Valuing a franchise

Are you considering investing in a franchise? There are many things to consider (doing due diligence is the term used to describe this) but one of the top priorities needs to be financial feasibility.

Am I going to make enough money out of this franchise to justify all the effort and money invested?

There are various reasons why people are looking to invest in a franchise but generally these fall into second place if there is not adequate financial return So, I would like to briefly outline an approach to assessing the financial feasibility of the investment before you make the decision.

Time to be cautious.

This is when you need to take plenty of time to consider rather than 'repenting at your leisure' later.

1. In doing a due diligence you may well need some professional assistance, especially on the legal side of the agreement, but never allow the ownership and understanding of the issues be passed to others. It is imperative that the key matters are identified and satisfactorily explained to you. Have a look at the current and past issues of this article and franchise website to identify many of these areas.
2. The impact of the current economic downturn has had a broad impact on many businesses in the economy in terms of profitability and value, so be careful in assuming that past performance will be the definitive guide to future performance. 3. Franchises come in many shades regarding the agreement details but the best way to view your investment in the franchise is that you are really renting the franchise business for the period of the agreement. This provides two benefits:

a. It helps you avoid any unrealistic expectations at the end of the agreement (if it is not renewed) when you effectively have to hand the business back Gust as in a rental situation). This can help you avoid what can be a major source of grievance with franchisors.

b. It forces you to think more realistically about recouping your capital investment in the franchise over the franchise period because you will not receive it at the end. Planning for your succession out of the franchise is critical.

In assessing the financial feasibility of investing in a franchise I would suggest you take the following steps. GST is excluded from the example figures below as it normally is refundable, and its main impact is one of cashflow rather than financial feasibility at this stage.

Step One: Calculate your investment in this franchise

You should be able to calculate this reasonably accurately. This is the total amount you require to start the business, irrespective of whether it is financed by debt or your own capital. This ordinarily covers all your expenditure to get the franchise business established to the point of being able to serve customers.

This should be obtainable from the franchisor, and can include

• Franchise fee
• Plant and equipment, fixtures and fittings
• Stock and supplies
• Security and other deposits etc
• Professional fees to establish
• Other working capital items

There are other franchisor expenses you will need to pay (marketing and royalty fees for example) however these are normally regarded as part of the operational expenses for any year rather than initial establishment costs.

So the amount of funding you will require to buy into this franchise is this initial investment amount plus you will need to have enough funding to finance the business (cover the operational expenses) until it is generating enough cashflow of its own. The length of time will vary depending upon the franchise, however three months is a commonly used time frame.

Step Two: Determine the return on that investment target (ROI)

What return should you be getting on this investment?

Another way of expressing this is to ask what level of risk is appropriate to have me invest in this franchise? Just as you would assess the risk and return on any money you invest in the bank (interest) or the stock market (dividends and capital increase) so it is for this franchise. Only you can answer this, however, let me suggest this should be in the vicinity of 20 per cent to 30 per cent per annum, especially in a franchise where you need to ensure you can recoup your original investment by the end of the franchise period. One way to determine a more objective basis for this rate of return is to break the rate into the three common risk components.

a. The risk free component (usually regarded as the Australian Government bond rate, which is about as risk free as you can get). Let's say five per cent

b. Add to this the business risk rate which will vary depending upon the franchise. How risky is this franchise? Be realistic on this as you are the one running the franchise with all the attendant risks and stresses. To ask this question will perhaps force you to do some more due diligence or investigatory work. For the sake of this exercise I shall assume this is triple the free rate (which is quite realistic for many franchises). Say 15 per cent

c. Then add some more for the exit risk, or the risk involved in getting your initial investment back over the term of the franchise agreement (plus extensions). Bear in mind that the franchise is like a rental agreement so you need to do this. This again forces you to ask questions about the term of the franchise agreement and the succession options available. This again is a variable you will need to assess yourself but let's say you believe you will hold the franchise for three terms (15 years) thus you will need to recoup seven per cent every year. Say 7 per cent

Total these three to give you an appropriate rate of return. Thus the return on investment (ROI) in this example is 27 per cent on your initial investment of $270,000 which is $72,900. Let us say $73,000

Step Three: Determine the return on your time and effort (salary)

What return should you be getting for your time and effort?

This does not come free. This is often a very subjective decision depending upon your motivation, drive and direct involvement in the daily operations of the franchise. Here are some guides that may assist you

i. Target at least a living salary to provide encouragement for pressing on in the business as well as providing for your practical needs.

ii. Perhaps you might use a salary that you would need to pay someone else to do your work in the franchise.

iii. Whatever you choose ensure you add at least 25 per cent to cover the on-costs. For this exercise I shall assume a salary of $80,000.

Step Four: Calculate the bottom line (profit/return) you require

This is just an addition of the two amounts in Steps 2 (ROI) and 3 (salary) being the two components that make up your bottom line.

In this example it is $73,000 plus $80,000 giving a target profit of $153,000

This profit target should be the key driver of your thinking as you consider investing in a franchise. It is helpful for these reasons

• It enables you to determine the sales turnover you require (see below for a description of how this is done) to achieve such a profit. This provides you with the detailed information required to assess if this is viable.
• It establishes a feasibility framework to ensure you will receive an appropriate return on your financial and time investment in the business.
• This will provide an indicator of the value of the franchise business. The main method of valuing a franchise business is by capitalising future maintainable earnings. This is based on the achievable profit (after a reasonable working owner's wage) and the risk factor (capitalisation rate - dividing the ROI rate into 100). Any profit achieved below or above this target is indicative of the loss/increase in value of the franchise.

So, in this example, where the risk factor is 27 per cent, this provides a capitalisation rate of 3.7. If the profit actually achieved/able is only $50,000, then the actual value of the franchise is really only $185,000 ($50,000 times 3.7) rather than the $270,000 actually invested. A decrease in value by $85,000.

Step Five: Determine your overheads

This means all the franchise expenses apart from your cost of sales (main variable expense), and your own salary.

These should be relatively easy to estimate from the franchisor disclosure document, your accountant or discussions with other franchisees. The real benefit of doing this exercise is that by developing a better understanding of the operational costs involved in running the business you can better assess its feasibility for you.

In this example we shall assume the total overheads are $350,000

Step Six: Calculate your target gross profit/contribution

This is a simple addition of the above two target figures for profit (step 4) and overheads (step 5)

In this example the profit target is $153,000 and the overheads are $350,000 giving a gross profit target of $503,000.

Step Seven: Determine your gross profit margin/contribution percentage

Gross profit/contribution is one of the key success indicators for a franchise. It is the amount you have remaining from your sales after deducting the main variable expense (usually called cost of sales, sometimes it may be wages of income earners in a service oriented business) in the franchise. Your accountant should be able to assist you with this. It is expressed as a percentage of sales.

This gross margin/contribution percentage should be readily available from the franchisor, other franchisees or your accountant.

In this example the gross margin is 40 per cent

It is very important that you have a clear understanding of the gross profit margin.

Step Eight: Calculate your sales target

This is your target gross profit (Step 6) divided by your target gross profit percentage (Step 7).

In other words what sales revenue do you need to achieve your profit target for the year?

In this example it is $503,000 divided by 40 per cent which equates to a total sales target for the year of $1,257,500 say $1,260,000

Step Nine: Is this feasible for me?

This provides you with the basis to make some very commonsense and fundamental decisions to determine if this investment really is feasible. What you are trying to do is relate this sales figure to more everyday aspects of running the franchise so you can ascertain if it is feasible. Here are some suggestions:

• Divide by 52 to determine a weekly sales target
• Divide by days open per year to determine a daily sales target
• Divide by hours open to determine an hourly sales target
• Divide any of the above by the average transaction size to determine how many customers per week, day or hour.
• Divide the sales by the products/services provided to relate to how many need to be sold on a weekly, daily or hourly basis.

Keep in mind that the primary driver of this whole process is receiving an adequate return on your time and money invested in this franchise. If, after reassessing the previous steps, it does not appear feasible to achieve this level of sales you need to seriously ask whether this franchise is overpriced and whether it is for you.

This is a reasonably simple but very effective way of assessing the true value of a franchise, and relating this to the amount of capital and time you are investing as well as your assessment of the risks involved. It is not foolproof but it can save you from the rocks of unrealistic expectations.

By Brett Stevenson -  Business Consultant for Lawler Partners , an Australian accounting and business advisory practice.