The example above shows what happens to the sale value of a business when the risk for the buyer is reduced. If the RRR used in the valuation calculation is reduced because of lower risk, then the maximum price a buyer is willing to pay increases. This has great significance for franchised businesses, because a good franchised business system includes many risk-reducing characteristics.

I group the risk reducing factors of franchised businesses into three types: those that support the system, the relationship between franchisor and franchisee, and marketing benefits. Some of the more obvious factors which reduce risk are given below:

Support Factors

There are a number of documents and procedures that have become standard items in well developed franchise systems.

1. Good franchisors issue disclosure documents to purchasers of franchises. The disclosure document gives background information on the identity, financial health and viability of the franchisor.

2. The franchise agreement sets out in detailed form, the responsibilities and authorities of both parties. In the final analysis it is an insurance policy for both sides and helps the business system to run smoothly and effectively.

3. In established franchises a proven business system has been developed and documented in a set of operational manuals. The manuals provide a clear operational path and detailed methods and procedures that keep the business operator focused on producing efficient outputs and consistent quality.

4. Even in younger franchises in most cases pilot operations will have been run to test the system. These provide invaluable sets of operational information that help new operators to be successful and also provide sets of performance benchmarks that can be used for financial forecasting.

Relationship Factors

1. Franchising differs from other businesses at the time of a sale in that the franchisor, who is directly or indirectly involved in the sale, stays in an ongoing and often personal relationship with the new operator. The success of the franchisor and the franchisee are bound together in an interdependent relationship. It is in the franchisor's best interests that the franchisee is successful.

2. In addition, a franchise system is a family of businesses which together represent a pool of experience and knowledge. Support and learning from other franchisees is always available.

3. In most cases the relationship with the franchisor extends to ongoing training and management systems support. This improves the competency of new business operators and provides a system of in-house management advice and trouble shooting.

Marketing Factors

1. Franchised businesses have stronger branding and market presence. They are more visible in the marketplace due to multiple locations and regular advertising.

2. Combined marketing budgets enable the use of professional marketing services. Promotion and advertising are well planned and organised, and advertisements are professionally produced, giving stronger communication to the market.

3. Group purchasing factors enable franchised systems to buy at better rates and from a wider range of sources than individual businesses. Lower costs convert directly into competitive advantage over other businesses.

4. The impact of competitive activity and market changes is often reduced because the franchisor will be working on future developments all the time. Franchises often lead market changes rather than following them.

These three groups together will have a significant downward impact on the RRR used for valuation purposes (dropping the market rate to perhaps 20% in cases of a well managed franchise). This reduced risk helps to explain the higher economic value attached to franchised businesses.

By producing good financial results over a number of years and recording them in reliable accounting systems, the value continually improves. An investor who runs a franchised business efficiently stands to make a good capital gain on resale of the business, because strong recorded profits combined with low risk will make the business an attractive opportunity and maximise the selling price.

VALUE FOR MONEY

One of the reasons people give for 'going it alone' rather than buying a franchise is because they resent paying a franchise fee – some comment that it is like paying goodwill for a business which hasn't got any customers yet.

But valuing assets, as we have seen, is a flawed process. If instead you use the procedure of capitalising NPBIT which looks at the whole performance of the business, you see a picture which more truly reflects the value of a proven franchise system.

If you look at the example I gave above and apply a RRR of 20% to the equation, it produces a value of $150,000 – or $55,000 goodwill. That figure is significantly higher, but reflects the lower risk of buying a franchise. Rather than goodwill, you might call it the franchise fee. And you might consider it a sum worth paying for a greater chance of success, because no matter how cheaply you buy a business, if it doesn't succeed you will lose your money.

At the end of the day, many will tell you that a business is worth what someone is prepared to pay for it. To some extent that is true, but as a prospective business purchaser it is up to you and your professional advisors to ensure that you do not pay more than the investment is worth to you. Buying a franchise can offer many significant advantages. The lesson to be learned from valuing businesses by their profitability is that the apparent 'additional' cost of a franchise fee may be worth every cent.

Supplied by Leith Oliver a lecturer in management, small business and franchising at the University of Auckland.

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