How to spot an undervalued franchise
It’s not often that buying a franchise is described as getting a bargain.
Typically, buying a franchise costs more at first than setting-up an independent business, but this is usually offset by improved cash flow, faster achievement of breakeven, more effective marketing, rapid operational deployment and reduced risks to the operator due to the training and support provided by the franchisor.
Franchise buyers will generally have a choice of two types of franchise: an existing business that is being sold as a going concern, or a “greenfield” (ie. start-up) which has not yet commenced trading.
Depending on a potential franchisee’s willingness to accept a higher level of risk in their business investment, it is possible to occasionally find an undervalued franchise, be it a going concern or a greenfield.
A going concern outlet in an established network may be sold for a lower price than a greenfield franchise for a variety of reasons, including:
- Outlet underperformance;
- The outlet lease or franchise agreement is approaching the end of its term without an option for renewal;
- If the outlet has ageing equipment, fittings or stock;
- If the owner is under pressure to sell, particularly within a compressed time frame.
An outlet might underperform for a variety of reasons. It could be in a poor location, the owner may not be managing the business particularly well, the outlet could be presented poorly, it may not offer a complete range of product or services, or any number of other reasons.
If you are able to identify the root cause of the underperformance in the business, and are confident that you can overcome those issues, then an underperforming franchise could be an excellent “bargain” for the savvy franchise buyer. Existing franchisees are often excellent candidates to buy an underperforming outlet as they have the operational expertise to address the performance issues, and are often capable of taking on an extra outlet close to where they are already trading.
End of lease or franchise term
A franchise sold toward the end of its lease or franchise term (where no renewal is offered or available) will be worth much less because a buyer will only have the business for the balance of the term available, and consequently will have much less time to earn back the price paid to buy the business.
If a business has only one year left on its five-year franchise agreement and retail lease, it is conceivably worth only 20% of the price of a business with a full five-year term available.
If you are new to franchising, then buying a business in these circumstances is not recommended unless you are prepared to accept the risk that your lease or franchise term will run out before you have made enough money to get a return on your investment.
Ageing equipment, fittings, etc
A business which has visibly ageing equipment, fixtures, fittings, or aged or depleted stock could potentially be bought under full market value because it needs a level of reinvestment that the current operator cannot afford or is otherwise unwilling to make.
An example might be a retail store which is looking old and tired, but which still has a considerable term left on its lease (or which requires a refurbishment as a condition of granting a renewal on its lease). If the existing owner has not set money aside to reinvest in their business their sale price will be reduced accordingly.
While a new owner might pick up the business at a lower price, the additional investment required to refurbish the store, upgrade the equipment and fittings, or buy new stock, might bring the total cost of acquiring the business to the same level as buying another at full price.
The owner is under pressure to sell
A colleague once told me that to get the best deal when buying a business, you should look for three things: debt, death or divorce.
These three things can all put pressure on an owner to sell a business. Too much business or personal debt can force a sale, a death in the family (or of the owner themselves) can force a sale, and the division of assets that usually accompanies a divorce can also trigger a sale.
In each of these cases, a sale is likely to be conducted quickly, and in a shorter timeframe than would be undertaken for a business operating under normal circumstances. The need to appease one or more third parties (eg. secured creditors, ex-spouses, the beneficiaries of an estate) from the proceeds of a sale can provide a strong incentive to sell quickly, even if it is not always for the best price. This might be bad news for a seller, but good news for the buyer.
Undervalued greenfield franchises are harder to find and come without an existing income stream, compared to going concerns.
Established franchisors will rarely, if ever, discount new franchises. However every few years they might review their franchise to reduce some of the costs in setting-up a new store.
For a retail businses with a set-up cost of say, $400,000, a review might be able to reduce the set-up cost by five or 10 per cent if a different fitout, fixtures or fittings are used, or a lower up-front franchise fee is applied.
While this might not be a large enough reduction to qualify as “undervalued”, it is still a valuable saving for a franchise buyer.
Generally speaking, undervalued greenfield franchises are most likely to be offered by start-up franchisors who are keen to attract enough early adopters to get their network to achieve a critical mass of outlets as quickly as possible.
However this occurs quite rarely as most new franchisors tend to need the capital injection from granting franchises more so than a critical mass of outlets. When it does occur, outlets may only be offered to those who already have a relationship with the new franchisor, and therefore the vast majority of potential franchise buyers will be unaware of the undervalued offer.
Regardless of the circumstances of a franchise offer, a potential buyer must always undertake extensive due diligence before commiting to a purchase.
So with this in mind, the best chance of finding an undervalued franchise is to look for a going concern that is underperforming, in need of reinvestment, or where the owner is in financial strife or has other serious distractions in their life.
Strangely enough, few of these circumstances commonly feature in “For Sale” headlines, so a closer look at the advertisements for existing businesses for sale will reveal whether or not they represent an opportunity to buy a bargain.
Happy hunting, and always remember that if a deal looks too good to be true, it probably is.
© Jason Gehrke, 2022
Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for more than 30 years at franchisee, franchisor and advisor level.
He advises both potential and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News, a fortnightly email news bulletin on franchising issues and trends.