This article is taken from Franchise New Zealand magazine Year 24 Issue 3.
Franchise businesses in a number of industries are doing well right now. Many franchisors have been revitalising their systems: costs have been cut, margins have been improved, new products or services introduced.
Despite some recent clouds on the economic horizon, top-performing franchises can be very profitable. If you’re new to franchising, though, you need to take care to ensure you pay a fair price.
One of the most common measures of a business’s value is earnings multiples: taking a company’s past or expected profits and applying a multiple to come up with a sale price. After the Global Financial Crisis (GFC), small businesses were selling at low multiples. That normalised after a few years, but recently we have seen people prepared to pay much higher multiples.
It’s fair to say that good franchises which have been consistently selling at very strong prices are generally worth it. The larger the proven profit, the lower the risk and the higher multiple people are prepared to pay.
Larger businesses, multiple-outlet franchises and franchise systems with a lot of depth are seen as more stable and presenting much lower risk, especially if part of a strong brand. Where you have a small business that is barely profitable, though, the risk is much higher, unless you know the industry really well or can determine the reasons for its poor performance.
Set yourself up for success
For prospective business buyers, it can be difficult to determine the true value of the business they are interested in acquiring.
If it is an existing business, is the trading history provided by the seller a true reflection of the current situation, and how much is the goodwill, fit-out, stock or future growth potential worth? In the case of a setting up a new franchise, there will be no trading history, but potential buyers should receive a detailed breakdown of initial and ongoing costs from the franchisor.
In either case, make sure you take professional advice from a franchise-experienced accountant who knows the industry and ideally the franchise you are considering. They will help you determine its true value.
If you are seeking funding from a bank, they will not usually have a view on how much you should pay for a business – that will tend to be dictated by the market. What they will look at is whether the business can afford to service the debt. In this case, the price you pay will definitely have an influence on the funding options available because of such factors as your own equity position, the scale of the business, sales trends and stability of cash flow, etc.
It’s worth noting that franchisors are certainly not in favour of incoming franchisees paying too much for existing businesses. They would much rather see the new franchisee being able to invest in the business with enough working capital and the ability to secure rental bonds or fund future growth.
One large franchise system recently told me that they are very uncomfortable approving incoming franchisees if they think they are paying too high a multiple because it puts the franchisee under immediate financial pressure.
And even if a potential purchaser has the ability to pay a very high price to the franchisees that want to sell their business, they may not be the right people for the system. If a purchaser doesn’t meet the selection criteria of the franchise, they are unlikely to succeed in the business. That won’t worry the seller, but it should worry the purchaser. Why insist on spending money to set yourself up for failure?
Signs to look out for
In addition to doing due diligence, consulting the franchisor and using a franchise-experienced accountant, what else should a prospective franchisee look out for to avoid paying too much?
Here are a few warning signs that may indicate you should carry out further research into any franchise or licensed group:
A large number of franchises in the same system suddenly being offered for sale. It’s normal for a proportion of outlets to be for sale in any mature franchise system – around 10 percent would be common. If a franchise has no turnover of franchisees, it often means they are making too much money to leave. If franchisee turnover is high, however, it could be a warning sign of profitability issues, or problems with the business model or franchise support.
A lot of negative press continuing over a period of time. Sometimes, sensational articles or social media can (wrongly) implicate franchise brands, or an issue with one franchisee may be exaggerated. Franchisors will normally take quick action to address any issues, so if negative feedback from the public or franchisees themselves continues, there may be a bigger issue. It’s worth noting, though, that corrections to sensational stories never attract as much coverage as the original, so do your research.
Regional inconsistencies. Some franchises may be very successful in some areas (certain provinces, regional towns, malls, etc) but find it difficult to compete in others. This may be due to all sorts of factors: for example, the rent ratio not working for the model in a mall, too much competition from businesses competing for the same dollar in urban areas, varying local competition or even differing levels of support from local master franchisees. If you are looking at opening a new outlet, make sure it matches the profile of successful franchise locations.
The bank not wanting to fund an established brand on a cashflow basis (ie. secured against the business itself). A bank with a specialist franchise division would often fund a large number of franchisees from the same system and may therefore have a good idea of the performance (or lack of) of individual franchisees. The situation is different for new franchises where the brand may be new into the market or not yet accredited for cash-flow lending.
No matter what business you are interested in, it’s important to pay a reasonable price for it if you want to give yourself every chance of making a reasonable return on your investment. That’s why you need to do proper due diligence with the help of a specialist franchise accountant, lawyer and banker. Talk to the franchisor and other franchisees in the system, too. They will all be able to help you get a clearer picture and assist you in making the right decision for your own circumstances.
This article is taken from Franchise New Zealand magazine Year 24 Issue 3