By Derek Larsen-Chaney and Jason Pill, Attorneys with Phelps Dunbar, LLP Part 1 of CBJ’s series on corporate expansion surveyed some of the underlying reasons for expansion and identified external expansion as a costlier—but ultimately quicker—route for business growth than internal expansion. Part 2 takes a closer look at the main types of external expansion, exploring the pros and cons and providing industry examples of each option.

Merger

In a merger, two or more separate companies mutually agree to the formation of a new single company. Typically, the companies are similar in size and share common goals, including the goal of expansion. After the merger, the companies operate as a new entity and share ownership, profit, and control. Sometimes the new entity will have a new name, keep one of the company names, or take on a combination of the two. If one of the companies is more reputable, merging companies may choose to operate under this brand name. A climbing gym brand wanting to expand by means of a merger may seek out another like-minded and well-known gym chain. Example: In 2018, the two popular climbing gym chains Earth Treks—based in Maryland—and Planet Granite—based in California—merged to form the parent company El Cap.

Pros: Combined resources of two (or more) established companies, often united in a friendly business environment. The merger should allow the new entity to gain an instant presence in a broader market or reduce competition in the same market. Ideally, the merger expands the footprint of the joint enterprise and results in more efficient and complementary gym operations. Cons: Accepting the weaknesses of each company—debt, damaged reputation, etc. There may also be employee and location redundancies that need to be addressed post-merger.  

Acquisition

An acquisition consists in the purchasing of one company by another company. The company that acquires the other company is known as the acquiring company, while the acquired company is considered the target company. The target company is almost always smaller in size, structure, finance and operations than the acquiring company. There are two forms of acquisition: acquiring ownership of over 51 percent of the target company’s share capital or purchasing all the assets of the target company. The former is less common in the climbing gym industry because few gyms (if any) have shares that can be bought or sold. A climbing gym wanting to expand by means of acquisition may consider purchasing all the assets of a smaller gym or smaller chain of gyms. Example: In 2019, El Cap acquired the Movement Climbing and Fitness gym chain in Colorado, extending the El Cap network to 16 climbing gyms and 4 million patrons annually.

Pros:  Similar to a merger, the goal of an acquisition is to combine resources and expedite growth.  In an asset purchase, the acquiring company may be able to pick and acquire only the more attractive assets of the target company and exclude assumption of some or all liabilities. Cons:  An acquisition is not always a friendly procedure, can be extremely expensive (including costly legal fees) and entails managerial risks for the acquiring company. It’s also difficult to avoid assuming some liabilities of the target company since the sellers will want or need to satisfy debts before relinquishing control.  In addition, there may be a premium to be paid based on the “enterprise value” or “goodwill” associated with the target company. In the worst-case scenario, a backlash can ensue by the loyal clientele of the target company.

Partnership

Partnerships can be like mergers but do not always entail the combining of two or more companies. A gym that wants to expand but does not have the financial status to do so may seek private partners to assist in the funding of their expansion vision. In addition to financial assistance, outside partners can also help promote and market the expansion. Pursuing external expansion through partnerships is not uncommon in the climbing gym industry. Example: Before merging with Planet Granite, in 2017 Earth Treks partnered with Tengram Capital Partners—a private equity firm that specializes in consumer brands—to open new climbing gyms in Earth Treks’ existing markets and expand into new ones.

Pros:  For new and emerging businesses, institutional sources of financing may be hard to come by. Taking on private partners, whether they are actively involved in the business or passive investors, is often the easiest way to raise capital and diminish personal risk. Cons: The term partnership does not always mean together. Private partners tend to be a lot like private lenders—some expect to receive a large percentage share in revenue made, while others contract based off credit and interest. Partnerships can also lead to a significant reduction in the control an owner has in his or her business and, unfortunately, partners who were initially aligned do not always stay aligned. There may be a need to allow or force a partner out of the picture and that can be costly, even in the best circumstances.  

Franchise

Franchising is a separate form of external expansion that enables a business’s brand to be publicized broadly. Franchising involves the right to use a company’s brand and business model for a set period of time. The franchisee pays the franchisor to use its brand and the franchisor’s success depends on the success of the franchisee and his/her application of the business model. Given the unique nature of climbing gyms, the franchise model has not been common in the US. Example: In 2014, the Gravity Vault in Middletown, New Jersey, became the first franchised climbing gym in the US when it opened. Gravity Vault has since expanded to nine locations, with four more climbing gyms coming soon to New Jersey, New York and Pennsylvania.

Pros: Franchise benefits include instant name recognition and established “back office” infrastructure. Typically, the payment of franchise fees and royalties entitles the franchisee to—among other things—accounting, payroll, and benefits help, which can be otherwise burdensome to put in place. When franchisees succeed, franchisors can avoid the liability of a chain and the burdens of investments while enjoying the success of its brand expanding into new regions and territories, thus opening new market opportunities and sales channels. The franchisee also has a greater incentive than a direct employee because they, too, have a stake in the business. Cons: Franchising only works if there is preexisting demand, an established customer community in a given location, and guaranteed profitability for both the franchisor and the franchisee. If a franchisee fails, it impacts the reputation of all businesses under the brand name. Franchising is very challenging in the climbing world because most gyms are defined by the unique experiences they provide customers (such as the quality of routes, shapes of the walls, unique layout and assortment of educational programs) and are not easily replicated when compared to a cookie-cutter fast-food restaurant or clothing store. Bringing in new owners (especially those without climbing expertise) can create differences in customer experiences at different gym locations, and these differences can dilute or devalue the brand. Additionally, franchise agreements require strict compliance with the franchisor’s operational guidelines, which may limit the franchisee’s ability to run the gym the way he or she desires.

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Note: The content of this article is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. The reading of or reliance on this article or the Climbing Business Journal’s web site does not create an attorney-client relationship between the author or the Climbing Business Journal and the user or reader.

By Derek Larsen-Chaney and Jason Pill, Attorneys with Phelps Dunbar, LLP Most large corporations began as small businesses, typically with one location, before expanding into multi-billion-dollar companies and nationally recognized chains. Before becoming the world’s largest restaurant chain, McDonald’s was simply a hamburger stand. In the fitness industry, LA Fitness is a +700-club chain that started off with one location. How does a business—specifically, a climbing gym—know when it would be an optimal time to expand? Part 1 of CBJ’s series on corporate expansion looks broadly at the topic of expansion and dives into the two main options available to climbing gyms: internal or external expansion. Whether merging with another gym chain, opening additional locations, moving into a larger venue, or adding new products or services to your business, this three-part series will address basic principles of expansion that every gym owner should know before starting the process.  

Know the Underlying Reasons for Expansion

Business growth—here defined as more demand and more revenue for a business—is often identified as a need. Business growth can be determined by various factors, but pursuing internal or external expansion of a business’s supply is often seen as a step in the right direction which validates an entrepreneur’s success. Yet, with expansion comes change, including different managerial, legal, and financial challenges. Chris Warner, Founder of Earth Treks (now part of the El Cap family of gyms), once explained to CBJ that many owners “underestimate the luck” and fortunate circumstances which played a part in opening their first gym and gain a false sense of security when they try to expand too quickly. Sometimes, this mistake can be fatal. Expansion must be deliberate. Expanding even a small business can be a complex process. Throughout the process, it will be important to research targeted markets and understand corporate formation and how businesses grow. Business growth can be planned or completely unexpected. Planned business growth is ordinarily achieved through the aspiration of the owner(s). The owner has a desire to see the business achieve its full potential and makes changes to reach more customers and increase revenue. Common methods of achieving planned growth include, but are not limited to, expanding the range of products or services offered—by selling more of the same and/or something completely different—or changing the underlying business concept. As for unexpected business growth, it can be a benefit and a danger. Unexpected growth occurs when a business begins to experience an increase in demand for its products or services despite no additional internal efforts to do so. While the increase in demand may bring with it an increase in business revenue, if a business is not prepared to effectively manage this demand then it can result in careless decisions which lead to business failure. Expanding by scaling up and adding new locations is not always the right answer for gyms experiencing a surge of business.   Determining the best way to create or respond to business growth calls for strategic planning. The type of business strategy an owner ultimately chooses will depend on several factors, including the goals for the future, the size of the business, and the capital available. It is imperative that business owners understand the risks and rewards of each type of expansion and determine which (if any) is best for their desired growth levels in the long run.

Consider Internal Expansion First

Internal expansion concentrates on expanding the business by using the resources of the company. In addition to using the company’s own established finances, owners are often required to use their personal investments, money, and time. Businesses that participate in internal expansion typically keep the same brand name and services. Internal expansion provides the business owners with the flexibility of maintaining control over their products and services. A huge bonus in expanding internally is the high rate of financial return because the money is staying within the business itself, as opposed to being shared with external forces. When a gym decides to expand internally, it can do so in various ways. For one, a gym can expand its venue. Venue expansion is necessary when the business has outgrown its original facility. This usually occurs when more customers are consistently interested in the services the gym is providing and, in order to meet these demands, a gym decides to relocate to a larger venue or add more space for climbing, fitness or other onto the existing one.

A gym also can open additional facilities. The gym must decide where to open the new location(s) and the types of services to provide (maybe a shiny new bouldering gym?). At first, it may be beneficial to open a location not too far from the original one because the business has already established a strong customer base in that area. Additionally, although the first location may be crowded because of growth in demand, some customers may not be willing or able to travel to a distant new location, even if doing so ensures fewer lines and fresh holds. Internal expansion does not always call for opening a new facility or adding onto the old one. Sometimes, internal expansion can simply be the addition of new products or services within your current facility. A gym can expand by adding services such as yoga classes, personal training, nutrition advice, etc., and possibly experience comparable financial success from offering new services as from operating new locations. Some gyms begin as fitness centers with only machines and weight equipment and then add a climbing wall as an additional service.

All three options for internal expansion give the business owner(s) control over the process and allow funds to be reinvested into the business. However, remodeling a gym or building a new one takes time, and internal expansion is therefore often considered a slow and steady process.

Research the Risks and Rewards of External Expansion

Unlike internal expansion, external expansion depends on seeking outside assistance in order to expand. External expansion is known to be the riskier of the two forms of expansion because there is generally more money involved. However, external expansion is also considered the faster option and can happen almost overnight. External expansion uses corporate funds to purchase other companies or obtain additional resources and can include mergers, acquisitions, or partnerships. This can result in a gym coming together with other gyms, purchasing and acquiring other gyms, allowing itself to be acquired, or taking on new private partners. External expansion can help a business manufacture more products, enter into a new market, and gain the customer loyalty cultivated by another brand.   While external expansion is attractive because it often provides a quicker path for growth, the owner(s) almost always loses some form of control during the process. Typically, the infusion of external investment brings about new loan conditions, increased collateral securitization and, in some instances, a dilution of the owner’s stake in the company. External expansion which results in an increased ownership base can change the entire power dynamic of the company and impact the gym operations (e.g., the new investor receives voting rights and now must approve all major decisions or expenses above a certain threshold). Given the complexities of external expansion and the kaleidoscope of options, the next article in this series will dive deeper into the various forms of external expansion, with insight into the pros and cons of each one.

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Note: The content of this article is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. The reading of or reliance on this article or the Climbing Business Journal’s web site does not create an attorney-client relationship between the author or the Climbing Business Journal and the user or reader.