Why You Should Be Concerned About Franchise Private equity Funds (2024)
Private equity can supercharge franchise growth, but not all investors are alike. While some focus on expansion and innovation, others may prioritize profits over franchisee support. Discover the pros, cons, and key dynamics here.
Table of Contents:
Introduction
Private equity is a net positive for the franchising industry as it brings in capital to this business model that depends on the product, the service being offered by the franchisor to the franchisee/end consumer can be really good for everyone in that value chain. It also professionalizes many brands.
Imagine a founder that was really good as a fitness instructor. Or a chef that has built up 10 locations with a couple of franchisees, and has hit a roof where that influx of capital can be really helpful. Adding the knowledge of the private equity fund and the relationships they have to bring in experienced managers, it would be very useful.
Types of Private Equity
1- Growth Oriented
Those are the ones I like. They generally want existing franchisees to open up more units, and grow the system from 100 to 1,000 units. They are going to invest millions of dollars in marketing, brand development, operations, and the management team, growing together with franchisees. The end goal might be to IPO, and sell the stock on the New York Stock Exchange or the NASDAQ. Or maybe sell to a larger private equity group.
There is potential to roll up other franchise concepts. You see that a lot in the home service business. I have identified at least five home service franchise platforms that are private equity-backed. Usually by competing with private equity firms. They are buying up smaller franchise brands. So there is the opportunity to grow something more significant. There might be synergies between those brands if executed correctly or the synergies might not be there, but that could be a whole nother episode.
2- Internal Improvements Oriented
There is a second type of private equity investor that is more about internal improvements. Or you could say extracting as much profit as possible. Focused on making improvements and profitability. The problem with this type of private equity investor is that there are some low-hanging fruits dangling for them in the franchise agreement that they can take advantage of.
An example is an education franchise that might have been bought last year. 200 franchisees. They were not using their own educational materials. They decided to have an affiliate company, use education materials and collect massive rebates from that affiliated company and dictate that their franchisees have to buy the materials to them. Even though they were super expensive and the workbooks are not as good. The education materials are not as good, but the franchise agreement says they are able to take rebates and control the vendors.
You as a franchisee have little say. And that franchisor might have just had a profit of 2 million-plus incremental. By being able to sell you at a nice markup the products and services that you are offering to the final franchisee.
Even some of the processes that you need to use are supposed to make your life easier as a franchisee. The franchisor, with the new ownership, can just decide “We do not like that old POS system. We are going to bring in this POS system that we are going to get more rebates from. Or that our affiliate company owns a POS system. Let’s also bring in that marketing agency that we are going to create another company owned by the franchise brand. It also owns this marketing agency that is going to do all the marketing for the franchisees. And it is not going to be transparent about where those ad funds are going, where those marketing funds are going.”
The franchisee is really trusting in the franchisor to do the right thing. And maybe with that founder, owner, or that growth equity-type private equity investor, they are going to do the same thing. They are really going to focus on the unit-level economics of the franchisee.
Advantages of Private Equity
Private equity is a blessing for the franchising industry. Essentially improves overall the economics of franchisees and franchisors.
And oftentimes, delivers a better product or service to the end customer. However, there is a big distinction between a growth equity investor and one that is more focused on internal improvements. “Let’s extract as much money as possible from these franchisees and then sell the business to someone else.”
Disadvantages of Private Equity
The sad thing is that not only a small minority of new owners are doing this. These private equity groups or family offices have done this multiple times for different brands. So they have gone in as cancer to these different brands and extracted as much money as possible from the franchisee without helping the franchisee be more profitable. It just leaves basically an organization that is defunct, and they try to sell that as fast as possible.
At Vetted Biz, we have been working with some of those growth equity-type private equity investors. I have no interest to work with the internal improvement private equity groups. Really prefer to support the growth equity investors. That type of private equity coming into the franchise space brands up to a different level. There, they can expand nationwide. And make more money for the franchisees.
The Key to Grow
The key to growth is private equity in the franchising space if the number one focus is on unit-level economics. The analysis should be focused on how much the franchisee gets. ETBITA, how much the owner is making, benefiting from the business, and what the sales are like. And if they are also supporting the franchisee to continue improving the unit-level economics and really hearing them out, it should work.
Maybe a franchisee with a previous owner averages two locations and made 150K operating those two locations. Then now with the new private equity owner and the system in place, the experienced franchise coach is helping franchisees. Franchisees are now able to have five locations and make 600K with the regional manager. The owner-operator is not just bouncing around those two locations but also has a more professional team. He is able to learn a ton from the new owners, and new management teams that have come into his franchise brand that he is a franchisee.
It can work out when it is growth capital and a company that really wants franchisees to make as much money as possible. Not profit on the franchisees and all different types of ways, but primarily focus on realty fees collected.
