In the Public Eye
Now may be the time to start thinking about an IPO
There is an absolute truth: The public market has been almost non-existent for franchise businesses. This tight market may continue to be tight for several more years; however, there does seem to be some encouragement from the recent Open Table initial public offering (IPO).
Open Table is an innovative and unique business proposition—a reservation system with a data-gathering mechanism. In my mind, it combines three important elements:
• It is consumer-driven, thus increasing sales to the restaurant owners;
• It is technology based; and
• It is cost-effective for the user.
What are the implications of Open Table’s IPO for franchise businesses?
It is important to have a unique business proposition. Open Table is a pioneer in the area of reservation systems and provides a real value to consumers. A franchise business that is not unique and does not meet today’s consumer needs, regardless of historic profits, is not an IPO candidate.
It is also important for concepts to have strong economics and good growth potential; and once market penetration is established, sustainable economics. Open Table certainly has a huge market potential and should be able to show sustainable growth.
Technology is key. Open Table has state-of-the-art technology. Franchise businesses must be state-of-the-art with their technology, both in operations and marketing. A franchise business that does not use social networking, Internet marketing and an advanced point-of-sale system has little chance of an IPO.
Given the above, now let’s get into the nuts and bolts of getting ready for an IPO:
Reasonable Capital Structure: It is extremely important to have a reasonable capital structure. That means there is a reasonable ratio between equity and debt. You do not want to initiate an IPO just to pay off debt; your goal is to raise growth capital. Also, as with existing investors, you need to have their investments stay in the company. It is difficult to use any type of public money to satisfy existing investors as the money is usually intended for growth.
Vanilla Offerings: Whatever happens in the next round of IPOs, I believe these IPOs will be fairly simple in terms of structure and easy to understand. All the financial engineering and complicated structures we attorneys like will be things of the past. Offerings will be fairly vanilla and have a simple structure allowing for future funding. I believe there will be one class of stock, no poison pills, and a lot of good, old-fashioned cash for growth.
Management Team: As in Open Table’s case, the management team is the key for IPOs, along with a strong Board of Directors. The management team must be proven—they must have been able to grow, manage and sustain the concept. In the franchise world, a management team has to show it can develop and support a strong franchise system. The Board should be varied with expertise in operations, finance and marketing.
Sustainable Growth: To get IPO money, there must be a reasonable—but not overly aggressive—franchise growth plan. Some of the things we are seeing today in the burger sector are franchisors granting franchises to non-operators, granting excessive development rights and, in general, trying to grow as fast as possible to take advantage of what they believe is a hot sector. These concepts will not be candidates for IPOs, as too many stores will fail.
Today, it is probably not a realistic goal to come up with a new concept, grow the concept to eight or 20 stores and then take it public. This scenario does not work because: One, it is difficult to find sites that will perform on a consistently high basis; and, two, the old model of concept development, initial growth and a national roll-out is probably an antiquated and inapplicable approach. Many companies that took that approach are now in bankruptcy.
Valuations: The 10-plus multiple valuations we have seen with past IPOs are gone. When the IPO market comes back for the franchise world, valuations will be more reasonable. For a pure concept that has not yet decided to franchise, you are probably looking at multiple of six- to eight-times the cash flow. In terms of a franchise company that has a good sustainable royalty stream with reasonable growth, you may be looking at a slightly higher value.
Timing of the IPO: People used to talk about a critical level of earnings to initiate an IPO. Some investment folks have said the level is $5 million in earnings—or maybe for a really high-growth company, $2 million may be the threshold. I do not know the magic number, but I do believe when the IPO market opens up combined with pent-up demand for growth investments, a critical level of earnings may be slightly lower than in the past.
Hair: In considering an IPO, make sure your company is “hairless.” Previously, companies that had substantial hair on them (such as a few stores that were not performing, balance sheet issues or potential intellectual property issues) could still access the public markets. This is not the case any longer. Any company that has hair on it should probably not look at an IPO until the financials, corporate structure, legal elements and personnel issues are clean.
The Open Table IPO gives us hope, and we can learn from it. It is a tough market and as of August 31st, the stock price of Open Table is down from its initial offering. IPOs are still a long shot for the franchise world, but they are a strategy to consider now and begin the planning process.
Next month’s column: End of the year tax planning.
Dennis L. Monroe is partner and chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions and taxation. Dennis can be reached at (952) 885-5999.