If you’re considering buying an existing franchise, you’ll have a lot of questions, the two primary ones being, ‘Is the price reasonable?’ and ‘Why is it being sold?’ Here’s your roadmap for figuring out whether it’s a deal you should go for.
There are two types of franchises offered for resale: Successful operations that are profitable; and units that are either losing money or barely making ends meet. Each group represents an opportunity, but the risk associated with the second group is a lot greater.
During your investigation, determine which group the unit falls into, and which group you think it can fall into after you’ve owned it for a while (and don’t assume it’ll stay in the same group it’s currently in once bought).
Questions to ask yourself
- What is the motivation of the seller to sell the business?
- Why now?
- They’re ready to retire or want a change of pace
- They’re trying to escape unbearable work hours, work load and hassles
- They know about some future change in the industry or brand that’ll make the business less viable and want out
The first answer is relatively easy, but the other two will take digging as the honest answer might lead you to abandon the sale. To be safe, you need to talk with the seller and look to other sources for information. These include the franchisor and competing chains.
What you really need to find out from the seller
- Is their reason for selling completely believable, and does it suggest anything negative in the future?
- What has the financial performance of the franchise been over the past year or two? What are the reasons for the trend if it’s positive, flat or negative?
- How important and likely is retaining key employees to unit success?
- How site-dependent is the franchise for success? Is the real estate secure and will there be any future road, building or centre construction that might affect positive results?
- Do they know anything that hasn’t been disclosed that might hinder future performance? (Your attorney can include the answer in the purchase contract to protect you.)
What to ask the franchisor
Investigate the franchise as if you were going to open a new unit. It will give you valuable information to understand the business and ensure you’ve asked the seller all the right questions.
Confirm with the franchisor that information you’re received from the seller is correct. They might be cagey because of legal liability, but they also don’t want you joining their system under false pretences. If the seller isn’t being honest, you’ll pick up clues from the franchisor.
How to determine reasonable price
If you’ve determined the existing franchise’s future performance will be positive, you’ll have a fairly easy time dealing with price since there are existing earnings to work with. The best valuation method is to use a multiple of the net cash flow you’ll receive from the business.
Determining Net Cash Flow
Net cash flow is the difference between a business’s revenue and the necessary business-related expenses required to produce the revenue. You’ll find these in historical financial statements of the business.
Many business owners run expenses through their company that aren’t really required to operate: Company cars, rugby season-tickets, meals, entertainment, or a handsome owner salary.
Take the business’s net income and add back unnecessary expenses to determine the true net cash flow to expect.
The price of a successful business should be two to five times the net cash flow number. The more stable and dependable the cash flow, the higher the multiple. The multiple is also higher when the trends of the business growth are positive rather than flat or negative.
Pricing when the business isn’t performing well…
This is when pricing is more difficult. The existing owner will have many good arguments why the business isn’t performing, but it ultimately comes down to whether a simple change in ownership will fix the problems.
About the only time this is true is when the existing franchisee isn’t following franchisor rules. If others are complying and doing fine; and you’ve determined there aren’t other problems, like bad location, proceed with some confidence. Here’s when you can get a real bargain.
Evaluating resale price
To evaluate the resale price on a struggling unit, start with the total cost to open a new unit, including all marketing and operating costs to operate a new unit until you reach average break-even time.
Then subtract a liberal allowance for investing in marketing and operating expenditures to get the resale unit to break-even. Also subtract a liberal allowance for any infrastructure investments you might need to get the physical store and staff up to scratch.
The difference in this calculation represents the absolute maximum price you should even consider paying
If the seller isn’t happy with this method of valuation, that’s fine. You’re the one who has to live with the purchase. Walk away unless it looks like a very strong opportunity to you.
Feel free to tell the seller to find a buyer at a higher price and call you back if that attempt fails… There’s no line of people waiting to buy unsuccessful units.
If/When they come around, get a good attorney experienced in business purchase agreements before going forward with the purchase. They’ll assist you with all the requirements for completing the transaction and can point out a host of protections you may not have thought of.