If you’ve got your sights set on purchasing an existing business with a financial history, there are some essential points to consider to ensure you buy second-hand not second rate. Tim Kilham explains the pros and cons of buying a resale franchise
You can buy a franchise from either a franchisor or an existing franchisee. When you buy a franchise from a franchisor it might be a greenfield franchise (a franchise that has not existed before in that area or place), an existing franchisor-owned business that is being franchised for the first time, or a franchisor-owned business that has previously been franchised but is currently owned by the franchisor.
When you buy a franchise from an existing franchisee you are buying a business that has already been operating as a franchise. The questions that need to be asked, and the due diligence that is required, are different when you are buying a business from an existing franchisee rather than a franchisor. This article provides some advice on issues relating specifically to the purchase of an existing franchise from an existing franchisee.
Reason for sale
There are many reasons why people sell businesses. They include a change of lifestyle, trading up or trading down, family reasons and so on. When the sale is for one of these legitimate reasons you will be told this. Not uncommonly, businesses are sold because they are performing poorly and not providing the franchisee with a reasonable salary or return on investment.
When this is the case, you will probably not be told this. You will be probably be given one of the other reasons.
So the first thing you should do when you are buying a franchise from an existing franchisee is to try to establish the true reason why the business is being sold. That is not to say that you should not buy a business that is performing badly – if the price is right, and you believe that you can turn the business around, then that may be a good reason for buying it.
When you buy a franchise business from an existing franchisee, the rights and obligations of the existing franchise agreement will be assigned to you. In other words, you take over the existing franchise agreement from the existing franchisee.
This means that you acquire the right to operate the franchise business for the remaining period of the franchise agreement. If the franchise agreement was originally for 10 years, and six years have expired, you have the right to operate the business for the remaining term of the franchise – a further four years.
It follows that when you acquire an existing franchise, you need to consider the remaining franchise period and whether it is of sufficient duration for you to achieve your investment objectives.
If you do not believe the remaining franchise period is long enough, it is often possible to enter into a new franchise agreement with the franchisor, but this may involve the payment of a franchise fee and other additional costs.
If the franchise you acquire involves leasing of premises, then you will normally take assignment of the lease, which means you have the right to operate the franchise from the premises for the remaining period of the lease.
If this is the case you need to consider two issues.
Firstly, you need to satisfy yourself that the remaining lease period is sufficient for you to achieve your investment objectives, in the same way that you need to satisfy yourself that the remaining franchise period is long enough.
Secondly, you need to consider the situation where the remaining lease period is different to the remaining franchise period. It does not make sense to have a franchise agreement that runs for a further six years but a lease that runs for just 24 months.
It is not unusual to find that the franchise you are purchasing from an existing franchisee is selling for less than the current selling prices of new franchises. There are usually good reasons for this.
One is that you may be buying second-hand plant and equipment that is worth a lot less than new plant and equipment. The second, and more common reason, is that the franchise has not performed to expectations and the price has been adjusted to reflect the lower than expected profits.
If you are able to purchase a business that is run down and jaded [or perhaps the owner is run down and jaded], and you are able to turn the business around, then the purchase will often prove to be a bargain.
But you need to be confident that you can turn the business around; sometimes performance is poor because the location is inferior and no amount of effort on your part will turn the business around. Always remember that the franchisee who currently owns the business is, usually, running the business to the best of their ability – so ask yourself whether you can run it any better.
Financial information from franchisee
You should expect the existing franchisee to supply you with full financial information. The existing franchisee is not required to do this – but equally, you are not required to buy the business without sufficient information.
The financial information you get should cover the period right up until the end of the most recent month. It is not enough for the franchisee to give you annual accounts prepared by their accountant that could be 10 or 11 months old. A great deal could have (and probably has) happened between the time you are thinking of purchasing the business and the time the last annual accounts were prepared.
You should ask the existing franchisee to provide you with the full annual accounts and tax returns prepared by their accountant. When I am advising potential purchasers of a franchise I often find that they have been given only partial information from the accounts and income tax returns, and that makes me wonder what the selling franchisee has to hide.
You should always ask the franchisee selling the business to provide you with financial reports that have been supplied to the franchisor. You should expect information in these financial reports to be consistent with the information contained in the annual accounts and ask questions if it is not.
Information from franchisor
Franchisors will not necessarily get involved when an existing franchisee is selling to a potential new franchisee, though some franchisors do have right of veto – after all, their brand reputation is at stake.
Involvement by the franchisor in the financial aspects of a sale involves a potential conflict of interest. It is not in the interests of the franchisor for a new franchisee to pay an excessive amount and as a result experience financial difficulties, but for the franchisor to involve itself in the process would be problematic.
Some franchisors will be prepared to provide you with the financial reports supplied to the franchisor by the existing franchisee. This is useful if full information is not forthcoming from the franchisee.
Financial information from other franchisees
I always advise potential purchasers of a franchise business to talk to other franchisees, whether the franchise is being purchased from the franchisor or from an existing franchisee. The existing franchisees usually know the business and the franchise system intimately, and can offer much financial and non-financial information. In many ways, the opinion of current franchisees is the litmus test for your purchase.
Disregarding the fringe franchisees [the outliers who are either exceptionally happy or exceptionally unhappy with the franchise, and who do not form part of the standard spread of franchisees] you should listen carefully to what the franchisees have to say – and particularly their answer to the question of whether or not, given all they know now, they would still buy the franchise.
Components of purchase price
When you buy an existing franchise business, the purchase price will usually include three components – stock, plant and equipment [including possibly vehicles] and goodwill.
Generally, it is in your interest to maximise the purchase price of the stock, the plant and equipment and to minimise the purchase price of the goodwill. Usually the opposite applies for the seller – the seller prefers to maximise goodwill.
There is no legal requirement for the purchase contract to apportion the price between the components, but if the contract does not, the Australian Taxation Office requires that the price to be apportioned between the different components is divided on a fair basis. The allocation between the components may not be the same for the purchaser and the seller – indeed the purchaser and the seller usually will not know the apportionment that each makes.
Co-ordinating the purchase
It is always advisable to use an experienced franchise solicitor to provide advice on the legal aspects of purchasing a franchise. A good solicitor is also very useful in helping you to co-ordinate the process of signing the documents when purchasing a franchise – indeed, the assistance of a solicitor is essential. The purchase of the business may involve the signing of a new franchise agreement, signing a contract of sale, the assignment of a lease or signing of a new lease, the signing of loan documents and a guarantee document with a bank, and so on.
You would not want to find yourself in a situation where you had signed a lease agreement and the loan documents to borrow the money, but then encounter a problem with the contract of sale and the purchase falls through. The services of an experienced solicitor are essential.
Tim Kilham is a director of Lanyon Partners Chartered Accountants and head of the franchising division. Contact Tim at email: email@example.com. Web: www.lanyonpartners.com.au