Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives.

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1 Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives. Prepared by: Joe Fahey, CFA, Senior Director of Planning, Business Advisory Services, Wells Fargo Bank. In this white paper 1 Overview 1 The strategic plan for the business 3 The strategic plan for the owners (personal financial plan) 3 The keep-sell decision 4 Conclusion

2 Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives Overview. For certain individuals who possess an entrepreneurial spirit or who simply have a goal of being more independent (as opposed to working as a career employee), franchising may offer a safer way to own a business and be the boss rather than starting a business from scratch. The franchise sector is expected to grow at the fastest rate in five years.* Franchising covers nearly every industry and trend in the economy. While franchising has the element of only the strong survive, like any other business, for those desiring to start a franchise business, there is usually a lot of coaching built in from the franchisor and other franchisees on how to be successful. The franchisor offers a proven infrastructure and market knowledge to help manage the risks of entry and increase the chances for future success for their franchisees. The costs and complexity of running a franchise may be lower than creating a start-up. In most cases, the franchisor has developed a proven product or service and, supported by market research, can identify locations that offer strong demographics for success. The franchisor seeks to identify, train, and develop a distribution network of franchisees to partner with and execute their strategic plan. The franchise relationship offers a strong incentive for cooperation and a win-win partnership among all franchisees and the franchisor. The beauty of the relationship lies in both the franchisor and the franchisee sharing mutual best interests and motivations for success. The leverage is finding as many franchisees to execute on a proven model and formula based on the market demand for the product or service. Just like any other business, franchisees may need help in planning for a seamless ownership and management transition. In this paper, we ll examine several business and shareholder strategies that serve as key discovery items to help you organize and simplify the complexities of entering into a franchisor/franchisee relationship. The strategic plan for the business. Shareholder value is all about gaining and sustaining a competitive advantage, generally measured as above average industry profits. Franchisors benefit from converting a successful business model and gaining scale at a rapid rate with lower risks by accelerating their growth strategy through a distribution network of franchisees. The efficiency of scale is shared among all franchisor and franchisee owned entities. Franchisors help control the client experience with marketing and branding of the product or service. Size matters for both the franchisor and franchisee, as it reduces average costs and increases profit margins. 1. Financing. Franchisors gain growth and market share with other people s money, as franchisees typically pay an initial fee and ongoing royalties to the franchisor and obtain their own financing. The amount of debt to equity is generally controlled by the franchisor. Financial institutions tend to find the risks associated with successful franchises less risky than a one-off business in the same industry. The potential buying power of the franchisor helps franchisees manage costs, maintain consistency of the client experience, and improve profitability. The key to successful franchise growth and development is accurate cash flow forecasting. Based on the growth strategy, the franchisee needs to estimate operating margins, then account for taxes, reinvestment for capital expenditure, and working capital. Additionally, franchisees need to stay abreast of technology and branding changes. Maintaining property standards via periodic renovations or branding also needs to be included in the forecast. The more accurate the forecast, the more likely the business is to be profitable, and this positions the business for additional opportunities to expand the number of franchise locations. In the hotel space, for example, major renovations may be required every 5 10 years. This all *International Franchise Association, Two Reports Show Franchise Growth Expected to Increase at Fastest Rate in Five Years, June Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives 1

3 needs to be budgeted into the forecasts. Poor forecasting could jeopardize the franchisee s ability to maintain the quality standards and branding, and thus risks having the franchisors cancelling their franchise agreement. 2. Management and human resources. Generally speaking, a franchisee will possess an independent spirit needed to succeed as an entrepreneur and a desire to transition from employee to employer and to build their management team. In a similar way, a franchisor should look at their franchisees as key managers or partners and help them build and develop each franchisee team to help execute the overall strategic goals of the organization. The problem with starting a new venture is that most people lack experience in running a business and it takes time to gain the knowledge to run a business. With a franchise, the initial fee paid to the franchisor is used to help the franchisee get the pre-start, initial start, and on-going training and development, helping to serve as a kind of soft landing into the business world. Once established, the franchisee has some flexibility, within reason, to be creative in marketing and positioning their business. They take responsibility to identify, train, and develop the management and employee base. The employee development and transition plan may need to consider factors such as age, demographics, and retirement plans of the current management team. Thus, building and developing bench strength and a strong corporate culture will aide in the smooth transition of the business. 3. Incentive. The saying you get what you incent is easily translatable for the franchise business. The return on investment (ROI) for both the franchisor and the franchisee is tied contingently to the success of the business. Both parties are highly motivated to see the business plan executed in an optimal way. It is crucial to reward employees for a job well done, and create a corporate culture and working environment that allows for career development. The other common saying that you inspect what you expect is well entrenched in franchising by way of the franchise agreements, which outline the rules of the road and sets appropriate expectations. The franchisor gets to approve the key management team and ownership transitions. Sharing a fair portion of the profits with employees, based on both quantitative metrics and intangible corporate culture objectives, may go a long way towards building a loyal and proud work force. 4. Communication. The key to success for any business is its ability to design, communicate, and execute the strategic plan and vision. In addition to initial training, front-end expectations, ongoing feedback, and feed forward communication between the franchisor and franchisee allows for proper execution on basic fundamentals, as well as the ability to adapt to changes in industry dynamics, customers tastes, and desired company innovations. Quality communication enhances the trust between the partners. Integrated Strategic Planning: The Model. BUSINESS TEAM Strategic Plan (Business) Business Vision and Plan Competitive Positioning Succession Strategy Financing Retained Earnings, Debt, Equity Distribution Policy Operating vs. Passive Assets Entity Structure (C, S & LLC) Talent Top Grading/Productivity Demographics/Bench Strength Corporate Culture Incentive Tied to Strategy Reward and Risk Management Keep, Sell or ESOP Communications Strategy Wealth Creation An Integrated Financial Blueprint Legacy BUSINESS OWNER Wealth Management Strategic Plan (Owners) Personal Finance Plans Wealth Transfer Philosophy Private Business Governance Financing Income Liquidity Risk Profile Estate Taxes Talent Rules for Entry Training and Development Compensation Incentive Valuation Planning Legal Documents Optimal Shareholder/Asset Communications Strategy WEALTH TEAM 2 Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives

4 For the best interest of all stakeholders, the franchisor s role is to ensure that both parties are mutually interested in the success of the franchisee. The franchisor has an obligation to remove the bad apples for the good of all franchisees and revoke (or not renew) the franchise agreements with such parties. Franchisors never want to be in a position where they are far more interested in the success of the franchise than the franchisee. Additionally, most franchises have franchisee committees and work with the franchisors to communicate up the chain of command so that appropriate changes are made to keep the business healthy. The better the communication and spirit of win-win, the less likely the cross purpose objectives and attitude of taxation (royalties) without representation will permeate across the franchises. The strategic plan for the owners (personal financial plan). Generally speaking, the rationale for business owners to start and build a franchise business is to gain independence and build financial wealth. Another key reason for building a franchise may be to get your children and grandchildren involved in building a family business and legacy. Ideally, the business succession and exit strategy of the owners begins when the franchise agreement is signed. Thus, a financial plan to cover all contingencies such as unexpected death, disability or long, healthy life with transition to family or sale to management or third party should be outlined early and reviewed often. 1. Financing. Oftentimes, the start-up capital and risks involved in starting a business can be very high. With a franchise business, there is a known business plan and financial model, with upfront and ongoing costs (royalties), providing a seemingly clear expectation of what is involved in running a franchise. The rewards may not be as high as venturing out on your own, but the risks of failure are substantially lower. With franchising, a strong and predictable income stream can generate income to expand the business to nearly any size. Thus, the opportunities for substantial wealth for you and your heirs may be balanced with lower risks. Just as we discussed financing for the business, business owners also need to budget for their personal wealth strategy. If you re a business owner, it s quite likely that your business is intricately tied to your personal wealth plan, especially in the context of your retirement and business succession. It s important to build and maintain a diversified, liquid pool of assets outside of the business. Any cash not needed to manage the operations of the business should be invested outside of the business to manage the risks of litigation and to build a financial nest-egg for retirement. Gaining core assets and cash flow to support your retirement goals should help make the ownership transition to the next generation more efficient and harmonious. 2. Management and human resources (family) For some, a key motivation for owning and running a franchise business may be the opportunity to bring your family members into the business and grow the business together. You may envision seeing your children work hard and earn their place to become your successor. The beauty of having competent and qualified children and grandchildren join and manage the business is that it enables you to create and cultivate your own bench strength so that your business is set up to operate from a long-term business perspective. Also, the breadth and depth of experience needed to run a business will often overwhelm many new business owners. In pooling the talents of your collective family, it may be that you have the skill set needed to run a franchise successfully. A family-run franchise may also help perpetuate the strong, long-term perspective of the founders. Much like the franchisor, your family s investment in the franchise presents them with a mutual interest and motivation in having the business succeed. 3. Incentive. The opportunity to build and transition wealth to your heirs can be high with a franchise business. The franchisor balances and aligns the incentives for both parties when the franchise agreement is fair and well designed. The beauty of managing a successful franchise is that you have the ability to cash in when it comes time to retire by selling the business to your heirs, back to the franchisor, or to another franchisee. The incentive of the franchisees to build upon and grow the brand ultimately helps maximize the value of the business, and the attractiveness and readiness of the business to be sold to another buyer. The keep-sell decision. The keep-sell decision for a franchise owner can be complex. To the extent the business owner has taken some of the profits over the years and developed a diversified, liquid pool of assets that can provide financial security without selling the business, this scenario can provide the greatest flexibility for a business owner to decide whether to keep or sell the franchise. Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives 3

5 We encourage you to develop a keep versus sell snapshot of your balance sheet (your personal financial statement), cash flow, liquidity, and safety profile with your financial advisor. Then compare this snapshot against your family dynamics to determine how you can provide a fair and equitable wealth transfer plan for your children, grandchildren, and perhaps your favorite charities. Think of it as a macro, multi-generational family balance sheet, cash flow, asset protection/trust planning. The biggest question when it comes to business succession and wealth transfer of a franchise business is how to divvy up your wealth among your beneficiaries when your wealth is potentially tied up in an illiquid, privately held franchise business. Often the range of valuations is more predictable in a franchise business. This can help make the decision to keep or sell easier. Let s say, for example, your franchise agreement offers you the opportunity to sell back to the franchisor for a five time earnings multiple. Thus, an operation that generates $1 million can be sold for $5 million. With this established, arms-length valuation between the franchisee and franchisor, it may create a valuation opportunity for the family and its intrafamily transfers. While there are many strategies to implement a smooth wealth transfer and business succession, some business owners may agree that distributing the assets from the sale of the business may be easier and more likely to promote family harmony rather than trying to choose one successor and incur family discord. Moreover, the franchise agreement may dictate who may own the business and what percentage can be owned. It may require ownership transition to only active, employee shareholders, which would eliminate the option to share the business equally among family members, both active and non-active. In another example, let s say mom and dad have reached financial security outside of the business and want to gift some of the shares of the business to their children, but do not want to relinquish control or decision making. They could create voting and non-voting interests in the entity. The non-voting share may be discounted by 30 percent to a value that is 3.5 times earnings multiple. In this situation, since mom and dad have reached financial security, the wealth transfer planning can be more efficient and reduce the cost to transfer their wealth and business to the next generation. Why is this so important? With estate taxes, the cost to transfer the business shares could amount to more than 50 percent of the value of the franchise. With federal estate tax rates at 40 percent, and factoring in various state and local estate taxes and other legal and administrative costs, the amount could exceed 50 percent of the value. The costs and obligation for the taxes are borne by the estate/family, but from a business perspective, these costs are a hidden liability on the balance sheet of the franchise, especially if most of the wealth is tied up in the business (and owner occupied real estate). The question that needs to be answered is: upon the owner s death, how do you pay 50 percent of the value of the business, in cash, to the IRS, simply to stay in the game? Generally, you can t, and the business may need to be sold in order to pay the estate taxes. Thus, the incentive exists to begin your succession plan as soon as possible. As you build your business plan, you should integrate it with your personal financial and wealth transfer plan. The earlier you begin, the greater the possibility that you may reduce or eliminate the estate tax exposure, and transition the business efficiently and harmoniously. First and foremost, begin with cash flow planning of the company and build up the excess cash flow outside the business. Too often, the dual cash flow modeling of business and personal wealth begins too late, and hinders the ability of business owners to retire and transition their business, limiting their options. Conclusion. You can never start too early to integrate your business plan with your personal financial plan. A franchisor may be able to offer best practices on the business of running the business, but they are unable to share sound principles around business succession and personal wealth planning. Franchisors are competing against other franchisors to attract franchisees to buy into their growth strategy. To the extent the franchisor encourages the franchisee to design and implement a long-term vision that builds financial security outside of the business, developing an ownership and management transition plan consistent with the franchisor s vision, and efficiently transitioning the business ownership and personal wealth over time is a win for all parties. Our Business Advisory Services team can help with your business and personal wealth planning, beginning with a deep discovery of key facts and objectives of both the business and personal dynamics. We encourage you to reach out to your relationship manager to start the conversation. 4 Common Denominator Relationships: Aligning the Franchisor and Franchisee Objectives

6 Disclosures Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A., and its various affiliates and subsidiaries. Brokerage services are offered through Wells Fargo Advisors, LLC, (member SIPC), a separate non-bank affiliate of Wells Fargo & Company. Insurance products are offered through Wells Fargo & Company affiliate non-bank insurance companies. Not available in all states. Wells Fargo Advisors is the trade name used by two separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company: Wells Fargo Advisors, LLC, and Wells Fargo Advisors Financial Network, LLC (Member SIPC). M&A Advisory Services are offered through Wells Fargo Advisors, LLC (Member FINRA and SIPC), a non-bank affiliate of Wells Fargo & Company. Wells Fargo Bank, N.A. (the Bank ) offers various advisory and fiduciary products and services. Wells Fargo affiliates, including Financial Advisors of Wells Fargo Advisors, LLC, a separate non-bank affiliate, may be paid an ongoing or one-time referral fee in relation to clients referred to the Bank. The role of the Financial Advisor with respect to Bank products and services is limited to referral and relationship management services. The Bank is responsible for the day-to-day management of the account and for providing investment advice, investment management services and wealth management services to clients. The views, opinions and portfolios may differ from our broker dealers: Wells Fargo Advisors, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, non-bank affiliates of Wells Fargo & Company. This information is provided for education and illustration purposes only. Opinions represent Wells Fargo Wealth Management s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. Wells Fargo and Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depend on the specific facts of your own situation at the time your taxes are prepared. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the strategies mentioned. The strategies discussed or recommended in the report may be unsuitable for some clients depending on their specific objectives and financial position Wells Fargo Bank, N.A. All rights reserved. Member FDIC. NMLSR ID WM29814 ( /15) CAR#

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