative position.  Anti-dilution provisions vary significantly from simple pre-emptive rights (the right to participate in a future equity deal at the offered price) to "ratchet" clauses, which automatically increase the equity percentage if a future round of equity financing is done at a lower valuation.  A full ratchet clause protects the existing equityholders, but is viewed negatively by new capital sources.

Horizon, exit and transition.  How long do the current owners intend to remain involved in the business?  Is a second generation of management ready (or expecting) to step in?  If the current owners have a plan for disposing of the business (selling it whole, in pieces, or by IPO), that should be discussed.  New capital may have a different plan or exit strategy.  More than one exit strategy can co-exist, but the two strategies must mesh.

The terms of a private equity transaction are dictated by the posture of the business.  The business is either on the cusp of success and needing cash for the next stage, or the business is in trouble and needs capital to regroup and rebuild.  Not surprisingly, in the latter case, the terms of the private equity will be more onerous and less negotiable.  Even so, investing energy and resources in negotiating and documenting the best possible terms can pay off later for a franchisor or multi-unit franchisee.

David W. Koch is a partner and chair of the franchise practice group at Wiley Rein & Fielding LLP, a law firm in Washington, D.C.  The article draws on materials prepared by firm partner Greg Cirillo.