Last Updated: October-31-2014
Franchise resale financial advice
Of course one of the key components to a successful franchise re-sale purchase is proper funding for both the purchase and future operating capital.
After several years of rather painless access to money for financing the purchase of a franchise or small business, accessible funds for starting a franchise or even buying an existing business diminished substantially in the after math of the subprime lending meltdown and economic recession.
But although it continues to feel “tight” too many would-be borrowers, many industry insiders and lending experts assert that that financing is out there! You just need to be willing to take the time to create a strategy that may include one of more of the options that are out there today.
How to finance a franchise resale
Buying a franchise…..especially a resale opens the door to many funding options. They include but are not limited to: The Franchisor. The franchisor is likely to have some recommendations for funding sources that have successfully financed recent resales in their system…and today many franchisors offer incentives to buyers in a variety of forms; Home Equity Loans. If you have been able to retain substantial value in your home…with a bit more paper work and patience this is still available; Retirement Funds. There are companies out there that specialize in this process where you actually create a C corp that can be used to buy stock in your new business; Conventional sources like local and regional banks, credit unions, and the Small Business Administration (SBA) are still available but to a much smaller pool of borrows…the SBA does not make the loan…they guarantee a significant portion of a loan. In principle this minimizes the risk for bank lenders, making them more keen to lend to new businesses. For the most current information, visit the SBA's website (www.sba.gov).
That is just a short list available to motivated buyers. With the tough economic climate that has limited access to traditional lending, franchise resale buyers can also seek out Angel investor or see if the seller is willing to finance the purchase themselves.
Lastly there are a number of options available for Veterans and Minorities that want to buy a business. So roll up your sleeves and start moving….…there are many roads that will get you to the funding necessary!
Calculating return on investment
When buying a franchise, understanding ROI is critical to making an informed decision. ROI, or Return on Investment, is a mathematical calculation that shows how much the original investment pays the investor after a specified period of time. Usually this is based on an annual term (one fiscal year). ROI is calculated by dividing the buyer’s original cost of the franchise into the projected net income after one complete year of operations. However, if the transfer of a pre-existing franchise will require bank financing, the payments on the loan that increase the owner’s actual equity should be included within the net income.
The reason is very simple. Let’s say, hypothetically that a buyer of a franchise re-sale invests $150,000 and $100,000 is financed by a bank. During the first year, let’s assume the new owner projects $100,000 net income, but before having made payments back to the bank. Now the owner plans to pay the bank back $75,000 that same year, increasing the owner’s equity by $60,000 after interest payments have been deducted. Without including the equity, the projected net income would only be $25,000. $150,000 divided into $25,000 shows, inaccurately, an ROI of 16.7%. The real ROI would be found by adding back the $60,000 to the $25,000, for $85,000. Dividing $150,000 into $85,000 shows a completely different picture. This accurate ROI of 57% after interest payments reflects a very acceptable return for the first year.
What exactly is an acceptable ROI for a buyer of a franchise on resale? A number of factors must be considered. For example, each industry has a different level of acceptable profits per year. The key is to first evaluate the specific industry of that franchise to learn what the average net income is for the past few years within the same geographical area. Net income projections must be obtained before ROI can be calculated.
The second consideration is to research what the best franchise within the same brand and general area is earning? This provides a net income as a benchmark for what is possible within the same company brand. By visiting and then comparing that franchise’s operations and location to the re-sale under consideration, the buyer can begin to get an understanding of what the potential ROI might be. This can be simplified also by requesting to review the franchisor’s Franchise Disclosure Document (FDD), and looking at any earnings claims made in item 19 of the document.
One big advantage to buying a resale involves faster ROI. For most business owners opening a new franchise, there is a period of maturation that limits the full potential earnings power for 2-3 years. In contrast, the buyer of a re-sale can begin earning a mature level of profits within a relatively short period of time, if not immediately, because the business is already a fully operational franchise. In addition, the FDD commonly provides the average earnings of the specific franchise over three years, which would lessen the difficulty of future projections tremendously.
The third point to consider is the difference between a passive investment and a franchise investment. A bank CD and a stock traded on the New York Stock Exchange are considered passive investments because little time or expertise is expended by the investor to obtain those earnings. They are passively accrued over time. In contrast, profits obtained from the investment of a franchise are earned through the hard work and management skills of the franchisee, in addition to the risk involved in the actual dollar investment. Whereas a stock investment would be considered adequate by providing an ROI of 10-15%, this would not suffice for a franchise.
The reason is that the buyer must consider the monetary value of his or her time. If a buyer of a re-sale ordinarily earns $50,000 in annual salary working for someone else, this amount must be included in the projected ROI from any business operations resulting from the purchase of the franchise. This is a must because the owner is no longer able to work for someone else, and is now self-employed.
In addition, the risk of the actual dollars has a time value. If the franchisee had not invested the money into a business, that money could have potentially earned a passive income of 10-15% in stocks. This passive return is precluded from occurring because the money was alternatively invested in the franchise. Therefore, it should be included in the projected ROI of a business acquisition to offset the capital gains that could have been earned otherwise.
Thus, as stated earlier, in calculating an appropriate ROI for a franchise re-sale, the buyer does not have to build projections out to the third year of operations. Instead, the prospective franchisee would base the projected profits on historical data of the re-sale and expect those returns within the first or second year. After researching to obtain such a figure, the buyer could then reach an informed ROI.
This could be accomplished a couple of different ways mathematically. Some people just divide the projected earnings by the total cost of the purchase price, as described above. This is a total ROI. However, this does not account for the values of time the buyer spends away from other income-generating employment working for someone else. For that reason, a more accurate calculation compares an ROI to a standard, passive investment. This is calculated by subtracting the potential buyer’s normal annual income from the projected franchise income and dividing the difference by the total cost to purchase the franchise. If the percent figure were higher than 15%, the buyer would be making a good ROI on the franchise, because earning a passive income above 15% in today’s economy is very difficult.
One final consideration involves the price itself. Potential franchisees should be leery of agreeing to a price above market value that the seller bases on projected sales increases. Projections are never certain. Basing a buy on facts rather than speculation will increase the likelihood for success. And if the buyer of a re-sale franchise institutes management strategies that increase the ROI then that expertise will be rewarded immediately and proportionately. After all, the seller could have kept doing business, and especially with a re-sale there is commonly a number of opportunities (i.e., past litigation, bad customer service) for increasing profits and ROI overall.
Financial advantages to buying a franchise resale
Obtaining financing for a new, independent business is difficult in the current economy. Formatted franchises, and particularly resales, are more attractive because they bring a number of stabilizing forces that increase their chances for success. These forces include the franchisor’s training, screening process, administrative support, and well-developed business format. For resales, the additional incentive for lenders is the history of net income and cash flow available for evaluation. Thus, for obtaining financing, all franchises with good brand images have an advantage, increased further when the franchise is a resale. Consequently, in this article both of these points will be discussed.
Banks and third-party lenders are more prone to lend money for a franchise brand with a solid history based on a proven business plan. These plans include a management matrix that franchisees can utilize to avoid many of the mistakes inherent to most independent start-ups. Lenders understand that a successful franchise concept has been tested and provides for rapid expansion and historically low rates of loan default. For this reason, as early as 2001 business format franchising had over four times as many establishments, employed four times as many employees, and produced two-and-a-half times the payroll as that of product distribution franchising (companies that do not follow a set franchise matrix of management and marketing).*
*Dave Thomas and Michael Seid, Franchising for Dummies 101 (IDG Books Worldwide, Inc.)
Getting loans is even easier for buyers of pre-existing franchises, commonly called transfers or resales. In these cases, the lender does not have to base the lending risk on hazy projections and hopes for a particular location. Instead, financiers can analyze the re-sale’s three-year record of gross income and cash flows, in addition to the demographics and consumer traffic of that location. These are concrete data upon which lenders can base a solid decision.
Lenders can also evaluate the seller’s management style and general practices by combining these data with information provided by the franchisor. Most franchisors are eager to get buyers financed and should facilitate the process with whatever information is needed. This might include cash flow or sales figures and profits for other franchisees in the same region. If a franchise seller is failing, the franchisor might know and offer the reasons why a buyer of the re-sale would have a higher chance for profitability, if that were indeed the case.
When lenders analyze the data provided, they can also review the seller’s spending habits. Some franchisees run unnecessary, sometimes extravagant expenses through the business for vehicles, hotel costs, or even seasonal sports events. These expenses can be added back to historical net income to provide a better reading of potential cash flow and net profit for the buyer’s and lender’s consideration.
The big question is whether or not the resale is likely to earn a decent margin with “new blood” flowing through the franchise operation. If the answer is yes, and the buyer has a solid credit history, getting a loan for the transfer should be much easier than attempting a loan for a brand new franchise location.
On the macro level this is also good news. In 2010 the federal government allotted $30 billion dollars to the U.S. Treasury Department under the Small Business Lending Fund Act. This legislation allows the Treasury to loan many multiples of that in new credit through the Small Business Administration and through conventional lenders. Franchising as a business model has been highly resilient to economic downturns. In past recessions and post-recessionary times, franchise operations have grown by 6%, and even during the tech bubble of the early 2000’s, franchises grew by 5% (SBA; FTC).
Since lenders have new credit available, but are paying closer attention to lending results, this spells good opportunities for buyers of franchises, especially for buyers of resales and their attendant histories. With new opportunities available for lenders to lend, the most likely place they will look is at re-sales, because they simply outperform other financing risks with historically low default rates. There has never been a better time than the present to get financing that is if it is a franchise resale.
What are transfer fees?
A transfer fee, usually described in the FDD, is an obligation placed upon the franchisee seller of an existing franchise. The fee requirement protects the franchisor from incurring the administrative costs of a transfer, which is another term for “resale.”
Without such a fee, the franchisor would be unable to re-coup the expenses associated with numerous resales, which would become prohibitively costly.
However, the fee is negotiable in most cases. This is particularly true if and when the franchisor is eager to dissolve the business relationship with the current franchise seller because of poor management.
The royalties are the franchisor’s income and reward for developing the brand and the structure of the overall operations. Royalties also serve to finance upgrades to technology, conduct Discovery Days, and manage the aggregate development of the corporation.
Usually royalties are 5-8 percent of the franchisee’s monthly gross sales. In other cases, a franchisor will charge a higher rate based on net sales (after expenses have been deducted).
What is seller financing?
Seller financing is similar, in many regards, to bank financing. The potential buyer might not qualify for the entire financing through a normal bank loan or even for a portion of it. In those cases, if the seller believes that the buyer is still creditworthy, he or she may allow the buyer to make payments, rather than requiring the buyer to pay the price up front.
The disadvantage to the seller is a higher than normal chance of default on the loan. On the other hand, seller financing usually allows for a faster transfer. It also allows the seller, now financier, to require monthly reports of inventory levels, revenues, and profit/loss statements to evaluate the performance of the buyer.
Finally, the buyer has the chance to become profitable without a large initial expenditure and the seller can commonly defer some of the tax burden of the transaction, otherwise incurred in a traditional resale.
Key Steps to Financing the Purchase of Franchise Resale
Finance Store is a one stop shop for business funding.
Our clients recieve a no obligation consultation and gain a complete picture of the funding available to their business. They are given a funding roadmap that reflects their unique goals and situation. Frachise resale clients recieve this as well.
Top 3 Ways to Fund Your New Franchise Resale
1. Business Directed Retirement Account (BDRA) - Finance your business through your retirement account with no penalties or taxable distribution. This program enables you to start your business debt-free and reach profitability faster with no loans, no banks and no credit involved.
2. Unsecured Business Finance (UBF) - We get you funded fast by leveraging the strength of your personal credit. Our in-depth understanding of small business lending means we can provide lines of credit to new or growing businesses in as fast as 2 weeks.
3. SBA - Established businesses with tax returns that show good cash flow can get extensive funding. All come with incredibly low interest rates and generous payback terms.
Do’s and Don’ts of Financing Your Franchise Resale
Don’t Shop Around - All banks and lenders run a hard inquiry only to learn if you qualify for financing. Each inquiry can drop your score by 3 points and make funding more difficult each time. Eventually making it nearly impossible. Finance Store's in-house underwriting department provide inquiry free and accurate projections. We will let you know what you qualifify for without damaging your credit.
Don’t Make Large Purchases - You can hinder your chances of financing a franchise if you make a large purchases on credit or with cash. It's best to hold off on any large purches until after the funding process is completed.
Do Your Preparation - Run a 'soft pull' credit check to gain a clear understanding of your credit and have this credit report available. Organizing as much documentation as possible will help the funding process move along more quickly. Include any information you have on an existing business, personal assets (including retirement), and the franchise you're looking to purchase. All of these will help you gain a more accurate picture of the funding available to you.
Do Get Ready! - Funding can take time, but it doesn't have to! Learn what funding is available to you within 24 hours. In some cases you can gain access to funds in just weeks!