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Unemployable with Jeff Dudan
What Private Equity Really Looks For In a Franchise System with Patrick Galleher
00:14:28
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- [00:00]
A
When I think about private equity, I kind of think about it as a ladder, right? You've got some people or some firms that are going to operate in the lower market and they're going to be, they're going to have a certain size fund, they're going to invest in certain size businesses, maybe a platform company that's healthy, and maybe they're willing to pay a good multiple for it. But then their goal is really through organic growth, through strategic partnerships and through accretive acquisitions to take that business and add on to it. And basically one plus one equals four or five. Because when you move it up to the middle market and there's funds that say I can't write a check less than 30 or $50 million, those companies are going to be writing bigger checks. And ultimately, the higher the EBITDA is or the cash flow minus certain things, then the larger the multiple genuinely is. So, so it's kind of this game of, of, of taking an asset and then figuring out how to enhance the asset for its benefit and for the benefit of any of the other assets that are put with it. And that's how extra capital is generated. And then of course, there's always some, there's always a bigger fish that if you can build it in the middle market and you build it to a 50 or $100 million EBITDA business and there's going to be somebody else at lat levels that's looking to make those types of investments, is that something that most business owners that you engage with understand the concept of, or is it even important for them to do so?
- [01:40]
B
It's part of. When we take on a new client and during the process of onboarding a new mandate, we really spend a lot of time with the client trying to. Do they want to be the platform? Do they want to be part of a platform? If you've become part of a platform like Empower brands or Neighborly or Authority brands in the franchise space or an Unleashed brand, you know, that's a different second by the Apple. Our client's going to get, you know, shares or roll forward into a diversified portfolio of franchisors versus just being, you know, a single franchisor investment. So there's a lot of benefits to becoming part of an, what we call a franchisor aggregator. But there's also, you know, you're, you're diversifying your upside and your risk by, you know, your firm isn't going to be the sole determiner of future value on the next exit. So. But there's been, you know, the, the great thing about the franchisor space is, you know, even KKR and KKR owns Neighborly now. And 10 years ago KKR had no interest in the franchisor space. So you're seeing much the largest of the large private equity firms invest in franchising. Blackstone has an effort now. They've made some big acquisitions in the franchisor space. So you're seeing all the way from the smallest private equity independent sponsors all the way up to the Blackstones and the KKR and the Susquehannas putting real money behind the franchise industry.
- [03:13]
A
What is it about the franchise model that they like so much?
- [03:17]
B
Predictability. You know, we, you know, we, we always term it in internally is, you know, a lot of our clients are recession resistant and pandemic resistant. So we have a lot of clients who did very well during the 08092010 recession because corporate refugees as they got laid off at the, you know, some of the big and some of the big firms, they went out and bought franchises in residential services business, you know, low cost, no lower initial cost franchises and bought themselves new jobs making 150 to 250,000 a year. So we've been able to prove to the private equity industry that through the recession of 08 to 2010, a lot of our clients did extremely well. And then during the pandemic, once again, franchisors did extremely well, excluding restaurants. But franchisors in residential services specifically did incredibly well during the pandemic because more people were staying homes and they wanted to spend money on new fences and new roofs, new siding, new carpets. So, you know, you know, franchisors have proven time and time again to have high predictability of royalty streams and future cash flow. And there's very low capex at the franchisor level. So your free cash flow from EBITDA to free cash flow is a very high conversion and so the ability to service debt. And the lenders love franchisors. So it's really proven to be a great industry for private equity to get behind.
- [04:51]
A
If I'm an operator listening to this, you've just started speaking the language of finance. And as I you helped us, I believe we were one of your first deals in franchising with my business at VantaClean back in 2018 through the year and then closing January 1, 2019. And what was apparent to me that was not apparent before is that finance is really a foreign language. And no matter how intently I listened, if I didn't have the Underlying fundamentals of finance, how, how the businesses are being evaluated, what the ratios are, how private equity firms evaluate risk inside of a brand, what they give weighted credit to, what they take credit away from. And really navigating that to your, to your extent. If you don't speak the foreign language of finance and you're an operator that's been doing painting or restoration or one of these things and you're going to get into a room and think that you're going, it's, it's like dropping in Portugal. And you, you haven't spoken a word of Spanish your entire life. You know that the Octopus is great. You love the, I mean there's things that, you know, you'll recognize words occasionally like bathroom, but at the end of the day you don't have a chance. So talk to me a little bit about some of the do's and don'ts. If you're, if you are a franchisor or if you're a direct business or if you're even a franchisee, which I'm going to want to talk to, about what's happening in the boxes, as we say in the franchise industry, going through the brands into the boxes and the consolidation that's happening there. I mean, right off the bat, what are some of the do's and don'ts that you can give value to our listeners here? Because we have a huge audience, I've found out in franchising and with brands and with business owners. Well, what's, what do I, what, what do we stay away from?
- [06:35]
B
Well, one thing is I would never share your internal financials with a private equity suitor before we've actually evaluated them and gone through and cleaned them up. You know, that's the one of the number one mistakes we see is, you know, we'll take on a client, we'll, we'll put together their, their new P and L that includes adjustments for one time expenses. And say you hired a new CFO and you spent 100,000 with the recruiting firm to find the CFO. That's a non ongoing operational expense that, that we eliminate in the P and L that we put together and then two, we create a maturity curve on sold benight open and locations that have been open less than, let's say a two to three year maturity curve. And we'll, we'll run that out and create an embedded EBITDA based on all the locations sold but not yet to maturity levels. So when you hear a franchisor got 20 times EBITDA, it's probably because it's 20 times their initial EBITDA. But the buyer, the private equity firm has, has, has paid 12 times EBITDA based on the pro forma adjusted EBITDA that we've presented to them. So you just got to be very careful. And it's very hard for us to convince a private equity firm that's already seen that you're at 5 million of EBITDA that you're now at 7 and a half. Once we're done all of our work, it's much better off if they've never seen your internal financials at 5. So that, that's a big mistake. And then I think, making sure that you have good legal advice. We see too many emerging franchisors trying to save money on their, their first FDD and franchise agreements and, and not really spending the time and effort and money to get their FDD and their documents right up front and then being too open to making changes to the franchise agreement just to get a franchise fee. You know, on those first 10 to 20 units, we, we see a lot of messy franchise agreements in the initial, the kind of, the first 20 units of most systems because they're, they're desperate or eager to start making progress on the franchise development side.
- [08:53]
A
So many mistakes are made. As, as you're aware, I was a participant in building a franchise sales organization called Fran Devco. And through the course of that, during that, that was my Covid project, right. I had sold my business and yet all day to be on Zoom, and I was on Zoom 12 hours a day during COVID It was unbelievable. But interviewing companies to, for representation by our franchise sales organization and more often than not, they had had some success, have stalled out. So they're trying to find a solution to relaunch or reinvigorate their franchise sales. And they would send us their documents and they had given the entire state of Texas away to a franchisor. Their territory model, I believe I've seen, I have seen some franchisors basically cap their outcome to 50% or even 25% what it could have been because of the construction of their program. And then unfortunately, they had success. So now they had 20 or 30 or 40 franchise owners out there. All the good territory was gone. They didn't have performance incentives in there, like I say, or, or things that would force consolidation or encourage people to spend the right thing. So you, you look at these, at these documents and now they've got to reel it back in. But that's really not that easy in FR a Deal's a deal and they've got to go through a cycle of renewals and stuff. So they, they took what could have been a five to seven year journey and they've just made it to 12 to 15 year journey really to get the value out of it. And I, I'm not trying to over dramatize it, but it's, it's true. I mean I, the, the genius attacks that people have in creating their franchise program without getting proper guidance or strategic disclosure documents. Not, I mean you can get a legal disclosure document from a lot of franchise attorneys, but they're not necessarily going to be strategic. And I think at Homefront Brands, one of the things we did was before we ever went to market, we brought in the chief legal officer who had been at Servicemaster, he'd been at servpro, he'd been at Valvoline, and his property service experience really helped us. There was things that we were able to put into our documents, I think for the benefits of the franchisees and the franchisor that I just didn't have visibility into. So, you know, really good, really tight. They've been, you know, they've, they've held up and they've aged extremely well and, and I think, you know, but again, this was my second time around or probably more like my tenth time around by then with all the brands that I helped or participated in between 2019 and 22. But, but for many people it's like, you know, I think that's, that's a critical advice is if you're still young in your franchise journey or if it's just starting, proper strategic advice from somebody who's actually built a brand or actually helped somebody sell the brands. Because there's lots of people giving advice out there, but I will tell you, probably 95% of them are going to take some money from you and give you some sort of a templated deal. So it's actually hard to get the good advice early in franchising. I think it's one of the challenges in our industry.
- [12:05]
B
Yeah, far too many brands have made very poor decisions when it comes to area developer agreements and oh yeah, just to get some quick cash in, in the first couple years of the franchisor journey and then those area developers sit on them and don't, don't do anything to produce additional royalties and then you gotta, you got a great brand sitting there and you know, no ability to push new locations and new territories being sold in those areas. And it just really is a limiting factor and it does hurt the future enterprise value of those brands. So I'm always very consistent when I'm speaking to emerging franchisors about getting the territory or protected, protected territory on a four wall location franchise. You know, make sure you're getting that sizing correct because you don't want to sell out the all the good white space and not get the royalty benefits from that. So.
- [13:03]
A
What are some dues in terms of preparing for the sale of your business 24 to 36 months from now?
- [13:12]
B
Focus on validation and franchisee health. I mean that, you know, when it comes down to are you going to get 8 times EBITDA or 18 times EBITDA? Everyone is going to want to speak to the validation. How many of your franchisees are profitable enough that they're buying a second or third location beyond the first franchise agreement? You know, that is one of Those kind of KPIs key success factors of a franchise system that really gets private equity excited. If your franchisees can easily afford to add a second third location in year two and three, that's what's going to drive value and drive. You know, you have good operators making money, they're validating well and they're opening new locations. So really focus on, you know, are my franchisees healthy? Are they doing the right things? And that's going to pay a ton of benefits down the road when you go to sell or bring in a private equity investor. Selling more locations that you can't support and that aren't in good locations, that aren't sized correctly isn't going to drive value. Getting locations open, getting the ramp curve, the maturity curve, as quick as possible launched, those are what really drives value in the franchise industry.