Franchising

Franchising A marketing system revolving around a two-party agreement, whereby the franchisee conducts business according to the terms specified by the franchisor Franchisee An entrepreneur whose power is limited by a contractual agreement with a franchisor Franchisor The party in the franchise contract that specifies the methods to be followed and the terms to be met by the other party

Franchising Arrangements
THREE KINDS OF FRANCHISES Trade Name Franchise Grants the right to use a widely recognized name within a particular territory
True Value Hardware, Associated Grocers Inc (AGI), Century 21

Product Distribution Franchise (Dealership) Allows you to sell a specific, brand-name product in a specified territory
Snap-On Tools, Toyota

Business Format Franchise Provides an entire business plan, marketing, and operating system Guidance from the franchisor is ongoing; supervision & monitoring are continuous
Subway, McDonalds

* * * * * * * * * * * * * * * * * * Single Franchise Owner Owns the franchise rights to operate in just one business location or territory Multiple-Unit Owner/Master Franchisee Has the right to open several franchised outlets in a given area or territory Piggyback Franchise A retail franchise operation within the physical facilities of a host store a Subway inside WalMart

The Pros and Cons of Franchising

Advantages
Probability of success
Proven line of business Pre-qualification of franchisee Overall lower failure rates

Limitations
Franchise costs
Initial franchise fee Investment costs Royalty payments Advertising costs

Training
Franchisor-provided

Restrictions on business operations

Products sold Hours of operation Restrictions on expansion/growth Franchisor only source of supplies

Financial assistance
Loans & loan guarantees

Operating benefits
Location feasibility study Marketing assistance Quick start-up time

Loss of independence Lack of franchisor support

Termination/renewal clauses

Franchisor Controls on Franchisees

Restricted sales territory Requires site approval and imposes requirements on the outlets appearance Restricts the goods/ services that can be sold Requires specific operating hours Controls advertising

An Attractive Franchise Opportunity Includes: - 1

Registered trademarks Successful prototype stores with a track record of profitability and a positive reputation A business that can be systematized so that it can be easily replicated.

A product or service that can be successful in many different geographic regions.

An Attractive Franchise Opportunity Includes: - 2

An operations manual that specifies all the functions of the business and their associated policies A training and support system Site selection criteria and architectural standards A detailed prospectus that spells out the franchisees rights, responsibilities, and risks.
The Federal Trade Commission requires disclosure...Uniform Franchise Offering Circular [UFOC]

Franchise Disclosure Requirements

Rule 436 of the Federal Trade Commission

Uniform Franchise Offering Circular (UFOC)

A document accepted by the Federal Trade Commission as satisfying its franchise disclosure requirements Litigation and bankruptcy history Investment requirements Conditions that would affect renewal, termination, or sale of the franchise

http://www.ftc.gov/bcp

Before Buying a Franchise

ASK QUESTIONS

Questions to Ask Before Buying a Franchise

Does the franchisor have an excellent reputation in the industry? Is the franchisor in partnership or any other legal relationship with another franchisor? If so, how will the franchisee be protected should that relationship fail? Is the franchisee required to do anything that appears questionable from a legal or ethical perspective? Under what circumstances can the franchisee or franchisor terminate the franchise agreement and what are the consequences to either party? Will the franchisor grant an exclusive territory? Is that area subject to reduction or modification? If so, under what conditions?

Questions to Ask Before Buying a Franchise - 2

Will the franchisor reveal the certified financial figures for one of its franchises and can those figures be verified with the franchisee? Will the franchisor provide a management training program, an employee training program, public relations and advertising support, or credit? Does the franchisor assist in finding a suitable location? What is the financial health of the franchisor? Can financial statements be verified?

Questions to Ask Before Buying a Franchise - 3

What is the track record of the franchise? Has the franchisor conducted an in-depth investigation of the franchisee to assure that he or she has the necessary skills and financial requirements to operate the business successfully? How much capital will be required to start and operate the business to a positive cash flow? Does the initial fee include an opening inventory of products and supplies? What do royalties pay for and how are they calculated?

How Risky is that Franchise?

Jeff Elgin, Entrepreneur.com/article /217285 9/2010

Are the number of franchise units growing/staying constant/or declining? (Item 20 of the FDD) Has there been an increase in litigation between franchisor and franchisees during the last couple of years? (Item 3 of the FDD) Scrutinize the last three years audited financial statements as part of the FDD.
Strong capital reserves, cash flows, and good profits? Are accounts receivables increasing? (may be a bad sign if franchisees cant pay monthly fees!)

Are the same-store sales figures increasing, holding steady, or declining? Is the business susceptible to economic downturns? What is the attitude of the existing franchisees? Call them and ask
How do you feel about the business? How have the past couple of years been? Knowing what you know now, would you do it again?

Buying an Existing Business?

Reduction of Uncertainties Acquisition of Ongoing Operations and Relationships A Quick Start

A Bargain Price

Good Reasons to Purchase an Existing Business

It is less risky than starting from scratch, because facilities, employees, and customers are likely to be in place. To acquire a business with ongoing operations and established relationships with loyal customers and reliable suppliers The business has established trade credit, which is crucial because relationships with suppliers and others take a long time to develop. It is an easier route to owning a business if the entrepreneur has limited business experience, especially if the owner stays on for a time to help with the transition. To begin a business more quickly than starting from scratch To obtain an established business at a price below what a new business or franchise would cost

Pros and Cons of Buying an Existing Business

Pros Higher chance of success Cons Existing problems

Less planning
Existing customers/ suppliers Necessary equipment Bargain price Experienced employees Existing business records

Poor quality of current employees

Poor business image Modernization required Purchase price based on inaccurate data Poor business location

Where to Find Business Opportunities

Attorneys Accountants Bankers The Wall Street Journal Liquidation auctions Business brokers The internet

What is a Business Broker?

When a business owner is looking to sell her business, she may turn to a business broker, who will look for a buyer for the business. Brokers typically charge one to 10 percent of the transaction price for their services.

Looking to Buy a Business?

How to Attract the Attention of a Business Broker
Demonstrate your strong interest in acquiring a business by providing information to the broker about your knowledge and interest in running your own business. Demonstrate strong financial qualifications Be willing to move to a new location to take advantage of a business opportunity Keep an open mind about the type of business; consider a wide range of opportunities. Be persistent and follow up with the broker Be ready to respond quickly when an opportunity emerges. This means having financial records in order and money available.

What to Look For in a Business

A business that had a broad scope that would insulate it from market downturns.

A business with existing customers and vendors

A low-tech business but with high growth A market that was not so large so as to encourage major players but not so small that the company couldnt grow. Available float from suppliers; in other words, leeway in having to pay vendors. Manageable seasonality Cost cutting potential

Investigating and Evaluating Available Businesses

Due Diligence The exercise of prudence, such as would be expected of a reasonable person, in the careful evaluation of a business opportunity Relying on Professionals Accountants Attorneys Other experienced business owners

Find Out Why the Business Is For Sale

Owners stated reasons for selling the business
Poor health or illness in the family
Wants to retire while he can still enjoy life Desires to relocate to a different section of the country Has accepted a position working for another company Wants to start a new business in a different industry

Has to sell the business to generate funds to settle a divorce, lawsuit, etc.
Beware of sellers who may have priced the business at more than its worth, or who have cooked the books to make the business appear to be more attractive than it really is.

The REAL reason the Business Is For Sale

Larger companies are squeezing the firm out of the market Key employees have been leaving The industry is very mature and there arent any new ways or places to grow Competitors products (or services) are superior The business has developed a negative reputation in the community The firm is facing a pending lawsuit The business is just not profitable The physical facilities are old or obsolete and in need of major renovation/repairs

Examining the Financial Data

Review financial statements and tax returns for the past five years. Recognize that financial data can be misleading. Assets overvalued

Expenses under-stated
Income over-stated Unrecorded debts Adjust asset valuations to reflect the true state of the business.

Valuing the Business

Asset-Based Valuation Estimates the value of the firms assets; does not reflect the value of the firm as a going concern. Market-Comparable Valuation Considers the sale prices of comparable firms; difficulty is in finding comparable firms. Cash-Flow-based Valuation Compares the expected and required rates of return on the amount of capital to be invested in the business.

Non-quantitative Factors in Valuing a Business

Competition Market Future Community Development Legal Commitments Union Contracts Buildings Product Prices

Placing a Value on a Service Business

The biggest asset of a service company is its employees, including senior management, followed by customers and the business system. The value of a service company is found in the quality of the relationship between its management (staff) and customers. Without those relationships, there is no business.

Getty Images

Possible Conditions on the Purchase of a Service Business

The owner must stay on as an employee for two years or perhaps as an employee for one year and as a consultant for two more. Any loss of an account or a large customer that was in place at the closing of the sale will reduce the payout by some defined amount. One-third of the total purchase price will be paid at closing. The remainder will be paid in equal payments over three years.

Negotiating and Closing the Deal

Negotiating the Terms of the Agreement Continuation agreement Non-competition clause Seller financing Earnouts and Indemnification agreements The final price Full payment vs installments Closing the sale Best handled by a third party
Bill of sale Tax certifications Payment agreements and guarantees

Do Your RESEARCH!
Develop a set of criteria for judging the business based on the entrepreneurs needs and goals.

Understand the industry and the market niche in which the business will operate Examine the records of the business

Getty Images

More Ways to RESEARCH!

Talk to employees, suppliers, and customers Examine equipment and facilities to make certain they are current and in good working order
Getty Images

Examine all contracts Verify the value of the business based on industry statistics and perhaps the advice of a professional business appraiser.

Valuation
There are a number of tools available to predict value including complex software tools that promise to reduce valuation to a simple formula. However, all of valuation comes down to this simple truth: A business is worth what a buyer is willing to pay.

What can the term value mean?

Fair market value.
This is the price at which a willing seller would sell and a willing buyer would buy in an arms-length transaction. By this definition, every sale would ultimately constitute a fair market value sale.

What can the term value mean?

Intrinsic value. This is perceived value arrived at by interpreting balance sheet and income statements through the use of ratios, discounting cash flow projections, and calculating liquidated asset value. Investment value. This is the worth of the business to an investor and is based on the individual requirements of the investor as to risk, return, tax benefits, and so forth.

What can the term value mean?

Going-concern value.
This is the current status of the business as measured by financial statements, debt load, and economic environmental factors, such as government regulation, that may affect the long-term continuation of the business.

What can the term value mean?

Liquidation value. This value assumes the selling off of all assets and calculating the amount that could be recovered from doing so. Book value. This is an accounting measure of value and refers to the difference between total assets and total liability. It is essentially equivalent to shareholders or owners equity.

Methods for Valuing a Business

Adjusted Book Value Multiple of Earnings Discounting Cash Flows Capitalization of Earnings
Getty Images

Adjusted Book Value

The book value of a going concern is simply the owners equity, that is, the value of the assets less the outstanding debts.

Getty Images

Multiple of Earnings
Using a price/earnings (P/E) ratio to value a business is a common method among publicly owned companies because its simple and direct. This ratio is determined by dividing the market price of the common stock by the earnings per share.
P/E RATIO = STOCK PRICE / EARNINGS PER SHARE

Discounting Cash Flows

Calculating how much an investor would pay today to have a cash flow stream of X dollars for X number of years into the future.

Getty Images

Three Factors Determine the Discount Rate

1. The rate achievable in a risk-free investment such as U.S. Treasury notes over a comparable time period. For example, for a five-year forecast, the current rate on a five-year note is appropriate. A risk factor based on the type of business and the industry should be added to the interest rate in item 1. The life expectancy of the business, because typically discounting is based on this factor.

2.

3.

Excess Earnings Method

1. Compute the adjusted tangible net worth of the business. Tangible assets are adjusted up or down for market value; then liabilities are subtracted. Compute the opportunity cost of this investment. How much would the investor/buyer earn by investing the same amount in another, comparable investment? Forecast net earnings. Earnings from previous income statements can provide a basis for the forecast, which is made before subtracting the owners salary.

2.

3.

Excess Earnings Method

Calculate the extra earning power, which is the difference between forecasted earnings and opportunity costs. Estimate the value of intangible assets or goodwill. If the business has extra earning power, that figure can be multiplied by what is known as a years-of-profit (YOP) figure. Calculate the value of the business by adding the figures.

Capitalization of Earnings
Either EBIT or EBITDA is divided by a capitalization rate, which is the return the buyer requires on the investment For example, if the companys EBITDA was $500,000 and the buyer needed a 20 percent return on investment, the price the buyer would be willing to pay would be $2,500,000.
EBITDA / REQUIRED ROI = MAXIMUM PURCHASE PRICE