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The less appreciated approach to making money in franchising

Franchisee entrepreneurs are attracted to buying a franchise business for a variety of reasons including brand passion or wanting the support and guidance of an established business system.
Universally, people invest time and effort into a business with an expectation of a financial return.

The conventional approach has broadly been one of two options depending on the individual’s risk profile, experience, and capacity to build and develop a business.

The first, invest into a new or greenfield opportunity – grow the business and hopefully enjoy both positive cash flows generated by a profitable business, and capital gains over time by increasing the value of goodwill. By and large franchises grow their footprints on this platform with franchisee entrepreneurs.

The second approach is to purchase an established well-performing business with a proven trading history. This tends to attract franchisee entrepreneurs with a lower risk profile.

They have the benefit of being able to see the history and performance of the business, and in many cases it can be an easier operational path to follow. They are of course making an assumption, and assuming an associated risk, that they will be able to maintain the performance of the business, continue to enjoy the benefits of the business’ profitability and protect the goodwill component.

The less-appreciated approach

There is a third and very neglected option for franchisee entrepreneurs, and one that I would suggest provides a number of potential upsides versus the two traditional approaches – this is to purchase an underperforming or even unprofitable franchise business. This sounds like it flies in the face of the universal objective of generating financial returns, but first we need to look at where and how financial return is generated.

What’s driving performance and can it be altered?

The incomparable advantage of buying into a franchise system is the ability to see and use benchmarking information.

Independent businesses may have industry benchmarking, but a good franchise system will have not only an abundance of benchmarking information but more importantly, an understanding of what and how these outcomes or measures can and are influenced.

When looking at an underperforming business, the potential franchise purchaser needs to ask the questions: is it a good system, how does this business unit perform against others, what key performance indicators are out of kilter, and can I influence these? Is it sales, a goods management or cost of goods issue, or is it wages or perhaps fixed costs that can be improved?

The franchisee factor cannot be underestimated and if the purchaser is able to align the performance of the businesses KPIs to the systems benchmarking, just a small number of factors could move the needle of profitability from red to black.

Altering return on investment ratios

For a vast majority of businesses, once established, their value is a function of their profitability or goodwill.

Unfortunately, an underperforming business will often sell for less than its asset value.

This creates two opportunities for the purchaser; firstly, they can acquire the business for less than what it would cost to establish it.

There are additional potential cash flow and establishment cost savings.

Perhaps more substantial is the franchisee’s ability to improve goodwill and the relationship this will have on business value.

Improved profitability creates goodwill which can create an opportunity for capital gains, for some business this can be substantial and create super return to investment ratios.

Made all the more attractive as in most cases there would be no capital gains tax if or when the business is sold.

Against this backdrop, I am not surprised that certain franchise systems have franchisees that are known as turnaround specialists who have bought and sold several businesses improving them along the way.

As greenfield opportunities shrink in some established systems and as well-established profitable business opportunities decline or command higher prices, I would not be surprised to see an increase in the skilled and less risk adverse franchisee entrepreneurs backing themselves and successful brands to take advantage or franchised turn-around opportunities.

Nathan Bonney
Director of Iridium Partners. He can be reached at nathan@iridium.net.nz or 0275-393-022

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