Refranchising: A Strategy to Consider for Franchise System Growth

Many franchisors have recently undertaken refranchising programs as a means to grow their businesses and enhance shareholder value. Franchisors with company-owned units may wish to consider this approach for the same reasons.

What is refranchising, and is it right for your system? Refranchising can generally be described as the sale of franchisor- or affiliate-owned units to buyers who will operate those businesses under the same system, pursuant to a franchise or license agreement. Such an arrangement can provide substantial benefits to both the franchisor and the franchisee.

Benefits to the franchisor

1. Redeployment of capital. The sale of the company-owned business enables the franchisor to liquidate its investment and thereby redeploy its assets to higher-priority uses.
2. Higher return on equity. The combination of the franchisor's reduced investment in the refranchised business and the ongoing revenue stream in the form of royalties and other franchisee payments (e.g., for the purchase of products and supplies) will often result in a higher return on equity for the franchisor.
3. Reduced earnings volatility. The nature of the franchisor's revenue stream flowing from the refranchised business will change, often resulting in more stability for the franchisor. Franchisees typically remit royalty payments to their franchisors based on the gross sales of the franchised business, rather than the profitability of the franchised business. As a result, refranchising of a business enables the franchisor to realize an income stream from the refranchised business, regardless of whether the refranchised business is profitable or marginally profitable.
4. Improved unit operations. In many franchised systems, franchised units realize higher revenues and stronger overall performance than franchisor-owned units. This is often a result of the fact that the franchisee has a greater commitment to the business in the form of its personal investment and efforts.
5. Geographic management. A franchisor may look to exit geographic markets through refranchising, in order to focus or concentrate its efforts elsewhere.
6. Refranchising to stimulate system growth. Refranchising is an effective tool to "seed" markets by offering development rights in conjunction with the sale of the refranchised unit or units. Under such an arrangement, the purchaser agrees not only to take over the refranchised locations, but also to establish and operate new units on a going forward basis.

Benefits to the franchisee

1. Faster development. The purchase of a refranchised unit allows the franchisee to commence operations far faster than establishing a new unit. The time, cost and expertise needed to select and construct or build out a site and to hire and train employees all have been expended by the franchisor. Moreover, the results of those efforts are relatively clear before the franchisee enters into the arrangement (e.g., the franchisee knows where the unit will be located, the terms of the lease, and the quality of the employees).
2. Greater investment certainty. Prospective franchisees have the advantage of being able to review the books of an existing operation before deciding whether to enter into the arrangement and before agreeing to the purchase price. There is less guesswork in assessing the prospective sales, expenses, and profitability of the refranchised business relative to an unestablished business.
3. Greater opportunities for financing. Because the refranchised location has an existing performance history, it also is easier for the prospective franchisee to obtain financing. A lender looking to reduce risks enjoys the benefit of that performance history in running its own numbers.
4. Leveraging existing overhead. Existing franchisees who purchase refranchised locations are better able to leverage their overhead and obtain economies of scale through the operation of multiple units, especially when those units are located within a single market or contiguous markets.

Business and legal considerations

Franchisors looking to refranchise existing locations should be mindful of a number of unique business and legal considerations applicable to refranchising. For example, the FTC's Franchise Rule contains a special exemption from its typical financial performance representation requirements. Specifically, franchisors are permitted to provide actual operating results of a specific company-owned unit offered for sale to prospective purchasers of that unit.

If the franchisor is refranchising an outlet that was previously franchised, it must disclose the following information for the past 5 years: a) the name, city, and state, current business telephone number, or if unknown, last known home telephone number of each previous owner of the outlet; b) the time period when each previous owner controlled the outlet; c) the reason for each previous ownership change; and d) the time period(s) when the franchisor retained control of the outlet. This information must be provided in either Item 20 of the franchisor's Franchise Disclosure Document (FDD) or in an addendum to its FDD.

In addition, franchisors should consider real estate issues affecting the refranchising arrangement. For example, if the franchisor owns the real estate for the refranchised business, the franchisor may opt to sell the real estate to the franchisee, lease the real estate to the franchisee, or sell the real estate to a third party who will, in turn, lease the real estate to the franchisee. If the franchisor leases the real estate from a third party, the franchisor may wish to consider extricating itself from the lease and arranging for the franchisee to lease the premises directly from the landlord, subleasing the premises to the franchisee. In these instances, the terms of the franchisor's lease and the receptiveness of the landlord to the transaction must be considered.

Most important, the decision to refranchise is specific to the franchise system and the objectives of the franchisor and the franchisee.

 Jan Gilbert is a shareholder with Polsinelli PC, a law firm of more than 875 attorneys in 22 offices, and is a member of its Global Franchise and Supply Network practice. Contact him at 202-777-8918 or jgilbert@polinselli.com.