Is Refranchising Right for You?
What do Wendy’s, Popeye’s, TGI Fridays, and McDonalds all have in common? Each of these brands leverage “refranchising.” Refranchising is the selling or conversion of company-owned stores to existing or new franchisees. Refranchising is not a new concept but is an increasingly popular trend in the restaurant industry.
Refranchising has the potential to improve profitability and increase value by achieving:
- Higher Profit Margins - Under the refranchising model, franchisors earn royalties from franchisees without the burden of the overhead costs from operating as a corporate store.
- Increased Cash Flows - If franchisors own the real estate, cash can be generated with the sale or rental of the real estate to the franchisees. In addition, additional rent based on a percentage of sales may be charged.
- Lower Capital Requirements - Refranchising requires lower capital expenditures and related debt as these costs are pushed down to the franchisees. This is attractive to investors because of decreased leverage on the franchisor’s balance sheet.
- Improved Operations - Franchisee locations typically perform better than corporate stores as individual franchisee owners maintain better control over labor, marketing, and pricing decisions. Further, typically under refranchising models, franchisor entities require certain remodel investments, thus improving business performance with increased foot traffic and brand reputation while passing on the capital outlays associated with remodeling to the franchisee.
- Eliminating Costs - Refranchising can eliminate corporate operations teams, making refranchising more profitable to the investors by reducing selling, general and administrative costs.
With all of these benefits, why are some brands avoiding the trend of refranchising? Refranchising is not the only way to turn around corporate-owned stores. Some companies focus on cutting costs, targeted marketing, labor modeling, and menu engineering. Further, the sale of real estate is possible through sale leaseback transactions while maintaining corporate store operations, thereby increasing cash flows. Other franchisors want to keep a strong relationship with the franchisees and show they have skin in the game and believe in the brand.
If you are considering refranchising, there are a few accounting and tax implications to understand. When refranchising occurs under generally accepted accounting principles (GAAP), a franchisor recognizes an initial franchise fee from the franchisee and a gain or loss on the sale of the property and equipment. Under current guidance, the initial franchise fee is recognized when substantial performance of the franchisor obligations is complete. Typically, completion of substantial performance is deemed to be the date of the opening of the franchise location or in the case of refranchising, upon transfer of ownership. Franchisor obligations often include initial training and new restaurant opening assistance, as well as other ongoing support and training. Under ASC 606, as described in a previous blog post
, initial franchise fees will generally be recognized over the term of the franchise agreement. The recognition of a gain or loss on the sale is calculated by taking the total consideration received from the sale of the business, less the net book value of property and equipment and intangible assets pertaining to the store. The gain or loss is recognized when all significant conditions of the sale have been satisfied.
The sale of corporate-owned locations will generally be treated as a sale of assets for income tax purposes. The tax treatment of the gain or loss on the sale will vary depending on the length of time the stores were previously owned, the amount of proceeds generated on the sale, and the amount of tax depreciation claimed on the assets. A typical sale will generate a mix of ordinary income and capital gain. Every situation is different, and you should consult your tax advisor for advice specific to your situation.
There are several factors to consider when deciding whether to refranchise, including: brand positioning, investor expectations, risk, opportunity, and GAAP and tax impact. It’s critical to weigh the full picture of refranchising and your business’ unique needs to determine if it’s right for you.