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Veteran franchisees well-positioned to add formerly corporate units

Veteran franchisees well-positioned to add formerly corporate units

It’s a buyers’ market out there for well-capitalized and experienced franchisees looking to increase the size of their operations by buying company-owned outlets their franchisors are eager to sell.

A rare alignment of regulatory changes in federal franchising laws, the weak economy and a number of refranchising initiatives already underway among several major foodservice franchisors offer franchisees an unprecedented buffet of opportunities to grow their businesses.

As many as 3,000 company stores under the umbrellas of Yum! Brands, McDonald’s, Jack in the Box and Applebee’s, to name a few, are slated to be sold by franchisors between now and 2011.

Jack in the Box, for example, reported that 17 corporate units recently were sold to franchisees, netting the San Diego-based company $15.2 million in the third quarter ended July 6. Jack in the Box has stated that its goal is to raise the proportion of franchised stores to 80 percent of the system.

All of the sellers are especially keen to work with strong franchisees already operating multiple stores. Though numerous hurdles to obtaining financing could slow the pace of some chains’ initiatives, savvy franchisees are taking advantage of the cornucopia.

Strong franchisees have two major bargaining chips: Their ranks are limited, and a new update to disclosure rules allows them to obtain more detailed financial information on prospective purchases.

“From one point of view, I think a franchisee has [an] advantage,” said Robert Bielinski, a managing director at CIT Group. “The strong operators will be welcomed by the franchise systems looking to divest the restaurants.”

Turning these tantalizing options into profitable acquisitions, however, requires both submitting to and conducting far more thorough due diligence than was common before the credit crunch. Operators should cast a sharper eye on their prospective acquisition’s historical financials and prepare for continued hikes in supply chain costs.

On the flip side, operators should expect increased scrutiny of their tax returns and personal finances.

“Certainly, someone who is already in the system and a profitable franchisee [has] already demonstrated an ability to run this kind of business,” said Bernie Siegel, founder and chairman of the Siegel Financial Group, which arranges financing for franchisee and small-business acquisitions and startups. “But even in those cases they are digging down a lot deeper on both sides, buyer and seller.”

Before entering into negotiations, an operator who wants to add units should prepare for the new financial fine-tooth comb lenders will be wielding. Siegel notes that many operators have high levels of personal credit card debt, and may not realize how much that can hurt their chances of obtaining business financing. In the past, a franchisee with a credit score of 650 and cash for a down payment would easily pass muster, but not now. Today many lenders have raised the minimum credit score to 670, Siegel said.

In addition, operators who want to take advantage of buying opportunities must be ready for thorough analysis of business and personal tax returns and be aware of the story these documents tell about a franchisee’s lifestyle. Lenders now want to ensure that car payments and mortgages correlate with annual incomes, and whether a franchisee has other business interests that might cause financial strain.

Potential franchisees, meanwhile, should ramp up their vetting of the prospective purchase, experts say.

First, a franchisee must find out why a unit is being sold. History and numbers are critical to answering this question, and to building realistic profit projections. There are many reasons a given unit can be for sale. It’s important to know whether the store faltered under the company’s management, was taken back by the company from a failed franchisee, or earned solid profits but is being sold anyway as part of an overall corporate divestment strategy.

In the past, franchisors rarely disclosed historical financial information on an individual unit available for refranchising. But a new update to a provision of Federal Trade Commission disclosure requirements known as Item 19 allows buyers who request more information to receive it. This provision always allowed franchisors to include historical financial information on franchisees in general in the disclosure document, and the update continues this practice.

But thanks to a recent amendment in the law, franchisors also can share historical financial data on individual units up for sale, as well as information regarding systemwide unit operating costs. Buyers should always request both general and store-specific data, experts said.

“One advantage is the brand-new franchise disclosure rule that allows the franchisor to provide financial information regarding a unit,” said Eric H. Karp, a franchise lawyer with Boston-based Witmer, Karp, Warner & Ryan, who counts among his clients a national franchisee association and individual franchisees. “They may do it but are not required to—you have to know to ask for it.”

Franchisees must also remain mindful of other costs that might crimp their profits after the acquisition. Many experts expect food costs, for example, to continue rising. Operators also should evaluate the condition of the unit to see how close it is to existing standards. If the unit was not built recently, a buyer should request improvements. If the franchisor will not make improvements, the franchisee should determine what kind of investment he or she will be required to make and include this sum in the overall negotiations.

“You don’t want to buy a store, and six months later they want you to spend $200,000 to remodel it,” said Adam Siegelheim, an attorney with Princeton, N.J.-based Stark & Stark, which specializes in franchise law.

Finally, experienced operators in good standing should take advantage of their incumbency to enjoy certain discounts in closing the deal. By selling to an insider, the company does not have to spend money on a franchise sales person or broker, and does not have to train the buyer in the system since the buyer is usually already qualified.

Given these savings, the operator should request that the initial franchise fee be waived.

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