Buying a franchise

by Leith Oliver

In New Zealand, the proportion of small business ownership has always been high. However, it is only recent that the idea of owning your own business through buying a franchise has come to the fore.

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 University of Auckland.