Buying An Existing Franchise

A re-sale can have great advantages over starting a new unit from scratch, but it can also be a veritable minefield. It is essential that you know what to look for and what to avoid in this process.

There are two types of franchise units offered for sale. The first group consists of successful profitable operations and the other of units that are non-profitable or barely making ends meet. Each group can potentially represent an opportunity for you, but the risk associated with the second group is much greater.

During your research you must figure out which group the unit currently falls into and which group you think it will fall into after you have owned it for a while. Do not assume it will stay in the same group it is currently in.

Ask yourself 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 do they just want a change of pace? Are they trying to get out of 70-hour working weeks and difficult employees? Do they know about some future change that will make the business less viable and want to get out before it happens?

This information is vital. It will probably take some effort on your part to find the truth. Most sellers will not tell you the business is in difficulty as you are not going to want to buy it from them after that. All businesses will be presented in the best possible light.

To be safe, you need to not only talk with the seller but also look at other industry sources or competing franchisors for further information.

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?

How has the franchise performed 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?

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 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 the business? Make sure to ask this question directly - your solicitor 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 understanding the business and to make sure you have asked the seller all the right questions.

Finally, you should ask the franchisor to confirm the information you are receiving from the seller. They won't want to because they do not want the legal liability, but they also do not want you to join their system under false pretenses. If the seller is not being honest with you, you will often pick up clues from comments made by the franchisor.

If the business is currently successful, you will 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 are not really required to operate the business. These can be expenses like company cars, 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 is 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 re-sale, 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 is not performing, but ultimately it comes down to whether you are convinced that a simple change in ownership will fix the problems.

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 - for example a bad location - then you can proceed with some confidence.

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

To evaluate the re-sale 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 break-even 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 re-sale unit to break-even. 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 speed.

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

If the seller is not happy with this method of valuation, that is fine. You are the one who is going to have to live with this purchase, and you want to walk away from this type of re-sale 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 is no line of people waiting to buy unsuccessful units, and you have got time on your side.

Re-sales can be an excellent way to enter the franchise arena. You can avoid much of the hard graft associated with starting a new franchise by buying one. Just make sure you are careful and diligent, and this process should work to your advantage.