Franchise Upside: An Expanding Playing Field

Key Takeaways

  • Franchising is a capital-efficient economic model that offers high margins and great free cash flow. As such, this popular business model is expanding into many new sectors.
  • The quantity and variety of businesses large enough to warrant investor interest is growing, and the strategies for participating in the segment are plentiful.
  • Best-in-class franchisors can demonstrate they have an attractive concept and they deliver significant value to their franchisees – and they can back that up with metrics that show their franchise system is healthy and growing.

The franchising market is evolving considerably, as this popular business model expands into many new sectors beyond its restaurant roots. That’s great news for both franchisors and investors. This long-standing area of private equity focus is providing a growing range of opportunities as it gains breadth and scale.

Harris Williams is a trusted advisor to a large variety of leading franchisors and franchisees. Based on this deep experience, Consumer Group Managing Director Brent Spiller shares his insights on how franchising is evolving, and what investors need to consider in their pursuit of premium outcomes.

Attractive Economics

To begin with, says Spiller, franchising is a capital-efficient economic model that offers high margins and great free cash flow. Franchisees buy into a proven business model, and invest in developing that model within a designated market. The franchisor is paid at the time franchise rights are sold, and receives royalties as the franchise grows. With minimal capital expenditures, the franchisor’s margins are typically high, and their cash flow is strong.

Franchisees also tend to have higher success rates than large, corporate-owned operations. “If you have a franchise business owner who is talented, passionate and all in,” notes Spiller, “results tend to be better than if that business was managed by a less-vested corporate manager. Franchisors get the benefit of that.”

And, unlike many independent business owners, franchisees are guided by coaches on best practices, and are provided with tools and technology that pave the way for success. According to both investors and industry analysts, far fewer franchises fail in the first five years than independent small businesses. By some estimates, the success ratio of franchises to independent small businesses is as much as 4:1.1

Identifying a Winner

In this attractive segment, how can investors identify a best-in-class franchisor? And, what are the keys for a franchisor to get a premium outcome from a sale? Three simple questions get to the heart of the matter.

Is it a good concept?

A good franchising brand has a concept that resonates in the market and attracts franchisees to it. There are many different ways that such differentiation can occur. A certain franchising concept may be more appealing than another because of the economic model, the lifestyle it offers, the fit with one’s professional background, or because it’s more mission-driven. For instance, a teacher may seek out an education company, or a healthcare professional may gravitate toward a home health service.

Spiller highlights this example: “Many people that think about owning a franchise business don’t immediately think about a cleaning business. But when they look at the financial returns, the recurring revenue, the hours – it’s really a Monday through Friday, no weekend commitment – it becomes attractive to the business-savvy, lifestyle franchisee.” Why a concept is attractive can vary widely, but a best-in-class franchisor has a concept that appeals to its target market.

How much value does the franchisor deliver to franchisees?

Better franchisors also tend to deliver greater value to their franchisees. Returning to the cleaning example, Spiller adds that “once an individual decides to enter the cleaning business because the economics and lifestyle are appealing, the franchisor has to prove why the person should franchise over opening his own business. What value is the franchisor offering over what the person could do himself? A good franchisor has a very strong response to that question.”

Franchisors are doing many things to help franchisees’ businesses run more smoothly, lower risk, ramp up more quickly than a stand-alone business and reach breakeven earlier, including such things as:

  • Providing a recognizable national brand
  • Helping with marketing and customer acquisition through services such as local advertising, search engine optimization and other digital marketing capabilities
  • Assisting with recruiting (a big benefit in a tight labor market)
  • Offering training
  • Providing technology and tech support

As Spiller points out, “When franchisors offer valuable services that help their franchisees, they tend to experience less franchisee turnover and have better market reputations. Such value delivery can foster healthier franchise systems, and separate the wheat from the chaff in this segment.”  

Consider Dwyer Group, which owns multiple franchise brands that provide a range of in-home services. It’s a sizeable franchisor that provides many benefits to its brands, including technology and other back-office capabilities. But Dwyer takes it a step further by tying its brands together and providing cross-promotional opportunities via its Neighborly platform (including the website getneighborly.com). Neighborly marketing materials also promote the group’s full range of services. Dwyer believes such cross-promotion provides franchisees with reduced customer acquisition cost, increased customer retention and shortened service intervals, all driving top line revenue.2

Spiller simplifies the imperative to deliver value succinctly: “If I’m a franchisee and I’m making a meaningful initial investment and then paying the franchisor a royalty, I have to see the value. A really good franchisor brings that value.”

Is it a healthy and growing franchise system?

Several metrics can help both investors and franchisees evaluate if the franchise system is economically strong and offers good growth potential. Best-in-class franchisors can demonstrate the efficacy of their system through data. Key metrics include (but are not limited to):

  • Sales-to-investment ratio – annual revenue versus upfront investment
  • Franchisee payback period and/or ROI
  • Average unit volume
  • Average franchisee profitability
  • Same-store-sales growth (or the equivalent for non-retail businesses)
  • Franchisee retention and termination, including any litigation

“Just like a potential franchisee, an investor wants to look at underlying franchise economics and business performance against the metrics that indicate a healthy system,” says Spiller. “For example, what is the franchisee investment, profit and return on investment? What is the franchisee turnover rate? Ultimately, an investor or a franchisee wants to make sure that the data proves out a healthy system.”

Typically, metrics are reviewed from two perspectives: a quartile analysis and a tenure-based cohort analysis. The quartile analysis compares the performance of the first, second, third and bottom quartile of franchisees based on size, growth or other metrics. For example, is the bottom quartile of performers profitable or just the top quartile? How much is each quartile growing?

The cohort analysis compares how newer franchisees perform versus older ones, and whether performance is consistent over time. For instance, if the performance of newer franchisees is lower than long-standing ones, it could be an indication that franchise system momentum is declining, or that the system’s expansion strategy is reaching saturation.

“Franchisors that are achieving premium valuations have the combination of a great concept, a leading brand, a healthy franchise system and significant growth potential,” says Spiller. “Growth can take many forms: same-store sales growth, the addition of new franchisees or locations, or, particularly for services businesses, the acquisition of new customers within a given geography. All of those types of growth attract investor attention.”

 

An Expanding Playing Field

Looking forward, there are many indications that the franchising segment will become more attractive and plentiful for investors. Three trends are driving that optimism.

More assets of an acceptable size for investors

The franchise market is evolving as the business model proliferates across many sectors – home services, fitness, healthcare, education, business services and more. There are more franchisors overall, including more that have reached sufficient size to be attractive to investors. Because the franchisor’s revenue is generated through a royalty model, a system must be fairly large to generate sufficient revenue and earnings before interest, taxes and depreciation (EBITDA) to be appealing to investors. There are more and more franchisors reaching that threshold with one brand or by adding multiple brands. “We’re now reaching greater maturity in the industry,” comments Spiller, “and these businesses are getting to scale. There are more assets in the strike zone of size and sophistication to be attractive to private equity.”

Multi-branded platforms and back-office consolidation

Because of how franchise businesses work, Spiller believes there is large potential for multi-branded platforms with consolidated franchisee support operations across the brands. He’s increasingly seeing this approach in the market, in part because the profitability gains can be significant. “Dwyer Group, Authority Brands and Driven Brands are all great examples of companies building a portfolio of brands within one common parent company,” says Spiller.

Generally speaking, the bigger the platform gets, the more resources it has and the more value it can provide to its franchisees. “With value delivery so critical to franchisor success, if the platform can offer franchisees better economic returns, customer acquisition, cross-selling opportunities, training and other benefits at scale, both the franchisees and brands benefit,” explains Spiller.

Increase in investor interest in franchisees

As the franchise space continues to gain sophistication, private equity is becoming an appealing exit option for some larger franchisees. For example, in the fitness sector, investors are acquiring franchisee businesses with as many as 100 individual locations. That trend is spreading to other franchisor markets as the segment continues to mature and evolve.

“If the franchisor’s concept has growth capabilities and the individual unit economics are strong, I think buying franchisees is a good financial model for private equity groups to consider,” says Spiller. “It’s a different valuation multiple, but I think we’re going to see more of that as these franchisors and the franchisees themselves get bigger.”

This trend can be positive for franchisors as well. Private equity groups want growth and return on investment. A primary way to grow is through opening more locations, which ultimately helps the franchisor. “This trend is still in the early innings,” says Spiller, “but it has started in restaurants, fitness and a few other concepts, and investors are now looking elsewhere. The lower price of entry, strong unit economics and well-defined growth potential make this an increasingly interesting way to participate in the evolving franchise segment."

Conclusion

The franchising market will continue to evolve as this attractive business model proliferates to many different types of businesses. The quantity and variety of businesses large enough to warrant investor interest is growing and the strategies for participating in the segment are plentiful. As the field of play expands, fruitful opportunities for both investors and franchisors abound.

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Published October 2018

Sources

1. Field, Nicola, “What you need to know before buying a franchise,” Money, May 12, 2017; Powell, Dominic, “No question: Franchises are more successful than other small businesses, says Boost Juice founder Janine Allis,” Smart Company, August 16, 2018.

2. “Ewen, Beth, “Dwyer launches Neighborly to fix cross-sales,” Franchise Times, May 24, 2017.