Is it better to buy a new or an existing franchise?

When a person decides to go into business for themselves via franchising, their thoughts inevitably turn to which system, and whether it should be an existing outlet or new operation.

This article addresses the issue of choosing between a new, start up outlet (also known as a “greenfield” outlet), or buying an existing franchised business and looks at a number of interdependent factors that contribute to the choices made by franchisees.

Location

In the first instance, the location of greenfield opportunities or existing outlets for sale will be a primary consideration for any potential franchisee.

Most potential franchisees will be looking for opportunities close to their home base, and generally within a 20km radius of where they currently live.

If there is an existing franchise servicing that location which happens to be for sale, then the potential franchisee may be well-poised to buy the business, however it is not always the case that a buyer and a seller will both exist in the same location at the same time.

Even if the business is for sale, there is no guarantee that the buyer will meet the seller’s price or sale conditions. Alternatively, if the buyer makes an unsolicited offer for a business that is not currently for sale, the buyer may end up paying a higher overall price than for a business that is already on the market.

Should a buyer not be interested in looking for a business in their home location, but are prepared to relocate (and usually to a place already in mind, such as a specific coastal, regional or metropolitan location for either a sea, tree or city change), then the same problem arises: What greenfield or existing businesses of the franchise are available in that location?

If there are none available on such terms that suit the potential buyer, then the buyer may actually change their preference for franchise system and look at competing offers if their location requirement can’t be fulfilled.

Timing

Closely linked with the issue of location is that of timing.

How long might a buyer be prepared to wait for a new or existing franchise to become available in their preferred location, and what other alternative and potentially more appealing opportunities will be presented to them in the meantime?

If a greenfield or existing franchise is not available in the desired place at the time that a potential franchisee makes an inquiry, it doesn’t mean that one won’t be available in the near future.

Even if a location does become available in the near future, a change in a potential franchisee’s employment situation, or a change in health or family circumstances in the meantime (such as the birth of a child) may reduce the buyer’s appetite for the risks of small business.

Potential franchise buyers may be prepared to wait up to a year or more for their preferred franchise to become available in their desired location, although this may be more likely for site-dependent retail rather than mobile services franchises, and linked to the overall investment level and potential returns associated with the business (ie. The greater the investment level and potential for associated profits, the longer a potential franchisee may be prepared to wait for an opportunity to become available).

Cost

The issue of cost can have a bearing on a potential buyer’s preference for location and timeframe, if for example, a high cost option may become available in the desired location in a year’s time compared to a lower cost option in an adjacent location that is available now.

An existing franchise may be offered at a higher or lower price than a greenfield franchise.

Subject to the valuation method used, a higher price might indicate that the business is performing well and trading profitably.

A price lower than the normal entry cost of a greenfield franchise might indicate a poor performing business, or indicate that the vendor needs to sell the business quickly.

Either way, a potential buyer must undertake due diligence to assess the viability and value of the offer.

Sale price valuation methods

Valuation methods determine both the price range at which a vendor proposes to sell, and which a buyer is likely to buy.

Unlike greenfield franchises for which either a universal price is set or is otherwise determined by the sum of the full establishments, costs plus the franchise fee, existing franchises can significantly vary in price.

Common valuation methods used to assess the value of a business for sale include market-based valuations, asset-based valuations and earnings-based valuations.

A potential buyer should ask the business seller what valuation method was used, and with the assistance of an advisor, calculate the value of the business under all three valuation methods to determine a reasonable price range for the business.

In addition to the three main valuation methods “pay-off-all-my-debts-and-give-me-something-to-live-on” valuation may be applied by the owners of financially distressed businesses in an attempt to get themselves out of a financial hole and set themselves up for their next venture.

Businesses valued in this manner will generally sell at a substantial discount, or close down before they can be sold.

Capital requirements

Capital requirements includes the investment capital to buy the business, reinvestment capital to maintain the business in good working order, and working capital to pay the obligations of the business until such time as the business is able to pay these for itself.

Where franchise networks are accredited by banks, investment capital lending for either greenfield or existing franchises may be more accessible than for non-accredited systems.

However, a loan to buy an existing business may not be enough if the business has old equipment or outdated inventory, software, corporate image, etc, so the buyer must have access to reinvestment capital.

On the other hand, buying a new franchise means that everything is new from the start and does not need to be replaced or upgraded for much longer (possibly even for the whole initial term of the franchise), and therefore the buyer should not need to raise reinvestment capital at the same time as buying the business.

The final capital consideration is working capital. An existing business that is already generating cash would be expected to require less working capital (depending on the nature of the business) than for a new business which will need to build up its cashflow from a standing start in order to pay its bills as they fall due.

In a new franchise, the experience of the franchisor will generally provide a benchmark of how much working capital is required to get the business up and running.

Leasing & franchise term issues

For franchises that are operated from fixed locations, the conditions of the lease and the time remaining on it are critical considerations for a buyer of an existing business.

These are equally important for a buyer of a greenfield franchise, particularly to ensure that both the initial term of the franchise and the duration of the lease match-up and are both long enough for the franchisee to get their investment back during this term.

Where an existing business is sold, the new buyer may only be able to operate it for the remainder of the lease or franchise term (or both), and if there is insufficient time left on either of these agreements when they are transferred, then the buyer may not be able to get their investment back on the business.

Training & support

A benefit of buying a new franchise is that the training and support is provided by the franchisor in accordance with the current business model, including the latest products and services and innovations in technology and other work practices introduced to the system.

When buying an existing franchise, the training may be provided by the vendor franchisee, who may not deliver the training to the standard of the franchisor, or be as familiar with the new innovations introduced to the system. Buying an existing franchise may also mean that the training is conducted in the business being sold, rather than off-site at a training facility.

Staff

An existing business may already have staff in place who can maintain the operation of the business while the new owner settles in. There can be problems though, if the staff don’t take to the new owner or their vision for the business, and key people could leave or may be invited to leave. Knowing who is critical to the business and getting them onside and securing their ongoing involvement is an important consideration for anyone buying an existing business.

For greenfield franchises, employing the right staff for the right jobs still remains a challenge, but at least the franchisee can choose their employees for themselves and start with a clean sheet rather than modifying the behaviours or expectations of existing employees.

Transfer of goodwill

When buying a new franchise, the franchisor’s brand and reputation in the marketplace is the goodwill to which a franchisee is granted access. When buying an existing franchise, the same applies but is supplemented by the goodwill that the previous operator has developed with the local market in their conduct of the business.

If goodwill is low because customers have experienced poor service or product quality, then a buyer will need to rebuild, which can provide an opportunity to increase the value of the business.

On the other hand if goodwill is high (for which the buyer would have paid a premium), then the buyer must also operate the business to the same high standards as the previous operator from the outset or risk losing customers and diminishing the goodwill for which they have paid.

Reasons for sale

Finally, what are the reasons for the sale of the franchise? It is easy to assume that a franchisor offers new franchises for sale as part of the natural growth of the network.

When dealing with an existing business for sale, the real reasons for the sale may not always be those which the vendor has stated. For example, the reason that “It’s time to move on and do something else” could actually be a disguise for “I’ve never made any money out of it and I’m tired of flogging a dead horse”.

A formula for due diligence

By conducting thorough due diligence on the proposed purchase of a new or existing franchise, a potential business buyer increases their chances for future business success.

As a general rule, people who are buying a business for the first time (or buying in an unfamiliar industry) should be prepared to invest one hour of time for reading, research and learning per $1,000 to be invested in the business.

Time spent on due diligence = 1 hour per $1,000 to be invested

This includes time spent with professional advisors (lawyers, accountants and business consultants whose advice should always be sought prior to buying either a new or existing franchise), time spent in the business as part of the research, and time spent speaking with current and former franchisees, customers and suppliers to the business.

In conclusion

In short, there are benefits and shortfalls when faced with the choice of buying a new (greenfield) franchise against buying an existing franchise. By taking into account the factors listed in this article, and undertaking appropriate due diligence, a buyer will be able to make a more informed decision best suited to their requirements.

Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia’s only fortnightly electronic news bulletin on franchising issues.