FINANCING THROUGH THE LIFE CYCLE By Corrine Novato For franchise companies, the search for capital is often an excruciating experience. Unlike other businesses, franchisers often don’t have a lot of hard assets. Their value resides instead in things like trade names, service marks, and operations know-how. This lack of tangible assets makes lenders and other prospective financial partners nervous. They cringe at the thought of financing any business that lacks real estate, manufacturing plants, or that anything that can be used as security. In place of assets, financiers sometimes will bankroll a concern that has developed an innovation in technology or know-how that provides a competitive advantage. Here franchise companies stand a better chance. Often, they get their start from the development of a new patented process or operational improvement. Boston Chicken’s spectacularly successful initial public offering, which stemmed at least somewhat from its rotisserie cooking method, is perhaps the most outstanding example. But here, too, franchise chains sometimes fail to impress. Despite the lucrative potential that a dent repair franchise might represent, for example, it just doesn’t make investors’ mouths water as much as the prospect of a new microchip. With these two strikes against them, it’s a wonder franchisors find financial backing at all. But some do. Is it just blind luck, or do they know something you don’t? Paradigms…Or a Pair’O Dimes? In the search for capital, the business owner is often perplexed by the lack of vision on the part of funding sources. Why can’t they see the value of your business contribution to the community, or appreciate the jobs you can create, not to mention the money you can make? And why does the search for capital take so long? Or as in the fairy tale, why do you have to kiss so many frogs before you find a prince? The problem is that business owners and funding sources operate from different paradigms (pronounced similar to “pair ‘o Dimes”). In other words, the two parties view the world through their own set patterns of experiences. These paradigms, which can sometimes be limiting, can inhibit communication and problem-solving when business owners and funding sources meet. Your challenge is to locate the funding sources with the smallest paradigm gap from your own in order for a positive flow of capital to come your way. How do you do that? Five key questions surface early in the capital-raising process: 1. Where is your firm in its life cycle? 2. What are your personal objectives? 3. What are your objectives for your business? 4. Will funding sources find your “story” difficult to understand? 5. How does your firm’s need for capital match different funding sources’ investment paradigms? The life-cycle analysis is the universal element in any financing paradigm. It is your first building block to bridging your gap with funding sources. This article overviews the most common transactions for each life-cycle stage and the impact of your company being misplaced in the life cycle. THE LIFE CYCLE The life cycle consists of four stages. In Stage I, your business is in a start-up mode, a stage full of struggles and setbacks. You must test your concept to determine if it earns a superior return. You also have to begin to develop the people, methods, and systems necessary for growth. You are ready for Stage II only when your concept format or “success formula” has been replicated at multiple locations. One of the problems of Stage I is cash. Since your business will be unable to finance its growth with an internally generated cash flow, you will need to find external sources of money. Unlike Stage I, Stage II is characterized by accelerated growth as you roll out your concept. Nevertheless, this stage will also require external financing, even as your firm becomes profitable. In Stage III, your firm has almost completed its roll-out in its key markets, growth is strong and cash flow torrential. Your new strategy is to backfill your selected markets, and this may involve significant opportunities to acquire competing chains. Finally, in Stage IV, your sales growth begins to slip. Market growth slows and the battle for market intensifies. Your new challenge becomes how to diversify, reinvent, or, if necessary, exit your business. Diversification, for example, can take the form of an auto-aftermarket retailer adding service bays. Reinvention can occur through the application of a new “technology,” such as Taco Bell’s value menu strategy. As you will see, different forms of capital and different sources of funding are appropriate at each stage of the life cycle. STAGE I: START-UP In this stage, you are on the far left of the life cycle curve, where the risk is greatest and the potential return is the most difficult to see. That makes finding capital difficult, to say the least. Hardest to find capital for your first unit. (Actually, if that unit flounders, finding funds for the second unit will be even more difficult). So, most likely, capital at this stage will come out of your own pockets and from your “sweat equity.” Another source, however, will be your friends. Because of their personal experiences with you, they’ll perceive the risk associated with your venture as being less than an investor who doesn’t know you would. In fact, raising capital from either private investors, called “angels,” who don’t know you from Adam, or from venture capital firms, is virtually impossible unless you’ve been extraordinarily successful with a service or franchise business in the past. Even in that case, investors will want you to have a considerable stake in the business. To raise debt from a bank or a commercial finance company is difficult as well. In other words, after speaking to everyone in town, you still may not get the financing unless you’re willing to put your personal assets on the line. STAGE II: ROLL-OUT In this stage you want to inject a large dose of capital into your company to catapult it forward and build market value. If you’ve been successful in Stage I, equity capital from private investors or venture capital firms will now become more available. Limited partnerships, build-to-suits, and sale/leasebacks become easier. Senior debt from commercial finance companies and banks may also be available, but only with tight covenants, intense monitoring from your loan officer, and personal guarantees. An initial public offering, or IPO, also becomes a real possibility. And, if your growth continues, you may be able to complete a secondary stock offering as well. This is especially true for situations where your growth strategy involves acquiring other companies. If you don’t mind waiting, you may want to postpone an IPO until Stage III. By doing so, you may receive a much higher valuation, meaning you’ll raise more capital for a smaller portion of your company. If you decide to wait, you’ll still need to finance your growth strategy. Non-amortizing debt with an “equity sweetener,” so-called mezzanine debt, can make that possible. Here a note about franchisees and the life cycle is appropriate. Unlike other start-ups, a new franchisee in a national chain begins life in Stage II, not Stage I. For a franchisee, it’s not necessary to prove the concept or develop methods and procedures as other start-ups must. The concept is already fully proven. This is what makes it possible for many franchisors to establish financing relationships that make debt or sale/leaseback capital more readily available to qualified franchisees. Franchisees in the food service industry may run into their own unique funding difficulties. If they establish a management company which typically earns fees for managing units and real estate owned by a third party, they may have trouble finding a financial partner. Management companies have many advantages, but capital formation is not one of them. Funding sources prefer investing in an operating entity with assets and cash flow, and quite often a management company has little of either. So the moral is, care must be given that the legal structure of your business does not inhibit your ability to raise capital in the future. Less capital means slower growth, and slower growth means less progress in your life cycle. STAGE III: MATURITY In Stage III, a dramatic change takes place: Would-be financial partners come knocking at your door, rather than vice versa. Nevertheless, while your business objective remains the same–growth, and as fast as possible–your financing objective changes. You still need to finance your growth, but you also need to establish a more permanent capital structure. Building permanent capital can include: 1) refinancing a revolving credit facility; 2) refinancing earlier rounds of venture capital or mezzanine debt; 3) raising equity to increase borrowing capacity; or, most importantly, 4) creating a personal liquidity opportunity. In other words, a way for you to get your money out. If you haven’t gone public, you can now do so. If market conditions don’t favor that, however, mezzanine debt, linked to a revolving credit facility, can provide alternative. Structured properly, this allows your company to finance considerable development, maintain growth, and increase value. A private placement of senior debt with an insurance company is another option. Insurance companies typically offer interest rates, amortization schedules, and covenants that are superior to those offered by banks. If you have already gone public, you can use a secondary stock offering to raise growth capital, as well as to sell some personal stock. A final alternative is a convertible debt security, one that comes with low-interest debt and that can be converted into common shares. For some nationally recognized franchise food service concepts, a securitized transaction may be choice. Or, if you are a franchisor who has lent money to your franchisees, this is the appropriate stage to consider selling that debt to a bank or commercial finance company. STAGE IV: HARVEST In the Harvest Stage, you’ll choose to exit, diversify, or reinvest your business. You will be looking to lower your overall cost of capital and maintain future flexibility. The chart below gives a quick overview of the different options if external capital is necessary. As a private company, you may find that your previous financings complicate your exit strategy. For example, earlier sale/lease-back transactions may limit your company’s valuation because a large part of your equity build-up ends up going to the lessor. Selling your company is another exit alternative. Prospective buyers would include franchisors, franchisees, buy-out firms, or perhaps your employees through an Employee Stock Option Program. Life Cycle Analysis–Bridging the Paradigm Gap As you probably know, searching for capital is a less productive use of your time than managing your business. The agony of your search is compounded by presenting your transaction to the wrong funding sources and by communicating the wrong message. When that happens, you’ll experience frustration, and you’ll pay more for your funding. You’ll also waste a lot of your time. Meanwhile, your competitors will seize your opportunities, and ultimately your vision will take longer to become a reality. On the other hand, by considering your stage in the life cycle you can target the right funding sources and save time and money. One franchise company, for example, wanted capital both to grow corporate operations and to provide a large financing pool for franchisees. The company went looking for funding without considering its place in the life cycle or the paradigms of these potential financial partners. Predictably, it came back empty-handed. The gap between the company’s paradigm and those of the potential funding sources was too great. Ironically, its eventual financier was right under its nose. The company’s own distributors viewed its potential much the same as the company did, and they agreed to make more capital available than other potential funding sources. Same company, same transaction, different business values. The life cycle allows you to explore the impact if you were to change the structure of your transaction. As an example, one company initially planned to use a term loan to finance acquisitions and new unit growth. It later learned that asset-based lenders positioned the company in a more mature life-cycle stage than cash-flow lenders. The company was able to complete an asset-based transaction that provided more capital at a lower cost. Same company, different transaction, different investor paradigms, different business values. You can better market your transaction to funding sources by using a life-cycle perspective. Your presentation needs to show that your transaction fits within the funding source’s investment paradigm. It does no good to address the right market with the wrong message. Another company was able to sell franchisee loans to a lender not familiar with franchising by showing the lender how these loans fit into his investment paradigm. Right market, right message. The life-cycle orientation allows you to proactively manage your capital flexibility. You can assess the impact of each financing on your future capital game plan. Having the capability to choose the best alternative allows you to maximize your company’s value. You don’t want to be forced into a sub-optimal transaction because of a previous stage financing. Of course, there is more to the search for capital than just life-cycle analysis. And there are many more financing options available than discussed in this article. No single factor, however, drives your search for capital more than your stage in the life cycle. Corrine Novato is an independent Walnut Creek-based franchise investment consultant.