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Over the last decade, franchise systems have been selling to private equity buyers at higher and higher valuations. In fact, not only have more mature systems been changing hands, but each year it seems buyers will not only seek out smaller systems, but place values on these less mature brands that were unheard of previously. Across a few recessions, a global pandemic and general economic uncertainty the growth in valuation continues unabated. Why?
In my opinion, there are three primary value drivers for franchise systems: potential, time and scarcity.
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The biggest and most obvious reason why buyers buy franchise systems is their untapped potential growth. Due to economies of scale, each new franchisee and additional revenue stream from a newly opened unit should be less expensive than the last.
This diminishing incremental cost for additional growth is where the upside lies. If buyers can see a path to double or triple the system with only nominal increases to the cost structure, they will step up and pay big money to take over a system. For them, paying a high price will seem like a bargain if they can recoup their investment through steady, predictable and profitable growth.
Most of the risk in building a franchise system is in the early years. An unproven model is just that: unproven. Buyers of franchise systems are looking for that sweet spot of potential. A system that has proven it can consistently attract high-quality franchisees and deliver them a business model that works will inevitably attract suitors for the entire system.
There is never such a thing as a sure thing, especially in franchising, but a business model that has harnessed the nimbleness of small business ownership with the sophistication of a larger enterprise is in a very good position to grow exponentially.
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It takes tremendous effort, with sometimes years of little to no profitability, to get a franchise system to the point that it’s able to open up profitable units consistently. Most founders of franchise systems will make a myriad of course adjustments along the way.
Scaling a business that is based on coaching and leading entrepreneurs — who, by their very nature, are strong-willed and independent — takes time, patience and a little luck. Even well-funded startups with the cash to do everything by the book still make lots of mistakes, missteps and course adjustments to get it right. Like a fine wine, you just can’t rush it. It is measured in years, not months or quarters.
All great franchise systems and founders can point to early mistakes. Those early years worked out the bugs and solved the scalability issues of how to take the business model from a local profitable enterprise into one that can drop into a new area and thrive against entrenched competitors. That is not an easy proposition.
The first location the system was based on may have taken years to dominate a local market. Translating that into a system with a goal to compete in a new market from day one is not something that can be done on a spreadsheet or in a laboratory. It must be done with blood, sweat and tears in the real world. The one common factor is always time, sometimes lots of it, to get it right. In our ever more impatient world, investors are willing to pay to skip the hard work of building the system one franchisee at a time and jump to the winner’s circle.
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No one knows for sure, but in my company’s research, we have estimated there are a little over 4,000 active franchise systems in the U.S. Of those, fewer than 1,000 systems have over 100 units, and fewer than 100 systems have over 1,000 units.
It is a remarkably small number when you consider the size and scope of the franchising industry. Most franchise systems don’t make it to these heights. Those that do are in an exclusive club commanding very high offers from potential suitors.
A franchise system becomes really valuable when it reaches the point where its royalty stream alone is sufficient to cover expenses, also known as royalty break-even. There are only so many that reach this point and have a growing, sustainable system not directly dependent on outside capital (which includes the cash paid by new franchisees for their initial franchise fee).
A good franchise system will rarely if ever make a lot of money from its first dozen or so franchisees. At this stage, the best practice is to reinvest all revenue for the future. The slow drip of initial royalties is rarely enough to support all the effort to support those first few units. Many of those early systems are built using the initial fees from selling franchises and the initial capital invested by the founder. But once a brand flips the equation and the royalty stream can properly support the existing franchisee base, the unit economics of the franchise system itself are very appealing. Since very few systems achieve this, there are many more buyers than sellers which basic economics tells us will drive up the price.
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The bottom line is: If you are a franchisor, you need to focus internally on getting it right. As a franchise attorney, I have watched many systems rise to stratospheric valuations, but have also unfortunately seen many stagnate and never reach their full potential.
I tell our new franchisor clients that most founders will overestimate the growth of their system in the early years, but underestimate the potential value in later years if they’re successful. Founders need to be patient — something many of them struggle with — and put in the time, money and effort to get it right in the early years. If they do, they will be in rare company with many potential buyers to choose from who will bid up their big payday for the potential to take it even higher.
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