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.
Strategic and Structural Alternatives to Franchising
These are difficult decisions. The solutions are not clear cut from a business or from a legal perspective. It is critical that a company in this position work with qualified counsel to identify an alternative that will have a reasonable basis for an exemption and still make sense from a strategic perspective. The balance of this chapter will look at the many alternatives currently being tested by many U.S. and oversees companies. As you can see, the lines of demarcation are not always clear. The differences between many of these alternatives may in fact be in name only. Some of these concepts are truly innovative and have not been truly tested by the courts or the regulators. In these borderline cases, a regulatory “no-action” letter procedure is strongly recommended. Other concepts are not very innovative at all and merely borrow from long-recognized and analogous legal relationships such as chapter affiliation agreements in the non-profit arena or network affiliation agreements in radio and television broadcasting.
Running a Franchise While Keeping Your Career!
Something that is possible with franchise ownership that may not always work with a start-up business is the ability to maintain your career while you run your business. Although many franchisees rely on their business unit as the basis of their revenue stream, there are more people interested in buying a franchise to generate a second source of income. A flexible franchise option makes this a possibility and can afford some opportunities that other franchises cannot.
What Draws Investors to Franchising
Most prospective franchisees are drawn to the business by previous frustrating experiences in their past employments. This could have been caused due to lack of control over one’s work environment, being bound to report to superiors and insufficient room to exercise one’s authority at their work place. The micro- managing bosses, unresponsive organizational structures, or lack of voice in the organizations process are a few of the reasons why many people decide on investing in franchises as their new career. By investing in this business they take control over their own life with a little risk as compared to starting their own business from scratch.