For Franchise Sellers (Brand Level) Due Diligence Basics: Handbook

Overview: Due Diligence

 

It is important for any business owner to maintain a basic state of “sale readiness.” The need (or opportunity) to sell can arise unexpectedly and in the heat of the moment it is much more difficult to prepare. In a franchise business, the discipline of collecting the below information can also help avoid legal compliance errors along the way. For example, the franchisor can assure that FDD receipts are carefully signed, collected, and filed as part of a robust franchise development compliance process. It has the added benefit of having those receipts “sale ready” because they are routinely added to the data room as a normal course of doing business, rather than being a separate effort to track down later.

 

Note: Until we put more distance between ourselves and the pandemic, most buyers want to see 2018 and 2019 data to show “pre-pandemic” conditions if you were doing business at that time.

 

Common Due Diligence Items Requested During Initial Buyer Discussions

 

1. Monthly financial statements (P&L, Balance Sheet, and Cash Flow Statement) going back at least five years (in Excel format) broken out between Franchisor and the corporate stores.
2. Current year monthly budget (in Excel format).
3. Year to date (YTD) franchise licenses sold, units opened, and projected sales and openings for remainder of current year.
4. Opened units by month since going back at least five years (if different formats, include that information).
5. List of all units (both franchised and corporate) showing: location (city and state), franchise sale date, open date, owner name (Franchised or Corporate), territory size (population), franchise fee paid, royalty %, termination / transfer date (if applicable), and monthly sales from inception through current month. Ideally this could be in one sheet and is in Excel format.
6. Most recent Franchise Disclosure Document (FDD) and prior two years for all versions of the FDD (e.g. different state versions).

Many prospective buyers such as private equity firms can make a quick go/no-go decision on whether they want to continue discussions just based on this short list of items.

 

Additional Items to be Provided Later in the Sale Process

 

Although usually not shared until a Letter of Intent (LOI) has been signed, these additional items are also smart to prepare and keep updated in your data room ahead of time.

 

7. Discovery Day presentation and marketing materials for prospective franchisees.
8. System sales growth and by category of product / service.
9. Log of FDD changes.
10. Prototypical franchisee P&L with payback analysis.
11. Updated operations manual.
12. Updated training manual and any supporting materials (e.g. video links).
13. Organization chart, management team bios, and employment agreements.
14. FDD signature receipts.
15. Franchise Agreements.
16. Development Agreements and any supporting materials (e.g. development schedule with status).
17. Corporate organization documents; operating agreements.
18. Litigation list (FDD Item 3) and any pending/expected along with status.
19. Brand fund organization documents and spend history.
20. Supplier list and contracts.
21. Corporate site(s) lease information.
22. Insurance policies.
23. Franchisee surveys.
24. Quality of Earnings (QOE) report if available.
25. Pro Forma, 5-year view.

Is this a lot of information to gather? Yes. And especially if you haven’t been keeping track of this information in a well-organized way from the beginning! But it’s an important part of building a valuable story about the business (the “what” and the “why”) but also creates a discipline of how you and your management team think about and run your business (the “how”) to build maximum enterprise value.

Immaturity in this area will not surprise private equity and in fact is something they know they can immediately come in and change to improve the business. But you will build more value ahead of time the more buttoned up and current these items are and if your management team actually uses this information to help them track progress.

PE’s familiarity with franchising and the speed with which they evaluate data and make decisions is one of the reasons why you don’t want to open formal discussions until you’re prepared. Things can move very quickly. To maintain a sale-ready stance, keep the above items handy in a virtual data room and make sure your finance, legal, and operations staff are updating the information once per month or quarter – depending on how often you collect the information. A buyer will judge the maturity of your business and strength of your internal processes by how fast and completely you’re able to respond to data requests.

As previously mentioned, your operations team should be digging into this information as a matter of routine to monitor system health so they can be proactive and help franchisees.

 

QOE and Pro Forma

The final two items – the QOE report and Pro Forma – are worth discussing further. While audited financial statements determine whether all the numbers tie off between the balance sheet, income statement, and cash flow statements, the purpose of the QOE analysis is to understand how the target company is achieving its financial results. It is a detailed examination of historical revenue, cash flow, and earnings across all business activities and related entities. Basically – how is this business making money? What are the major profitability drivers? The QOE also attempts to account for and normalize any one-time, non-recurring revenue and expenses.

Having a QOE report completed in advance of entering a sale process is optional (the buyer, especially if private equity, will usually hire a third party for this), but can be useful to speed up the sale process. It will also reveal potential gaps that a seller may want to close prior to entering a formal process. For example, all lines of business will not be valued equally by buyers. Revenue related to one-time franchise fees, captive supply chain, rebates, and royalties are valued differently by buyers. For a franchise business, while topline EBITDA (earnings before interest, taxes, depreciation, and amortization) is of course important, the proportion of that EBITDA related to recurring, growing, sustainable revenue streams such as royalties, compared to one-time franchise fees, is even more important.

Regarding your pro forma, once you enter a sale process, you will be “living with” your own growth forecasts. Many deals have been scuttled because the seller failed to live up to its own internal projections while in the middle of the sale process (which can take months). This is not the place for puffery. Call your more aggressive goals “stretch goals” and strive to deliver the on realistic growth objectives in your forecast.

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