last updated 23/09/2019
Making A Good Investment
last updated 23/09/2019
With the housing market slowing, investing in a profitable business with stable cash flow is increasingly attractive
One reason many people choose to buy a business is as an investment. They see a franchise as their superannuation fund, or a good place to invest surplus money – perhaps a redundancy payment. And, if they have a lot of free equity in their property after the past few years, a good franchise can offer a great opportunity to make use of that equity without selling.
A franchise offers many advantages over an independent business, such as brand, buying power, training, systems and support. In analysing a franchise as an investment, though, there are a number of unique issues which have to be taken into account.
choosing the right business
The first of these issues relates to the type of business you choose in the first place.
the economic environment
Changing economic times mean that some industries are growing whilst others are slowing. Those that have enjoyed growth over the last 3-5 years have seen increased sales and profitability. This is good news for those looking at new outlets, while existing outlets may offer strong cashflow – although prices will be higher. Higher prices may tempt those ready to retire to sell profitable businesses that do not normally come on the market, offering more choice. With funding costs still at historically low levels, good opportunities can be very achievable.
This has to be balanced by the fact that, in other industries, sales may be static or declining. Some existing businesses may be for sale because they are not economically viable, but some great opportunities may also come up. That’s why it’s important to carry out careful due diligence with the aid of franchise-experienced advisors.
All businesses carry risk. The risk factor of a good, well-proven franchise is significantly less than that of a non-franchised business, but it still exists. Some risks are within your control but others, such as competitor activity, product or location failure, are not. Consequently, you must allow for risk in determining what level of return you are looking for. You would want to achieve a higher rate of return on a business investment than you would expect from a term deposit where the risk is very small.
A term deposit is a passive investment which consumes very little of your time. If you invest in a franchise, though, it is an active investment and you will be involved on a day-to-day basis. While some franchises allow for part-time working, in many cases you will have to devote the majority of your working time to the business – in fact, the franchisor may insist upon it. Choose a franchise that matches the time you are prepared to put into it.
A good franchise can generate ongoing income as a wage for the owner and as a return on investment.
Because a franchise is an active investment, you should allow for a reasonable working wage commensurate with the type of work you will be doing before looking at the investment return you can expect. After all, your labour is a real cost of running the business.
It is better to buy a more expensive, good, profitable business than to buy a low-cost business that offers little or no profitability or growth potential. When assessing an application for finance, banks don’t just look at the security you can offer. They take into account factors such as the profitability, quality, debt servicing potential and risk of the business – and so should you.
In any particular sector there may be 10 different franchise brands, each with a variety of new and existing locations for sale. Of these, not all will be truly profitable and growing businesses – some may be marginal. You should take your time to identify the true jewels out there which can offer you a return on the capital you have invested in it. A marginal business will paint the owner into a corner with negative cash flow and mounting debt ratios; on the other hand, the biggest problem created by a profitable and growing business could be paying too much tax.
In addition to the ongoing return, the other issue is how much you will get for your business when you sell it. A successful business in a high-performing franchise is likely to attract a considerable premium and offer a good capital gain. However, there are some unique factors in a franchise that may have a material bearing on the sale price.
Most franchise agreements have certain restrictions on re-sale. A common clause is that the prospective purchaser must meet the franchisor’s selection criteria for new franchisees. This is understandable as it protects the whole system. However, good franchisors would not unreasonably prevent a franchisee from selling.
treatment of goodwill
The goodwill associated with the intellectual property (trademarks, operating system, etc) belongs to the franchisor. However, as a franchisee, the business which you are selling includes the right to use the intellectual property, and the goodwill associated with this right is usually considered to be yours. Check how this is treated in the franchise agreement, as there are some cases where the franchisor shares in the goodwill.
Some agreements provide for a transfer fee to be payable to the franchisor upon sale of the franchise. It is reasonable for the franchisor to be re-imbursed for any costs it will incur because of your decision to sell, but check the franchise agreement to see if such a fee is payable and how much it is. Another area you should check is who is responsible for the training of the new franchisee, and who pays for it.
Franchises are granted for a defined period of time, with some agreements containing rights of renewal subject to the franchisee meeting certain conditions. You must be aware of what you have to sell to a prospective buyer. Let’s say your original term was for eight years, and you are selling after five. Will the buyer be granted a new agreement with a new eight year term from the franchisor, or will they take over your existing term with only three years to run? Is there a right of renewal? Banks normally only finance for the period of the franchise agreement. These are all factors which will affect the value of your business to a purchaser.
As with any business (or home), at the time you wish to sell the market may be buoyant or depressed, with resulting impact upon the value of your investment. This is another aspect of the risk element alluded to earlier, and is beyond your control.
funding is available
Even if you are buying into something you have always wanted to do, you should ensure you are spending the money wisely. Before buying any business, therefore, you should take care to do your research wisely, take legal and financial advice from franchise-experienced professionals, and ask lots of questions. If the opportunity stacks up, your local Westpac Franchise Specialist will be happy to help with funding.
At the end of the day, the return on investment will be determined by the franchisee’s own effort and performance. Unlike that term deposit, it’s up to you.
The information contained in this article is intended as a guide only and is not intended as an exhaustive list of matters to be considered. Persons entering into franchise agreements should seek their own professional legal, accounting and other advice.
See this advertorial on page 74 of Franchise New Zealand magazine Year 26 Issue 4
Contact details for Westpac
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