Buying a
Franchise
- by
Leith
Oliver
In
New
Zealand
,
the proportion of small business ownership has always
been high. However, it is only recent that the idea of
owning your own business through buying a franchise has
come to the fore.
Despite the success of many
franchise systems both in NZ and overseas, there still
exist some misunderstandings and even suspicion about
franchising on the part of prospective purchasers. If
you buy an existing business you can look at the outlet
or the plant, look at the trading history, see real
figures and real customers. But if you buy the rights to
set up a franchise in a new territory, doesn't it seem a
lot of money to pay for something which doesn't even
exist yet?
In any existing business, the
seller will ask an often substantial amount of money for
an item called "goodwill" – the factor which assumes
that because the business has an established client
base, they will keep on coming when the new owner takes
over. There is certainly merit in this concept, but I
have seen many cases where goodwill figures of
$30-50,000 have been asked when the real value of the
business has been nowhere near the total amount asked.
The problem for any prospective
purchaser, whether of an independent business or of a
franchise, is to know what it is really worth. I would
like to suggest a way of working this out, and to look
at how you can apply this process to evaluating a
franchise.
From a purchaser's point of view,
buying a business is an investment decision. Like any
other investment decision, the value of the investment
is based upon the returns available from it. Where you
are purchasing a business, the returns are represented
by the trading profits, and so the purchaser is mostly
interested in the value of the available profits that
the business can generate.
Of course, in a new start-up
business (such as a franchise), there may be a
particularly important element of capital gain to be
considered as well.
WHAT DO YOU VALUE?
When a business is offered for
sale, the seller will ask a price based on the values of
various assets. The most obvious of these are the
tangible assets of the business – the plant and
equipment used to run the business, and the stocks of
goods that are traded. In many cases, other intangible
assets are also included in the asking price. These may
include goodwill, branding and trademarks, and
manufacturing or trading licences.
Although they are the most obvious
of the items to be valued, establishing the true value
of tangible assets is not straightforward. For example,
should assets be valued at book value (the value they
have in the business's accounts) or at market value (the
price you would get for them if you sold them tomorrow)?
Computer equipment is a case in point. If the business
paid $5000 for a computer system last year, it might
still be worth $3300 on the company's books – but who
would buy an out-of-date computer for that much money?
Ultimately, the price for the
assets is a matter of negotiation between buyer and
seller. If the value of the assets is set at a higher
level, then the buyer benefits from future available tax
write-offs. If the assets are valued low in the purchase
transaction, this benefits the seller through current
tax write-offs.
Another question to ask about
tangible assets is: "Are they the right assets? Are they
the right type and quality, and is there the right
amount?" If the assets are inadequate, then extra funds
will be needed quickly to get the business functioning
properly. Alternatively, if too much money is tied up in
inefficient assets then the business returns will be
poor. When you buy a franchise, you know that you will
be getting the benefits of the franchisor's experience
to ensure that you buy the right equipment and the right
stock to start up with.
INTANGIBLE ASSETS
From a purchaser's point of view,
the intangibles such as goodwill and branding present an
even greater difficulty in valuation because the values
used may be discretionary and subjective – they may be
just what the seller thinks they are worth, and may have
no foundation in reality.
On the one hand, the fact that they
add value to the business is obvious – but how much
value? On the other hand, what happens if the business
doesn't do well and the assets need to be sold – will
these intangible assets have any value then? A good
franchise brand will – an independent name won't.
These questions are all hard to
answer, and generally mean that a purchaser should not
use asset values directly in establishing a purchase
price for the business.
VALUING THE PROFITS
To my mind, valuing the profits is
the solution to the problem of valuing a business. If we
regard the purchase of a business as an investment, then
the true value can be established by valuing the profits
that result from its operation in a given business
environment. This method takes the business as a total
operational unit and values its ability to produce
returns for the shareholders.
The following outlines how to value
a business by capitalising the net profit.
Every investment has three
components:
1
The dollar amount invested
2. The dollars returned from the
investment.
3. The return expressed as an
interest rate received on the investment.
These form a simple equation:
The Investment x The Interest Rate
= The Return
Eg, an Investment of $20,000 at 10%
Interest Rate would give a return of $2,000. And,
rearranged, you can say The Investment = The Return ÷
The Interest Rate.
When purchasing a business, we want
to calculate what the Investment value (ie, the price)
should be. Using the equation above, we can calculate
the maximum total price that the business is worth to us
as an investor if we know:
i) the annual dollar return figure,
and
ii) what we
expect as an interest rate on our investment.
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