Season 1 Episode 18: Tension in M&A Transactions - Franchisors and Franchisees



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Title: Welcome to The Restaurant Boiler Room Episode 18. I’m your host, Rick Ormsby, Managing Director at Unbridled Capital.

Today, in the Boiler Room:
Tension in M&A Transactions - Franchisors and Franchisees
Drive-thru’s Outpacing Dining Room Sales
Taco Bell Ramps Up International Development

The Restaurant Boiler Room is a one-stop-shop for multi-million dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations, and risk – delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on an every-other-week basis. Feel free to find our content at Unbridled Capital’s website at

Now, let’s enter the Boiler Room:

A. Tension in M&A Transactions - Franchisors and Franchisees

Background: Since the advent of franchising, franchisors, and franchisees have had competing and complementary interests. Most of the time, their common interests prevail for the benefit of the entire brand, however, at times of excess and distress, these relationships are often tested more fiercely. In the current environment, these relationships are developing more strain than in the recent past. For the foreseeable future, it appears that the franchisor-franchisee relationship will continue to be tested.

Comments: At the very core, both franchisors and franchisees want to protect the integrity and success of the brands in which they operate. Both parties want strong operations, great restaurants, innovative new products, food safety, reliability of employee programs, a strong supply chain, consistency across each restaurant nationwide, growth amongst competitors and high revenues – to name a few. However, their interests are not totally aligned. For example, many franchisors have largely gotten out of the business of operating restaurants. This asset-lite model is increasingly common, whereby franchisors own very few, if any, restaurants, preferring to sell them to franchisees. This has several benefits for franchisors – less operational headaches, lower G&A structure, less financial risk (the franchisor becomes a coupon-clipper – much like a bondholder), and an increased valuation for the brand (because investors will pay a higher price for a royalty stream). For the franchisee, however, an asset-lite model offers up plenty of concerns: the franchisor has less context on the operational side of the business, franchise services are severely cut (as an example, which one of you listening franchisees has seen your franchisee area rep in your markets in the past few years???), new executives are hired.

have little understanding of the restaurants they support, and there’s a growing lack of interest in smaller franchisees whose royalty payments and growth potential are small or negligible.

There are other concerns as well. Franchisees are primarily interested in maximizing their profitability – they are entrepreneurs and are one of the best sources of self-starters in our country. However, a franchisee will make self-serving decisions in many cases in order to maximize profits. They might delay remodeling a restaurant, reduce store hours to become more profitable, understaff a restaurant, pick the wrong trade area for a new site because they can’t afford expensive real estate, disobey franchisor-mandated menu pricing in order to serve their local needs, etc.....

Franchisors, on the other hand, are managing a brand and are largely beholden to investors, who often are concerned with policies that will drive shareholder value or stock price in a way that can be detrimental to a franchisee. For example, most franchisors want to avoid store closures at any cost. Why? Because store closures reduce royalty payments and are viewed negatively by the public markets. Just google the term ‘net new unit growth’ to learn more about this. Additionally, franchisors want to expand a franchisee’s footprint by pushing them to develop new restaurants and remodel existing ones, often to the chagrin of the franchisee. And since most remodeling projects don’t have a healthy return on investment, franchisors are largely out of touch with the financial commitments needed to implement new remodeling efforts across a franchisee’s portfolio. Franchisors are also concerned with their profitability, so it is always enticing for them to cut services to franchisees to save money. Finally, franchisors will often push for standardization of pricing when, for example, San Francisco and small-town Kansas are two totally different places with completely different pricing sensitivities.

These competing interests start to flare up when things are either good or really bad. In times of distress, a franchisee is just trying to survive financially (often making poor short-term decisions), but a franchisor still has brand standards, remodeling projects, store closure restrictions, and profitability goals for investors. In great times, most franchisors are trying to use a good economy and easy lending to push for greater development requirements and remodeling projects, and they sometimes get too big for their britches – franchisees are unwilling to risk their financial portfolio for growth at such a haphazard pace with some amount of cannibalization.

Effects on M&A: At no time is the conflict more apparent than when a franchisee decides to sell their restaurants. All franchisors have a right of first refusal – meaning they can buy the restaurants at the same price offered by any buyer – and if the franchisor decides not to purchase, they get to approve or disallow the transfer to the buyer. Today, because of the asset-lite philosophy, franchisors almost never exercise their right-of-first refusal – in other words, they almost never buy a franchisee’s restaurants when a franchisee wants to sell.

The natural conflict then occurs as follows – a franchisee wants to maximize their sale price, assuming that they can sell the restaurants to the best buyer at the highest price. However, a franchisor does not care at all about a franchisee’s take-home proceeds in a sale - they care more about the ongoing integrity of the restaurants and protecting the interests that maximize their shareholder value. To do so, franchisors are getting more manipulative in the sale process to try to orchestrate deals into the hands of certain franchisees. In many cases, their favorite franchise buyers are the healthiest financially and best operationally, but there are sometimes spurious motives. Some franchisees will inherit likely store closures and keep them open; some franchisees will commit to developing new units more quickly, etc...

The store-closure hot-button is a big one in today’s market as we are seeing an oversaturation of restaurants after the past 7 years of economic expansion. Franchisors often prevent unprofitable stores from closing in order to meet net new unit growth requirements to propel stock price and preventing store closures can cost franchisees hundreds of thousands if not millions of dollars of value in a sale. New unit development is another big hot button. In a recent transaction, we sold 20 restaurants in a given brand, and the franchisor – as a condition of approval – asked for 10 new units to be built in the trade area over a several-year period. This was a financial burden for the buyer, who dropped their price later in the transaction to account for the surprising new unit development commitment that they had to make. In both instances, franchisees are unable to maximize the value of their business in a sale – due to the differing goals and financial interests of the franchisor.

As the economy nears the likely end of a long up-cycle, I expect to see this franchisor-franchisee relationship getting tested with greater pressure, and M&A is at the center of this controversy because there are so many stakeholders involved when a franchise sale takes place.

Drive-thru’s Outpacing Dining Room Sales
Background: Danny Klein wrote a recent article about Jack-in-the-Box and their drive-thru’s, saying that 70% of the brand’s business comes through the drive-thru, with 15% coming from takeout and 15% from dine-in. As such, he cites the brand as considering where to invest their remodel dollars when most customers don’t eat in the dining room on any given visit.

Comments: Restaurant dining rooms across America are less and less occupied. Start with the casual diners – they have had massive store closures and negative traffic trends in recent years. Then jump to pizza companies – Pizza Hut is a notable example of how the dine-in business has suffered recently as well – delivery and take-out are the key drivers in the pizza business. With the advent of digital ordering, take-out, catering, and third-party delivery, we still have flattish sales across most other restaurant concepts in this current environment. What does this mean? The huge pick-up in sales from these sources is being met with a big reduction elsewhere – namely the dining room.

  • Effects on M&A: Other than EBITDA, one of the biggest drivers of restaurant valuations is future remodeling expenses. If remodeling costs can be refocused on the area of a restaurant that drives better profitability – namely a speedier drive-thru or better technology for greater ordering capacity – then this type of remodeling cost will be much more welcomed than changing ceiling tiles and carpet in empty dining rooms. Sales-driving remodeling programs will always be met with much more excitement in the M&A and buying community than remodeling programs that don’t drive sales. Executives at franchisors should be commended when they are looking for new ways to increase the sales and profitability of their franchisee locations. Taco Bell Ramps Up International Developmenta. Background: In another article by Danny Klein, it is reported that Taco Bell has entered into a master franchise agreement with Burman Hospitality Private Limited in India for a commitment of 600 restaurants over the next decade. This would add 20,000 jobs to the economy there, make India the 2nd largest Taco Bell market in the world, and help Burman become Taco Bell’s largest franchisee.Comments: When I worked at Yum Brands Corporate, I got a first-hand look at how incredibly important the international business was and still is for Yum Brands. KFC was exploding in China and several other countries throughout the world. Pizza Hut had a successful business in many countries, including Europe and Latin America. However, for some reason, Taco Bell could not find any international momentum. They continually bounced in and out of international markets with little success. At the time, one of the reasons I was told was that Taco Bell was an upscale restaurant internationally, unaffordable to many potential customers. If true, that’s the opposite of here in the US – interesting, huh?

    Effects on M&A: The international business will be a key driver of value in many brands over the next decade. American markets are stagnant for growth – there are few trade areas to develop new restaurants, and sales in existing restaurants can only grow by 2-3% annually over the longer- term. Especially for public companies, international growth is one of the only long-term ways to support 10+% op profit growth needed to justify a higher stock price. For Taco Bell, the opportunity is huge for Liz Williams’ team (Liz was CFO at Taco Bell and is now President of Taco Bell International). There are only 35 locations in India right now. Sydney and Melbourne, Australia are debuting Taco Bell soon. Canada is on a big growth curve for the Taco Bell brand currently. Other markets on the horizon include New Zealand, Indonesia, and Portugal. And as a personal aside, I was always surprised at how the Spanish and Portuguese cuisines do not use much spice. I wonder how they will like the fire sauce!? Good luck to Taco Bell as they look to ignite international expansion.