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.
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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.
To read Part 1 of this article,
click here.
Jeff Elgin has almost 20 years of experience in franchising,
both as a franchisee and senior franchise company executive. He is
currently the CEO of FranChoice
Inc., a company that provides free consulting to consumers
looking for a franchise that best matches their needs. He can be
reached at jelgin@FranChoice.com.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.