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Buying an Existing Franchise, Part 2

How to get the right price on a "used" franchise.
August 2, 2006
URL: http://www.entrepreneur.com/article/63588

Q: I'm considering buying an existing franchise operation from an acquaintance, and I want to be careful. What should I look out for?

A: Last month, we discussed how to investigate a used franchise so you can make a knowledgeable and safe evaluation of a resale. This month, we'll look at how to determine a reasonable price for the existing unit and when you should pay for advice.

There are two types of franchise units that are offered for sale. The first group consists of successful operations that are making money. The other group consists of units that are not successful and are either losing money or barely making ends meet.

In either case, you first need to determine whether you think the future performance will be positive under your ownership. If the answer is no, or you're uncertain about potential risk factors, your best strategy is to forget the resale. The risk is just too great.

But if the answer is yes, and the business is currently successful, you'll have a fairly easy time dealing with pricing, since you have existing earnings to work with. The best valuation method is to use a multiple of the net cash flow you will receive from the business.

Net cash flow is the difference between the revenue of the business and the necessary business-related expenses required to produce the revenue. You should have access to the historical financial statements of the business to derive this number.

Most business owners run expenses through their business that aren't really required to operate the business. These can be expenses like company cars, football season tickets or meals and entertainment. There might also be extraordinary salary costs associated with the owner. Take the net income of the business and add back these unnecessary expenses to determine the true net cash flow you can expect.

The price of this type of successful business should be about two to five times this net cash flow number. The more stable and dependable the cash flow, the higher the multiple that's reasonable for you. The multiple is also higher when the trends of the business growth are positive rather than flat or negative.

The second type of resale, when the business is not currently performing well, is more difficult to price. The existing owner will always have many good arguments about why the business isn't performing, but ultimately it comes down to whether you are convinced that a simple change in ownership will fix the problems.

About the only time this is true is when the existing owner is not operating the business according to the system designed by the franchisor. If you have confirmed that most or all other franchisees following this system are doing fine and have determined that there are no other problems related to, say, a bad location, then you can proceed with some confidence.

In this circumstance, you are looking for a real bargain. If you're not going to get a great deal on the resale, why bother? You can always open a new unit with this franchise as an alternative to buying this resale.

To evaluate the resale price, start with the total cost to open a new unit in the system, including all the marketing costs and operating reserves necessary to operate a new unit until you reach the average breakeven time on operations. From this figure, subtract a liberal allowance for the money you need to invest in marketing and operating expenditures to get the resale unit to breakeven. Also subtract a liberal allowance for any infrastructure investments you feel might be necessary to get the physical plant and employees of the unit up to snuff.

The difference in this calculation represents the absolute maximum price you should even consider paying for this unit. A reasonable person would almost certainly discount this difference substantially to offset the risk associated with buying someone else's problem.

If the seller is not happy with this method of valuation, that's OK. You're the one who's going to have to live with this purchase, and you want to walk away from this type of resale unless it looks like a very strong opportunity to you. Feel free to tell the seller to try to find a buyer at a higher price and call you back if that attempt is not successful. There's no line of people waiting to buy unsuccessful units, and you've got time on your side.

The final question you asked is about advisors. You don't need an advisor to determine whether this may be a reasonable transaction for you to pursue. You absolutely do need a good attorney who is experienced with business purchase agreements if you want to go forward with the purchase.

Your attorney will assist you with the letter of intent, the purchase agreement, the assignment documents, the bill of sale and all the other requirements to complete this transaction. This process isn't brain surgery, but a good attorney will point out a host of protections that you might not have thought of, and the fees are generally not a large percentage of the purchase price.

Resales can be a wonderful way to enter the franchise business. You can avoid much of the pain associated with starting a new business by buying one. Just make sure you are careful and diligent, and this process should work to your advantage.

Read Buying an Existing Franchise, Part 1 of this article.