Everyone - But Tread Carefully and Know What You Want

There's nothing mysterious about what investors and franchisors want from one another: a reliable partner who can help them achieve their goals. For the franchisor, it's all about brand and unit growth; for the investor, it's return on investment.

Just as franchisors differ, all equity investors are not alike. Some focus on franchisors, some on multi-unit franchisees; some like large deals, some smaller; some are public, some private; some are in for the quick turn, while others prefer a longer-term partnership; or they may focus on companies at different stages of growth.

For franchisors, the need may be short-term (cash to fund immediate expansion in a specific market, or within a certain time frame); for others, an equity partner may be part of a long-term vision (grow the business over ten years to sell and provide a nest egg for family members). Or it can be the last big step on the path to retirement.

Using other people's money to start or build a company is a time-honored strategy--if you can get it. Sure, private equity has invested at the topmost levels (big money always finds big money), but for most small to medium-sized franchisors, attracting equity firms was not so easy. For years, they had to rely on their own resources, the SBA, and banks. It was the rare equity investor willing to invest in franchise companies. Franchising appeared too risky, or they just didn't "get" the franchise business model. There's not a lot of collateral in a UFOC or operations manual, compared with say, an auto plant. But equity investors have come around to see royalties as an annuity, and franchise fees as a low-cost method of funding expansion.

(To learn more about franchisees and equity investors, see www.areadeveloper.us/article.php?id=116 in Franchise Update's other publication, Area Developer, Issue IV, 2005; as well as Area Developer Issue I, 2006.)

In an era of franchise growth and an excess of investment capital looking for opportunities, the logical conclusion would be that this is a good time to be in franchising. You'd be correct. But the usual rules still apply: strong brand, proven growth and potential for more, strong management, good system, and a solid, healthy network of franchisees. Access to money does not ensure success.

Yet, with all the variations possible for a franchisor looking to use equity funds to grow (minority vs. majority interest? founder cashes in or stays on for a few years? which firm to choose? how to structure the deal?), it's best to hire the expertise and perform extraordinary due diligence on all serious suitors. That's what Jacques Lapointe, founder of Jan-Pro International did, when he pursued an equity investor strategy (see Cover Story). That's also what Primrose Schools did when it was sold from one equity owner to another earlier this year.

Tale of a sale

In April 1999, Primrose was acquired by equity investor Security Capital Corp., which bought the company from its founders for $27.4 million. Seven years later, in April 2006, Primrose was sold again, this time for $63 million to American Capital Strategies, a publicly traded investment firm. Primrose currently has 149 schools in 13 states, and just signed its 200th franchise agreement.

Primrose franchises private, curriculum-based preschools and after-school programs. The system serves two markets: early childhood education and high-quality child care services for children six weeks to five years old; and specialized after-school programs for children five through 12.

Founded in 1982 and headquartered in Acworth, Ga., the school began its franchising effort in 1988. Soon afterward, Jo Kirchner entered the picture. That's when she met the company's founders, Paul and Marcy Erwin, and joined them in developing their fledgling franchise program and building the company. When the Erwins sold the company in 1999, there were 100 schools, Kirchner was CEO, and has remained in that position.

The recent sale is standard procedure in the world of investing: equity firms acquire or invest in companies, hold them for a time, and sell them based on a timetable. After seven years, it was time for Security Capital to cash out.

There also was a second reason. At 150 units, says Kirchner, Primrose is an emerging brand decidedly in the growth stage--"and that's where we needed to get a stronger capital investment firm to push new growth. We will open 20 to 25 new schools a year." And although the company practices a patient growth strategy, Primrose lacked the financial resources to make it happen on its own terms. The challenge was to find the best partner to maintain the brand's integrity and ensure manageable growth.

Capital Partners worked with financial advisor UBS Securities to package the offering, says Kirchner. "But I was very involved with packaging, and I handled all the presentations. We went through 10 or 12 investment groups," trying to find the right fit.

"One of the goals was to be able to maintain slow and steady growth," she says, a formula that had allowed the company to expand while retaining its quality. "We wanted to maintain a differentiated brand, not be merged, and maintain controlled growth."

While Primrose's model is not simple, it is packaged in a way that makes success highly achievable for franchisees. The company is extremely particular about its franchisees, selecting about 1 in 50 who apply. "We're talking about a delivery model for children, not fast food or hotels," she says.

Enter the investor

"I'd like to say we have a strategic vision for child care or franchising, but it's not true. We are an investment firm," says Bill Dyer, vice president at American Capital. Security Capital, the previous owner, hired an investment bank (UBS), which contacted perhaps 100 firms, he says. "We got a book, an offering, at random, and liked the business," he says. In fact, after studying the company, he says, "It was a lot more what didn't we like about it?"

While there was no "epiphany" about the wonders of franchising, nor was American Capital looking do a franchising deal per se, the company had already considered one franchise deal when the Primrose offering arrived. The previous summer, the firm had seriously looked at investing in a franchise company in the personal health care and beauty segment, but passed it up.

"We looked really hard at that one, cut our teeth, and learned what to look for and what to watch out for," he says. Although that deal didn't pan out, he says, "We became very interested in the franchising model, the power of it."

Unlike last summer's prospect, he says, "Primrose had everything going for it," he says. The company was positioned to grow, had a strong system, good financial results, was very profitable, growing at a healthy rate, and had a management team that was extremely solid. "Jo Kirchner is a rock star of a CEO," he says. "It's much more of a mission than a job for her."

At Primrose, Dyer saw a strong management team "incredibly committed" to being a national player in childhood education. Compared with the previous franchise, it was "night and day in terms of the management team."

Primrose was also in a prime position to capitalize on several demographic trends, he says. These included the nation's growing child population, an increasing need for child care, the demonstrated long-term effects of early childhood education on future school performance, and increasing parental demand for specialized early child care. And as a premium brand in a fragmented and expanding marketplace, the opportunity for growth was abundantly evident.

From the investor's perspective, says Dyer, Primrose represented a sure thing. The franchisor and franchisees were profitable and had been for years, making it extremely unlikely the system would fail or the royalty stream dry up. And, he adds, "If all sales stopped tomorrow, we'd still get our money back. We'll make money on this deal."

While Kirchner says Primrose went with American Capital because it represented the best fit, Dyer adds another perspective. "They chose us because we bid the most. If there's a banker involved, you can bet on it." Regardless, both parties seem pleased going forward.

Investor to the rescue

"Our greatest challenge is real estate," says Kirchner. In addition to the high price of land for a site (about 1.5 acres and built from scratch), the permitting process can take up to two years--a very long time for a franchisee to wait, and a long time for the franchisor to tie up limited funds.

American Capital, says Dyer, can provide "bottomless financial resources for this. We can put $300 million to $350 million into any deal." (The company is a publicly traded buyout and mezzanine fund with capital resources of approximately $7.7 billion.)

This kind of financial backing, says Kirchner, opens important new avenues for both growth and innovation. Primrose's expansion has focused on the Southeast and Southwest, where land has been easier to find and develop than in the Northeast, for example, where the right sites are scarce and expensive, and zoning is much more restrictive.

"We need capital up front, though we get it back later," says Kirchner. With "bottomless" funds to tap, Primrose now can use its real estate expertise to locate, purchase, prepare, and win permitting approval of sites for new schools--and have them "on the shelf," ready to go when the franchisee is.

Admittedly lacking in franchising experience and wisely willing to defer to the expertise and track record of Primrose's seasoned management team, American Capital does nevertheless bring valuable assets of its own to the mix. The firm, says Dyer, has capitalized Primrose "more appropriately" than it was before. "Primrose now has ample capital to spend money on real estate to start seeding some sites."

While Dyer doesn't expect his firm will bring any expertise in education, "Our involvement may allow the company to have a better board, with a little better governance than before," he says. "But Jo Kirchner knows what she's doing."

How long?

Private equity firms usually are constrained by a timetable for repaying investors in their funds (whether three, five, seven, or ten years). But as a public company, American Capital's portfolio investments don't have a limited life, says Dyer. "We can hold on forever, or sell in five years." However, he adds, "If someone came in tomorrow and offered to pay us a ridiculous amount of money, we'd take it." But he doesn't see a sale in the near term.

Looking ahead, Dyer says American Capital is thinking about doing some focused marketing to franchise companies. "As we look for additional deals, we'll be building relationships with current owners who haven't decided to sell but may be interested."

Why franchising? The simple answer, says Dyer, is: "The franchising model is very attractive if you have the right management team and the right business. It's tremendously scalable and you don't need a lot of money to grow." (Even if you already have a lot of money.)