The selling price of franchise businesses has significantly increased. Nearly every week someone asks us if it is time to sell. Even though it may be an appropriate time to sell in terms of the market, it may not be the appropriate time to sell in terms of your business cycle or being prepared to sell—both of which can give you a significantly lower price than the market data would indicate.
Let’s look at five areas of planning for a franchisee preparing to sell: (1) unit economics; (2) financial statements and reporting; (3) legal structure; (4) tax planning; and (5) financing issues.
- Unit economics. It is important that each store in your franchise business be reasonably profitable. If you have a large number of stores, it is unlikely that all of the stores are profitable; in fact, you may have a group of stores that are dragging down a higher overall profitability of your company. It is important to deal with the unprofitable stores prior to marketing the business for sale. There are two common approaches:
- Drop the unprofitable stores into a separate entity. This will segregate these stores from the overall business and allow the good stores to be sold under either an asset or stock sale. More importantly, the unprofitable stores will have separate books and records; thus, not confusing the buyer.
- Bite the bullet and deal with these troubled stores by closing or reletting. If you own the real estate, sell the real estate.
Buyers may love your business but won’t want your troubled assets. If the unit economics are merely a result of a short-term problem (such as road closures or population growth, which are inevitable), then it may be important to tell that story in conjunction with the unprofitable stores. The bottom line is the troubled stores need to be culled out and dealt with prior to a sale. This will give you an overall higher price for your profitable stores and the possibility to make some money off the troubled stores through a separate sale of assets.
- Financial Statements and Reporting. One misconception sellers have is that they can restate their financial statements when they get ready to sell. When I say “restate” I am not talking about restating from a GAAP standpoint but restating from a normalization of profits or EBITDA. Sellers normally take out items they believe are not necessary to the business from their profit and loss statements (such as excess owner salary, personal expenditures, and lifestyle items, such as off-site housing, boats, planes, etc.) and then restate their financials with a number of these items removed (particularly items the seller believes are excessive general administrative expenses). While this is a valuable exercise, most buyers are somewhat suspect of restated financial statements as they do not believe they can operate the stores with less expense than the seller. The key is to clean up your P&Ls for at least a year before marketing your stores.
In addition to P&L clean up, there may be Balance Sheet issues such as unrelated business assets on the financials. Any time the Balance Sheet contains assets that do not pertain to the business, there is a certain suspicion that may develop in the buyer. The buyer will be concerned that there are other items in the financials that are inappropriate or not correctly reported. Prior to the sale it is important that assets which are not part of the business be taken out of the business. Additionally, the seller should deal with related party receivables, payables and notes that have no value to the buyer. Again, clean up the Balance Sheet for at least one year prior to a sale.
In summary, any time you are being encouraged to restate your financials (or what we call “normalize” your earnings), look at that request with some degree of skepticism. While buyers who are anxious and may be at first willing to accept the explanations, it is much easier if there has been a reasonable reporting period with clean financial statements.
- Legal Structure. Another roadblock to a sale is an overly complicated legal structure for the selling business. This particularly occurs when each store is in a separate entity. There can also be problems as it relates to use of management and separate real estate holding companies. All of these are good tax planning ideas (which will be discussed below) but they do create complications for a buyer in understanding what they are buying. Therefore, do whatever you can in terms of trying to consolidate entities, look at various holding company ideas (which will create consolidated financial statements) and in general, try to provide for a structure that is easily understandable. If you know there are certain assets that will be sold and other assets that will be retained, it may be a good idea from a structural standpoint to drop those down into a separate entity. In general, the structure needs to be looked at and the simpler, the better.
- Tax Planning. Most often tax structure is dealt with when the seller gets an offer. This is unfortunate because many things can be done prior to a sale. Look at the following issues:
- Overall type of entity. If the selling entity is a C corporation, double taxation can occur. Even if a sale is pending within the next year, it may be wise to make an S election for the corporation now. There is a 10 year rule that says that if assets are disposed of within 10 years, appreciation at the time the election was made is subject to some degree of double taxation. If there is the period of time from the time of the election (many times you can go back one full year), then the appreciation in the value of the assets from the time of the election is not double taxed.
- Allocation. Think about allocation prior to going to market. Most often buyers want to allocate to assets that are rapidly depreciable, such as fixtures, furniture and equipment (“FF&E”). We all know these used assets do not have a high market value. Therefore, make it clear to a potential buyer that you are looking at a true market value allocation for the FF&E assets. The balance can then go to intangibles (i.e., franchise rights). Franchise rights are amortizable over 15 years and create a long-term tax savings for the buyer.
- Loans to shareholders. Look at assets or liabilities on the Balance Sheet that may carry adverse tax consequences, such as loans to shareholders. Loans to shareholders need to be repaid or need to be distributed out so you do not have debt forgiveness and can plan the timing of any tax consequences. Additionally, loans made by the shareholder to the company may be a way of getting money out of the company without additional tax, particularly in the case of a C corporation.
- Net operating losses. Look at the use of any net operating losses prior to the sale. When using flow-through entities it is preferable to have the net operating losses offset by ordinary income versus capital gains income that may come from the sale of assets or stock.
- Stock or membership sale. Consider the use of a stock or membership sale versus an asset sale. You will have to make certain price adjustments to offset the company debt, but it still may be overall advantageous even at a lower sale price because of a lower tax structure and higher after tax dollars.
- Financing Issues. In almost every case the buyer will need to obtain some type of outside financing to acquire the assets or business. Some of the key components relating to financing are:
- Do the leases the franchise business operates under allow the successor tenant to provide to the lender a leasehold mortgage?
- Are there assets under the equipment leases that require a substantial prepayment penalty? Prepayment penalties make it costly to refinance.
- Are the titles to personal property and real property in good shape? Always look at the title, environmental and liens issues prior to a planned sale so you know what you have to deal with. We recommend our clients do all appropriate lien searches prior to starting the sales process to make sure there is nothing on record that they are unaware of.
- Conduct an in-depth review of your franchise and development agreements.
- Can the franchise and development agreements be transferred without being subject to the franchisor’s approval?
- Make sure these rights (particularly development rights) can inure to the benefit of the successor.
- Look at the termination dates for the franchises and leases. Make sure these agreements have a long enough period of time for the buyer to realize the full value of the assets or businesses being bought.
In general, do your own due diligence prior to putting the business up for sale. This would be the same type of due diligence the buyer will do. Have everything in order so any issues can be answered. Issues that often come up are employee claims, employment agreements that need to be terminated, vacation compensation, EEOC claims, and immigration issues. All of these issues can be planned for prior to a sale.
In summary, if you are going to look at a sale, it is best to spruce up the business and deal with the tough issues such as poorly performing stores, lien concerns, and inefficient tax structures prior to putting the property on the market. Today’s buyer is very sophisticated and will not see your business through rose-colored glasses.
Next month’s article: “The 10 Best Financing Ideas of 2006”
Dennis L. Monroe is a partner and the chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation. Krass Monroe, P.A. is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999. For previously published articles, and other Krass Monroe information, please refer to our Web site at www.krassmonroe.com