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Buying a franchise can seem like an easy way to get into business, but there are pitfalls.
Phil Blain, a franchise consultant at business advisers BDC, says that along with getting advice from an accountant and a lawyer, potential franchisees should ring existing members of the franchise and ask if they’re getting all the support they need from the franchisor and if they would still buy into the franchise had they their time over.
Here are seven things franchise owners say they wish they had known before they bought in:
It’s hard work
Jane Tepper bought into licensed cafe franchise Billy Baxter’s in 1996, thinking it would allow her to work flexible hours while staff ran the business, but soon discovered how demanding a franchise can be.
“I had a young family and I thought maybe I’d work 10 to 3 and wander in and out, but it’s not that way at all. You have all the ongoing problems of staffing and people going sick, and you have to be there to oversee things because people want to see the owner,” she says.
You’re not your own boss
A lot of people get into franchising because they like the idea of being their own boss, but Tepper, who successfully sold her franchise in 2002 and is now a franchise consultant, says that’s a common mistake.
“You are definitely accountable to someone else and they have the right at any time to come in and ask what’s going on, ‘show us your books, show us how you’re running things, show us how you’re running your staff’,” Tepper says.
“So if you’re the type of person who just wants to run your own business and do it your own way, you have to rethink a franchise.”
It costs more than you think
When people weigh up the cost of a franchise, they usually just consider the franchise fee and the cost of a shop fit-out. They often overlook other costs, such as solicitor and accountant costs, says Blain.
And many franchisees underestimate how much working capital they’ll need, to buy stock and support themselves while the business gets established. “If you’re scratching to the last cent to get in, don’t do it,” Blain says.
You’re not buying a business
When you buy a franchise you’re not buying a business in perpetuity. What you’re buying is the right to use the franchise name and system for a set number of years, often a decade.
Blain says franchisees should be prepared for when the agreement expires: they might have to buy the franchise again or pay a renewal fee, or in some cases the franchisor might not let them renew the franchise agreement and the business will be at an end.
Watch out for shopping centres
Along with answering to the franchisor, owners of retail franchises are at the mercy of their shopping centre, which has a lot of power.
Once the franchisee’s lease is up, the shopping centre can demand that the franchisee refits the shop, the cost of which can run to hundreds of thousands of dollars. “Those refits can be anything from a touch-up to a complete new shop, at the insistence of the shopping centre and the shopping centre’s designer,” says Blain.
Second, the shopping centre can move the franchise to a less favourable position in the centre if it has a better tenant, and while the franchisor might have promised in the agreement to use their “best endeavours” to negotiate with the landlord, there’s often little they can do.
“Some franchisees are faced with closing their business as a result of these things,” Blain says.
The territory might not be all yours
Brian Keen bought into a franchise retailer called Bedsheet in 1981. While the investment was ultimately successful and he ended up owning seven stores, he was surprised to discover that the territory he thought he’d bought didn’t actually belong to him.
The franchisor opened a new store near his own when Keen was trying to get his business established. “I was panicking. I was really distressed about it,” he says.
While people who buy into franchises think they’re buying a “territory”, Keen says sometimes this can be unclear in the franchise agreement and the franchisor can have some discretion over where to open new shops.
Keen was also surprised to hear that the franchisor was taking undisclosed commissions from a supplier when the members of the franchise purchased stock from them.
Keen, who now works educating franchisees, says such practices aren’t uncommon and anyone thinking of buying into a system should check to see whether the franchisor is taking any commissions.
Buying an existing small business can be easier than setting up a new business from scratch. But the process can be daunting, especially if you’ve never been in business before. The main reason most people buy a small business rather than starting one is for the established infrastructure and ongoing cash flow. People buy franchises for similar reasons – they usually come with supplier agreements and a proven system of what works and what doesn’t.
Once you’ve found a suitable business, you’ll need to verify the state of the business before making an offer. This includes ensuring that sales are as good as the owner says they are, that employees will be happy with a new owner, and that customers will remain loyal once you take over.
Make sure you investigate all aspects thoroughly. Are the business systems sound and documented, and is the cash flow sustainable? A business owner will want to sell their business for as much money as possible and as the buyer, you’ll want to pay as little as possible. Your aim is to make the seller want to sell the business to you – on your terms and at your price.
Establish your credibility
Formally register your interest in buying the business. The owner will usually have instructed a business adviser, such as a business broker, lawyer or accountant, to sell the business. Approach the advisers, rather than the owner to register your interested. Your integrity and your future plans for the business are usually extremely important to the seller.
Analyse the seller’s objectives
Working out the seller’s motivation will assist you later in the process:
- Does the owner have to sell? If yes, is the owner under time pressure?
- Does the owner wish to sell just the trading part of the business, or a company that holds both assets (such as a building) and the trading part?
- Is money the prime motivation for selling or is there some unrevealed reason, such as a competitor planning to open nearby?
If you can uncover the seller’s motivations, you’ll gain an advantage in the negotiation process. For example, if the owner has to sell within a certain time period then you may be able to negotiate a lower price.
Before you make any offer, complete a preliminary ‘due diligence’ to ensure the business has no major problems. Always ask yourself this question – “If the business is as wonderful as they make out, why they are selling?”
Sellers often gloss over the weak areas of the business or create short-term gains to give a favourable impression of the business. For example, lowering stock levels to artificially inflate profit (before stock needs to be re-ordered) can make a business seem more profitable. Ensure you investigate thoroughly before you show your interest in buying the business.
Get a feel for the business
Immerse yourself in the business:
- Research its market and main competitors.
- Assess the risks associated with the business’s future trading and with the industry as a whole.
- Talk to customers and others involved such as suppliers.
- Try to gain as much access to a business as you can before you indicate any interest.
- If the location is important, stand out of view outside and estimate the sales activity.
- Visit the business at different times, both announced and unannounced. A buyer of a restaurant was fooled into believing the business was doing well because the seller invited friends around for a free meal every time he knew the buyer was appraising the business.
Ask industry experts
Tap into the knowledge of those in the know:
- What’s the current and future demand for the business’s products or services?
- Are prices (and margins) rising or falling?
- How is the competition in that market changing? For example, which new competitors are entering or who else is looking to exit?
- Contact the relevant industry association if there is one. For example, if you’re interested in a retail business, talk to your state retailing association.
If the business is not making a profit, try to uncover why. For instance, it’s not a good investment to buy a café in a location where three other food and beverage businesses have gone bust.
Conduct detailed due diligence
Once you’ve indicated that you’re interested in buying the business and you’ve signed a Heads of Agreement or confidentiality statement, you can usually get access to more detailed information.
Speak to customers
Establish existing customer perceptions:
- Who is their main contact at the business? If this is the owner, then the owner’s continued involvement during the transition will be more valuable.
- What are the strengths and weaknesses of the business’s products or services?
- Do the customers use competitors? If so, what are competitors’ advantages?
- To what extent will they continue to support the business after a changeover?
Get a feel for the business’s credit history:
- Does the business pay on time?
- How does it compare with competitors?
Analyse results and trends
Analyse historical information and trends:
- Look at sales growth, profit margins, overheads and working capital (review debtors, creditors, stock and work-in-progress).
- Is there scope for improvement? What specific value can you add to this business based on your skills and experience?
Look for changes
Take care to look for changes or inconsistencies:
- Has the business recently changed its accounting policy to show better profits?
- Compare the business’s financial projections with other evidence you have. Do the forecasts tally with the historical trends?
- Is the sales forecast achievable given the current order book and what you’ve learned from customers?
- Does the forecast reflect the outlook for the industry and the whole economy?
You may need to revise any projections that are out of step with these indicators.
Check the finances
Does the business have an efficient accounting system in place and does the owner monitor key performance indicators regularly?
Check the major balance sheet items:
- When was the last full audit? If it was over six months ago, ask for another one.
- What are stock levels? Rising stock levels may be a dangerous sign, especially in manufacturing, seasonal or fashion industries.
- How large are the bad debts and why did they happen?
Conduct an employee audit
If you’re allowed access to the business, consider an employee audit:
- Identify the key employees so you can plan how to run the business.
- Compare the general skill levels, employee turnover and pay with industry averages.
- Ask employees how they feel about a change of ownership.
- Would you expect any to leave? If so, would the key people stay?
Uncover any legal issues
Complete a legal due diligence:
- Confirm legal ownership of all key assets. This might include property, equipment, vehicles and intellectual property (such as registered patents, designs and trade marks). Is the ownership clearly defined in all cases?
- Check for any past, current or pending lawsuits.
- Examine all contractual obligations. This includes employment issues and contracts with third parties such as customers and suppliers. Look for any contingent liabilities.
- Consider what effect a change of ownership will have. Are you likely to lose any contracts?
Making the first offer
Before you make an initial offer, get professional advice to help you value the business, especially if there are any tax implications. Make your own sales and profit projections rather than relying on supplied figures.
If you have ideas on how to increase profits, this is your good fortune, so don’t inflate your offer price because of opportunities you’ve identified. If you can’t identify where savings can be made and where there is scope to increase profits, then you shouldn’t be buying the business.
What is the risk?
Consider your level of risk. The risk is higher if the target business:
- has assets (stock and equipment) worth less than your offer price
- relies on one or two major customers – or suppliers or key employees
- is currently unprofitable or has a history of losses. In this case, you may have to fund losses for some time to come.
Though it sounds obvious, making a lower offer and increasing it if required is always a better strategy than going in high at the start. Ultimately, the business is only worth what someone will pay for it. The seller might have to lower their expectations.
Goodwill is an amount the seller might expect from you for the value of the business’s intangible assets such as an established brand, loyal customers, high profit, quality staff, good location, long lease or supportive suppliers.
Get advice from your accountant on the most favourable way to deal with goodwill. Try to negotiate it down if you can. For example, it may be more favourable to pay more for assets than to pay goodwill because assets can be depreciated over time.
Buy now, pay later
Sellers usually prefer a lump sum for the business, but in reality the seller often has to leave some money in the business to help finance the deal.
Try asking the seller if you can pay off the business over a period of time rather than in a lump sum. This allows you to pay using cash generated from the business itself and hints that the seller is confident the business will be able to fund repayments from cash flow.Read more