Article on Financing a Franchise

Financing Franchise Business
Author: Todd AndersSource: Franchising World October 2004; www.franchise.org
When considering the purchase of a franchised business, potential acquirers often begin by targeting third-party funding sources, asking who would provide the debt or equity required to purchase the target company.

There are two other potential sources that should be considered before targeting third party financing: the target and its shareholders; and the internal resources of the acquirer.

The Target and its Shareholders
If the acquirer gains a complete understanding of the target’s assets (e.g. real estate, equipment, machines, vehicles, buildings, receivables, inventory, patents trademarks, other intellectual property, and franchise agreements), each of these items can be examined for how it might be used to raise cash for acquisition. If the target has substantial real estate holdings, they may be used to provide funding through sale/leaseback transactions. Underperforming units might be sold to reduce financial drag and provide cash that can be used to pay down the acquisition costs. Receivables and other streams of income like royalties from franchise agreements can be used to support cash-flow borrowing. Intellectual property, such as trademarks and patents, can provide additional security to third-party lenders or investors. Each category of the target’s assets has value and should be exploited to provide cash or access to third-party financing.
Secondly, the acquirer should consider how the existing shareholders of the target might be used to provide funding. This will necessitate conversations to determine if the shareholders are open to providing seller financing (on a subordinated basis) and, if so, on what terms. Alternatively, will the shareholders take a portion of their compensation as earn-out, or some other form of contingent payment? If so, how can this be structured to provide the maximum benefit to the buyer without putting too much at risk for the selling shareholders? This negotiation often entails finding the optimum amount of earn-out, the period of time over which it will be paid, the line of the income statement to which it will be tied, and any minimum or cap to be placed on the earn-out. In addition to owner financing and earn-outs, the acquirer should consider the selling shareholders’ willingness to accept equity in the acquirer in exchange for some or all of their stock in the target company. If they are willing to take some portion of the purchase price in stock, issues around exchange rates, forms (i.e. class of stock, options or warrants), and amount of equity will need to be considered. All of these structural mechanisms can be used by creative acquirers to reduce the cash outlay and provide financing for the transaction.

Internal Resources
In addition to potential financing provided by the target or its shareholders, the acquirer should consider leveraging its own assets to pay for the transaction. Just as it did for the target, the acquirer should consider its existing assets and how it might be used to make the acquisition. The acquirer should also consider its existing shareholders and whether they are willing to provide additional equity to consummate the transaction.

Some of these resources include:
assets that can be turned into cash through sale/leaseback or other transactions,
revenue streams that can be monetized for cash today, and
existing financing sources which may increase their lending based upon post transactions financial numbers.
Each of these options should be evaluated as ways to finance the transaction. If the acquirer and its shareholders believe in the transaction, they may be willing to take additional financial risk in exchange for gaining the financial rewards of the acquisition.
Third-Party Sources
Once the acquirer concludes that “new money” must be brought to the table to facilitate a transaction, it should begin the search for third-party financing sources that are a good fit for the transaction. In evaluating potential financing sources, the acquirer must consider the industry of the target, and the general terms of the deal. Groups that provide financing can typically be categorized by:
uses of the funds (e.g. growth capital, liquidity, acquisition);
type of financing (e.g. debt, equity, mezzanine debt);
industry preferences (e.g. retail, service, franchise, food);
size of financing (i.e. how much will they fun);
level of post-transaction involvement (e.g. control, minority, passive); and
other key deal characteristics (e.g. international, turnaround).
Each of these elements plays a part in identifying appropriate sources of financing. The more squarely a deal fits into a funder’s general criteria, the more likely it is that they will seriously evaluate the opportunity.
Acquirers who need third-party financing to get their deal done should not look at the usual suspects, but also be creative about who might have an interest in seeing the transaction close. One example of non-traditional third-party financing when the target is a franchise, is the franchisor. In cases where the target is an underperforming franchisee, acquirers occasionally receive royalty relief, loans, or even grants from franchisors. The phenomenon punctuates the fact that financing can be found in unexpected circumstances. There have been instances where vendors have provided financing to facilitate an acquisition by a friendly acquirer to avoid losing the business.
The International Franchise Association has on its Web site a list of debt and equity players who fund franchise deals, and organizations that host conferences specifically designed to help franchise companies locate financing. However, many of the best sources are available through research on the part of the acquirer, or by using a financial advisor who knows the players and types of the transactions they are interested in evaluating.-->