Buying a Franchise - part 2

- by Leith Oliver

ESTABLISHING THE ANNUAL RETURN

The first of these, the annual dollar return figure, is the figure for Net Profit Before Interest & Tax (NPBIT). Note that the interest cost is excluded because it relates to the borrowing needs of the owner – not the business.

This figure will be provided by the seller either from past trading records or from budgets of future trading figures (in the case of new start-up franchise businesses, actual figures may be provided from the trading histories of existing franchises or a pilot operation). It is up to the buyer to satisfy themselves that the expected future profits are reliably represented in the valuation process.

The NPBIT figure represents Total Sales Income minus Total Costs. In most cases, the business costs are easily identified and future predictions can be checked for validity with some certainty. Note that a reasonable salary for the owner/manager must be included as one of the oper costs (not all businesses show this).

The Total Sales Income, however, is a different story. Many complex factors influence the future sales revenue of any business. Changes in the economy, increased competition, new regulations and shifting markets, along with the unknown performance of a new owner, all mean that sales predictions suffer from a high degree of uncertainty (and much more with an independent business than a franchise). For this reason, it becomes the buyer's responsibility to make their own forecast of future sales, using the seller's figures as a starting point only, and then moderating those to arrive at a conservative prediction.

Note, however, that when you are dealing with a reputable and well-established franchise, they will be basing their projections on a substantial amount of data, and will often already be providing cautious figures. Beware of revising these down again to the point where an obviously sound proposition begins to look unprofitable!

When the buyer is satisfied that the sales and cost figures are realistic, the NPBIT can be calculated for use in the next process.

ESTABLISHING THE REQUIRED RATE OF RETURN

The Required Rate of Return (RRR) is tied to one main business factor – risk. This marriage between RRR and risk is all around us in the commercial world. An investment in Government Bonds gives low interest because the commercial risk is low. Placing your money in an investment account with the local Savings Bank pays a little more because the risk has increased slightly. In contrast, investing on the stock market carries much higher risk and therefore investors expect much higher rates of return. Credit card companies give you an unsecured loan each time you use your card, and consider the risk to be high enough to warrant the current interest charge of around 20%.

The question is: "What rate reflects the risk of investing in a small business?" In this case, the RRR must take account of two risk factors: i) the financial market rate for an unsecured small business investment, and ii) the unique risk attached to a particular purchase situation.

A quick check with finance brokers suggests that the current market rate for small business investment risk is about 33%. Add to this an allowance for unique risk factors (eg. short trading history, lack of reliable figures, seasonal business, aggressive competition, etc) and you could easily have a RRR on the purchase of 40% or more.

Alternatively, the risk might be reduced by circumstances (eg. the vendor leaving money in the business or remaining associated with it, the presence of some unique competitive advantage, forward contracts assuring future sales revenues, etc.). In this case the RRR may reduce to somewhere below 30%.

Whatever factors are present, the point is that the buyer must take responsibility for establishing a RRR that they believe compensates them for the business risk they are taking.

AN EXAMPLE

Last year I was asked by a prospective purchaser to help in valuing a business that distributes machine parts to the crop harvesting industry. The business was being offered for sale as follows:

Sales $200,000pa

Price:

Vehicles and

Other Plant $30,000

Goodwill $25,000

Stock $65,000

Total $120,000

After analysing the trading accounts for the past three years, we established that the NPBIT had been reliable and consistent at about $30,000 per year. Independent valuations on the assets verified the value of the plant at $30,000 and stock at $65,000. The seller was prepared to leave some money in the business and would also remain associated with the business as a supplier. These factors acted to reduce the risk but were more than offset by another concern. The crop harvesting industry is very dynamic and unpredictable. Its fortunes are governed by weather, the volume of growing contracts from the food processing industry, and fluctuating market prices for produce. Because of the variability and riskiness of the industry we decided that an RRR of 35% was an appropriate reflection of the purchase risk.

The amount my client was willing to offer for the business could now be established using the equation introduced earlier:

The Investment

= The Return ÷ RRR

= $30,000 ÷ 35%

= $85,714

With reference to the original asking price of $120,000, my client's eventual offer of $86,000 was in fact saying "given the riskiness of the venture there is not enough net profit to generate a goodwill figure, and there is probably too much stock being carried relative to the trading performance of the business."

Note that if we had used another RRR the result would have been different. A 30% RRR, for example, would have given the following result:

Investment

= $30,000 ÷ 30%

= $100,000

The maximum price the buyer would pay with a RRR of 30% now has room for $5,000 of goodwill.

FIVE STEP PROCESS

The valuation process for a purchaser can thus be summarised as follows:

1. Establish a reliable estimate of the future sales.

2. Forecast the costs and expenses.

3. Calculate the resulting forecast of net profit before interest and tax.

4. Establish the required rate of return.

5. Calculate the value of the business by using the equation above to capitalise the expected future NPBIT.

A valuation that results in a figure less than the tangible asset value indicates operational inefficiency in the existing business, and eliminates any value for goodwill or other intangible assets. Conversely, if the valuation results in a figure that is higher than the tangible asset value, then the extra establishes the value of the intangible assets.

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