Legal & Financial Advice

by Simon Lord

last updated 02/09/2017

Private equity and franchising can make bad bed-fellows

by Simon Lord

last updated 02/09/2017

August 2017 - The problems surrounding Veritas Investment's franchised brands will make investors wary of franchises - but is it franchising or the management of a relationships business by financiers that is the problem?

Franchising is fraught with all sorts of perils and pitfalls for the unwary, as we've been pointing out for over 25 years but, done well, it can be a superbly efficient way to deliver a wide variety of products and services. However, the concept of a lot of small business owners investing in, and having some say in, a large brand often sits uneasily in the minds of venture capitalists and the Stock Exchange. Despite the undoubted success of the franchise sector (as detailed in the recent Franchising New Zealand survey), following the announcement that Veritas Investments is in trouble with its bank, we can expect financiers to look down their noses at franchising again.

It's not possible at this stage to say what went wrong in the franchised parts of the Veritas business - Nosh and The Mad Butcher - but an article in the Australian Financial Review (AFR) in July 2016 about the problems of the Eagle Boys pizza franchise gives some insight into how the financial markets might think.

The article was headlined Eagle Boys collapse puts franchising sector on notice and detailed the decline of the struggling chain, which once had 340 stores and was the second largest pizza chain in Australia. Today, the AFR said, it has just 112 franchised stores, with 20 existing franchise agreements having already expired and another 40 due to expire by the end of 2018.

‘Eagle Boys has not only rocked the fast food industry but has put the $170 billion franchise industry on notice,’ the AFR mischievously reports. ‘In 2015 the top 10 leading players in consumer foodservice in Australia operated through the franchising system.’

It all sounds pretty bad, doesn’t it? And if you are an Eagle Boys franchisee, it was bad, no question. But how did things get to this state – and is Australian franchising really doomed because of it? AFR seems to want you to think so, but if you read on, it becomes apparent that the fault lies not so much with the franchise model but something else entirely – a change of ownership that put the wrong people in charge.

Lack of understanding broke the business

The report says, ‘After private equity group NBC Capital bought 85 percent in 2007, cracks started to appear in the business as it repositioned the brand and introduced a new management team. Things started to unravel, with a revolving door of management and litigation with franchises. Against this backdrop, arch-rival Domino’s went from strength to strength.’

In other words, one franchise failed while another succeeded. What was the difference? Domino’s was owned and run by people who understood how franchising works and the importance of selecting, training and supporting franchisees to make sure they succeed. Eagle Boys was bought by people whose only interest was in achieving the maximum return on their investment and who destroyed existing relationships in doing so. Now their investment – and that of many franchisees – is pretty much worthless.

As the AFR notes, ‘Franchisees have spent a fortune investing in the network, which suggests a lot of money has been destroyed in recent years. Who lost what, and how it came to this, needs to be properly investigated.’ It certainly does – but, despite the headline, I don’t think it will be found that franchising was the problem.

Long-term development vs. short-term gains

In truth, private equity and franchising often do not mix well – franchising is about long-term development, not short-term returns. There are exceptions: as franchising lawyer Stewart Germann points out, in New Zealand it worked for Guthrie Bowron for a while, although that has now returned to private ownership and, as Callum Floyd points out in this article, private equity and listed company ownership can have pros as well as cons. ‘But as for the Dick Smith brand, private equity was greedy and the inflated price paid by the purchaser caused the demise of those wonderful Dick Smith stores in Australia and New Zealand,’ Stewart says. ‘There also seems to be a problem at present with private equity in the form of Veritas Investments owning the Mad Butcher brand. What do I put it down to? Simple – the relationship between a franchisor and its franchisees is built on mutual trust and respect, both of which are often lacking when private equity investors come into franchising.’

As Reacher Gilt, the exemplary venture capitalist in Terry Pratchett’s Going Postal says, ‘You make money as it runs down, you make money building it up again, you might even make a little money running it, then you sell it to yourself when it collapses.’ That might be all very well for managed businesses (although the thousands of little tragedies it creates for employees along the way say otherwise), but it’s a recipe for disaster when you have a business model like franchising.

In franchising, the health of the franchisor depends upon the health of the franchisees – people who have also invested in the brand, if not the company, and who expect to make their money ‘along the way’. You have to care about people as well as profits. That’s why private equity and franchising often make very bad bed-fellows – for the franchisees, at least.

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