Outside Capital: Why Seek it, What Types Exist and What’s Right for You?

By Steve Romaniello, CFE

At some point in their lifetimes, many franchisors and franchisees, whether startup, mid-sized or large, and well-established in the marketplace, will consider raising outside capital.

For many business owners, particularly those with little or no experience in the domain, understanding the right reasons to seek outside capital, the different types that exist and most importantly, which kinds of outside capital are right for them, can feel like an overwhelming task.

If business owners are not well versed on the matter, the consideration of outside capital can be simplified by breaking it down into manageable steps. Once this occurs, the process not only becomes easier to swallow, but the possibilities presented become exciting. Business owners start to see the tremendous potential that outside capital can offer their companies and their futures.

Step One: Self Examine

Literally, ask the question, “Why should I consider outside capital?”

The two most common reasons to seek outside capital are to accelerate growth and provide shareholder liquidity. Substantial growth usually requires investments in people and systems, research and development and the addition of new locations. More rapid growth also may involve other initiatives such as strategic acquisitions that require capital or expertise that the company may not have.

In addition to growth goals, owners of businesses may consider outside capital as a means to diversify their personal net worth through full or partial liquidity. Or, they may be thinking about a generational change of ownership, or a combination of both, partial liquidity and a “second bite at the apple.”

When it comes to liquidity, a business owner should consider the following additional questions:

• How much of my net worth is tied to the company?

• What risks do I face going forward?

• What continuing role in the business do I want?

• Do I currently have the resources needed to win and take advantage of the opportunities available?

• What percentage do I want to sell?

If business owners are not well versed on the matter, the consideration of outside capital can be simplified by breaking it down into manageable steps.

Step Two: Study Your Options

Once the franchise owner has sufficiently examined and answered the question of why he wants to consider outside capital, it’s time to become educated about the different capital sources and the pros and cons of each. The end goal is to decide which option is best suited for him and the business.

For new concepts, start-up capital may come from personal savings, friends and family or angel investors.

For established businesses and franchise organizations, liquidity and growth capital sources include debt, strategic buyers, public equity markets or IPO, and private equity. Here is a quick look at the pros and cons of each.

Debt

Pros: One option for growth or liquidity would be to acquire debt or to simply borrow money from a lender. With this scenario, the benefits are that the business owner would retain all equity and continue to manage the business. Also, since a lender is in a more secure position and will generally complete less due diligence than equity investors.

Cons: There are some down sides to debt. For example, the lender will likely require restrictive covenants that may result in less flexibility, and the lender will have limited strategic value-add in helping grow the company.  Also, debt may not provide as much liquidity as some of the other options, such as a strategic buyer or a private-equity partner. With debt, the business owner will have to provide collateral or personally guarantee the loan, potentially putting other assets at risk.

IPO

Pros: An initial public offering, or IPO, is another option for some companies. Similar to securing debt, raising funds through an IPO allows one to play a continued role in the management of the company. With an IPO, the franchise owner can offer stock options to the management team; this option may help the owner to recruit superior talent to increase the company’s performance.

Cons: With an IPO, the business owner will be embarking on a costly and time-consuming process that carries legal risks and limited liquidity opportunities. Because the market interest is cyclical, it is difficult to predict what the ultimate outcome will be prior to incurring the costs to prepare for the offering. In addition, operating a public company may cause one to focus on short-term gains instead of a better plan that will build more value over the longer term.

Selling to a Strategic Buyer

Pros: Selling your company to a strategic buyer offers several benefits. First, given their potential synergies, an acquirer that operates in the same space or industry can typically pay the highest price. Selling to a strategic buyer also offers immediate liquidity.

Cons: On the down side, their interest is often cyclical, so the opportunity may not be available when the franchise business owner is ready. Also, maintaining confidentiality throughout the process is difficult and the owner may risk losing important team members or customers before he is certain a transaction will take place. Selling to a strategic buyer also often leaves the current team with little or no future role in the company, and seldom offers the owner a chance to participate in future growth.

Partnering with a Private-Equity Firm

Pros: Private equity is capital managed by professional financial firms on behalf of pension funds, endowments or wealthy families. Private-equity firms make investments for an ownership stake in a company that can be used for infrastructure and growth or liquidity for shareholders.

It is important to find a private-equity partner that is a good match for the franchise business.

A private-equity investor with experience in some or similar industries could be a source of synergistic opportunities. For example, Roark Capital Group specializes in the franchise industry. This allows for collaboration and information sharing, access to best practices and shared buying power among its portfolio companies. This is particularly evident during Roark’s annual “Franchising Summit,” in which executives of all its portfolio companies gather to share success strategies and problem solving techniques.

Private-equity firms will back the company, which allows the owner to have a continued management role. Most firms typically provide equity incentives for the business owner and his team and often will allow the owner to invest in the transaction going forward, providing him the opportunity for a second bite of the apple. When compared to operating a public company, a private-equity firm’s focus is longer term in nature, so one can manage the company to create value over a longer period of time.

Cons: However, partnering with a private equity firm is not necessarily the best option for everyone. They will usually engage in a longer and more thorough diligence process and will want some say in the more important decisions facing the company.  For this reason it is important to find a private-equity partner that is a good match for the franchise business.  The owner should be sure that his partner has experience in the size and type of the company and has a comfortable style and approach.  One should also share similar values, and be sure that the views of leverage and exit time frames are in sync.

Step Three: Know the Process

Typically, investment process starts with initial courtship, which may lead to an indication of interest and eventual letter of intent or LOI. The LOI will typically include an agreed upon valuation for the business and structure of the transaction and an exclusivity period for the potential buyer to conduct due diligence.

The due diligence process will include business and financial diligence, legal diligence, customer and supplier interviews and interviews with the team. Upon conclusion of due diligence, a definitive agreement is signed, followed by the actual closing of the deal.

In the end, consideration of outside capital should be a careful, thorough process that starts with business owners and franchisors asking the right questions, first of themselves, then of others.

It’s all about looking inside and determining if and why the franchise owner needs the capital to begin with, then cautiously weighing all of the options before moving forward. It could be that the process ends with the first step or it could proceed to an outcome that involves an equity infusion that helps take the company to the next level. Either way, the likelihood of a successful outcome is significantly increased with the business owner’s eyes and ears wide open, as well as being as educated as possible about what’s out there and what to expect.

Steve Romaniello, CFE, is managing director of Roark Capital Group and chairman of the board of FOCUS Brands, the franchisor and operator of more than 3,300 restaurants in the United States and 32 foreign countries under the brand names Carvel, Auntie Anne’s, Cinnabon, Schlotzsky’s, Moe’s Southwest Grill, Seattle’s Best Coffee (in certain international markets) and Wingstop.  He is IFA’s Second Vice Chairman of the Board of Directors, chairman of the IFA Educational Foundation and a member of IFA’s Diversity Institute.