Never See Franchise Fees Negatively Again
A Head to Head Look at Goodwill, Franchise Fees, and What’s right for you
Written by; Rick Schell Feb. 10, 2020
Franchise or Existing Business
I talk to people almost every day about businesses and franchises. I am a business broker and I also sell franchises. I speak with people that are better suited for existing businesses and I speak with people that I strongly try to help them see the benefit of going in the direction of purchasing a franchise. Some buyers know exactly what they want. They have vast experience in a specific industry, and they have the means and the experience to purchase an existing business. They know what to look for during the due diligence process, they know how to properly place a realistic valuation on the business, they know what it takes to run and grow that business and they are focused on purchasing a company that fits all of the criteria they are looking for.
In contrast, for every one person I speak with that fits that mold, I speak with one hundred that don’t have a specific business or industry they want to target. They have never owned their own business, they have not decided on a specific industry, and they have never gone through the due diligence process of purchasing a business and they will either all but ignore due diligence, or they will overcompensate for their lack of knowledge and experience and over-complicate due diligence. Except in rare cases, I will at least show these potential buyers the advantages of purchasing a franchise or trying to purchase an existing business.
Goodwill vs Franchise Fee
I am amazed how often I speak with people that are willing to spend anywhere from $500,000 to over $1 Million dollars for an existing business yet object to paying $30,000-$120,000 for a franchise fee. Goodwill is the value placed on the net profitability of a business. Goodwill varies by industry and other factors, but typically the value of the goodwill is between two and three times the annual seller discretionary income, or SDE with three times being the national average. Some industries adjust for inventory and FFE (furniture, fixtures and equipment), and in other cases intangibles such as long-term contracts and patents will affect the value of a company.
In some ways, you can think of the franchise fee as the goodwill of the franchise. The franchise fee helps to cover certain marketing expenses, training, startup expenses, staff and administration expenses. It also goes to pay for the systems and processes that are in place that have proven to be successful and will help you as a new franchisee to get up and running. All this has value and they are legitimate costs involved in purchasing a franchise. Some franchisors will give laptop computers and or iPads preloaded with all the software, programs, and apps you will need to run your new franchise. They may include training material to help you get up to speed as well.
Another expense that is covered by franchise fees is the initial support you will receive by the franchisor. Many times, you will find that franchisors have staff support that will work very closely with you during the first few weeks, months or even years to help you get your business up and running. Remember Franchisors have a vested interest in your success, so they want you to get your new business up and running and they want you to be profitable as quickly as possible.
Let’s look at another benefit of starting a new franchise territory
Let’s look at this example of two scenarios. One is an existing business with annual net profits of $150,000. We will use the national average and say that this business is three times earnings plus an additional amount of $50,000 for FFE and inventory. We will also take into consideration a 20% cash down payment and using standard SBA timetables at a ten-year loan and $50,000 of additional working capital. Based on a 5% interest rate, the monthly payment for the next ten years is going to be $50,911 annually. We will also account for the $100,000 cash injection from the buyer and divide this by the ten years and pay zero interest so that will come to an additional $10,000. This means that the net benefit of the business will pay the owner $90,000 per year. This does NOT account for any potential loss of revenue OR potential growth; both would be very realistic possibilities especially in the first 1-3 years.
The next example is starting a new franchise territory. I have multiple franchises that have great six-figure income potential. Most of these franchises run between $80,000-$180,000 with everything included including working capital. We will use $150,000 as the figure for the “all in” amount with working capital included with this. Using the average first-year earnings of several of my franchises based on their FDD, (Franchise Disclosure Document), in this example IF you do your part to see approximately $500,000 - $800,000 in annual revenues at the end of your first full year and $800,000 to over $1 million in revenue by the end of your second full year in business. It is easy to see that If you are doing your part and working this business the way you would if you purchased a business that 15-25% net profits would have you achieving income of over $100,000 even in your first year in business. Many of the franchises I represent see their franchisees well into six-figure incomes by the third year.
When you look at these two examples, the existing business starts out day one with income where the franchise starts out day one utilizing working capital. The existing business starts out day one with over $50,000 in annual debt service and this lasts for ten years. The franchise in this example starts out debt free and remains that way so every dollar of profit goes into your pocket. If we compare that after two years as an owner in each example if both companies are hitting $1,000,000 ($1 Million) of gross revenue and netting 15-20% profit to the owner before debt, the existing business will net after debt service $90,000-$140,000. The franchise will be netting $150,000-$200,000 and no debt service to pay. As you can see in the big picture, purchasing a new franchise territory can be more beneficial.
When you purchase an existing business, there are several factors to take into consideration. One, you never really know the reputation of that business. Two, you don’t know the underlying status of the employees. I have literally seen a 100% turnover of employees within one year of a new business owner purchasing a business. Three, you don’t know the condition of the equipment or the value of the aging inventory. And, when the owner sells the business to you, he has no incentive to help you succeed. Most sellers disappear very shortly after the business is sold.
When you purchase a franchise, you are starting fresh with a clean slate. You have all new equipment. Your employees are loyal to you, not a prior owner. You build the reputation, and you have a recognizable brand backing you. The franchisor always has a vested interest in helping you succeed. Finally, you have a proven business model that has shown to be successful over and over.
When considering whether to purchase an existing business or going with a new franchise territory, remember, you will get out of it what you put into it. You cannot expect to have a thriving, growing business whether you purchase an existing company or start a new franchise territory if you don’t put the effort into building and growing that business.
Do you want to do it all on your own or do you want to have experts in the industry at your disposal to help you build and grow? If you think you could benefit from utilizing an existing business model with ongoing back office support, you probably should take a good hard look at franchising.