The Right Operator - A Crucial Yet Scarce Commodity


Franchised concepts have attracted both consumers and investors alike for decades now, who often feel compelled by one simple notion: they know what they are going to get. Whether it’s a familiar menu or a stable cash flow, recognizable brands simply put people at ease. This common mindset has played a huge role in creating such a successful climate for multi-unit concepts over the years, with more and more people looking to buy into franchised systems.

In the restaurant space for example, the interest is so great that there’s ample opportunity to acquire restaurants in scale and all segments of the industry. However, the ability to invest does not necessarily translate into the ability to operate, which rings true in regard to any franchised business, regardless of its industry. Herein lies the problem: the ratio of skilled operators to prospective purchasers/investors is skewed heavily towards the latter group.

The fact is, there is more capital available for transactions presently than there are talented operators. Equity is available from a variety of sources, be it embedded equity in franchised stores from Franchisees of the same brand, embedded equity from investments in other brands, Family Offices, or Private Equity, there is no shortage of capital. Debt markets are also functioning well, with an adequate debt-level available, attractive advance rates, and terms/conditions for major brands being already well established.

What we have found is that quite often the missing piece of this puzzle is a proven operator or operating partner who runs the business on a day to day basis. Talented operators are truly a scarce commodity and finding the right person for the job can be one of the greatest challenges facing investors today.

As already mentioned, it is not difficult to find parties seeking investments in franchised concepts – investors are usually comfortable with the segment and the risks involved, and already understand how to own and operate a business in general. Financial returns and engineering are largely applied across any industry, also adding to the investors’ basic operational knowledge. The primary issue stems from the investors’ lack of skill or experience in operating a specific brand.

Franchisors will typically embrace or consider different types of equity capital ownership, but they are consistently seeking out franchise groups that have operators experienced in their brand or similar concepts, especially when it comes to deals that are larger in scale. All companies and their respective systems were not created equal, and having the proper knowledge and insight into how a specific brand functions can be of paramount importance in achieving operational success.

Franchisors are well aware of this truth, and thus approve and select prospective purchasers fitting this description at a significantly greater rate than those who do not have the same brand or segment specific operating experience. Too often, new equity investors fail to address this critical need early enough, often chasing the deal before solving the operator question. As a result, they often get passed over in a competitive process, regardless of their financial strength. Additionally, Franchisors undertaking refranchising initiatives can make their brand more attractive to prospective purchasers by assisting in the placement of operators.

Therefore, operators proving to be the “right fit” find themselves in the unique position where they can and should demand attractive opportunities in exchange for partnering with an investor. Furthermore, in certain situations deals may be contingent upon keeping the current operators with the business, providing them with an even more critical ongoing role. That being said, operators would be wise to augment their skillset to be viewed as capable of running the business as opposed to simply managing restaurant operations.

Essentially, the two main takeaways here are as follows… If you are an investor looking to purchase stores in a new brand or industry, it would greatly behoove you to seek out the right operator as one of your first steps. This will substantially increase your chance of being selected as the winning bidder, while also boosting your capacity to achieve subsequent financial success. On the flipside, if you are an experienced operator, it is imperative to remember that you have a highly marketable skillset. There are numerous investors out there today searching for you, so make a point of becoming visible to those groups and you will likely find an exciting opportunity in the future.
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Casual Dining's Upside


I frequently receive questions from clients and prospective buyers asking, “What’s the hottest new opportunity in the marketplace”? While it’s true that discovering the new McDonald’s or sexiest “Brand du Jour” seems most exciting, often times the greatest opportunities are far less glamorous. Do new and flashy concepts seem instinctively more appealing? Perhaps, but glamour is inherently fleeting, and as we operate in the multi-unit franchise industry and not the fashion industry, this subjective allure will forever be eclipsed by stability and the potential for operational upside.

This might come as a shock to some, but I believe that Casual Dining might just be that opportunity in 2017. So, what about the widely-publicized fact that the Casual Dining subdivision has suffered greatly over the past few years? It turns out that the explanations for this are legitimate, but also manageable, and by no means going to cause the downfall of the entire segment. For example, some of the primary reasons for Casual Dining’s downtrend include more competition, consumers’ shifting preference towards take-out and delivery, changing tastes, demand for high quality offerings, and demand for speedy service. Considering these aspects, it’s not farfetched to see Casual Dining as behind the times, but it is also important to note that all of the aforementioned elements affecting this segment are not solely problems for Casual Dining, or even restaurant concepts at large, but instead factors that affect all businesses operating in the market today.

Yet despite these issues, Casual Dining concepts will almost certainly bounce back in the future. There is one particular phenomenon I have witnessed time and again during my 35+ years working in the restaurant industry that is particularly relevant in this case: brands don’t die. Some brands will inevitably dissolve, but most find a way to survive and even thrive. Some relevant examples of this happening can be found by examining the Burger King, Arby’s, and Denny’s systems. All of these brands found a way to weather some serious hardships, and are now arguably operating better than ever before. Thus, it is reasonable to expect that Casual Dining can and will experience a similar rebound.  

Furthermore, the Casual Dining segment is certainly not sitting idly by, waiting for the market to bring about this rebound; the big, savvy brands are making some crucial adjustments to address the issues they are faced with. Due to their established nature, these organizations have the ability to leverage their large-scale infrastructure to put the necessary resources behind these initiatives in order to win back their customer base. With a renewed focus on higher food quality, improving menus, and refining mobile apps and online ordering, these restaurants are ready to fight for the consumers’ attention. Casual Dining is also in a unique position, as it is perfectly situated to capitalize on the growing take-out and delivery trends that are making a huge impact on the restaurant industry today.

Interestingly enough, it is this current conflict in the Casual Dining segment that consequently presents prospective buyers with the most substantial opportunity. The underperformance of the segment as a whole has significantly brought valuations down to the lowest multiples seen in years. On the flipside, valuation multiples for the top performing QSR brands, such as Taco Bell, have reached record highs, making the Casual Dining financials look far more attractive to a prospective purchaser. We must also consider the fact that it wasn’t so long ago that the QSR segment was experiencing a nearly identical struggle, further demonstrating the ebb and flow of concept and segment success that is fundamental to the industry. Granted, Casual Dining restaurants will experience their own distinct complications – such as more limited financing options and a larger capital requirement – but nonetheless these strong, broadly recognized concepts possess the brand equity to maintain consumer interest and subsequently adapt to better address the demands of the marketplace.

Everyone who is active in the field plays with their own strategy, and there is no basis upon which any one specific approach can be touted as best, but before determining which method best suits you, ask yourself this: As a buyer, what do I find more compelling right now – a hot QSR brand at 8.0x EBITDA or a national Casual Dining brand sitting at 5.0x EBITDA? We think some buyers will make the move towards Casual Dining and ultimately be happy that they did.
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Refranchising Gains: Selling Corporate Stores Benefits All Players


The modern franchise business model was created by Isaac Singer, a highly successful entrepreneur whose automated machine revolutionized sewing in the 1800’s.  Prior to Singer’s invention, most sewing was done by hand, a slow and labor intensive process.  Singer’s machine could produce 900 stitches per minute - a huge advancement for professional and amateur sewers alike. Mr. Singer knew that his product had the potential to change the industry, so he formulated a plan to get his sewing machines into the hands of as many consumers as possible. Initially, he came up with the first ever installment payment plan as a way to make his machines more affordable to the masses.  While important, this only solved part of Singer’s problem; he still needed a way to distribute his machines across the country and eventually the world.  The impact of Singer’s sewing machine was obvious, so he could easily attract business people across the country that paid him an up-front, licensing fee for the right to sell his sewing machines in a specific geographic territory. Mr. Singer’s franchised business plan proved to be incredibly successful, with many other companies in various industries ultimately recognizing the benefits of his model and adapting it to fit their respective businesses. 

However, it was the McDonald’s model under Ray Kroc’s leadership that forever changed the way in which multi-unit concepts do business.  Kroc saw so much potential for a franchised business model at McDonald’s that he acquired the brand from the McDonald brothers, took it public in 1965 with 500 stores, and grew it to the global franchised brand that is McDonald’s today. 

Franchising has proven to be a successful business model across a wide spectrum of industries utilizing multi-unit retail distribution.  At its heart, franchising allows everyone to focus on what they do best – manage, support, and grow the brand in the case of the Franchisor with Franchisees focused on delivering a high quality, consistent product or service to the ultimate customer.   Refranchising – the sale of franchisor owned units to new or existing franchisees – allows franchisors to address both financial and strategic goals in their business by optimizing the mix of company and franchised ownership.  Refranchising has been a hot topic in the restaurant industry in particular with a number of national chains executing large scale refranchising initiatives over the past 5 years.  The Cypress Group led most of these large scale refranchising programs and sees this activity continuing for the foreseeable future, and likely spreading to multi-unit segments outside of the restaurant industry. 

Historically, most franchised restaurant concepts have operated under an ownership structure that had the franchisors owning and directly operating a “material” percentage of their overall system. While this ownership percentage has varied from brand-to-brand, it was historically significant – generally in the 25% to 50% range. The thinking was this level of ownership meant franchisors would lead by example, essentially showing their franchisees how to operate the business.  Additionally, this direct ownership was seen as the best way to align the interests of the Brand and its operators.
 
As it has matured, the chain restaurant business has become much more complex.  Increased competition, governmental regulation, changes in the workforce, and consumer preferences make the business more challenging today than ever.  Many chains have concluded that new thinking is needed to address today’s environment, with Refranchising initiatives becoming an important Brand strategy.    Although Franchisors have historically fine-tuned their ownership of units, today’s refranchising initiatives tend to be larger in scale with more strategic implications. Franchisors in recent restaurant initiatives have seen franchisors go as far as zero company-owned restaurants. The trend towards larger and more sophisticated restaurant franchisees has helped operators deal with the more complicated business we see today, as well as create demand for large scale refranchising initiatives in national systems including Wendy’s, Burger King, Applebee’s, and TGI Fridays.

            So can refranchising be a “win/win” for franchisors and franchisees? In our experience the answer is “Yes” if designed and executed correctly.  Benefits can include:

Franchisor

Growth:
  • Comp Sales growth driven by renewed focus on menu, marketing, technology, reimage initiatives, etc.
  • New unit growth with expanded franchisee footprint ideally in combination with new prototype, and corporate initiatives including enhanced RE & Construction resources, incentives, etc.
  • Entrepreneurial / Growth Opportunities for Brand Employees
Improved Financial Metrics:
  • Reduced volatility in Revenue, Earnings, and Free Cash Flow
  • Capital re-deployment to System growth initiatives
  • Ability to optimize capital structure
Franchisee

Growth:
  • In core brand – from both acquired units and franchisor’s broad brand initiatives
  • As a supplemental brand
  • For People – enhanced career paths
Improved Financial Metrics:
  • Frequent ability to improve unit level profits
  • Leverage existing overhead
Stronger Overall System
  • Encourages partnership with strong players – both new and existing franchisees
  • Growth creates opportunities for all
 
Ultimately, we believe refranchising is here to stay. These initiatives have the ability to revitalize and improve the operational strategy of major franchised organizations. Franchisors undergoing the process are finding they have a renewed sense of purpose, focusing on new innovations and brand management without having to worry about daily restaurant operations. Franchisees are granted the opportunity to grow their store portfolios large enough that they become capable of streamlining operations, leading to greater efficiencies, sophistication, and success. While restaurant refranchising initiatives remain a hot topic, we expect to see the discussion quickly expand into non-restaurant, multi-unit retail systems that can benefit from the same sort of dynamics experienced in restaurants.    
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Franchisee Consolidation Grows

Trend To Spread Beyond Restaurants

Consolidation - this has arguably been one of the largest and most important trends in the franchised sector over the past few years, and it’s not hard to see why. One definition of consolidation is “a solidification and strengthening”; terms that also describe two of the most critical aspects of running a successful multi-unit operating company today. While we expect this trend to continue in the restaurant industry, we also believe that consolidation will have a significant impact on other franchised brands in new and exciting ways.
 
The consolidation trend in franchising has historically been driven by traditional, restaurant industry tier 1 and tier 2 brands in the QSR and Casual Dining segments.  The economic reality of declining traffic, heavy discounting and prime cost pressure, combined with heavy governmental regulation, has created a much more complex business model for our industry.  Smaller operators have taken the brunt of these changes, and in many cases, the answer has been to sell to a “consolidator” in the same franchised system.  These consolidators typically have an established organization and infrastructure that allows them to deliver a level of professional management and leverage fixed overhead costs in a way smaller franchisees simply can’t match.
 
The traditional consolidation model witnessed in recent years will remain prevalent as we move forward, but this activity is likely to slow down as the seller pool of small companies, whom operate top tier restaurant brands, shrinks. To be sure, we believe that this specific archetype will maintain its strong momentum for the foreseeable future; with large absolute numbers, a significant number of aging franchisees, and a new era of sophisticated buyers looking to achieve rapid growth, this form of consolidation is not going anywhere soon. Tier 1 and 2 brands have been the frontrunners in attracting buyers seeking growth through mergers and acquisitions due to the sheer number of restaurants in their respective systems, large geographic footprints, and simply a greater number of available opportunities to consider.
 
Eventually, there will come a time where these massive consolidated operators, will reach a critical mass and no longer have the desire or ability to acquire more stores. We have already started seeing certain franchisors implement size limits on their franchisees, creating incentive in these large scale operating companies to seek opportunities in new franchised brands. Although mega-franchisees benefit from their immense size due to the greater predictability of operational results and returns through economies of scale, implementation of modern technology, market control, and fixed cost leverage, there is still a point at which big becomes too big, and benefits turn into inefficiencies.
 
Now the question is, once top tier consolidation slows, where will this leave the franchise industry? First and foremost, we suspect that strategic buyers will turn their attention to tier 3 and 4 restaurant brands, as well as regionally specific brands. It is within these smaller brands that the greatest untapped potential for consolidation lies. The opportunity in this segment will additionally attract a greater number of interested purchasers due to the inherently lower valuations these brands receive. Also meaningful is the risk and reward tradeoff a buyer would encounter upon entering a less mature brand’s system with high growth opportunity. In turn, this leads to another appealing aspect of consolidating brands smaller in scale: the buyer’s greater ability to control a larger portion of a system’s franchised universe. This is especially desirable when purchasers are seeking “the next greatest thing”, with the intention to enter a system at the ground level into order to obtain superior control within a brand.
 
We are already seeing this consolidation trend follow suit in the non-restaurant franchise world. While it remains true that restaurant franchising is the most widespread use of the business model, the industry will inevitably become overpopulated in the future. This saturation in the restaurant realm will make franchisees seek outside opportunities that have a less competitive purchasing process. The industries that are likely to see an uptick in attractiveness include auto services and repair, service businesses such as house cleaning, day spas, health centers, fitness centers, senior care, pet care, dry cleaning, and early childhood development. The opportunity for franchising consolidation in the future is immense, as transactions in these industries are desirable for the same reasons as the smaller restaurant brands: purchasers are typically working with lower valuations and have a greater chance of controlling a significant portion of the franchised system.
 
The bottom line is that the franchising business model works. It enables entrepreneurs to run their own businesses without falling prey to the fundamental risks of creating a new and unique concept. Operating a franchised brand gives buyers a sense of safety and security, having stemmed from the existing familiarity with the concept. We will continue to see the application of the basic, time honored concept of franchising push itself into other non-food industries; this is clearly the free market at work, with the survival of the strongest business models, like franchising, reigning supreme. It is because franchising has proven itself time after time that it’s an incredibly successful way in which to run a large, multi-unit company that we believe there are no upper bounds in what can be achieved in operating businesses in this domain.
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The Dos and Don'ts of Successfully Executing a Transaction


In nearly 30 years since founding The Cypress Group, I have encountered a multitude of client-types on both the buy and sell-sides of transactions. Having spoken with colleagues and other industry experts, it is clear that while the unique circumstances of each deal can vary significantly, there are a number of common threads that can either make or break a divestiture or acquisition. In this article we are going to examine the “dos and don’ts” of successfully managing a transaction from both buyer and seller perspectives.


Sellers

Decisiveness:
Decisiveness is key when it comes to being a successful seller. It is imperative to thoroughly contemplate all of the major decisions that may come into play in a sale process.  This way, you and your working group have a shared philosophy and action plan with which to respond to both the known and unknown. Indecision or deviating from a planned course is one of the top reasons that transactions fail, as it can lead to reevaluating, renegotiating, and retrading during the course of a deal. As a seller, do develop a transaction philosophy and do map your game plan and stick with it, don’t waffle and fall victim to indecision or a significant change in mindset.

Post-Sale Planning:

It is critical for sellers to have a post-sale plan in place. The best way to establish your plan is to answer the following question: “Why am I selling right now?” The answers to that question are likely numerous, but lead by one or two strong desires.  Let’s say the answer is that after a long, fruitful career you are ready to retire. A retiree’s post-sale plan should focus on wealth and life stability. Have you worked with your advisors and tax counsel to understand valuation, net proceeds, and other sources of funds such that you are able to maintain a safe, stable cash-flow to live your life comfortably? Outside of a retirement scenario, a multi-brand operator might be selling to focus on a different aspect of their business. Are you divesting one brand to concentrate on another? If so, then your post-sale plan should address topics such as how your operating platform must evolve to sustain an alternate business model.  We’ve often advised sellers of large, stable QSR brands on how to evolve their development, marketing, and training infrastructure to adopt a Fast-Casual development agreement.  The two businesses are certainly similar, but the infrastructure needs and cash flow planning vary, particularly in the early years.  It is also important to note that all post-sale planning should happen in conjunction with your decision to sell; this way you know up front if you’re trying to sell all of your assets or if it makes more sense to retain some. Do understand your post-transaction operational and financial picture as part of the decision process. Don’t go into a sale blindly and unsure of your future plan.

Know Your Franchisor:

If you are a franchisee looking to sell your restaurant assets, it would behoove you to be aware of your franchisor’s growth and acquisition strategy. Is your franchisor currently selling company-owned restaurants, acquiring franchisees, and/or developing new units themselves? Are they looking to bring new franchisees into the system or expand with existing franchisees?  Even if the answers to those questions are not perfectly known, a thoughtful analysis of your business geographies, operational and financial metrics, and development rights will help you prepare for the franchisor’s reaction.  It is in your own best interest to be well versed in your franchisor’s approval guidelines and expansion plans so that you may select a buyer accordingly. Do know your transfer rights as a franchisee and do be aware of what makes a buyer attractive to your franchisor. Don’t let the franchisor dictate your process and don’t select a buyer that won’t pass their approval process or provide them leverage to force a less than ideal alternative.

Identify & Own Potential Problems:

It is almost impossible to operate a multi-unit restaurant business without experiencing some issues over time. Store closures, lease expirations and assignment issues, specific unit performance problems, environmental issues, and more will almost undoubtedly affect you and your business at some point. As a seller, it is understandable to feel the need to mask any struggles your company has experienced, but it is crucial that you resist the urge to do so. Any problems concealed initially will surely be transparent during due diligence, which discourages the buyer and hinders the overall transaction process.  A constructive business issue identified late in a transaction is more punitive than if it was articulated in advance. Do have any business, operating, and legal issues identified and do have a plan for addressing them prior to bringing a transaction to market.  Don’t ignore these issues and think that prospective buyers won’t identify or will overlook them in their process.
 

Buyers

Decisiveness:
Are you starting to see a theme here? As with sellers, it is imperative that buyers operate in a direct and decisive manner. This means establishing what your target criteria is before you begin looking at acquisition opportunities, and then subsequently sticking to that game plan. It is easy to get distracted when confronted with the sheer breadth of options in the multi-unit restaurant industry, so instead of running yourself ragged looking at every deal in the market, set yourself up for success by knowing exactly what it is you are seeking. If you find Casual Dining concepts to be the most enticing, you shouldn’t be wasting your time and energy examining a QSR transaction. Do decide which factors make a deal most compelling to you, and do center your acquisition strategy around these criteria. Don’t start actively pursuing transactions before you have put your decided upon strategy in place.
 
Financing:
Most people wouldn’t go to the supermarket without first knowing how they planned on paying for their groceries. While this seems to be common sense, not everyone applies this same logic to the way they seek restaurant acquisitions. Buyers should be mindful of establishing strong relationships with various financing sources before they even begin looking at buy-side opportunities, so that when the right deal does come around, they aren’t scrambling to secure the acquisition capital. Furthermore, a bid that details the buyer’s proposed debt/equity structure, in addition to a signed commitment from a capital provider, is substantially more compelling to a seller than a bid that is lacking these things. Do have a preemptive financing options in place, don’t wait for a sell-side advisor to tell you your bid was interesting, but their client chose the buyer with more certainty around funding.
 
Know The Franchisor:
Whether you are an existing franchisee in the system or not, it is vital that you know the franchisor that you will be dealing with. What does their current growth strategy look like? What kind of franchisee do they prefer? Are they trying to bring new blood into the system or solely bulk up the operating platforms of existing franchisees? This last question is crucial, especially if you are looking to enter a new brand. Before pursuing a specific opportunity, meet with the franchisor to discuss their approval process and present your operating plan and team. Transactions move far more easily and quickly when a buyer is preapproved and in good standing with the franchisor. Do establish this relationship early, don’t wait until the bid process is complete to find out that the franchisor doesn’t view you as a viable buyer.

Be Aggressive:

In today’s market, restaurant acquisitions are highly attractive, making for an exceedingly competitive environment. Buyers must be aggressive in pursuit of these opportunities.  This is especially true in instances where the transaction represents the buyer’s initial investment in a franchised brand.  Existing franchisees may have built-in advantages in acquiring these restaurants, ranging from synergies with which to bid higher to strong ties to the franchisor.  New entrants be wary: you may have to pay a premium in order to tip that first deal in your favor.  Additionally, buyers must always be prepared to move quickly.  Delays often cause sellers to get discouraged or re-examine the sale altogether.  Another way to anger a seller and potentially lose a deal is to delay the purchase process in an attempt to retrade at a lower price. If you’re actively looking to buy and you come across the right deal, do pursue it aggressively and don’t dawdle and miss your opportunity.
 

Both

Proper Advisors:

Regardless of which side of a deal you are on, engaging experienced, industry specific investment advisors as well as transaction specific legal and tax counsel is paramount to your success. Acquisitions and divestitures alike have many moving pieces that can seem overwhelming when the owners aren’t receiving proper counsel. To achieve the utmost success, it is necessary to enlist the help of people who know how to plan, position, and execute transactions to your benefit.  The resources and intricacies needed to navigate a transaction in the multi-unit restaurant industry are considerable. Do hire professionals with proven insight and transaction expertise in the industry’s inner-workings, don’t solely rely on your everyday business advisors or attorneys.

Be Realistic:

This is quite possibly the most important concept when it comes to successfully completing a transaction. On both sides of the fence, everyone must be realistic about their expectations for the process: if a seller has an unrealistically high purchase price or multiple stuck in their mind, finding the right buyer will be a far greater challenge than it should be. On the flip side, it isn’t realistic for a buyer to propose a purchase price that is based on a 2009 transaction multiple. Simply put, the market has moved. The most realistic thing either party can do is recognize that every transaction is a constantly moving, two-way street. If you want a deal to be successful, know that the negotiated terms must be satisfactory to everyone involved. Do view transactions in an objective and realistic manner, don’t rely on subjective inclinations or conjecture.
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