This guide to buying an existing franchise business was written by Daniel Slone, our contributing franchise reviewer.
Often those looking to buy into a franchise brand focus on opening a brand-new outlet. While there is certainly a lot of excitement associated with this process, especially if you attend a franchisor’s “Discovery Day” or similar event, it is not the only path.
I regularly review various franchise opportunities primarily from the perspective of someone establishing a new franchised location. However, the organization that employs me has actually purchased a large number (almost 60 all told over the past few years) of existing franchised quick-service restaurants of various national brands, so I am very familiar with the process.
In this discussion I want to share some of what we’ve learned from our experiences.
Basic Mechanics of Buying Any Existing Franchise
First, you must understand that the buyer of an existing franchise must be approved by the franchisor prior to the transfer, meeting essentially the same criteria that a brand-new franchisee would. In fact, the requirements may be even steeper if you are buying out a multi-unit franchisee, because the franchisor will want to ensure that you are financially capable of taking on the challenge.
Second, you will not be paying only the seller. The specifics vary from system to system, but at a minimum you will pay a transfer fee. Those fees are normally less than the franchise fee but still significant, ranging from a couple of thousand to several thousand dollars per unit. The specifics will be disclosed in the franchise disclosure document (FDD) which you will receive as part of the qualification process, so this will not be a surprise.
In some franchise agreements the language specifies that the seller will pay the transfer fee, but even if that is the case you can expect that the amount will be built into the purchase price. In other words, go ahead and tack the fees onto your valuation of the business itself.
Third, what happens with the franchise agreement varies.
Some franchisors will simply transfer the remaining term of the existing franchise agreement or agreements, so if for example the agreement has an initial term of 20 years and your seller has been in business for 12, you will have eight years remaining. At the end of that time you will sign the then-current version of the franchise agreement, which is standard for renewal in any franchise system, and pay the renewal fee.
In some cases the franchisor for some of our restaurants granted an extension of the existing agreement to delay renewal for a modest fee (around $5,000 per unit, though this is a very specific example, and the same franchisor did this for us in some cases but not in others).
The third possibility is that the franchisor will require you to immediately execute the current franchise agreement with a modified term matching what remained on the seller’s agreement, but this is the least common occurrence.
Again, the precise mechanism of the transfer will be spelled out in the FDD and the franchise agreement (the current version of which is included as an exhibit to the FDD).
Since your attorney will carefully review these documents and advise you, it will be possible to calculate any financial impact of the transfer requirements and include it in your negotiations with the seller. (You will have an attorney review the FDD and franchise agreement, right?)
Knowing What Price You Should Pay
Broadly speaking, the value of the business (which may or may not have any bearing on the asking price, depending on how rational the seller is) is fairly simple: It is the value of any associated assets (in the restaurant business existing stores are often leased rather than fee properties, taking real estate out of the equation) plus the value of the business itself.
If the deal includes any real estate, that’s fine. Getting appraisals from a neutral party is not difficult, and if you have a lender involved in the deal—which you almost certainly will—they will insist on them anyway.
Beyond that, cast a wary and critical eye on any valuations attached to other assets like furniture, fixtures, and equipment (FF&E), vehicles, tools, and so forth. While they may be necessary to the business, their intrinsic value (that is, what you could take them out and sell them for) will be a fraction of what they originally cost.
Your seller may also attach a cost to the franchise agreements themselves, which certainly do have value—that’s the whole point of franchising, after all.
As a buyer you would want to see the seller take a pro rata portion of what he or she paid as a franchise fee based on how much of the term remains. A clever seller might take a pro rata portion of the current franchise fee (assuming it has increased) using the rationale that this is what it would cost you to enter the franchise system now. The actual number will be a matter of negotiation, of course.
The final and primary component is the EBITDA (earnings before interest, taxes, depreciation, and amortization), which is a thumbnail of the cash flow the business generates. Profit and loss (income) statements do matter, but cash flow matters more.
The Three Typical Scenarios of Buying an Existing Franchise
There are three basic conditions under which you will acquire an existing franchise, and fortunately (for the purposes of this discussion, that is) my organization has experienced each one. Think of Goldilocks and the Three Bears: there’s too hot, too cold, and just right.
In the following sections I will describe in general terms our experiences and include some hard numbers (within the limits of preserving my organization’s confidentiality). The case histories all involve quick-service restaurants, so bear that in mind when considering the degree of applicability to your target industry or specific franchise brand, but the good news is that these three cases all involve the same national brand, so we will have good apples-to-apples-to-apples comparisons.
In general terms, there are only a handful of common reasons for someone to sell a business. One is that someone comes along and offers a price that the owner simply can’t refuse. The old saying about poker is that if you sit down to a game and don’t know who the sucker at the table is, it’s you. Deals like this tend to be that way: either the buyer or the seller probably knows something the other doesn’t. People don’t build the financial wherewithal to buy a business by making stupid financial moves, and overpaying for a business is one.
Another reason is that the business owner is ready to retire, get into a different business altogether, or otherwise move on and does not have family to whom he or she can (or will) hand over things. These are usually the good deals. The business is reasonably healthy, and the purchase can normally be negotiated to a reasonable price.
The final major category is what we politely call “distressed operations.” These are the businesses that have gone to hell in a handbasket for whatever reason and that the owner must sell—whether because he or she no longer has the financial means to operate, because the franchisor is leaning hard on him or her (failing operations make the brand look bad, after all), or because for whatever reason a fire sale has become necessary. These can be winning deals—we’re about to look at one that was—but there are a number of conditions that go into achieving success.
Papa Bear’s Porridge: Too Hot (Case Study #1)
In March 2011 we had the opportunity to purchase nine units (as a reminder, all three of these examples involve the same national QSR brand) in a significant East Coast market. This was no fire sale; instead, these were franchisor-owned stores that the parent was willing to divest.
This opportunity is found most often with very large, very established franchise systems; if that’s the sort of franchise you want, buying corporate stores can be the best way to gain entry.
They had been operated and maintained well and were producing good cash flow and EBITDA. In November we added a tenth location, followed by an eleventh at the end of May 2012.
The key to success in this situation—something we replicated multiple times—was to bring in the right operating partner who had expertise in the business and pay and incentivize him properly to run the operations. Our organization provided the back-office administrative and financial support, but our guy on the ground—who had about 20 years working for the franchisor—had full rein over running the restaurants.
The principle here is pretty simple: Don’t get into a business you don’t know well unless you can bring the right expertise on board.
Starting out with new franchises is different; in addition to full training from the franchisor, you’ll have time to learn the intricacies of how the business works as your holdings grow. But an existing multi-unit business is like a fire that can too easily get out of control and burn away your operating capital before you learn what you need to know—a painfully expensive education.
The Results in Numbers
Year-over-year growth for the original nine stores from April 2011 to April 2012 was about 0.8 percent—certainly nothing to write home about. But performance was already solid; 2011 net ordinary income (only from mid-March for nine stores and from mid-November for the tenth, remember) was nearly $700,000, a rate of 7.9 percent of gross revenue.
Total expensed acquisition costs were only about $16,000 (things like franchise fees that are part of the purchase price are not taken as an expense immediately; rather, they are amortized over varying periods). But in addition we executed a sale-leaseback of one of the stores (a sale of real estate in which the buyer agrees to lease the property back to the seller). The proceeds of the sale were $900,000, which we used to reduce our long-term debt.
Speaking of debt, we initially financed $3.45 million; another $432,000 came from investors and the rest from us. So a purchase price of $4.2 million plus another $615,000 for the tenth unit in the first calendar year generated a 14.3 percent return on investment.
In 2012 gross revenue was $11.83 million—bear in mind that an eleventh unit was added at the end of May. Net ordinary income increased to 8.9 percent of gross revenue, or nearly $1.042 million.
There was not any significant deferred maintenance—one of the major risks of buying existing businesses. Repair and maintenance costs in 2011 were 2.9 percent of revenue, dropping only slightly to 2.7 percent in 2012. (A typical number for our operations is between 2.0 and 2.5 percent, but typically on the higher end of that range for older stores.) We did invest in remodels of four units at roughly $150,000 each.
In late 2012 we were approached by an interested buyer. Although we had not been actively seeking to sell the operation, the offer represented a significant premium over our purchase price—not counting the nearly $2.1 million in income the operation generated for us between March 2011 and March 2013.
You may wonder, then, why I described this deal as “too hot” when in actuality it worked out very handsomely for us. The “too hot” moniker refers to the fact that a successful existing operation will often command a premium price.
Of course, such a business should also be generating healthy income and cash flow and should not have many blemishes that require attention. As long as you do not overpay—and sometimes that’s the trick—you can be very happy with Papa Bear’s porridge. But don’t expect any bargain-basement prices.
Mama Bear’s Porridge: Too Cold (Case Study #2)
The most common way to get a bargain price is to find a distressed operation. Other than scale, there is little difference in buying a distressed business and buying a fabulous but beaten-up antique at a garage sale: if you have the skills, patience, and money to restore it, you can end up with a gem at a great price.
Those “ifs” can be significant, though—something we experienced with our third acquisition.
Our third deal was also for 10 units. They were owned by a large franchisee with about 150 units total in the system scattered across the U.S. (and outside it; they have stores in the Virgin Islands, which is also where they are headquartered). The seller also had other business interests, and frankly these restaurants had clearly been a very low priority.
If you can name the problem, these stores had it—delinquent property and sales taxes, pending remodels, a truckload of deferred maintenance, rampant theft and waste, poor store-level management, and an operations manager who ran the units like his own little fiefdom—his own little poorly-managed, nepotism-ridden, drowning-in-red-ink fiefdom.
We took over at the beginning of August 2012, and for 2012 food cost was a whopping 35.5 percent, repair and maintenance costs hit 3.6 percent, and we incurred a net operating loss for the year (which was only five months) of $268,000 or 9.4 percent.
This past year was better, but only in relative terms. We cut the net operating loss to 3.8 percent, but as we got heavily into remediation our repair and maintenance costs for the year shot to 4.3 percent—about double what it would be for “normal” stores. We hired a new operations manager, fired him, and hired another new one.
We sank a few hundred thousand into mandatory remodels, and by January 2014 we had closed three underperforming stores.
Creative Financing—and Its Limits
We actually paid more for these units—$5.65 million—than we did for the ten better-performing stores in our first deal. While that might seem counterintuitive, the price was higher in part because of creative financing. This deal was done with no cash out of pocket. How?
The first piece was that $1 million of the purchase price was owner-financed. The seller was willing to agree to this since he understood how distressed the stores were and how hard they would be to sell at anything approaching a decent price.
But the truly creative part was the simultaneous sale-leaseback of seven of the stores (three were already leased properties) to provide the capital for the deal. In other words, the purchase included the real estate for seven locations (the other reason the purchase price was higher than our first deal, which had included almost no real estate).
We closed the purchase and simultaneously sold the properties to a third party and leased them back, using the proceeds to buy the stores that we had just sold them. (If the chronological contradiction inherent in that notion makes your head hurt, have some sympathy for me—I had to figure out how to accurately book the transaction.)
In other words, rather than incurring debt we incurred rent. Now, your first reaction might be that debt eventually gets paid off while rent is forever. You’re absolutely correct. However, our intent is to rehabilitate and eventually resell this operation, hopefully in a timeframe that would not have permitted full repayment of long-term debt.
Besides, once we get this operation to profitability and taxes become an issue, rent is fully deductible, but only the interest portion of debt maintenance is.
Of the three deals under discussion here, this was by far the least successful. The bottom line is that the operations have been harder to rehabilitate than they were in the second deal (coming up next) and there has been far more expense involved in bringing the stores up to par.
This is why purchases of distressed operations require very careful due diligence. If you are not capable of pumping $250,000, $300,000, or even more each year into the business for a few years, you would be better off looking for something in better shape even though it is more expensive.
Baby Bear’s Porridge: Just Right (Case Study #3)
Our second deal (chronologically) illustrates a favorable outcome of rehabbing distressed operations. This is the story of another ten units—only one state away from our first set of stores, as it happens—that were in pretty dire straits. However, in this case the problems were more with the owners than with the restaurants themselves.
The owner was behind on royalties to the tune of about $230,000, had delinquent property taxes hanging over him, and even needed an advance from us (applied against the purchase price, of course) to meet payroll.
We acquired these stores in stages between May and October 2011, and only purchased the associated real estate for seven of the locations in April 2012. This deal was conventionally financed with a combination of debt (approximately $5 million) and cash flow, plus a small portion ($350,000) of owner financing.
In the first calendar year of operations we suffered a small net operating loss of less than $23,000 or 1 percent. Another $300,000 in acquisition costs has to be added to this, however. There was a little deferred maintenance to address—repair and maintenance costs for the year were 3.2 percent—and we had to begin a series of mandatory remodels that we are finishing up this year.
In 2012 we had another net operating loss, this time 1.2 percent or a little over $100,000, but EBITDA was positive — we booked $305,000 in depreciation and amortization alone. Cash flow for the year was positive. Repair and maintenance came down to a more typical 2.6 percent, although it must be remembered that remodels are capitalized and so not included in this expense.
Getting Things “Just Right”
In 2013 our rehabilitation paid off. Net ordinary income jumped to 4.9 percent or $446,000. Cash flow doubled from its 2012 level. Revenue increased from $9.064 million in 2012 to $9.272 million in 2013.
During this time we also restructured the balance sheet. In 2012 we began a gradual process of sale-leasebacks (in this case to individual buyers) of the seven fee properties. The sale of six in 2012 and 2013 (we still own one) produced gains on asset disposal of $1.19 million in 2012 and $1.411 million in 2013.
Most of those proceeds were combined with some of the proceeds of the sale of our first operation to retire all of the long-term debt for these companies, which provided a boost to income in 2013 by cutting interest expense from over $163,000 in 2012 to only $17,300 in 2013.
This deal was also the first time we gave our operating partner—another veteran of the franchisor’s corporate organization—a small (15 percent) sweat equity stake in the company in addition to his salary. Equity can be a great way to bring on board operations talent that you might not otherwise be able to afford.
As you can see, creative financing and identifying a business that was less distressed than its owner allowed us to fix what was wrong, retire debt, and improve both revenue and income all in fairly short order. In the course of just over two years we turned 10 restaurants into 31 and by early 2013 had no bank debt. Every deal is different, though, and as you can see we had significantly varying degrees of success even among just three deals for the same franchise brand.
Buying an existing business can be a great way to enter an established brand that has few available new markets and to immediately enjoy significant revenue. However, with significant revenue comes significant expense, and if the business in question is not generating positive cash flow, the money to cover the difference will have to come from you. Be absolutely certain you can take on the burden, and assume that things will be worse than you initially expected—in my experience they usually are.
In the course of your due diligence remember that what the current owner’s financial statements say is not the whole picture. In the case of distressed operations, it is safe to assume that money that needs to be spent isn’t being spent, and so to rehab the business you will have to take on increased costs. In other words, if the seller’s income statement looks a bit scratched up, yours may well look bruised and bloody, at least for the first year or two.
Taking on an existing business can be gratifying, exhilarating, frustrating, and exhausting all at the same time. But just as with buying a new franchise, you have the opportunity to build something of value to either keep and hand down or sell that will carry your stamp and the unique signature of your efforts.