Buying a franchise
- byIn
Despite the success of many
franchise systems both in NZ and overseas, there still
exist some misunderstandings and even suspicion about
franchising on the part of prospective purchasers. If
you buy an existing business you can look at the outlet
or the plant, look at the trading history, see real
figures and real customers. But if you buy the rights to
set up a franchise in a new territory, doesn't it seem a
lot of money to pay for something which doesn't even
exist yet?
In any existing business, the
seller will ask an often substantial amount of money for
an item called "goodwill" – the factor which assumes
that because the business has an established client
base, they will keep on coming when the new owner takes
over. There is certainly merit in this concept, but I
have seen many cases where goodwill figures of
$30-50,000 have been asked when the real value of the
business has been nowhere near the total amount asked.
The problem for any prospective
purchaser, whether of an independent business or of a
franchise, is to know what it is really worth. I would
like to suggest a way of working this out, and to look
at how you can apply this process to evaluating a
franchise.
From a purchaser's point of view,
buying a business is an investment decision. Like any
other investment decision, the value of the investment
is based upon the returns available from it. Where you
are purchasing a business, the returns are represented
by the trading profits, and so the purchaser is mostly
interested in the value of the available profits that
the business can generate.
Of course, in a new start-up
business (such as a franchise), there may be a
particularly important element of capital gain to be
considered as well.
WHAT DO YOU VALUE?
When a business is offered for
sale, the seller will ask a price based on the values of
various assets. The most obvious of these are the
tangible assets of the business – the plant and
equipment used to run the business, and the stocks of
goods that are traded. In many cases, other intangible
assets are also included in the asking price. These may
include goodwill, branding and trademarks, and
manufacturing or trading licences.
Although they are the most obvious
of the items to be valued, establishing the true value
of tangible assets is not straightforward. For example,
should assets be valued at book value (the value they
have in the business's accounts) or at market value (the
price you would get for them if you sold them tomorrow)?
Computer equipment is a case in point. If the business
paid $5000 for a computer system last year, it might
still be worth $3300 on the company's books – but who
would buy an out-of-date computer for that much money?
Ultimately, the price for the
assets is a matter of negotiation between buyer and
seller. If the value of the assets is set at a higher
level, then the buyer benefits from future available tax
write-offs. If the assets are valued low in the purchase
transaction, this benefits the seller through current
tax write-offs.
Another question to ask about
tangible assets is: "Are they the right assets? Are they
the right type and quality, and is there the right
amount?" If the assets are inadequate, then extra funds
will be needed quickly to get the business functioning
properly. Alternatively, if too much money is tied up in
inefficient assets then the business returns will be
poor. When you buy a franchise, you know that you will
be getting the benefits of the franchisor's experience
to ensure that you buy the right equipment and the right
stock to start up with.
INTANGIBLE ASSETS
From a purchaser's point of view,
the intangibles such as goodwill and branding present an
even greater difficulty in valuation because the values
used may be discretionary and subjective – they may be
just what the seller thinks they are worth, and may have
no foundation in reality.
On the one hand, the fact that they
add value to the business is obvious – but how much
value? On the other hand, what happens if the business
doesn't do well and the assets need to be sold – will
these intangible assets have any value then? A good
franchise brand will – an independent name won't.
These questions are all hard to
answer, and generally mean that a purchaser should not
use asset values directly in establishing a purchase
price for the business.
VALUING THE PROFITS
To my mind, valuing the profits is
the solution to the problem of valuing a business. If we
regard the purchase of a business as an investment, then
the true value can be established by valuing the profits
that result from its operation in a given business
environment. This method takes the business as a total
operational unit and values its ability to produce
returns for the shareholders.
The following outlines how to value
a business by capitalising the net profit.
Every investment has three
components:
1
The dollar amount invested
2. The dollars returned from the
investment.
3. The return expressed as an
interest rate received on the investment.
These form a simple equation:
The Investment x The Interest Rate
= The Return
Eg, an Investment of $20,000 at 10%
Interest Rate would give a return of $2,000. And,
rearranged, you can say The Investment = The Return ÷
The Interest Rate.
When purchasing a business, we want
to calculate what the Investment value (ie, the price)
should be. Using the equation above, we can calculate
the maximum total price that the business is worth to us
as an investor if we know:
i) the annual dollar return figure,
and
ii) what we expect as an interest rate on our investment.
ESTABLISHING THE ANNUAL RETURN
The first of these, the annual
dollar return figure, is the figure for Net Profit
Before Interest & Tax (NPBIT). Note that the
interest cost is excluded because it relates to the
borrowing needs of the owner – not the business.
This figure will be provided by the
seller either from past trading records or from budgets
of future trading figures (in the case of new start-up
franchise businesses, actual figures may be provided
from the trading histories of existing franchises or a
pilot operation). It is up to the buyer to satisfy
themselves that the expected future profits are reliably
represented in the valuation process.
The NPBIT figure represents Total
Sales Income minus Total Costs. In most cases, the
business costs are easily identified and future
predictions can be checked for validity with some
certainty. Note that a reasonable salary for the
owner/manager must be included as one of the oper
costs (not all businesses show this).
The Total Sales Income, however, is
a different story. Many complex factors influence the
future sales revenue of any business. Changes in the
economy, increased competition, new regulations and
shifting markets, along with the unknown performance of
a new owner, all mean that sales predictions suffer from
a high degree of uncertainty (and much more with an
independent business than a franchise). For this reason,
it becomes the buyer's responsibility to make their own
forecast of future sales, using the seller's figures as
a starting point only, and then moderating those to
arrive at a conservative prediction.
Note, however, that when you are
dealing with a reputable and well-established franchise,
they will be basing their projections on a substantial
amount of data, and will often already be providing
cautious figures. Beware of revising these down again to
the point where an obviously sound proposition begins to
look unprofitable!
When the buyer is satisfied that
the sales and cost figures are realistic, the NPBIT can
be calculated for use in the next process.
ESTABLISHING THE REQUIRED RATE OF RETURN
The Required Rate of Return (RRR)
is tied to one main business factor – risk. This
marriage between RRR and risk is all around us in the
commercial world. An investment in Government Bonds
gives low interest because the commercial risk is low.
Placing your money in an investment account with the
local Savings Bank pays a little more because the risk
has increased slightly. In contrast, investing on the
stock market carries much higher risk and therefore
investors expect much higher rates of return. Credit
card companies give you an unsecured loan each time you
use your card, and consider the risk to be high enough
to warrant the current interest charge of around 20%.
The question is: "What rate
reflects the risk of investing in a small business?" In
this case, the RRR must take account of two risk
factors: i) the financial market rate for an unsecured
small business investment, and ii) the unique risk
attached to a particular purchase situation.
A
quick check with finance brokers suggests that the
current market rate for small business investment risk
is about 33%. Add to this an allowance for unique risk
factors (eg. short trading history, lack of reliable
figures, seasonal business, aggressive competition, etc)
and you could easily have a RRR on the purchase of 40%
or more.
Alternatively, the risk might be
reduced by circumstances (eg. the vendor leaving money
in the business or remaining associated with it, the
presence of some unique competitive advantage, forward
contracts assuring future sales revenues, etc.). In this
case the RRR may reduce to somewhere below 30%.
Whatever factors are present, the
point is that the buyer must take responsibility for
establishing a RRR that they believe compensates them
for the business risk they are taking.
AN EXAMPLE
Last year I was asked by a
prospective purchaser to help in valuing a business that
distributes machine parts to the crop harvesting
industry. The business was being offered for sale as
follows:
Sales $200,000pa
Price:
Vehicles and
Other Plant $30,000
Goodwill $25,000
Stock $65,000
Total $120,000
After analysing the trading
accounts for the past three years, we established that
the NPBIT had been reliable and consistent at about
$30,000 per year. Independent valuations on the assets
verified the value of the plant at $30,000 and stock at
$65,000. The seller was prepared to leave some money in
the business and would also remain associated with the
business as a supplier. These factors acted to reduce
the risk but were more than offset by another concern.
The crop harvesting industry is very dynamic and
unpredictable. Its fortunes are governed by weather, the
volume of growing contracts from the food processing
industry, and fluctuating market prices for produce.
Because of the variability and riskiness of the industry
we decided that an RRR of 35% was an appropriate
reflection of the purchase risk.
The amount my client was willing to
offer for the business could now be established using
the equation introduced earlier:
The Investment
=
The Return ÷ RRR
=
$30,000 ÷ 35%
=
$85,714
With reference to the original
asking price of $120,000, my client's eventual offer of
$86,000 was in fact saying "given the riskiness of the
venture there is not enough net profit to generate a
goodwill figure, and there is probably too much stock
being carried relative to the trading performance of the
business."
Note that if we had used another
RRR the result would have been different. A 30% RRR, for
example, would have given the following result:
Investment
=
$30,000 ÷ 30%
=
$100,000
The maximum price the buyer would
pay with a RRR of 30% now has room for $5,000 of
goodwill.
FIVE STEP PROCESS
The valuation process for a
purchaser can thus be summarised as follows:
1. Establish a reliable estimate of
the future sales.
2. Forecast the costs and expenses.
3. Calculate the resulting forecast
of net profit before interest and tax.
4. Establish the required rate of
return.
5. Calculate the value of the
business by using the equation above to capitalise the
expected future NPBIT.
A
valuation that results in a figure less than the
tangible asset value indicates operational inefficiency
in the existing business, and eliminates any value for
goodwill or other intangible assets. Conversely, if the
valuation results in a figure that is higher than the
tangible asset value, then the extra establishes the
value of the intangible assets.
ARE FRANCHISED BUSINESSES ANY DIFFERENT?
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