There has been a profound impact on the restaurant industry due to the Coronavirus pandemic. Over 1.4 million jobs had been lost and over 32,000 franchise businesses had closed as of the beginning of Q4 2020. With states opening up and business returning to normal, we are cautiously approaching the end of the tunnel. Despite the return to "normal," franchisees are still considering their futures.
As reasons for considering exiting the health care system, they cite labor market issues, the lack of a formal succession plan, capital expenditures required to complete impending renovations, or simply fatigue from the stress fostered by the pandemic. Franchisees who are less risk-averse and interested in expanding their businesses through acquisition also have a plethora of options available. Nevertheless, potential restaurant buyers should proceed with caution: the pandemic has introduced new obstacles and pitfalls. Let’s look at four of them here.
Valuations
Franchisees are having difficulties determining the actual value of the restaurant they want to sell since the pandemic has altered their 2020 financials so radically. Some sellers will seek to treat 2020 as an anomaly and implement a blended average methodology, whereby 2019’s pre-Covid financials are taken into consideration when valuing their networks. But that strategy comes with a risk. There is no guaranty their store’s performance will return to 2019 levels; thus, the ensuing valuation may be artificially inflated, resulting in the buyer overpaying for the restaurants.
Many sellers find it more beneficial to use the trailing 12 months' sales as a benchmark for valuation. Under such circumstances, buyers must be cautious to recognize that 2021’s sales figures are likely enhanced by: 1) an increase in average product pricing, and 2) the stimulus checks, which were rolled out as part of the CARES Act.
Drive-thrus
When restaurants became short-staffed during the pandemic, the drive-thru contact-light model saved them. The largest percentage of stores closed are restaurants without drive-thrus. In 2021, most drive-thrus continue to outperform despite the pandemic. Those without drive-thrus are therefore much harder to sell and market for the same reason.
Covid-Deferred Rents
As a result of the pandemic, many franchisees negotiated rent deferments with their landlords. Occasionally, deferred rent was to be repaid as "additional rent" throughout the lease term. Buyers must demand that the seller repay all such deferred rents before the closing date. A failure to do so could result in the buyer being saddled with additional rent payments after closing, despite not receiving any benefits from the deferment.
CARES Act Funding
The two most prevalent forms of CARES Act funding franchise owners took advantage of during the pandemic were the Paycheck Protection Program (PPP) and the Economic Injury Disaster Loan (EIDL).
The PPP funds took the form of an unsecured loan, which, if used for its intended purposes, can ultimately be forgiven by the SBA. On Oct. 2, 2020, the SBA issued a notice, setting forth the required procedures for changes of ownership of an entity that had received PPP funds. Among the mandates is the requirement that the seller of any business with yet-to-be-forgiven PPP loans obtain consent for the transaction from their PPP lender. Consent entails a two-step process: 1) the borrower must apply for the forgiveness of all outstanding PPP loans; and 2) the borrower must enter into an agreement with their PPP lender to escrow the full amount of all outstanding PPP loans until forgiveness is granted. As a result, any prospective franchise network buyers need to ensure that all necessary consents are obtained from third parties, including the PPP lender, before closing the deal.
EIDL loans were made directly by the SBA to many franchise owners. Unlike the PPP funds, EIDL loans in excess of $25,000 were secured with blanket liens on all of the borrower’s business assets. Thus, in advance of any closing on a franchise acquisition, the seller should be required to obtain a payoff letter from the SBA, including the full amount of the payment necessary to satisfy the loan, and a covenant to terminate the lien upon receipt of such payment.
Forbes magazine recently quoted IFA data predicting 2021 will bring the largest yearly growth in franchise establishments ever. We will have to see if that comes to fruition, but many units are already changing ownership. As such, it is more important than ever that franchisees adhere to their attorneys’ advice.
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