The purpose of due diligence is to evaluate the nature and value of what is being acquired as well as to identify potential issues, risks, and liabilities. Put another way, a buyer’s objectives include ensuring that it receives the expected value in exchange for what it paid, evaluating any obstacles that may stand in the way of carrying out its strategic objectives for the business, and avoiding, ameliorating, or allocating as best as possible the risks associated with the acquisition.
The franchise business model is unique, and thus the due diligence process in the acquisition of a franchise system must take into account its distinctive features.
Certain indicators are immediate “red flags”. These include high franchisee turnover or poor franchisee satisfaction, weak unit-level economics or declining same-store sales, lack of financial or accounting controls across the system, poorly drafted franchise agreements or significant variation between agreements, incomplete or poorly maintained franchisee files, material ongoing litigation, and obsolete technology. These red flags will be discussed in an upcoming post.
Beyond red flags, in this post of the Franchise Mergers & Acquisitions series, we discuss 4 franchise specific due diligence considerations for buyers conducting due diligence on a franchise system.
1. Brand Strength
A franchise system’s brand forms an integral part of its value. In conducting franchise specific due diligence, buyers must assess the strength, resiliency, stability, and future potential of the business’s brand. Is the business concept proven, replicable, and adaptable across markets? Is its operating platform and infrastructure (in the form of manuals, training, ongoing consultation, franchisee communication strategies, compliance monitoring, marketing, technology, and processes for modification and updating of products and services among others) well suited to supporting both existing operations as well as future growth? Are there any factors, such as regulatory shifts or emerging market disrupters, which may affect brand strength?
Business Highlights:
One of the challenges in assessing brand strength is that it is generally somewhat qualitative. In recent years the “net promoter score” (NPS) has become a more common method of obtaining a measure of customer engagement as a proxy for brand strength. NPS measures the percentage of a company’s customers who have become promoters of the brand based on the strength of their personal experience. This is measured by asking 1 simple question – “On a scale of 1 to 10, how likely are you to recommend the products or services of ABC Co?” If survey participants respond with a 9 or 10 they are defined as promoters, a score of 6 or below is defined as a detractor, and a 7 or 8 result is interpreted as neutral. NPS is calculated by subtracting the percentage of detractors from the percentage of promoters. Calculating NPS can provide meaningful guidance as there is a significant amount of benchmark data available (by industry) to which target companies can be compared. Temkin Group is one source of NPS benchmark data by industry (https://temkingroup.com/). A simple survey of a company’s customer base with one simple question can provide an acquirer with a measure of a brand’s strength.
Google can be used to obtain macro level online brand awareness measure. This can be assessed by reviewing the growth (or decline) in Google searches for a company’s brand name/products/services over time using Google Trends. This tool exposes consumers’ search behavior over the past decade. A healthy growing company would expect to see an increase in people searching for its brand name/products/services over time. You can also compare the searches for a brand against its competition to get a sense of the competitive landscape.
While neither of these approaches provides a perfect value of brand strength, it can provide a potential acquirer of a franchise system with valuable insight on directional perspective of a brand, and can be used as somewhat of a proxy for brand value.
Dan Monaghan, Managing Partner, Clear Summit Group
2. Financial Viability
A franchise’s royalty stream is its fundamental recurring and long-term revenue source. Part of assessing and testing the royalty stream in a franchise M&A transaction involves considering the remaining term on franchise arrangements and the likelihood of renewals, the age demographic and level of sophistication of the franchisee population, jurisdictional or regional trends or differences, and any patterns of payment delinquencies. Buyers should also assess future royalty potential through increased sales from existing units, an increase in the number of franchisees, the introduction of new products or services, or other strategies.
3. Unit Economics
The financial success of a franchise system greatly depends on the performance of each member of the franchisee population. Importantly, buyers should assess financial information and trends vis-à-vis same store sales as well as comparisons between stores in a given jurisdiction. Is there a wide discrepancy in franchisee results and, if so, what are its causes? What are the turnkey development costs for a franchised business unit (the major investment cost for a franchisee)? What is the average annual net profit per franchisee? Are there strategies for increasing revenues (eg, through improved products or services), reducing operating costs, or reducing initial and refurbishment development costs?
4. Human Capital
Unless a buyer of a franchise system intends to replace a franchise system’s management team (which, particularly in the case of financial buyers, is usually not the case), due diligence on each member of the team and their specific roles is critical. Buyers should interview and consult with the executives and managers they believe are important to the long-term plans of the franchise system. Particular attention should be paid to those with unique skills who may be difficult to replace, such as franchise sales/development executives and international expansion/operations managers. Is it necessary to incentivize such individuals to remain after the completion of the transaction? Will any post-closing changes be required (eg, as a result of economies of scale)? If so, buyers should carefully review and consider any unfavourable arrangements and obligations with respect to retirement or termination.
To receive further information or resources on franchise-related mergers and acquisitions, please email me at andrae.marrocco@mcmillan.ca. Stay tuned for our next post in the Franchise Mergers & Acquisitions series.
This post is published to inform clients and contacts of important developments in the field of franchise and distribution law. The content is informational only and does not constitute legal or professional advice. We encourage you to consult a McMillan franchise lawyer if you have specific questions or concerns relating to any of the topics covered here.