If you are considering to buy an existing franchise that is for sale, you’ll need to know how to determine a reasonable price.

Existing franchises that are offered for resale are either successful operations that are making money or unsuccessful businesses that are losing money or barely making ends meet.

If the operation is currently successful, it will be fairly easy to calculate its value.  According to Jeff Elgin, CEO of FranChoice, Inc., a company that provides consulting services to consumers looking for a franchise, the best way to do this is to use a multiple of the net cash flow - the difference between the revenue and the necessary business related expenses required to produce the revenue.  This number can be derived from the financial statements of the business.

Most business owners expense items that really aren't required to operate the business, such as company cars, meals, phone and internet expenses.  The owner may also be paid an extraordinary salary.  These types of expenses should be added back on to the net cash flow number, to determine the true net cash flow.

A successful business is worth about two to five times the true net cash flow number.  The multiple can be on the higher end of this range for businesses that are more stable, have reliable cash flow and are in an industry that is trending in positive growth, rather than flat or negative.

If the business is currently not performing well, it will be more difficult to price.  The business owner may have many reasons about why the business isn’t performing.  If the owner is not operating the business according the franchisor’s guidelines and you can confirm that most other franchisees following the system are doing fine and there aren’t any other related problems, such as a bad location, then you can proceed with some confidence that a simple change in ownership can fix the problems.

Under this circumstance, you should be going for a good bargain.  To evaluate the resale price on this type of business, take the total cost, including marketing and operating costs, to open a new unit in the system and subtract a liberal allowance for marketing and operating expenses to get the resale unit to breakeven.  Also subtract the amount for any infrastructure investments that you feel may be necessary.  This is the absolute maximum price you should consider to pay for an underperforming business.  Discounting this amount is recommended, to offset the potential risk.

It’s okay if the seller is not happy with this method of valuation.  Remember, you are buying someone else’s problem and you are the one who is going to have to live with this purchase.  You need to be prepared to walk away from this type of resale, if you do not feel like it is a good opportunity for you.  You can always tell the seller to call you back if he can’t find a buyer at a higher price.

Purchasing a resale can be a very rewarding way to enter a franchise system.  Much of the pain associated with starting a new business can be avoided, by buying an existing operation.  The important thing is to make sure that you are careful and do your due diligence to determine if the future performance of the business will be positive under your ownership.

Click here to read the full Entrepreneur article about Jeff Elgin’s advice on buying an existing franchise.

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