The size of the primary (greenfield) and secondary (existing) markets for franchise businesses continues to grow every year in Australia. The decision of a potential investor as to which is the most attractive option is as much dependent on the make up of the individual as it is the business itself. In each person is a risk aversion characteristic that drives the thinking as to whether there is a preference for a greenfield location, with all the consequent start up risk, or the certainty of some track record with an existing operation.
There are common areas people research when making these decisions such as location, demographics, financial performance, franchisor performance, bank accreditations and existing franchisees to name a few. It is not an exact science but the more information that a prospective purchaser can identify will ensure a fully informed decision can be made. This must be balanced with over analysing the situation. There is inherent risk in both the greenfield and existing options but there is a potential return as a consequence. In the following article Adrian McFedries, Managing Director at DC Strategy draws on the real experiences of many franchisees across a diverse range of franchise systems and provides some answers to often asked questions.
Starting from scratch – a smart idea?
The answer is dependent on a significant number of variables that in truth can only be assessed on a case-by-case basis. There are a number of key issues that potential franchisees focus on in making the decision to purchase an existing business or start a greenfield operation.
Greenfield Business Pros
? There is no payment for goodwill for the efforts of previous owners
? It is a brand new operation at commencement
? A contribution to fit out is possible from landlords
? The reputation within the area can be established as desired
Existing Business Pros
? The business is proven
? There is a lower risk at commencement
? A refurbishment can restore the business to a new state
? Proven history of cash flow
? Existing reputation in the business
The reality is each person needs to consider many of the above factors and the final decision is impacted more by the perception and risk profile of the potential franchisees. The propensity to assume risk is part of the genetic fabric of any person and only they know how comfortable any set of circumstances will be.
What kind of research can be undertaken for a new location?
There are many forms of research that can be undertaken which interestingly enough many potential purchasers are not thorough enough at using the options at their disposal. The following are examples of some of the methodologies used to make a factual judgment in relation to the likely success of any given location.
? A people traffic count
? Examining neighbouring business performance
? Researching previous tenant performance irrespective of the business type
? Shopping centre reports
? ABS data for the territory
? Bank advice on how risky the bank rates the industry and the consequent accreditation rating they detail for the franchise system
? Industry research, IBIS World, Retail Association, other available sources
? Competitor study in surrounding locations
There are many ways in which to research data to ensure people are making a more informed decision. This must however be balanced with the fact that risk will never totally disappear. Experience has highlighted franchisees who have missed great opportunities over time due to prolonged dithering in relation to making a decision either way. This is just as frustrating for the franchisor as it is for the franchisee. People finding themselves in this position should focus on the key issues impacting the decision and try not to be too consumed with the multitude of other issues that can divert attention from the important considerations.
Buying an existing business – what to look for?
Where do you start? – numbers, numbers, and numbers. There is no substitute in business for having detailed and accurate numbers for the performance of a business. This is easy to say, some will say obvious but the variety of numbers that actually exists in the market continues to defy belief at times.
Numbers
It is important to cross reference any numbers that are being indicated by the franchisee with the previous financial reports, BAS statements, reporting to the franchisor, the franchisees accountant, and any benchmarking that exists in the network. The businesses that carry a cash component are the most difficult to calculate. If the numbers appear in anyway inconsistent this must be focused on – this is not an area where close is good enough.
In addition to reviewing the financial performance it is important for the purchaser to ensure a detailed budget has been prepared outlining the sources and uses of funds and the cash flow from the business. This will have to include financing costs and a buffer for any reduction of revenue. The single greatest cause of stress in franchisee businesses is being undercapitalised at the start.
Legal Documentation
The review of the legal documentation has to focus on the key areas including, but not limited to:
? Any precondition for renewal or assignment which may include a refurbishment clause or IT upgrade which will trigger a capital expenditure
? The assignment fees for the transfer of ownership in the franchise and who they are paid by
? The terms of any property or equipment leases
? The tenure of franchise
? The contents of the Franchise Agreement and Disclosure Document
Franchisee Peer Perspective
Given the purchase of an existing business contains a franchisee that has operated in the network it is worth speaking with other franchisees to gain a peer perspective. The objective is to understand the performance and any views that may assist in making the decision. Typically, if a franchisee has been a good performer and a decent operator they will be respected by their fellow franchisees. This is not always the case and it must be remembered there will be franchisees in a network that should have their views taken with a pinch of salt.
Circumstance Change
Time never stands still and consequently it is important for a potential franchisee to consider whether there are any circumstance changes that are likely to impact the performance of the business in the future. Past performance is no indication of future performance. There maybe a competitor that has signed a lease just across the road, a new DFO about to open, a major anchor tenant leaving, or a change to surrounding parking or road infrastructure. All or none may be relevant to the performance of the franchise and the decision to purchase.
Should growth be expected in an existing franchise?
Growth is an expectation in nearly every business. This is no different in an existing franchise but there are factors to consider. All businesses and brands go through the cycle of start up, growth, and maturity. Whether decline or reinvigoration is the next step is down to the network and the operator. Any purchase should achieve an acceptable return on the invested capital that will typically require a degree of growth.
The other part of this question is growth in what? – revenue, profit, cost base. The reality is all will grow over time but growth in profit is the most important measure. Revenue can fall but improvements in gross margin, productivity or cost management will deliver a profit.
When assessing a franchise system the growth opportunities must be considered in the context of where the industry and the company are going. A new franchise system may have questions of sustainability or may be defining a completely new speciality. A mature system may be on the verge of a slow down or at threat from a younger more dynamic competitor. Stepping back from the business to analyse the industry and key players will assist in making an assessment of the growth trajectory.
Employees - should they stay or should they go?
There are three key issues to resolve as to whether you should keep existing employees after an acquisition is complete.
1- Do they have the skills to match your expectations of the role?
2- Is there any strong impact on performance if they leave?
3- Is there a cultural and personal fit with the new owners?
Individually none of these provide an answer, it is the combination of factors that matters. For instance, you could have a strong operator that customers are particularly aligned to which would impact performance if the employee was to leave. However, the same employee could have no interest in the new ownership structure and consequently not only fail to deliver the previous results but impact the future results because of the cultural or personal disconnect with the new owners.
A decision needs to be made very early as focusing on developing a business after the transaction has occurred is a challenge enough without having to worry about whether some of your people are not aligned with your direction. There is no substitute for a direct conversation with the existing team and seeking some input from the franchisor or outgoing franchisee.
Another interesting consideration is whether you should keep former head office staff if it was a company operation that has been converted to franchise. There are some key advantages in that they know the business, how head office operates and have relationships with other head office team members which could be to your benefit. There are some disadvantages that also need to be considered such as more concern in the head office perspective rather than the franchisee, a lack of motivation to work with a franchisee breathing down their neck, or the perception that a career path progression has been removed as they are no longer part of the company operations. Again a candid conversation is a great first step to understand these issues.
How can you determine if the passing trade is sufficient to make a profit?
Profit is a function of revenue minus costs. The impact of passing trade impacts the revenue which is a function of price x volume. The price movement must be considered as some traders can operate for years without passing on a price increase to the consumer. The volume component requires the purchaser to focus on the location, demographic and volume of passing people. Mass of people in itself is no measure if they are not predisposed to your product or service offering for financial, age or location reasons. A personal assessment of an area is not a bad idea and there are organisations that will conduct traffic counts on your behalf.
It is also important to consider the usage details for the operation. For example in a food retail operation is coffee able to be sold. Key usage issues can impact revenue significantly.
Location, location, location is the key aspect to focus on. Great shopping centres have less than desirable sites to operate from. At the end of the day any purchaser needs to be very pragmatic about the location and the performance of surrounding businesses.
As a consequence preparing a budget of future performance is recommended and detail the sensitivity to a variation in the volume of passing trade. This will give you an idea of the breakeven point or sensitivity of the profitability to passing trade. Calculate the average transaction price and use volume of traffic as the remaining variable.
14-May-2007