A Different World: Private Equity Investment

Part two of a three-part series

Last issue, we discussed growth through nontraditional franchises. Private equity firm investments of significant amounts of capital in franchisors and in franchisees represent another avenue for sales growth. Economic travails have led to the availability of sites with increased negotiating leverage for prospective tenants and experienced franchise talent. But in this tight financial market, where are the dollars to take advantage of those opportunities? We explore private equity firm concerns, what to expect in negotiations, and when franchisors should "just say no."

Key business considerations

Over the past few years, private equity firms have invested in troubled franchisors; brands that are mature and well-known; brands that lack the funds to go to the next level; and multi-unit franchisees that control their markets. Predictability, clarity, and meeting investors' expectations for a return on their investment are paramount considerations. Those considerations require a franchisor willing to compromise on some long-standing policies and franchise agreement provisions and that understands the private equity firm's need for expansion rights. Private equity firms research when to get in, and conversely, when to get out. When the time is ripe, private equity firms will seek to exercise an exit strategy consistent with their investors' expectations, usually within 3 to 10 years.

Key agreement considerations

Exit strategy drives negotiations between private equity investors and franchisors (even when the potential investment is in a franchisee). Expect requests to:

• Loosen restrictions on transfers
• Waive a franchisor's right of first refusal and options to buy
• Permit initial public offerings
• And, as a method of growing value before exiting ownership, grant development rights for additional units or new territories.

Additional considerations

Exit strategies are not the only concerns in a potential franchise relationship. Other important negotiating points for private equity investment are to:

• Eliminate restrictions on ownership in other concepts--even similar brands--and delete or narrow in-term non-competition covenants with carve-outs (private equity firms often invest in several concepts in a particular industry, such as foodservice); eliminate post-term non-competition covenants altogether; and delete the requirement for all owners to agree to non-competition covenants
• Delete obligations for owner involvement in the daily operation of the business or to devote to the business full-time
• Clarify the extent of the franchisor's exercise of its sole discretion
• Eliminate cross-default provisions
• Add materiality standards to avoid technical defaults
• Eliminate the requirement equity owners sign personal guarantees
• Revise training requirements, as private equity firms often provide experienced management personnel or retain existing franchisee management.

Key franchisor interests

Balancing the interests of the franchisor and the interests of a private equity firm may take some fine-tuning. How important is sales growth to the franchisor? Might a franchisor favor concentrating on improving its concept or providing extra help to its franchisees, rather than on expansion while financing is unavailable? Where will expansion financing come from, if not from private equity groups? How much control will a franchisor want to abandon to entice private equity investment? All are tough issues for franchisors to think about.

Protect the brand

If a franchisor decides that private equity financing would be beneficial for the overall health of the chain, it will nevertheless want to stand firm on any provision in a franchise agreement that protects the brand. A franchisor will want to:

• Maintain control over brand standards, including confidentiality of specifications
• Protect all intellectual property, insisting on strong confidentiality provisions, especially when considering the probable elimination or weakening of non-competition covenants
• Insist on confidentiality of all nonpublic financial information provided to the private equity investor
• In lieu of personal guarantees, negotiate financial protections, such as a letter of credit and ensuring that the general partner of the private equity investor has and maintains a minimum investment in the acquiring or investing company
• Maintain control over supply arrangements, which may be difficult to negotiate when a potential private equity firm that owns multiple concepts wishes to capitalize on its own volume-buying capabilities.

These and other critical issues must be carefully evaluated, often with the assistance of an experienced business and legal professional. With an understanding of this different world, challenges can lead to opportunities.

Jan Gilbert is a partner and Gayle Cannon is of counsel in the Franchise and Distribution Practice Group of Haynes and Boone LLP and can be reached at jan.gilbert@haynesboone.com and gayle.cannon@haynesboone.com.