If you’re considering buying an existing franchise operation from an acquaintance, and want to be careful, there are certain things you should look out for. You also need to know how to find out if the selling price of the business is reasonable.
In franchise terminology, the purchase of an existing unit in any system is referred to as a ‘resale’. A resale can have some wonderful advantages over starting a new unit from scratch, but it can also be a nightmare. It’s essential that you know what to seek and what to avoid in this process.
There are two types of franchise units 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. Each group can potentially represent an opportunity for you, but the risk associated with the second group is substantially greater. During your investigation, you must determine which group the unit falls into right now, and which group you think it will fall into after you’ve owned it for a while. Do not make the assumption that it’ll stay in the same group it’s currently in. So how do you figure this out?
The first question to ask yourself is, “What is the motivation of the seller to sell the business? Why do they want to get out of the business, and why now?” Are they ready to retire, or just want a change of pace? Or are they trying to escape an unbearable grind of 80-hour work weeks and constant employee hassles? Do they know about some future change that’ll make the business less viable, and want to get out before it happens?
At the risk of appearing cynical, this is critical information. It’ll probably take a little digging on your part to find the truth. Most sellers are smart enough to figure out that if they tell you the business is horrible, you’re not going to want to buy it from them. They all dress up the business in its Sunday clothes for your inspection.
Ask the right questions
To be safe, you need to not only talk with the seller, but also look at other sources of information. These other sources should include the franchisor as well as competing chains in the business or other industry sources.
From the seller, you need to find out:
- What is their motivation for selling? Is their reason completely believable, and does it suggest anything negative in the future?
- What has the financial performance of the franchise been over the past year or two? What are the trends, and what are the reasons given for the trends, particularly if the recent trend data is flat or negative?
- What is the status of the employees of the franchise? How important is retaining key employees in successfully producing future projected results? How sure are you that they are going to stay?
- If the franchise is site-dependent for success, what is the status of the real estate? Is there any challenge with the continuation of the lease? Is there any scheduled future road construction or other impairment that might affect otherwise positive results?
- Do they know of anything that has not yet been disclosed to you that might hinder future performance of the business? Make sure to ask this question point blank; your attorney can include their answer in the purchase contract to protect you.
You should also go to the franchisor and conduct a complete investigation of the franchise just as if you were going to open a new unit from scratch. This exercise will give you valuable information to understand the business and to make sure you’ve asked the seller all the right questions.
Finally, you should ask the franchisor to confirm the information you’re receiving from the seller, including specifics. They won’t want to do this, because they don’t want the legal liability, but they also don’t want you to join their system under false pretences. If the seller is not being honest with you, you’ll often pick up clues from comments made by the franchisor.
This article focuses on the negative potential of the resale process. Don’t misunderstand, though: resales can be great, as long as you avoid a few basic mistakes. Invest the time to gather the relevant information, and you should be fine.
Getting the right price
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.
Turning it around
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 scratch.
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.
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.