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The Consolidators

Between due diligence, risk assessment, negotiations, indemnity agreements and insurance as well as a bit of handholding and education along the way, it’s no small task to get a deal done in today’s market. And given the extreme competition for deals across the franchise space, it’s not
getting any better.

“Deals are not getting easier, but if they were, we’d be out of a job. So I can’t totally complain about that,” said David Paris, one of the founding partners of Paris Ackerman based in New Jersey and a Franchise Times Legal Eagles Hall of Famer.

His firm was behind one especially complex deal that saw a franchise restaurant operation split into seven groups and sold off to various buyers—each with their own desires and needs.

Across the table working for the seller was Andrew Bleiman, the managing lawyer at the Illinois office of Marks & Klein. He said in this market, one big issue is the sky-high valuations seen across the M&A space. That means negotiations and adding value when possible so while it might not hit the huge multiples of EBITDA (earnings before interest, taxes, depreciation and amortization), everyone walks away happy.

“Whether it’s covering the cost of reimaging or the cost of transfer fees, or whether it’s having the buyer pay for fees an costs associated with the landlords,” said Bleiman, “there may be other areas where they can find value other than just money in the purchase price.”

Those valuations are drawing attention, and new entrants from private equity, family offices and strategic buyers are driving valuations even higher.

Amy Cheng, partner at Cheng Cohen and legal adviser to private equity firm NRD Capital during the firm’s 2017 take-private acquisition of Ruby Tuesday, said new buyers have her playing the role of educator.

“I think the market shift has brought more sophisticated players into franchising, which I think is a good thing. But it also means an opportunity to educate more people,” said Cheng.

So what do these three consolidation experts do when a deal crosses their desk?

Amy Cheng

“You never want to make a price or set a price and after you do the due diligence, reduce the price. Neither party is happy at that point.” — Amy Cheng, Cheng Cohen

Due diligence

The first thing on the buy side is a deep look at every business document out there from the franchise disclosure document (FDD), to the franchisee contracts, insurance, leases and everything in between so buyers have a true view what they’re buying.  

“It’s our job to minimize surprises and keep them at bay,” said Paris.

That’s not generally fun work but important. It mostly consists of eyeing every line and every word to uncover oddities or potential legal risks in a huge number of documents that cover every aspect of the business. Paris said it does require a team with a varied skill set to take it all in.

“These are not the most complex or sophisticated deals—we’re not buying subsidiaries of Microsoft or Google, but they do get sticky and you want people who can think on their feet,” said Paris. “Real estate, M&A and finance all come together on these deals, so you need a cohesive team.”

He said he’s dropped his litigation process altogether and has been bulking up with seasoned lawyers to help with the ever-growing list of transactions.

From the seller’s perspective, due diligence consists of a credit check and being prepared for the buyer to dig in.

“At its most rudimentary level, it’s, ‘Do they have their information organized in such a way that they can present it to potential acquirers?’” said Bleiman. “Having the due diligence materials in order, having the leases in order, understanding the state of the lease, the state of the franchise agreement, and the amount of term left on them. Understanding what the reimaging requirement will be for them. If they have a store remodel that is due that will impact the value of that store.”

He said all that work should start before a buyer shows up. Making the business better will only mean a better sale price.

“It’s trying to be more proactive in making sure that even if they have this interest that they are ready with the documents. And I think on the front end there’s work to be done to make sure that the person you chose as your buyer is going to pass muster with the franchisor down the line,” said Bleiman.

“You don’t want to do a deal with the first guy who comes to the table with the most money. That’s all well and good but if they don’t have experience or infrastructure, that could complicate matters.”

At the brand level, Cheng said the first order of business is scouring the central franchise document.  

“Right away, we would do certain due diligence. We’d look at the company FDD—that’s the first thing I’d look at,” said Cheng. “That gives you a pretty good sense about how the company has conducted business.”

Within the FDD, attorneys are looking for a handful of key things: lawsuits, openings and closings, and compliance with franchise laws. The FDD also offers a clue to whether the franchisees are happy—and they’re usually happy when they’re making money. But that’s not the whole picture.

“The quality of the royalty stream is huge and the term of the royalty stream,” said Cheng. “Let’s say this year’s royalty stream is $10 million, that’s great. But what often people don’t pay attention to is the term. If a term is three years and most of them are expiring next year, you can’t count on that royalty stream.”

A big group of expiring franchise agreements isn’t necessarily a deal killer, but it will certainly affect the price. That’s why Cheng says it’s important not to take the cocktail napkin math to heart; it might be best to skip the ballpark figure altogether until the diligence work is done.

“My advice to people is to understand those basic parameters before you get into the pricing. You never want to make a price or set a price and after you do the due diligence reduce the price. Neither party is happy at that point,” said Cheng. “People forget the disclaimers, they remember that you said $100,000.”

David Paris

“Deals are not getting easier, but if they were, we’d be out of a job. So I can’t totally complain about that.” — David Paris, Paris Ackerman

Getting it done

After all the due diligence work is done, the clock starts ticking. There’s an old adage that time kills deals, and it’s true. The longer the clock is ticking the more issues pop up. That means a transactional legal firm goes from bleary-eyed document readers to full-time negotiators. They’re pushing all the stakeholders to move fast as soon as the initial price is calculated.

But in a market like this, all the players know valuations are high, the buyers are generally well capitalized and the gatekeepers are looking to get in on the action as well. Landlords are some of the chief boat rockers.

“On the landlord side, you typically need to obtain lease assignments and a host of other documents that the party or the bank requires, so when you’re up to 20, 30, 60 stores, you’re usually dealing with a commensurate number of landlords. Not to over-generalize, but they view this process as a way to take a pound of flesh,” said Paris. “That can impact the timing of the closing and the integrity of the asset.”

If some of those landlords are being stubborn, it can mean a new agreement for a select number of stores or the former operator acting as a guarantor—adding complexity and time. Bleiman said this phase can trigger another round of due diligence and negotiating around the new leases.

“You try to have a handle on that and make sure that there aren’t any unusual lease provisions, take-back provisions or requirements to pay off the landlord,” said Bleiman. “We’ve seen some crazy things in these leases.”

He said it’s a lot of phone calls and emails, “prodding and cajoling” to ensure they work efficiently.  

“I always say, it’s our No. 1 priority and it’s their 101st priority,” said Bleiman. “I don’t begrudge them, so we just have to push and push.”

There’s also pressure on the deal from the brands. First and foremost, they are protecting the brand from poor operators so sellers need to make sure a buyer will make the grade. And while they’re not always looking for that pound of flesh in an immediate monetary sense, they’re often looking at M&A as fuel for growth and updates.  

“When you either unilaterally allocate assets to different buyers or when the franchisor steps in and takes a stake in that asset allocation process, it becomes tiered or staggered closings. That is very much a recipe for disaster if it’s not dealt with right,” said Paris.

It’s a lot of communication, organization and getting franchisors excited about the deal, hence the growth and update provisions that have become so common in franchise transactions.

“It’s a process. I would say most franchisors understand the situation and aren’t going to stand in the way of a deal; having said that we’ve seen them do it,” said Bleiman. “We’ve seen transfers that aren’t being approved or buyers that have been rejected.”

For Cheng, after due diligence is done, there’s a lot of education for the new buyer, especially for the new entrants to the franchise world.

“I think most are trying really hard to educate themselves, that’s my No. 1 priority,” said Cheng. “A lot of the people that are looking for private equity are not just looking for money but also a certain support for their system. That’s important when these matches are being made, that both parties understand that.”

Right-sizing the risk

The final step in the whole consolidation process—after the leases are checked, the franchisor is happy and the bank is on board—is negotiating around risk before signing all the documents.

“No system big or small is going to be perfect. Just because we uncover certain things about a system, doesn’t mean that we suggest our client doesn’t buy it,” said Cheng. “Our advice should be, what are the risks and what we can do to minimize the risk.”

There will almost always be certain legal questions, potential liabilities and other legal issues that transactional lawyers must negotiate around.

Sellers rarely wash their hands completely and buyers rarely move on risk free. In short, it’s never a picture-perfect happy ending, but the right legal partner can make it better.


CONTENTS: Legal EaglesHot topicsThe Consolidators • The New ClassThe Hall of Famers


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