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Franchise trends you can’t afford to ignore

Thinking of franchising? Here’s what to consider before talking to your lawyers.

 

 

Things are much better than two or three years ago” for people in his line of work, says franchisor Tom Sacco, president of Dallas-based Homestyle Dining, whose franchisees operate some 250 Ponderosa and Bonanza Steakhouses and who recently rolled out a new fast-casual concept in Lindale, Texas, called Bo’s Steak & Grill.

Are such optimistic outlooks warranted for franchising, or is that just the perspective of the bullish entrepreneurs the model attracts? Before making up your mind, consider these five currents running through the industry.

 

1. Credit is available—for some

The outlook for franchising appeared bleak shortly after the financial downturn, as lenders turned off the debt-financing spigot even for multiunit franchisees. “You could have had the best credit in world, a great location and be a Tier 1 guy, but you still wouldn’t have qualified for credit,” says former franchise-development executive and consultant Joe Caruso.

Some operators say that’s no longer the case, although it’s still very difficult for small and first-time franchisees to borrow from banks. “Banks are still not taking chances, but things have gotten better since the recession,” says Irving, Texas-based Dairy Queen franchisee Bill Spae, who has been on both sides of the franchise fence. As chief operating officer of CiCi’s Pizza until last year, he recalls that the Coppell, Texas-based budget-pizza chain offered financing to experienced franchisees capable of opening multiple units. The majority, however, were “growing one here, another there,” Spae says, and had to turn to friends and family or an SBA loan to open their first or second restaurants.

Roughly 10 percent of the SBA’s government-backed loans go to franchisees. “I do see credit for Main Street restaurants loosening up,” says Bob Coleman, publisher of the Coleman Report, a quarterly compendium of government-lending data and commentary. In 2012 (the most recent public data available), SBA lenders made 367 7(a) and 504 loans, for example, to Subway, Dunkin’ Donuts, Jimmy Johns and Dairy Queen franchisees totaling $129.5 million; the average loan for franchises was $416,000.

Coleman sees opportunity in local banks, even in light of allegations from the Government Accountability Office last year that a loan agent likely inflated annual sales of an unnamed franchisor, causing the defaults of a number of SBA-backed loans made to franchisees from 2000 to 2011. Even after the scandal, legitimate banks still are lending. “Don’t give up on them. With today’s low interest rates, banks must make loans to make money,” Coleman says.

 

2. Franchisors are under fire

The Federal Trade Commission and various state agencies already monitor franchisor disclosure and business-relationship activities. But the appointment of David Weil on May 5 to head of the Department of Labor’s Wage and Hour Division has franchisors bracing for increased scrutiny of their franchisees’ labor practices.

IFA Chairman Steve Caldeira had attempted to persuade the Senate not to approve the former Boston University business professor. In a letter dispatched in April to all 100 senators, he wrote: “Dr. Weil has consistently targeted the franchise industry in his writing, accusing franchise companies of being a ‘fissured industry’ that intentionally separates operations and responsibilities between franchisees and franchisors in order to neglect their obligations to workers.”

Weil has argued that enforcement of the Fair Labor Standards Act needs to be revised because franchisors, among other businesses, bear no responsibility for a third-party’s (i.e., a franchisee’s) employees. Weil says this has created an environment for labor abuse and low pay. As a remedy, he has suggested holding franchisors accountable for systemic labor violations among a brand’s franchisees.

“Weil’s appointment is not something to be complacent about,” warns franchise-law attorney Tom Pitegoff of LeClairRyan in New York City. His advice to franchisors: Do not offer specific employment practices or policies to franchisees. “Talk instead about standards of behavior, excellence and quality,” he says.

 

3. Emerging brands shine

Once upon a time, founders proved a restaurant concept’s viability by opening and debugging a body of corporate stores before they even thought about franchising. “These days, you have two or three units in different locales before franchising,” says Andy Gunkler, a veteran development executive-turned-consultant in Louisville, Ky.

Some say there’s no reason to wait when the fast-casual market is exploding. The costs are low, and the sales are there. “To do a new Bonanza is a $1.5 million project,” says Homestyle Dining’s Tom Sacco. “If you can open a Bo’s for $500,000, it doesn’t make sense to open the bigger restaurant.”

Many new fast-casual concepts boast sales-to-investment ratios in the 2.5-to-1 or 3-to-1 range. And Sacco and others are discounting franchise and royalty fees for those who get in early on the action.

Not only is it less expensive to build fast-casual restaurants, it’s less complicated to operate them, given the characteristically small footprints and high-tech equipment. That helps widen the pool of franchisees. 

 

4. Websites can be a top sales tool

Dallas-based Dickey’s Barbecue Pit, the fastest-growing chain with sales greater than $200 million, according to Technomic, debuted a new franchising tab on its Facebook page in May with information for potential franchisees plus articles and announcements.

But social-media sites are just one way to connect with potential franchisees. Because Facebook charges for a business page and limits reach, a franchisor’s website can be a more effective selling tool—if it’s up-to-date, says Nick Powills, founder and president of No Limit communication agency. He says the savviest franchisors are feeding their websites with a steady diet of news and blogs.

Marco’s Pizza (not a client of Powills), for example, maintains a blog on its franchising website that is updated regularly by its development team. Posts note accomplishments such as its 500th-store milestone, tell its story and spotlight individual franchisees.

 

5. Everyone is willing to sell (and buy) for a price

Last year, the M&A market was robust for multiunit franchisees selling their companies. Interest rates, after all, remained low. Multiples of EBITDA, a crucial measure when selling a concept, soared as a result.

There also was a ton of buying on the part of Tier 1 franchisees in 2013 as franchisors, realizing that experienced franchisees were better operators, spun off corporate units. Franchisees in the same system gobbled them up, possibly encouraged by lenders, says J.H. Chapman’s David Epstein, author of the Chain Restaurant Merger & Acquisition M&A Census. Last year, 31 of the 97 announced or closed M&A deals involved a franchisee acquiring units of their concept.

As a result, franchisees are getting bigger and more powerful. Controlling more of the system, they theoretically have more say over its direction.

Epstein sees the refranchising trend continuing. “Franchisors that have more than 50 percent of their systems company-operated have to be looking at the huge refranchising success that Wendy and Burger King have had,” he says.

Yet it was private-equity funds that were the single most acquisitive deal-makers last year, accounting for 35 percent of all transactions—franchise and otherwise—J.H. Chapman reports. The often-towering prices they paid for large franchisees have yet to retreat, though, and some observers believe the buying spree will end this year. Rising food costs and falling traffic counts, in addition to a possible minimum wage hike and health-care issues, are making such investments riskier.

Sentinel Capital Partners, which purchased heavily franchised Huddle House two years ago, doesn’t appear worried. The private-equity firm has acquired three franchised chains this year alone: Checkers/Rally’s, Newk’s Eatery and TGI Fridays. And in May, private-equity firm Golden Gate Capital agreed to buy Red Lobster from Darden Restaurants for $2.1 billion. Investment advisor and former franchise executive John Gordon of Pacific Management Consulting Group says the legacy brand is ripe for franchising, though no announcement to that effect has been made.

 

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