WHAT ARE YOU PAYING FOR?

Daniel Cloete of Westpac looks at return on investment, exploring what you are paying for when buying a franchise business

Let me start out by that saying banks do not really have a view on what you should pay for a business. After all, it is what the market would pay. But the price you pay will most definitely have an influence on the funding options available.

A host of factors influence the debt servicing ability of the business; these include your own equity position, scale of the business, trends, profitability, stability of cash flow, etc. And banks will look at the same factors that you will when weighing up business options.

The franchise business model offers many benefits that underpin the initial franchise fee and ongoing royalties, marketing, and other fees. But the potential business owner needs a good understanding of what they get in exchange for these fees.

Return on Investment

Before leaving employment and going into business for yourself, you need to make a proper assessment of the risks, preferably with professional advice. One such consideration is the Return on Investment (ROI) - what you can expect to make from for the investment and the hard work you will have to put in.

STIHL SHOP is a nationwide network of locally owned stores offering a wide range of high quality garden equipment, supported by fully equipped service workshops.

There are many formulas and definitions of ROI. For this purpose, it is simply the return, divided by the total investment (your contribution, plus whatever portion you fund). For example, with a $100k return and a business investment of $500k, the return would be 20% p.a. For reference, the long-term average return of the S&P500 is around 10% (7% after considering inflation).

With business valuations, ROI is the inverse of a multiple. In one such measure, for example, small businesses may typically sell for between 1.5 times and 4.5 times earnings before tax, interest, and depreciation. Selling for 2.5 times this would indicate an ROI of 40%, five times would equal a return of 20% etc.

Systems use different valuation metrics (such as times weekly sales), but the banks (and you) are most interested in debt servicing ability and bottom-line profitability.

Daniel Cloete

Changing business models

In the current economic environment, the fundamental profitability of many franchise business models may have changed. Higher costs, including wages, food costs and rent, different sales margins, and higher (or lower) average sales numbers may influence the profitability of the business.

Look at the latest financials and benchmarks when assessing any opportunities. Ask, will you be able to recoup the set-up cost within the term of the franchise agreement? This is where a good franchise system/ franchisor can make all the difference in helping tweak a model to make sure it stays competitive and profitable.

Are you paying more?

When setting up a new franchise, potential buyers have the advantage of being able to get a detailed breakdown of initial and ongoing costs from the franchisor. This will normally be found in a disclosure document. Akin to a prospectus, this tells you more about the business, its owners and history. While this is not a legal requirement in New Zealand (it is in Australia), all members of the Franchise Association of New Zealand (FANZ) are required to have a disclosure document. Availability of quality information can influence the premium you are prepared to pay.

Characteristics shared by good franchise systems include solid management, clear information on performance of existing franchisees, a proven product or service, strong brand or trade name, and a tried, tested, documented way of doing business. Ongoing training and support, plus continued development of a concept is also important for systems to stay competitive, as is increased purchasing power.

Here’s a summary of initial costs and ongoing fees for starting up a franchise outlet.

Franchise fee

This is an upfront fee to buy into a franchise. It covers intellectual property, value of the brand, development cost of the franchise system for the franchisor and sometimes includes training and other fees. The stronger the franchise system, the higher the fee, and it could be worth paying. This can range from $10,000 to $100,000-plus.

Set up cost

This can be significant, particularly for a retail outlet. It includes furniture, fittings, as well as stock. If a franchisor has set up several franchises before, they’ll likely source components from the best value suppliers and can accurately predict set-up costs.

Look into fit-out contributions available from landlords. Do make sure, however, that franchisors or landlords do not load the price, as has been known to happen.

Ongoing costs

Royalties

These tend to be payable as a percentage of turnover (sales) or could be a flat fee, in service franchises, for example. Usually paid for the system’s brand, processes and other intellectual property, they should also cover the support given to franchisees.

Marketing fees

The system may also have a marketing contribution. This tends to be used for national advertising. You may still be responsible for local advertising.

If your bank is a franchise specialist, they may place significant value on the benefits and proven track record of a good franchise system, making getting business finance much easier. In the next article, we will cover in more detail funding aspects and the effect of the price of a business on obtaining funding.

About the Author

Daniel Cloete is the National Franchising Manager for Westpac. For more information, contact your local Westpac Franchise and Business Banking Specialist on 0800 177 007 or email: franchising@westpac.co.nz

The information contained in this article is intended as a guide only and is not intended as an exhaustive list of matters to be considered. Persons entering into franchise agreements should seek their own professional legal, accounting and other advice.