Hayes Knight franchise teaches you how to get the right price
by
Hayes Knight
With well over 1,000 franchise models available in the market and different levels of activity in different franchises, there are a huge number of franchised businesses being offered for sale.
They may come from a glossy brochure or a website that explains the features and benefits of the business. They typically belong to different industry sectors, have different operating models, and require different levels of investment.
One thing common to all of these franchises, however, is that they come with a price tag. And, at the end of the day, when you purchase a franchise, you need to be comfortable that the price you are paying not only gives you entrance into the franchise, but also represents a reasonable investment.
The question is how do you know if the price is right? Is it simply a matter of gaining comfort that other business owners have paid a similar amount? Or are there ways to test the price to know that the amount being asked is reasonable?
In the typical franchise model there are, in reality, two levels of price being asked for the franchise. The first is the upfront amount that you pay to acquire the business or establish your franchise. This is typically the purchase price, and covers your initial investment in the goodwill, plant and equipment, fit out, and perhaps trading stock of the business.
Then there is the secondary price that applies. This incorporates the various ongoing fees that you may need to pay to the franchisor for the continued operation of the business.
Whilst there are ways to test the reasonableness of both the upfront price and ongoing fees, there are no absolutes. At the end of the day, the market and the success of the franchise will govern the reasonableness of the cost.
The only problem with this – if you are a buyer – is that you need to actually have invested in a franchise and be operating it as a business to form your view on how reasonable the price is. This is a decision made after the event, at a point when you’re already financially committed. Prior to making that commitment, however, there are some general guidelines that you can follow to test the pricing. Let’s have a look at some of them.
The upfront purchase price
This is where most people will concentrate their initial focus. How much am I being asked to pay for this business? This upfront purchase price typically covers your purchase of goodwill or franchise rights, the amount required for plant and equipment, fit out (where necessary) and also an initial level of trading stock, if required.
In assessing the purchase price on a franchise, you should consider it as you would with any other business. Fundamental to the decision to buy a business is the question of what you are getting for your money, and how readily you could resell the assets.
With a good business, the secondary market will support your purchase price. So in buying a business, you should also ask yourself the question: how saleable will this business be in the future? Good businesses increase in value.
Poor performing businesses tend to depreciate in value. Normally, with any purchase, you can divide the purchase price up into some clear segments. These would normally include goodwill, fixtures and fittings, plant and equipment, and trading stock.
Plant and equipment and trading stock should be the simplest to assess for fair value. They should simply represent a reasonable cost price for the items being purchased.
Fixtures and fittings tend to be more difficult, because whilst you may be able to prove or agree with the cost of those items, they will only have their worth if the business is trading and trading profitably. Goodwill is another area that will always be open to some debate. Whilst goodwill is an intangible asset, it arguably can be the most valuable asset of any business. The combined values within goodwill represent the ability of a business to produce future cash flow.
When buying goodwill – and this can be in the form of brand names, franchise rights, franchise systems and other intangibles that go into the value of the business – the reality is that you’re paying a price for the future free cash flow of the business. That’s what goodwill really is.
When assessing the reasonableness of the upfront purchase price, consider the following:
1. Pay back period
How long will it take you to pay back your initial investment from the profits of the business? As a guide, your pay back period should not be any more than five years, and ideally three years or less.
During this period of time, the business should be able to accumulate sufficient profits to repay your investment. Be careful here: when we talk about profits, we’re talking about profits after owners’ wages.
Depending on the ownership structure of the business, or how the financial forecasts are presented, profits can be shown before or after owners’ wages. Assuming you’re going to be working in the business, you need to allow a reasonable wage for your time involved, and it is the profit after owner wages that you should focus on.
Real profits only occur after all of the costs have been met and this includes your wages if you are working in the business. From those profits, if you cannot repay your initial capital investment within a three to five-year timeframe, then this could be an indicator that the business is overpriced.
2. Return on investment
This is another way to assess the relationship between the price and profit return. With a small to medium-sized enterprise (SME), you would expect the return on investment in the current market to be in excess of 20 per cent per annum.
To measure return on investment, you simply assess the profit of the business (again, after reasonable owners’ remuneration) against the purchase price. So in a simple example, if you paid $250,000 to purchase a franchise and it was returning a profit of $50,000 per year, then your return on investment would be 20 per cent. Typically, good SMEs will have a return on investment in the range of 20 per cent to 50 per cent.
If the return on investment you’re looking at is less than 20 per cent, this could be an indicator that the price is too high.
3. Interest cover
Another way to look at the profit-to-price relativity – particularly where you’re going to borrow money to purchase your franchise – is to look at how many times your interest bill is covered by the net profits of the business. This is simply the relationship between your interest cost and the projected profit of the business.
You should expect to see interest cover more than three times over. So, as an example, based on your level of borrowings for the business, if your interest cost is going to be say $20,000 per annum, then you would expect to see a net profit of at least $60,000.
Interest cover is an important measure – particularly if you are going to borrow most of the purchase price. Having an interest cover greater than three times provides protection against any increases in interest rates during the loan period, and also allows for some movement in trading conditions, whilst still maintaining the overall profitability of the business.
While no financial measure is an absolute, you can test the purchase price of a business against these indicators and get a feel for whether or not the price seems to be reasonable.
If you’re buying an existing franchise, you’ll be able to test these numbers against the historical performance of the business. On the other hand, if you’re purchasing a new franchise, then you’ll be testing these figures against forward projections.
It is important in any situation where you are testing against forward projections to make sure those projections are both reasonable and also conservative in nature. It’s far too easy to have optimistic revenue and profit projections that distort reality.
A good idea here is to have an optimistic projection, a pessimistic projection, and a realistic scenario. This is called ‘sensitivity analysis’ and helps to give you a better picture of what you could be facing.
4. Ongoing fees and charges
Unlike non-franchised businesses, when you buy a franchise, you also sign up to a level of ongoing fees and charges. These fees come in a range of different formats. They include franchise fees and marketing contributions, you may be required to purchase products and/or services through the franchise group, and there could be additional costs such as attending franchise conferences and the like.
Again, there is no set formula that indicates whether the fees are reasonable or otherwise. You simply need to factor them into your cost structure to see what type of profit is available to you after payment of all of the franchise costs.
Typically, franchise fees and marketing contributions will be linked to turnover. The fact that they are linked to turnover generally makes them easy to calculate. However, this also means that you pay these fees – irrespective of your level of profit.
In assessing the ongoing fees you are liable for, you need to consider the overall impact they have on your profitability and also the reasonableness of what you are paying for. In particular, where you are buying products and/or services from the franchise group, you should compare the pricing with what might be available on the open market.
For marketing fees, it will be important to get a good understanding of exactly what the franchisor must provide for the marketing contribution. Costs, such as marketing fees, may have been something that your business would have incurred anyway. The difference is that, where you are locked into a marketing contribution, you may have little or no influence over how the money is spent, and you won’t be able to vary the timing of the marketing expenditure.
This will all be centrally controlled with your contribution being calculated most likely on your turnover. The important thing is to know exactly what you’re up for and what impact it will have on your bottom line. Often, the various additional costs are detailed in your franchise agreement and may be expressed as percentages of turnover.
The percentage amount in isolation may be small, however, you need to take the time to work out exactly how much you’ll be paying for the various fees and services being provided. It’s not uncommon to see ongoing franchise fees, marketing contributions and the like to be in the range of 9 per cent to 15 per cent.
The higher these are, the more you should be looking to critically assess the value they add to the business. Where you’re being provided with financial modelling on the franchise, these amounts should not only be disclosed, but should also be built into the financial forecast on the franchise. If you’re purchasing an existing franchise, these costs will appear in the historical figures.
It’s important, with any franchise, to thoroughly read the franchise agreement to understand what all the financial commitments are, and then to have a look at how these financial commitments work out in your financial forecast. It’s also important to understand that when you buy a franchise you are, in fact, buying into someone else’s business model. Arguably, they have done much of the hard work for you. They are providing you with systems, expertise and experience, brand value and marketing support.
These are all costs that most businesses incur in some form or another. The upside with a good franchise is that they are all provided for you, and provided at the level of an experienced operator. The downside is that you have little or no discretion over the cost item. Like anything else, if those costs are delivering value at a reasonable price, then this should only add to your bottom line.
The warning signs are where the costs are fixed and certain. However, what is being delivered is either of marginal value or cannot be readily identified. Another way to assess these costs is to talk to existing franchisees. Where there are franchise operators who have been in the business for a few years, they will have a fairly good feel for the value of the ongoing franchise costs.
Their experience can be invaluable to you. They may also be able to point out costs that you have not yet recognised or allowed for.
Can there be any hidden traps?
There are risks in any business transaction. And, when you’re signing what could be a lengthy legal agreement, the risks only increase.
You need to allow enough time to obtain a thorough understanding of the agreement. This will most likely require some good commercial legal advice to explain all of the different parts to the agreement.
It’s too easy to allow your eyes to glaze over when it gets to fine print and think that none of this will apply to you. Incidentally, this is normally the area that will cause the greatest problems or come back to bite you.
Sometimes, it is this fine print that can also help to identify additional costs that you may be liable for in certain circumstances, as well as the rights of the franchisor to vary prices over time. The standard rule is to know what you are buying, know how much it will cost, and understand the rights the franchisor has to increase or vary that cost over time. Franchises, as with all other businesses, have their good and bad points.
When you invest in one, you are not only making a significant upfront capital contribution, but you are also tying yourself into a long-term financial commitment.
Always go into these things with your eyes wide open. If you understand both the upfront and the ongoing costs and can factor them into your financial projections so that they produce a good return, then this should represent a smart financial decision.
Not allowing for all of the upfront and ongoing costs will not only impact the profitability of your business, but may also influence your ability to sell the business in the future. Every business bought today should have in mind its ultimate sale. A little bit of extra homework at the beginning will save a lot of heartache further down the track.
This article was written by Greg Hayes, a Partner with Hayes Knight accountants and business advisors in Sydney. He specialises in advising small to medium-sized businesses. 23.07.2007
Contact Hayes Knight
Level 6,
9 Hunter St
SYDNEY
NSW 2000
Tel: 02 9221 6666
Fax: 02 9221 6305
