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Are We Experiencing The End of The Small Franchisee?

It seems like every day we read about more and more franchise acquisitions where one franchisee is becoming larger by purchasing another. It seems like franchisees are becoming ever greater in size, and there are fewer small franchisees existing in the marketplace. Is this really what’s happening? If so, why are we seeing the change?

The Franchise Model

Franchising, created as a way for capital intensive, multi-unit businesses to rapidly expand their reach, has now been a common business practice for over 50 years. It has provided a great opportunity for entrepreneurs who wanted to operate an independent business, but didn’t want the risk associated with the creation of their own concept. The franchise model was perfect; franchise operators were equipped with a formulated method for how to successfully operate and market their business, but were able to own and operate their own companies. Initially most franchises were sold to individual operators on a location-by-location basis. In some instances larger territories were granted, but most franchisors elected to expand their concepts with one-location franchisees.

Evolution of the Franchise Model

Success creates opportunity. As franchise concepts demonstrated success and became increasingly accepted as mainstream, a greater demand for more locations was created. Not only did this mean more franchisees were needed to maintain the growing franchise system, it also meant existing franchisees wanted to expand their own companies by operating more locations. Franchisees started developing better managerial practices, ultimately allowing them to focus on operating multiple locations. The replicable nature of most franchise concepts also benefitted franchisees by making it simpler to develop and manage additional locations. However, financing was a limiting factor. Through the early 1980’s, many franchisees were still relying heavily on personal financial resources and some form of very conservative bank financing as the means to fund their growth. As the industry moved forward into the mid 1980’s, we started to see an evolution of specialty franchise lenders that understood the franchise model and were willing to extend more aggressive levels of financing to help facilitate rapid expansion. This was the start of the multi-unit franchise revolution.

Franchisee Life Cycle

Over the past few decades, many early stage entrepreneur-franchisees started contemplating retirement and selling their businesses. Many elected to cash-in on their years of hard work and enjoy a profitable liquidity event. Others continued to grow, consolidate, and transition to future family generations, but this is not the norm. While the restaurant industry has been growing at an annual rate of between 1-2%, the Top 200 Restaurant Franchisees are growing by close to 20-30% annually, primarily through acquisition. The reasons vary, but for many existing franchisees it is some combination of age, desire for retirement liquidity, the capital intensive nature of operating a business, the constant need to invest in infrastructure and technology, and the overall complexity of running a business in today’s environment. Unit-level economics and overall industry dynamics have also created an environment where efficiency through size is a must, making it more challenging for the small and mid-sized franchisee to compete with their larger colleagues.

Who is Becoming Larger & Why

The groups that are growing dramatically are those that have been able to attract outside equity capital to expand the base of their current holdings. Historically, franchisees seeking to expand through acquisition resisted outside investors, instead using their own embedded balance sheet equity along with higher levels of leverage to finance their acquisition activity. In many instances, they were “one-and-done”, without enough capital to sustain any meaningful acquisition growth plan.

The franchise companies that have seen success with a consistent growth model through acquisition have raised outside equity in sufficient amounts to facilitate their plans without relying solely on the limitations of their own equity and the availability of high leverage.
So why has the franchise segment become attractive to financial investors? For years, professional and institutional financial investors (private equity, family offices, and wealthy investors) were more interested in investing in franchisors rather than franchisees. They sought to make investments that provided total brand control and offered the possibility of high returns if they selected the right brand. This thinking still exists today, and brand-level investments are still highly sought after.

However, over the past 15 years we have seen a change in the way investors think about franchisees. At first, it was a small minority of private equity and institutional investors that embraced the notion of a franchisee investment. As interest rates declined and risk tolerance became more of a factor, many early stage professional investors recognized that they could achieve a nice stable return by investing as a franchisee in a successful brand. It became less important to achieve a 30% return from every investment, with investors starting to desire the premiums of safety and stability from franchisees’ consistent cash flows instead. Additionally, the risks were far less than trying to pick the right franchisor investment, which also carried a much higher price of entry. Today we see larger private equity firms participating in the space with names like Apollo, Sentinel, Dell and others, all investing at the franchisee level. With no shortage of investment capital, we see the trend of investing in franchisee businesses to be bright.

The Future

So what does this mean for the future of the small franchisee? We won’t see the small franchisee completely disappear from the landscape, but the scenery will change. Many franchise brands, such as service concepts, lend themselves to smaller, independent-franchise ownership. It is these brands that will provide the franchising opportunity for future generations looking to own a small franchise business. Mature concepts and those requiring greater levels of capital and operational sophistication, while providing the greatest opportunities for economies of scale, will be the franchise concepts that will continue to experience consolidation, with a reduced presence of the smaller franchisee. However, owning your own business is the dream of many and that demand will likely never cease to exist. As long as the demand is out there, franchise opportunities will continue to be available for those looking for independence.