Common Mistakes Made By the Franchisor Buyer During the Due Diligence Investigation
Franchise merger and acquisition talks always start with the best of intentions. After all, a well-executed franchise system merger can lead to enhanced scale (for increased buying power and leverage over suppliers), reduction of overhead and operating costs (through elimination of duplicate staff, departments, and locations), and increased revenue (through cross-selling of products or services, optimization of distribution channels, and bolstered brand recognition and standing in the eyes of prospective franchisees).
In this post, FranchiseHelp.com contributor and Jones Day Partner Andrew Sherman outlines some of the top mistakes that franchise executives tend to make when evaluating a potential merger or acquisition transaction. Read up, dear franchise executive, and perhaps you will avoid making these same costly mistakes yourself.
Despite all the potential benefits of a successful franchise merger or acquisition, a bad franchise M&A deal -- often caused by a lack of appropriate pre-deal due diligence -- can lead to extensive value destruction or even total disaster (see: Wendy's / Arby's and Popeyes / Church's). Unfortunately, many franchisors, spurred on by fee-hungry wall street investment bankers or just their own lust for announcing a blockbuster deal, rush into merger and acquisition frenzy without knowing exactly what to look for in a prospective acquisition or merger target.
Here is a list of common mistakes to avoid when considering any franchise system merger or acquisition deal:
- Mismatching information and personnel: A buyer should make sure that the documents provided by the seller are reviewed by the right members of his or her team.Perhaps the seller has particularly complex financial statements or highly technical reports that must be truly understood by the buyer’s due diligence team. Make sure there is a capability fit. Once a deal has closed, a buyer has little recourse or chance of recovery if bad facts emerge about the seller's business that were disclosed in the documents the seller furnished during the pre-deal due diligence process. Leave no document unexamined!
- Poor communication and misunderstandings: Communication between the deal evaluation teams of the buyer and the seller should be open and clear. This process must be well orchestrated to avoid misunderstandings or accusations of misrepresentation down the road. Oftentimes investment bankers are brought in to facilitate any M&A (mergers and acquisitions) discussions; as deal-making and deal negotiation specialists, investment bankers can be a very useful resource in the deal process. Their experience managing complex financial transactions can help make the deal proceed extremely smoothly. However, even when investment bankers are retained, it's critical that key decision-makers for both the buyer and seller stay personally involved in the deal discussions and understand the meaning of any communications, verbal or written, that are sent back and forth during the due diligence and negotiation periods.
- Lack of planning and focus: In the preparation of the due diligence questionnaires and in interviews with the selling franchisor's team, planning and focus are key concerns. The focus must be on asking the right questions, not just a lot of them. Sellers will resent wasteful fishing expeditions when the buyer’s team is unfocused. At best, unfocused due diligence requests and questioning will waste both buyer and seller time and communicate to the seller that the buyer may not be particularly savvy about the key drivers of the seller's business. At worst, unfocused requests will cause the seller to break off negotiations in favor of remaining independent or in favor of a more efficient and organized buyer. Bottom line: there should be a clear fit between the questions asked and the compelling strategic rationale underlying the transaction.
- Inadequate time devoted to tax and financial matters: The buyer’s (and seller’s) CFO and CPA must play an integral part in the due diligence process in order to gather data on past financial performance and tax reporting, unusual financial events, or disturbing trends or inefficiencies. No deal, no matter how news-worthy, can work if the numbers don't work.
- Being mistreated by the seller: The buyer must insist that its team will be treated like welcome guests, not as spies from the enemy camp. Many times the buyer’s counsel is sent to a dark room in the corner of the building to inspect documents without coffee, windows, or phones. Providing reasonable accommodations and support for the buyer’s due diligence team enhances and expedites the transaction. If a virtual data room / electronic data room (where critical financial records and other corporate documents are uploaded for inspection by potential buyers) is not provided to the buyer, the seller should at least make utilizing the physical data room a pleasant and efficient experience.
- Failure to examine intangible factors: Many deals fail because of a lack of a shared vision or conflicting corporate cultures. The franchisor’s due diligence must include a process for measuring the likelihood that the two cultures and systems will ultimately fit after the post. Many initially promising franchise mergers fall apart post-deal because of cultural integration issues. Don't fall victim to this trap: take the time to truly understand the differences in culture and attitude between the two entities being combined.
Andrew J. Sherman is a Partner in the Washington, D.C. office of Jones Day, with over 2,500 attorneys worldwide. Mr. Sherman is a recognized international authority on the legal and strategic issues affecting small and growing companies. Mr. Sherman is an Adjunct Professor in the Masters of Business Administration (MBA) program at the University of Maryland and Georgetown University where he has taught courses on business growth, capital formation and entrepreneurship for over twenty-three (23) years. Mr. Sherman is the author of twenty-one (21) books on the legal and strategic aspects of business growth and capital formation. His eighteenth (18th) book, Road Rules Be the Truck. Not the Squirrel. (bethetruck.com) is an inspirational book which was published in the Fall of 2008. Mr.Sherman can be reached at 202-879-3686 or e-mail firstname.lastname@example.org.
Know Before you Go – Non-Compete Provisions in Franchise Agreements
In general, non-compete provisions state that the franchisee will not, during the term of the franchise agreement and for a reasonable period thereafter (typically two or three years), own or be involved in any “competitive business.” What constitutes a “competitive business” will vary from franchise system to franchise system, but most franchisees can generally expect to be prohibited from taking part in any business that offers goods/services that are either identical to or competitive with the goods/services offered under the franchise system. Non-compete provisions must be limited in geographic scope, and generally cover a set radius (usually somewhere around 5 to 25 miles) around the former franchised outlet, and possibly also the outlets of other existing franchisees.
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Like the franchisor, the subfranchisor signs a subfranchising agreement with the franchisees (when a franchise is sold) in the area. Technically, the subfranchisor takes over the role of the franchisor in certain geographic regions.