by Simon Lord
last updated 19/06/2023
VISION – Looking at the long term when buying a franchise
by Simon Lord
last updated 19/06/2023
Building a great business takes time. Can buying a franchise help you achieve your financial and life goals?
What do you want out of life? Increased net worth, financial independence, a home of your own, a good education for your children? Do you want to be your own boss or contribute to your community somehow? These are the goals that help you create what you want in your life.
The important thing to remember is that these goals all require long-term thinking – you can’t achieve them overnight. And when you buy a franchise, it’s wise to apply that long-term approach, too. How many years are you prepared to put into a business of your own – and what do you want to get out of it? According to surveys, most franchisees in New Zealand stay with their chosen system for over 8 years – almost 20 percent stay more than 10 years. And there are many examples of franchisees like Mike Vickers, who has been with V.I.P. Home Services for 20 years already and has no intention of stopping.
That’s why, although it’s important to know how long your business will take to break even (pay its own way) and to generate personal income in the short term, it’s also important to consider your long-term prospects.
What goes around, comes around
Over the course of, say, 10 years, any business is going to face challenges. The changing economic cycle will see periods of boom and bust, rising and falling employment levels, changing rates of inflation, and higher or lower interest rates. Experienced franchisors – and franchisees – will already have lived through one or more of these cycles. For the new business buyer, then, what is important is not so much where we are on the cycle right now, but how well their chosen franchise can perform over time.
‘If you look at the share market, shares go up and down in value constantly, but the underlying trend for good companies has historically been positive,’ points out Daniel Cloete, Westpac’s National Franchise Manager. ‘That’s why shares are best viewed as a long-term investment. If you apply a similar approach to buying a franchise, and choose something that not only suits you personally but is solid, profitable and sustainable over time, then you can do very well.
‘The normal business environment is one of ups and downs. If the business you are looking at can deliver positive results in the current tight market, then it’s a good sign. It means that when conditions ease, you’ll be well-placed to reap the benefits.’
Advantages of franchises
As Daniel says, one of the advantages of buying a franchise is that it’s a lot easier to find out about how the business really performs than if you buy or start up an independent business. ‘People might show you their pre-Covid figures, but the world has changed since then and what is important is how the business is performing now, and how it could perform in the future.
‘If you buy a franchise with an established company, you’ll be able to check the reputation of the brand and how it has fared during previous downturns, but you’ll have access to so much more information, too: information from across the whole network on rents, sales, wages, Gross Profit margins, and you’ll be able to compare your prospective figures to these to assess the long-term potential of your investment.
‘Talk to accountants who know the franchise, talk to other franchisees in the group, and don’t be afraid to talk about risk. Just as with buying shares – or property – starting any business does involve risk and you need to be comfortable with the level of risk you are taking on.’
Daniel continues, ‘A good franchisor will work to reduce risk for its brand and its franchisees all the time. For example, franchisors normally have supplier arrangements in place which have helped them deal better with the supply chain issues of the past few years. The result was that their franchisees had supplies, while others ran out. Leases are another area where franchisors are getting directly involved to lessen the impact of inflation on franchisees. The result is that, even in the current market, some of our franchise clients are still very profitable.
‘And don’t discount the value of the franchisor’s oversight. One large franchise I talked to recently collates information throughout its network to produce detailed analysis of the margins on all its products. They take action if the margin moves a fraction. This is why you pay a premium for their franchise system – their pro-active approach lowers the risk for their franchisees.’
What about newer franchise systems which might not have the experience or size of some of the more established brands?
‘It’s fair to say that there is a higher risk with a new franchise, and you shouldn’t discount that, but there are also potentially higher rewards, too,’ says Daniel. ‘Entry fees should be lower, because you aren’t paying a premium for an established brand, and there will be more choice of territories, better locations and quite possibly less competition, too. Some hot new franchises can drive unbelievable numbers, and that applies just as much in the regions as in the cities. But the risk is higher with a newer brand, so you need to do your research and take all the advice you can from experienced professionals to lower your risk as far as possible.
‘One thing you will have to be aware of is that when you are seeking funding, a new franchise will require you to have more security or more equity than an established brand with a proven track record.’
How long do you have?
One major difference between a franchise and an independent business is that franchises are usually granted for a fixed term, often with rights of renewal. A common approach might be a 5-year initial term with two further terms of 5 years, giving a possible 15 years in total. Why not just grant a 20 year term in the first place? Dr Callum Floyd of Franchize Consultants explains.
‘It’s as hard for franchisors to see 15 years into the future as it is franchisees, so the shorter terms with rights of renewal enable the franchise to better evolve over time to suit changes in the sector. In practice, as we’ve seen, most franchisees renew for at least one term, and I know of many examples where franchisees have been with a system for over 10 years through several renewals. If a franchisee’s business is going well, the franchisor will almost always want to renew the term.
‘The other reason for terms is in retail-based businesses where the franchisee is reliant upon a particular location – say, in a mall. In that situation, it makes sense to tie the length of the franchise term to the length of the lease term. It’s not so important in home- or service-based businesses.’
Solid returns in good times and bad
So when Franchize Consultants are advising new franchisors, what do they take into account?
‘Any franchise model needs to be able to produce a solid Return on Investment (ROI) for both the franchisor and the franchisee, ideally within the period of the initial term,’ Callum says. ‘It needs to be reliable and robust, so that it’s not just reliant on the economy doing well; it can ideally be scaled up or down so that it remains sustainable in good times and bad.
‘We pressure-test the model for profitability at franchisee level, taking into account the franchise fee, due diligence costs, training, working capital, vehicle costs and likely financing costs, as well as potential owner returns, including ROI. If the franchisee is investing $500,000, how long before they get it back and start to make a good return? And if the intended ROI is, say, 20 or 30 percent, how do the upfront and ongoing costs allow for that, and how long should the franchise term be? If you can create a model that achieves a good return in the initial term, then subsequent terms become even more attractive.’
Three ways to make money
When it comes to evaluating a franchise business over a longer term, there are three potential sources of returns:
- Return on Investment (the capital you have put in);
- Owner’s salary or drawings;
- Profit upon sale.
This last can be another big benefit of buying a franchise rather than an independent business, as brokers say that known brands tend to attract more buyers and higher resale values.
‘Again, this is an area where the ability to compare results across a franchise network has real value,’ says Callum. And be aware that in some industries, a business can be almost too successful to sell – a construction company with profits of $400-600,000, for example, might not sell easily because people willing to put in the work don’t have the capital to pay what the seller expects. In this case, the long-term return is more about what you earn along the way – which is why it’s important to be clear about your goals at the start.’
Lawyer Stewart Germann says that if resale is an important part of your planning, you should work hard to build up the goodwill. ‘A profitable business should have considerable goodwill by years 9 or 10 and that may be the time to sell it. That way, the purchaser still has a 5-year term to go, and I’d suggest he or she would ask the franchisor for one or two additional rights of renewal on top.’
- Buying a franchise is not a way to ‘get rich quick’ overnight.
- To maximise the return you achieve on your investment, you need to think 5-10 years.
- Returns can increase even more after this time.
- You’ll probably go through the ups and downs of the economic cycle at least once during your time as a franchisee.
- If you choose a franchise that is sustainable when the economy is down, like now, you should do well when it’s up.
- Established and new franchise systems have different risks and rewards.
- The initial term should be long enough to offer a fair ROI.
- Don’t automatically rely upon resale value to make your figures work, although it can be an additional benefit.
- Franchises are often worth more than independent businesses.
- Think about the best time to sell well in advance.
- Take good professional advice.
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