in this article:
Dean Madsen of Westpac provides a guide to using the equity in your property to fund a business
With the improvement in the New Zealand economy in recent years, there’s been a significant uplift in the number of people looking to invest in a franchise business. Some of the factors that are helping to fuel this interest in business ownership are:
- Higher level of net migration;
- Current low interest rate environment;
- Increase in house prices resulting in borrowers having a higher level of available equity;
- Changes to current housing investment rules;
- Better economic environment for starting a business;
- High levels of business confidence.
The housing market – especially in Auckland – has been the subject of hot debate recently. REINZ data suggests that house prices have risen by 16 percent in Auckland over the past six months alone.
This increase in property values will make home owners feel wealthier, as they can now borrow more using the available equity in their home or investment property. While some will use this for further investment in property (which potentially fuels further growth in the property market), our experience shows others will leverage this increased wealth to look at purchasing a business.
This desire to own a business could be driven by perceived lifestyle benefits, or the potential for a greater return than investing elsewhere. In some cases, where investors are asset-rich they may be looking to generate cash flow to lower their risk.
If you are a home owner, a bank will typically lend up to 80 percent of the value of your residential property. What this means is that if your property is worth, say, $1.0m, you may be able to borrow up to $800k against the property. If you already have existing debt of $500k then you may be able to borrow an additional $300k using the equity available in your home. Of course, this presumes you will have enough income from either the business and/or other sources to be able to service the level of debt you need to purchase the business.
Just like purchasing a property, any prospective business purchaser needs to do due diligence on the business (assets) they are purchasing. This should involve a thorough assessment of the business’s profitability and the quality of assets being purchased. Part of this process will involve deciding how much you are willing to pay for a business, especially if you are buying an existing franchise outlet or territory.
There are several methods by which the value of a business may be measured. One of the more common methods we see is based on an ‘Income and Return on Investment’ approach.
Under this approach, the sale price is based on a multiple of Earnings (profitability). Profitability is usually measured based on either Earnings Before Interest and Tax (‘EBIT’) or Earnings Before Interest Tax Depreciation and Amortisation (‘EBITDA’). The multiple represents the sale price divided by the EBIT or EBITDA.
The lower the perceived risk, the higher the multiple a purchaser may be prepared to pay. One of the advantages of franchising is that you can often compare (benchmark) the sale of one business with the sale price of another. From our experience, this can also sometimes create an expectation within a franchise system that other franchisees should also achieve a similar multiple value for the sale of their business, but that’s not always the case. In assessing a fair market value for any business, you need to understand there are a number of factors that may affect the multiple. These include:
- Has the current business owner continued to reinvest in their business or have they let assets get run down, which may result in expensive upgrades in the future or costs associated with replacing old equipment that continually breaks down?
- Where is the business in the current economic or industry cycle? If the business or industry is mature, or it is facing increased level of competition, then profit levels may fall in the short term. You could pay too much if the profit used to calculate business value is at peak levels unlikely to be repeated until next cycle.
- Are there any lease issues? For instance, there is unlikely to be any guarantee that the term of the lease will be extended at the end of the current term. Also, many malls may require a full refit of a retail site upon renewal to ensure that standards within the mall are upheld.
- Does the profit and loss statement reflect the real level of expenditure levels involved in running the business, or has the owner cut expenditure to increase the level of profit and enhance the business value? Some costs essential to running the business in the long term may have been cut out to show inflated short-term profit levels.
The above factors also affect what a bank may be willing to lend against the business.
A benefit of the current low interest rate environment is that it lowers the total borrowing cost when purchasing a business. This can effectively reduce the term over which any loans are paid back. However, this may also lead to a purchaser being willing to pay a higher multiple as they can still afford to pay the debt back within an acceptable period.
The payback period should therefore take into account the lifespan of the assets being purchased and/or the length of franchise term (and lease agreements) provided. You should also allow for some movement in interest rates during the term of the loan and analyse your sensitivity to rate changes.
All these variables make it essential that before buying a franchised business you take proper professional advice from a franchise-experienced accountant and lawyer. They will help ensure you get the right information and assess it accurately.
Finally, another important member of your team should be a specialist franchise banker. They are likely to be familiar with the franchise system that you are thinking of buying into, and will know the sort of financial arrangements that are best suited. They can also add value by helping you put the right debt structure in place to meet your business requirements from the start.
Using the equity in your property can be a great way to fund a business but you need to take care at the beginning to ensure you don’t risk what you’ve built up. By building a good team of advisors around you, you’ll increase your chances of making a wise investment at the right price – whatever business you choose.
This advertorial is taken from Franchise New Zealand magazine Year 24 Issue 2
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This material is copyright © Franchise NZ Marketing Limited, Franchise New Zealand ™ magazine and Franchise New Zealand On Line . While it may be downloaded for personal use, no part may be reproduced in any form whatsoever without the specific written permission of the publisher.