Private Equity's Role in Franchising (Ft. Alicia Miller)

Hello everybody, welcome to On Try. I am really pumped up for today's podcast in our franchise speed series because we are going to discover the world of private equity and franchising with someone who actually knows it inside out. So we've got Alicia Miller. She is the author of Big Money in Franchising, which very well explains how businesses can scale up in the era of private equity. So Alicia, not just talking the talk, she has been herself a multi-unit franchisee, so she gets what it is from the inside out. She's been writing for the Franchise Times, been featured in The Entrepreneur, Forbes, and founder of Emergent Growth Advisors, an advisory firm which is at the intersection of private equity and franchising. list goes on. So I wanted to have Alicia here today because after reading your book, I realized that understanding private equity is so crucial for everybody in this space, be it investors, franchisors, franchisees, as you mentioned, brand advocates, executives. So I'm sure these players will have a lot to learn from this episode. And let's go ahead. Welcome to the show, Alicia.

Thanks for having me.

How are you doing?

I'm good. Busy. It's a busy time.

Indeed. Anisha, I would like to begin with first asking you, why did you decide to write a book on private equity in franchising business? What compelled you?

Sure. Well, I could see there was a gap that needed to be closed. Private equity has come into franchising over the last couple decades and now pretty much dominates the sector and influences outcomes for multiple stakeholders in franchising. But nothing had really been written about it to unpack what's going on and help people move forward in an empowered way. And I felt that the need was there, so I decided to write a book about it.

Okay. And did you write this book while you were in your multi-unit franchisee phase?

No, I had sold my business as a multi-unit franchisee and was working as a consultant. Helping franchisors prepare for their usually first institutional capital, and also private investors looking for acquisition opportunities, helping them with due diligence and so on. And I could see that even founders that had had a few conversations with private equity really still didn't entirely understand how the mechanism works, how they're judged by outside investors. How to approach those conversations, how to prepare for them. And the book gives kind of a playbook of what's happening from lots of different perspectives and provides checklists and a perspective that I hope is helpful for people as they navigate their way in franchising and decide, you know, how they want to achieve the outcomes they're looking for, given that private equity is now so much a dominant player.

I definitely agree. While I was having my hands on the book, I re— I had this one question, um, in the beginning, and it was, how does private equity actually help franchise brands grow? And why private equity? Because when we think of investment, there are a lot other players. And this was a question actually posed by one of the members in my community as well. Why do you opt to talk about this topic? Why private equity? Could you expand on that?

Sure. So private equity's entire function is to buy companies, invest in them, grow them, and sell them, hopefully for more than they paid in the first place, and therefore get a good return for their investors. So they're looking for growing businesses that they can assist with adding staff, adding marketing, you know, improving the supply chain, etc., etc. That's what they are good at. So franchising happens to be, at its core, a distribution and growth model. That's the entire reason you would get into a franchise. So the private equity natural playbook of how to invest and grow businesses happens to work really well in franchising. And moreover, once you learn the franchise model, then as an investor, you can pull that playbook out and repeat it over and over and over. It doesn't really matter if it's an automotive franchise or a wellness franchise. or a food franchise, many of the tactics and strategies are the same regardless of what type of franchise it is. And then there's nuance, of course, in the type of business it is. But that's why many of the PE investors we see in franchising have actually become serial investors in franchising.

Interesting.

Generalists are— it's hard to be a generalist in this day and age. The market's very competitive. So, having a specialist knowledge and a sector like franchising can be a really powerful, really powerful thing.

Okay, so being a specialist, when you're talking about private equity firms, right? Okay. And is this a trend that has evolved recently, or we had generalists in the past?

It's a trend across private equity, right? So there are specialists who invest in healthcare, in tech firms, in manufacturing and retail, you know, because knowing that sector really well, building relationships allows you to be more effective.

Right.

And build relationships that you need in order to find companies to buy. So we've seen that in franchising as well, where many of the investors are serial investors. The biggest is Roark. They've got more than 100, 130 brands, I believe, Now that they've invested in franchising. So, if you think about all the franchise brands that have been touched by private equity since the '90s, Roark has touched 1 in 7 of those. So, that's pretty profound, but it just shows that once you sort of get franchising, that flywheel of investing can continue and you can make other investments across the sector.

Wow, this is quite insightful. And one quick question about the type of investors. How is private equity different from venture capital? This is a question I've been having for a long time.

Yeah, that's a good question. And, you know, now that the space is sort of very picked over, it's forcing private equity firms to contemplate going into smaller and smaller, less and less mature firms, right? Because typically a PE investor, you know, they've all got the minimum check size, but Usually about $2 million of EBITDA is at a minimum for at the franchisor level. But some, you know, can't touch you unless you're $5 or $10 million of EBITDA. They need much bigger businesses. But some are now dipping into much smaller brands that aren't yet mature or maybe even not even cash flow breakeven in order to find good investing opportunities. That's really more where venture capital and angel investors play. So it's forcing them to be very disciplined about what they're buying and why, because it takes so long to get a small brand to scale and make it a worthwhile investment.

Right.

So VC is different from private equity because they're willing to take on more risk. They tend to pick up earlier-stage businesses that have, you know, potentially a big payoff in growth. But private equity, traditional private equity is tries to avoid risk and prefers a sure bet that already has some amount of proven scale. So they invest at different points in a company's lifecycle.

Okay, I understand. So you mentioned $2 million EBITDA. So other than that, at what point does a franchise become appealing to private equity? What are other signs that, let's say, I as a franchisor should be aware of When it comes to attracting PE's interest?

Yeah, I think this is where private equity's influence has been the most important for franchising. PE wants to back good management teams, good brands, differentiated brands that have long-term potential for scale. You can only really achieve that if you have happy, satisfied, profitable franchisees.

Right.

So, this mechanism where you're only going to really appeal to a traditional PE firm, if you bring that to the table, is forcing franchisors to more closely examine their economic model in ways that, you know, previously they might not have been forced to do, which I think is positive for franchising. They want to back, you know, As I say, good teams, good brands. They want something they can get behind and accelerate, but still have more growth potential yet beyond that, because they're going to want to try and sell it to another buyer. So there's still got to be growth left in the engine for that next buyer as well.

Definitely. Now I can connect the dots. I remember you mentioned in the book, PE allows the franchise space to become more professionalized. I believe when you speak about management operations, it's in a way allowing the franchise space to become, pull up their socks, become more systematic in the way they conduct their operations. All right. This was a number, correct me if I'm wrong. So there are around 4K franchise brands?

Around 4,000 active franchise brands. That's according to FranData.

Got it. And there are about 400 new ones that are emerging each year. Why is the overall number the same, staying the same? Is it because not many franchise brands are growing? Are they dying off? What is it like?

Sure. It's a great question. I think we're launching too many brands that really aren't ready for franchising. So, if you launch a brand that's undercapitalized, or if the model really hasn't been proven out, then eventually you just stop franchising. Right? So it's not that the business necessarily failed. It's now they're just no longer offering it as a franchise to other people.

Mm-hmm.

So, you know, unfortunately, there's really not a high barrier of entry. For around $30,000, you can get a basic franchise disclosure document written for you, and you can get your legal paperwork put together so that you can now offer the franchise. But that's just the first If you don't have enough cash to support the franchisor and these now franchisees that you're bringing in, you're going to stall out. And I think that's what we've seen is that a lot of these brands realize, hey, it's kind of hard to be an effective franchisor. It's an entirely different business than the one that they, you know, maybe they started a restaurant or a salon or something else, and it's a good concept and they decide, well, okay, we should franchise this, but— Personally, I think you should have at least 3 to 5 corporate units before you consider franchising it. First, to prove out the concept and make sure that it works. And secondly, because you'll need the cash flow from those units to support building the franchise. You're going to need people supporting your franchisees. You're going to need to build out a marketing function.

Hmm.

You're going to need to invest in, you know, if it's a brick-and-mortar concept, you got to help them pick locations. So, you've got to have good analysis around how territories are designed and how you choose locations. You've got to have a really well-functioning finance team or person initially when you get started. All those things cost money.

Right.

And then in addition, you know, it's very competitive to sell franchise licenses. All of these, all this PE activity and all of the third-party professional sellers out there have made it extremely competitive and expensive. to find qualified franchisees. So now you're— you've launched your business, you're undercapitalized, and you can't get above the noise to attract anybody to your brand. And a lot of those little brands eventually decide, you know what, franchising is too hard. I'm going to stop franchising. I'm just going to keep running my restaurant or keep running whatever. We're not going to franchise anymore.

I see. So 3 to 5 units is something that you mentioned is essential. before one considers to think of franchising. Cash flow is a term I took, extremely important, and operations, which is the backbone of franchising. Okay. And how has the influx of private equity capital impacted the competitive landscape? So if we just talk about private equity here.

Sure. So if you think about it, we've got a lot of platforms. So one way to solve for this problem of having smaller brands that need help is put them in a platform so that now you have shared services. This makes it much more efficient to help lift and pull these smaller brands forward. So, and many of these spaces are very fragmented to begin with. So home services, for example, I think there's—

Right.

I read a stat somewhere that there's 13,000 HVAC companies, air conditioning and heating companies in the US. That's so many mom-and-pops as well as franchise concepts out there.

So many.

So that's what private equity does really well is they consolidate fragmented sectors, right? And rationalize it and pull them all under one umbrella. Well, but if you're a single brand and you've launched your franchise and you're competing against a platform that's got 30 brands in it, you're outgunned. You just— it is really going to be difficult for you to rise above that noise and attract franchisees. So, you've got to have a really strong organic amount of interest in your brand. You know, your customers should be asking you, are you a franchise? I love what you're doing. I want, you know, I might want to join this. Because if you try to win this battle on the internet, it's going to just be— very expensive and very hard for you to break out. And I think in some ways, you know, private equity has helped franchising think about itself differently, has refocused us as we should be more on unit-level profitability. But I think they also serve— they've changed the competitive landscape and made it harder for small brands to break in and break out. Which in some ways is good because it forces those smaller brands to build more corporate units first and really get that model right, or they don't have a chance of breaking out at all. And PE doesn't want those little firms, right? So they can't, they're unlikely to find a buyer as well to solve that problem.

Interesting. And so you mentioned platforming. Is there a chance these little franchise brands can find a way how they would be accepted within the platform? I mean, for that also, I believe there is some kind of filtration going on.

Yeah. Yeah, that's right. Some platforms cannot do that. They can't take a small brand. So, let's say you're an emerging brand with 2 corporate units and 5 franchisees. That's really tiny, right? So, by any standard. A few of the platforms might be willing to consider it, but think about it from their perspective. The lift of taking that business to the next level is just really high, and it's certainly not going to command a premium. They'd be just as well off, and some folks in franchising have done this, where they find a compelling mom-and-pop business, non-franchise. They buy that, build it up a little bit, and then start to franchise. That, that they could do that just as easily. So why would they want to acquire your, your tiny little emerging brand, right? They're not going to be interested until you're proven and have many more units and that they can see that you've got, you know, 20, 50, 75 franchise units operating and doing well. Now you start to look interesting.

Definitely. I think it's interesting to have these numbers in place because you realize if you're at 5, no way you stand a chance.

You've got a ways to go. Yeah, that— so that's where the undercapitalized issue comes in. I think people launch and don't realize they're going to be on their own for a while. It's— you're not even going to get to royalty self-sufficiency. That is the point at which the royalties you're collecting pay your bills. For many systems, that's at least 50 units, could be more. You know, you've got to run the numbers and figure out What is the break-even point for the franchisor? And you've got to have enough cash to get to that point, right? So, you know, the flip side of this is we've got franchisees taking on a big risk. Any business is a risk, but now they're going into a business that is very small and where the franchisor may be undercapitalized. for that franchisee, that's really tough as well.

Okay. So, understanding this landscape now, what would be the best way for franchisors to attract PE investment? I know you earlier mentioned operations, cash flow, etc. But what are the things that stand out and what should franchisors avoid in the process that would be a big red flag?

Yeah. So, you're looking for a model they can underwrite. Is this a good franchise proposition for the franchisee? If it's not, eventually growth will stall. And that's what PE wants. They want growth. So, they will back you if they see that you've got a sustainable, good model that they could get behind. They're willing to fix a few things, but it can't be a very heavy lift. They're not— most of them are not turnaround.

Right.

investors. They just want to accelerate an already pretty good growth proposition, right? So—

Right.

There might be some things they can help you tweak. So, for example, you might have a good concept, but maybe you haven't quite figured out how to break out in franchise development. You haven't quite nailed the marketing. They can come in and potentially fix that. But what they're not going to fix is a broken model where franchisees are not making money. So that's on the list of things to avoid. It's got to be a good economic model. They also, they want to back a good management team. This is where it's helpful to get some outside perspective on the team and sometimes even yourself as a founder. You know, it's hard for founders sometimes to hear that they're not the right person to take the business to the next level. But they shouldn't be surprised because there are certain skill sets in a lifecycle of a company. The person who is super creative and comes up with the concept in the first place probably is not the same person who can take it to 1,000 units of scale, right?

Absolutely.

So you've got to really think about your team and be prepared for the level of scrutiny of an outside investor who is not emotionally invested in your brand. To look at the team and go, is this a team I believe in? Can I back this team? And if you're not the right person to take it to the next level, being upfront about that and saying, I'm willing to take a different position or leave in order to take this business to the next level, is important. But usually they won't come in if they don't believe the team is good. They also don't like drama. Really of any kind. So, especially legal drama. You know, a couple of legal hiccups is just, it's part of business. But if you've got wide-scale issues, especially franchisee issues, they just, there's too many other opportunities. They're not going to waste their time trying to fix your mess. You got to fix it yourself.

Fix the legal drama. I see. So, you mentioned good proposition for franchisees. And this brings me to the question of franchisee relationship. So, when PE steps in, let's say they have a good proposition, all is good. When PE steps in, do they change the support system for franchisees? What should franchisees expect after the investment?

Yeah, this is— it's another good question. And I think why when people are considering a franchise investment, they need to really think about where that brand is headed. If it's a good brand and it's not already private equity backed, at some point it probably will be, which means change. Change is hard, right? So, even if changes are made that are well-intentioned, that change can still be hard on franchisees. So, for example, you might come into a brand and you're used to calling the founder, just pick up the phone and call the founder. But PE comes in 5 years later and now you've got to submit a help desk ticket, right? Okay, that doesn't feel as good and it can be irritating for franchisees. So, there's change of that manner, but that change would've happened anyway if the brand had achieved scale. They would've had to put systems in place to handle franchisee support issues and questions, right?

Right.

The difference is it's accelerated when you're working with private equity. They'll come in and make those changes really fast. And that can— the pace of change can be very jarring. But look, these are also profit-seeking entities, and sometimes they make changes that franchisees don't like because it hurts their perception of the economic model they thought they were signing up for. So, for example, if they change suppliers, if they push on development agreements, whereas before they might have been able to slide on them a little bit, now the PE-backed management team is going to enforce those agreements. And so that's when conflict can be set up. But overall, to be effective as an investor, you generally have to make changes franchisees are on board with, or you're going to have a stallout.

Right.

So that's where any investor, and it could be publicly traded, it could be privately held, it could be PE-backed, doesn't matter. If you're making changes and not at least consulting with your franchisees as part of a robust change management process, you're probably going to eventually run into problems. So, some PE firms understand that and know how to manage change in a good way, and others frankly can make mistakes.

And I bet in your experience, you would have witnessed PE firms that stepped in and might have had— there might have been chaos as far as franchisor-franchisee relationship is concerned?

It's helpful to get a franchisee association or an advisory council or both set up early. You want to get that set up before there's any sort of issue to contend with because you need that muscle memory of handling change together in a productive way, right? I mean, this is a dynamic world we live in. Change is what we all have to live with. How you handle change is whether or not that brand survives long-term. Think about the number of changes that have come along for some of these brands like McDonald's that were founded decades ago, right?

Yes.

That they have had to come back to over and over and over and figure out how to manage change together. There's a good way to do it and a not so good way to do it.

Adaptability and also, you know, looping in the franchisees because, yes, you are correct. In this particular industry, you have to factor in your franchisees. You can't just go without them. Earlier you mentioned that it's become a very competitive space as far as attracting franchisees is concerned. So when PE firms check franchisees' development pipeline, how do they check it? What are the red flags that they look into? What is it about?

Well, the first thing they check is your track record of getting units open. So your sales funnel is only as good as your track record of getting prior units open that you've sold. So if you open everything you sell, Then it almost doesn't matter how large that funnel is because they're more likely to say, okay, well, they've got a track record of getting these open. If you sell a bunch of units, especially if you're selling multiple packs at a time, so if you're selling 3 or 5 territories at a time, they're going to have more skepticism. They're going to say, well, okay, you've sold to Alicia. Alicia has 3 units that she's bought, but she's only opened the first one. And if all of your franchisees look the same way, then that funnel starts to look less and less valuable because you haven't proven that that franchisee returns to get the second one and the third one open. So you've got to be careful about building a funnel that's real. They will call franchisees and they will ask, Alicia, do you plan to open the other 2 units you bought? And Alicia will say yes or no, and here's why. Okay.

Wow.

So your critics are out there and they, you know, everyone's got an opinion and they take this validation with a little bit of a grain of salt. But if the theme is consistent across lots of franchisees that, no, I'm not going to open anymore because I'm happy with what I'm making, or worse, you know, this isn't what I thought it was going to be. And so I'm not going to get those other units open. Suddenly you've now really eroded your value. So you've got to be really careful about your sales strategy and how, how many of those units you want to sell in multiple packages and also ensure that you're getting them open.

That's a very good point. So they are also looking into second-degree funnel, which is after you sold it to your franchisees, what is their take on taking on the other Interesting. Okay, so funnel development is, is a very interesting process. They should have more and more prospects within their funnel, right? I mean, I'm just thinking it's about probability, right?

Yeah, I mean, they'll look at your success rate selling franchises for sure, but they care more about your ability to get them open and profitable.

Get them open. And retain them.

Correct. And retain them, right? So if you get them open and then 2 years after they open, a bunch of them are closing, now you've got a real problem on your hands, right? So, and they will call franchisees. They sometimes will do it directly. Sometimes they'll hire somebody like me to mystery shop and to pose as a franchisee and start asking those questions, right?

Interesting.

Because they don't— well, in a due diligence process, you've got to keep it confidential, but you've got to get the information you need. So, they will— they'll also check surveys that you may have done with your franchisees, and they'll want to read those. So, There's a lot of information they can glean from that, but they'll also want to look at your franchisees' numbers. And for emerging brands in particular, very often they're not collecting the P&Ls from their franchisees, and they should be, right? Because that's the data that suggests, okay, franchisees are making money. Yes or no? Are they making money? That's what they want to know.

Absolutely.

And if you're not collecting that data, then you can't prove it. And more importantly, they say, oh, well, maybe they don't care. Why aren't you collecting that data? And if you are collecting it, what are you doing with it? What do you do when you identify an underperforming franchisee? How do you help them? What can be done to turn that around?

This goes in hand with the— yeah, this goes in hand with the second-degree funnel you were talking about.

Yeah.

In a way, it does give an insight into whether they are planning to open Yeah.

Okay.

Got it. Do you think a potential franchisee, if I'm somebody looking for a franchise opportunity, should I keep an eye on PE's involvement before investing? Why should I care about it as a franchisee?

It's something to watch for sure. As I said, if it's a good business and it's not already PE-backed, at some point it might be and there will be changes. some of them you will agree with and some of them you won't agree with. So that's something to just keep in mind. Also keep in mind, you know, if there is no PE in there, why?

Yes.

Is it because it's a family business and they just simply don't want PE in there? That's fine. Some quite large businesses like Jersey Mike's has been, is not currently PE-backed, has been owned, you know, by that guy for a long time and has done quite well without PEs help, thank you very much. But you, you really need to assess what's going on in that brand and decide if it's right for you. But start with unit-level profitability and that relationship between the franchisees and the franchisor.

It's good that you mentioned Josie Mike's. It's good to factor in other brands that are doing great without PE as well. So, at the end of the day, it truly depends on your core needs, your where you are. And you mentioned that very well in the book, the lifecycle stage, and then being able to decipher from there on. There was one point you made in the book, which was about PE firms trying to balance short-term profitability as against the long-term brand development— no, preferring the long-term brand development as against the short-term profitability. What about that then?

Sure. So a traditional PE firm, that is a firm that's backed by pension funds, university endowments, sovereign wealth funds, that sort of thing, they have a timeline that they invest on, right? Usually they're buying it, holding it, building it up, and selling it all within— the average now is 6 years. 6-year hold time is the average, but it could be as few as 3, could be as long as 12 or 15, depending on the life of the fund. that's going to determine how long they can stay in the investment. So when they're thinking about making investments to grow the business, they're going to naturally prefer investments that have a fairly short-term payoff. So for example, improving a marketing campaign, right, to drive sales, to drive business, might be preferred compared to, say, a technology platform investment, which might take a couple of years to get going and then even longer to manifest as a benefit to the business. So, that is something also for franchisees to keep in mind is where if they're joining a brand that's been held by PE for a while, it's probably going to trade soon. And in which case, they might not be making as many investments in the business at the moment because they're kind of positioning it for sale, right? So—

Right.

Those cycles are just something you need to be kind of aware of. That's why having a franchisee association that can keep on that stuff to say, you know, look, it's— our technology platform is starting to get— make us noncompetitive. At what point do we— let's address that, right? Don't just let it fester. The association can kind of help steer those conversations to make sure that periodic investments are still being made in the business to keep it—

relevant. Totally, 100%. Okay, um, I, I have a very interesting question. This is something that I've been pestered about for a long time. It's, um, very industry-specific. So, you know, Cody Sanchez, she's been advocating for these less glamorous service sectors like home services, laundromats, window washing. How— and tell me if it's true— does Is PE interested in these sectors and what makes them such a good investment?

Yeah, the so-called unsexy categories are very sexy to investors because they kick off cash. That's what they care about. So think about non-recurring or recurring revenue versus non-recurring, right? So a one-time purchase is much less valuable than a membership or recurring subscription, to something. So for example, landscaping, you get the grass has got to get cut every week, right? That's much more interesting than a one-time visit to your house. So having businesses that have a lot of recurring revenue or have a membership model are highly prized by investors. And some of those services like window washing, gutter cleaning, landscaping, are very attractive for that reason.

Subscription. I think this is something that you mentioned in the book, but that was for another aspect. Once franchise brands scale up to a level, it's more or less like a SaaS subscription business, which attracts PE firms a lot.

Yeah.

Then furthermore, as you mentioned, maybe if it's the kind of vertical that you're looking at, which is more subscription-based, which is recurring revenue, that would attract PE investment as well.

Yeah.

Great point.

Yeah. Okay.

So here's my final question, and which is related to exit strategies. I just took note of that. So how do PE firms approach franchise enhancing franchise portfolios? You mentioned platforming. You also mentioned corporate-owned locations are turned to franchise units. What about that? And how does that play a role in exits for private equity firms?

So every brand is different on their philosophy of how many corporate units they want to have. Some are 100% franchised, have no corporate units at all when they get to scale. Others maintain some small number of corporate units. I personally am in the camp of having a few corporate units is good. It keeps Talent. You have a deeper bench of talent. You've got more credibility with franchisees because you're actually running these locations yourself, so you know what they're going through every day. It gives you a place to test new ideas, new products, and so on before you take it to franchisees to say, we tested it in our locations and here's our experience with it, right?

Right.

So, it also creates a little bit of extra cash flow to help fund operations. So all of those things are good. At exit time, though, what investors care about is the scale, the ongoing scale of the business, how much momentum it has, how much green space there's still available for unit expansion and recurring revenue, right? Because as you say, once you've got this flywheel going and you've covered your corporate costs, then every unit you add drops quite a lot of profit to the bottom line past that point, right? Because you can support 1,000 franchisees with a pretty small corporate staff. So that's why these large-scale franchise businesses, provided they're still staying relevant in the market and they're still growing and demonstrating they're a healthy business and and a good one for franchisees, they're kicking off a lot of cash flow and that's why they're attractive.

Okay, so my biggest takeaway is focus on the cash flow, focus on your operations, your relationship with the franchisees, and obviously the units, the funnel that you spoke about. This was a very interesting conversation, Alicia. I literally suggest giving all the players in this industry, try reading the book. You will have a fair understanding on why understanding PE's role in the franchise space is so important. And Alicia, thank you a lot for your time. I truly appreciate that.

You're welcome. I'm happy to be here and I'm glad for the questions.

Cheers.