The Benefits of Financial Due Diligence in M&A Transactions for Multi-Unit Franchise Operators

Mergers and acquisitions (M&A) involving multi-unit franchise operations requires a meticulous approach to ensure a successful transaction. Potential buyers will need to understand all facets of the business on an overall and individual location basis. Financial due diligence (FDD) is a critical component of this process, offering numerous benefits that can significantly impact the outcome.

Both sellers and buyers will find value in this process. For sellers, when completed in advance of a sale process, it provides the opportunity to professionalize the data, identify and prepare answers for questions likely to arise and will generally lead to a faster smoother path to closing a transaction. For buyers, FDD will support the valuation or perhaps raise the need to renegotiate the purchase price or terms, identify potential errors or risks and aid in the decision-making process for investment committees, lenders and insurers. This article focuses on the key advantages of conducting financial due diligence in M&A transactions for multi-unit franchise operators.

One of the primary benefits of financial due diligence is the ability to accurately assess the value and future potential of the target business. By verifying financial results, normalizing earnings and assessing cash flow requirements a buyer will significantly improve the decision-making process both leading up to the transaction and during the integration phase.

Financial due diligence involves a thorough examination of the revenue streams of the multi-unit franchise operation. This can include unit-level, regional and overall analytics, a proof of revenue reconciling reported revenues to cash receipts, and a price volume analysis to consider contributing factors to changes in revenue. Additionally, an analysis of revenue by product, product line, customer or other relevant characteristics will be prepared to identify winners, losers and any concentration risks.

Examining the cost of revenue is crucial for understanding the profitability of the business. Cost of revenue includes the direct costs associated with producing goods or services, such as raw materials, purchased finished goods, labor, and freight expenses. Analyzing these costs helps determine the gross margin, which is the difference between revenue and the cost of revenue. A healthy gross margin indicates that the business is effectively managing its production costs and generating sufficient profit from its sales. Financial due diligence involves a detailed review of these margins overall and by other pertinent categorizations to ensure they are accurately reported, profitable and aligned with industry standards.

A detailed analysis of operating expenses is another critical aspect of financial due diligence. This involves reviewing rent, utilities, payroll, supplies, and other operating costs for each franchise unit. Understanding the cost structure helps identify areas where expenses can be optimized and provides insights into the overall efficiency of the business. Financial due diligence can also help identify potential missing expenses that may be paid by a management company or related entity with no allocation back to the unit-level. By comparing expenses to industry benchmarks, you can assess whether the business is operating efficiently or if there are opportunities for cost savings.

A significant benefit of financial due diligence is the ability to present a consolidated view of all (and only) the franchise units to be included in the transaction, which may or may not align with current reporting practices. This consolidated view provides a comprehensive picture of the overall financial performance, making it easier to assess the business’s value and potential. Assessing the profitability of each franchise unit individually is essential for understanding the overall financial health of the multi-unit operation. This involves analyzing unit-level financial statements to identify underperforming locations and areas where profitability can be improved. Additionally, FDD helps in normalizing store-level results by adjusting for non-recurring expenses, one-time revenues, and other anomalies. This normalization process provides a clearer and more accurate representation of the business’s sustainable earnings, which is critical for valuation and decision-making. By presenting both consolidated and normalized results, stakeholders can gain a deeper understanding of the true financial health and performance of the multi-unit franchise operation.

Cash flow is a critical indicator of a business’s financial health and its ability to meet financial commitments. Financial due diligence involves a thorough analysis of the cash flow of the business to determine if it has sufficient liquidity to operate effectively. This includes examining cash inflows and outflows, assessing working capital requirements, and identifying any potential cash flow constraints. A strong cash flow position is essential for the stability and growth of the business.

Assessing the debt levels and financial obligations of the target business can be crucial for identifying potential financial risks, though debt is often restructured in an M&A transaction making the existing debt structure less relevant. Evaluating the terms and conditions of other financial obligations, such as future equipment purchases, unit remodels and lease renewals helps identify any potential risks and ensures that the business can meet its financial commitments.

Performing financial due diligence builds trust and confidence among stakeholders and potential investors. Providing timely, detailed and accurate financial reports during the due diligence process fosters transparency and open communication. This transparency is imperative for maintaining trust and collaboration throughout the transaction. Additionally, having a thorough understanding of the business’s financial health provides leverage during negotiations, ensuring that the deal is structured fairly and transparently. This increases the likelihood of a successful transaction and benefits both parties involved.

Financial due diligence is sometimes performed in-house; however, most often a third-party advisor is engaged to run this process. The selection of the advisor can make all the difference in product quality, project timeline and risk management. Seek out a provider with a specialization in M&A who is familiar with multi-unit franchise operations. Ensure that you are working with individuals who are full-time M&A professionals with an understanding of the market and familiarity working with businesses of your particular size and complexity. Finally, choose a team of professionals you feel comfortable working with because financial due diligence is not a quick or easy process. FDD will consume time you may not have to spare and require the production of documentation that may not be readily available. However, working with the right advisors will dramatically lessen the strain on you and your team.

Financial due diligence in M&A transactions for multi-unit franchise operators offers numerous benefits, from accurate valuation and revenue verification to expense analysis and profitability assessment. By conducting thorough financial due diligence, stakeholders can make informed decisions, mitigate risks, and ensure the long-term success of the transaction.