Lecture 4: Buying an Existing Business and Franchising

Effective Small Business Management: An Entrepreneurial Approach by Scarborough and Zimmerer

Learning Objectives
Understand the advantages and disadvantages of buying an existing business. Conduct the detailed level of analysis necessary before buying a business. Describe the methods used in the valuation of a business. Discuss the process of negotiating the deal.

Learning Objectives
Explain the importance of franchising. Define the concept of franchising and describe the different types of franchises. Describe the benefits and limitations of buying a franchise. Explain the right way to buy a franchise.

Buying An Existing Business

Buying a Business
Advantages
Business may continue to be successful Can use experience of previous owner Business may have best location Employees and suppliers are in place Equipment is installed Inventory is in place and trade credit exists Easier time finding financing

Buying a Business
Disadvantages
Its a loser Possible ill will from previous owner Employees may not be suitable Location may be unsatisfactory Equipment may be obsolete Change and innovation can be difficult Inventory may be obsolete

Accounts receivable may be worth less than face value

Business

may be overpriced

Valuing Accounts Receivable

Age of Accounts (days) 0-30 31-60 61-90 91-120 121-150 151+ Total

Amount
$40,000 $25,000 $14,000 $10,000 $7,000 $5,000 $101,000

Probability of Collection
.95

Value
$38,000 $22,000 $9,800 $4,000 $1,750 $500 $76,050

.88 .70 .40 .25 .10

How to Buy a Business

Analyze your skills, abilities, and interests.

Develop a list of criteria.

Prepare a list of potential candidates (Remember the hidden market). Investigate and evaluate candidate businesses and select the best one. Negotiate the deal. Explore financing options. Ensure a smooth transition.

Five Critical Areas for Analyzing an Existing Business

1. Why does the owner want to sell.... the real reason? 2. What is the physical condition of the business? 3. What is the potential for the company's products or services? Customer characteristics and composition Competitor analysis 4. What legal aspects must I consider?
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5. Is the business financially sound?

Determining the Value of a Business

Balance Sheet Technique Earnings Approach Market Approach

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Balance Sheet Techniques

"Book Value"of Net Worth = Total Assets - Total Liabilities = $266,091 - $114,325 = $151,766

Earnings Approaches
Excess Earnings Method. Step 1: Compute adjusted tangible net worth: Adjusted Net Worth = $274,638 - $114,325 = $160,313

Step 2: Calculate opportunity costs of investing: Investment Salary Total Step 3: Project earnings for next year: $74,000 $160,313 x 25% = $40,078 $25,000 $65,078

Excess Earnings Method

(Continued)

Step 4: Compute extra earning power (EEP): EEP = Projected Net Earnings - Total Opportunity Costs = $74,000 65,078 = $8,922

Step 5: Estimate the value of the intangibles ("goodwill"):

Intangibles = Extra Earning Power x "Years of Profit" Figure*

= 8,922 x 3 = $26,766

* Years of Profit Figure ranges from 1 to 7; for a normal risk business, it is 3 or 4.

Excess Earnings Method

(Continued)

Step 6: Determine the value of the business: Value = Tangible Net Worth + Value of Intangibles = $160,313 + 26,766 = $187,079

Estimated Value of the business = $187,079

Market Approach
Step 1: Compute the average Price-Earnings (P-E) Ratio for as many similar businesses as possible:

Company P-E Ratio 1 3.3

2 3.8

3
4

4.7
4.1

Average P-E Ratio = 3.975

Step 2: Multiply the average P-E Ratio by next year's forecasted earnings:
Estimated Value = 3.975 x $74,000 = $294,150

Exit Strategies
Straight business sale Family limited partnership (FLP) Sell controlling interest Restructure the company Use a two-step sale Establish and employee stock ownership plan (ESOP)

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The Five Ps of Negotiating.

Preparation - Examine the needs of both parties and all of the relevant external factors affecting the negotiation before you sit down to talk.

Poise - Remain calm during the negotiation. Never raise your voice or lose your temper, even if the situation gets difficult or emotional. Its better to walk away and calm down than to blow up and blow the deal.

Patience - Dont be in such a hurry to close the deal that you end up giving up much of what you hoped to get. Impatience is a major weakness in a negotiation. Persuasiveness - Know what your most important positions are, articulate them, and offer support for your position.
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Persistence - Dont give in at the first sign of resistance to your position, especially if it is an issue that ranks high in your list of priorities.
Copyright 2006 Prentice Hall Publishing Company

Franchising

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Franchising Grow th Num ber of Units (in Thousands)

400,000

Number of Franchised Units (in Thousands)

350,000 300,000 250,000 200,000 150,000 100,000 50,000 2000 2001

290,605 274,265

341,579 310,044

337,693

351,459

2002 Year

2003

2004

2005

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Franchising
Franchising semi-independent business owners pay fees and royalties to a parent company in exchange for the right to sell its products and services under the franchisers trade name and often to use its business format and system.

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Types of Franchising

Trade name Product distribution Pure (Business format)

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Why Buy a Franchise?

Franchisees benefit from the franchisers experience. Franchisees get a proven business system and avoid having to learn by trial-anderror. Franchisees earn a great deal of satisfaction from their work. Before buying, ask: What can a franchise do for me that I cannot do for myself?

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Benefits of Franchising
Business system

Management training and support

Brand name appeal Standardized quality of goods and services National advertising program

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Benefits of Franchising
Financial assistance

Proven products and business formats

Centralized buying power Site selection and territorial protection Greater chance for success

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Drawbacks of Franchising
Franchise fees and profit sharing

Strict adherence to standardized operations

Restrictions on purchasing Limited product line

Unsatisfactory training programs

Market saturation Less freedom

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Ten Myths of Franchising

1.
2.

Franchising is the safest way to go into business because franchises never fail.
Ill be able to open my franchise for less money than the franchiser estimates.

3.

The bigger the franchise organization, the more successful Ill be.

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Ten Myths of Franchising

4. Ill use 80 percent of the franchisers business system, but Ill improve upon it by substituting my experience and know-how. All franchises are the same.

5.

6.

I dont have to be a hands-on manager. I can be an absentee owner and be very successful.

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Ten Myths of Franchising

7.
8. 9. 10.

Anyone can be a satisfied, successful franchise owner.

Franchising is the cheapest way to get into business for yourself. The franchiser will solve my business problems for me; after all, thats why I pay an on-going royalty. Once I open my franchise, Ill be able to run things the way I want to.

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Detecting Dishonest Franchisers

Claims that the contract is standard; no need to read it. Failure to provide a copy of the required disclosure documents. Marginally successful prototype or no prototype.

Poorly prepared operations manual.

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Unsolicited testimonial from a highly successful franchisee.

Detecting Dishonest Franchisers

(Continued)

Unusual amount of litigation by franchisees. Promises of future earnings with no documentation. High franchisee turnover or termination rate. Attempts to discourage your attorney from evaluating the contract before signing it.

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Detecting Dishonest Franchisers

High pressure sale.

(Continued)

No written documentation. Claims to be exempt from federal disclosure laws. "Get rich quick" schemes, promising huge profits with minimal effort. Reluctance to provide a list of existing franchisees.

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Evasive, vague answers to your questions.

How to Buy a Franchise

Preparation, common sense, and patience are vital ingredients in choosing the right franchise. Evaluate yourself - What do you like and dislike? Research the market. Consider your franchise options.

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What Should You Look For?

A unique concept or marketing approach Profitability A registered trademark A business system that works A solid training program Affordability A positive relationship with franchisees

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How to Buy a Franchise

Talk to existing franchisees.
Ask the franchiser some tough questions. Make your choice.

(Continued)

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Table 4.4 Advantages and Disadvantages of Buying a New vs. an Established Franchise Pros
Can be new and exciting Business concept can be fresh and different in the market Possibility of getting lower fees as a pioneer of the concept Potential for a high return on investment Business concept likely is wellknown to consumers and market for the products or services is already established. Franchiser has experience in delivering services to franchisees Franchiser has had time to work the bugs out of the business system

Cons
Business is not tested or established in the market Unknown brand and trademark Possibility that the concept is a fad with no staying power Franchiser may lack the experience to deliver valuable services to franchisees High franchise fees and costs that often are non-negotiable Concept may be on the wane in the market Franchisers brand and trademark may remind customers of an outdated concept Franchisers trade dress may be in need of updating and redesigning

New Franchise

Established Franchise

Source: Based on Andrew A. Caffey, Age Issues, Entrepreneur, January 2002. p. 118.

2007 Fastest-Growing Franchises

Top Ten
1. Subway 2. Jan-Pro Franchising Int'l. Inc. 3. Dunkin' Donuts 4. Coverall Cleaning Concepts 5. Jazzercise Inc. 6. Jackson Hewitt Tax Service 7. RE/MAX Int'l. Inc. 8. CleanNet USA Inc. 9. Bonus Building Care 10. Jani-King
http://www.entrepreneur.com/franzone/fastestgrowing/

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