Investing in an established franchise outlet in South Africa
Most people enter the world of franchising by setting up a new unit of an existing franchise. Although they enjoy all the benefits a bona fide franchise offers, the fact remains that they are starting a new business from scratch, albeit under an established brand. They have to set up the business and build the brand in their area.
In a bona fide franchise, the franchisor will have done much of the groundwork and the brand is likely to attract business from day one but there is no denying the fact that an element of risk remains. Even at the best of times, it can take from six months to one year before a new franchised outlet reaches break-even.
This prompts some people to invest in a resale, also known as a second-hand franchise. On the face of it, a second-hand franchise offers investors the best of both worlds. In addition to the usual benefits members of a franchised network enjoy, they acquire a business that is well established in its area and has a traceable performance record.
Sounds promising, but like most things in life, it has potential drawbacks as well. Should you consider going this route, this article draws your attention to some of the pros and cons you need to consider before signing off on the deal. Let’s deal with the positives first.
By investing in a second-hand franchise, you gain access to an established location with an existing customer base and a traceable track record. Keeping in mind that good trading sites are in short supply, this may be the only way to gain access to a location with above-average trading potential.
Of course, not every second-hand franchise that comes on the market has been trading profitable in the past. That’s OK, too. Depending on the reasons for under-performance, astute investors can turn this to their advantage. Let us assume, for example, that the brand is doing well in other areas and the site is right but the existing franchisee is unable to realise the potential of the business.
This gives the investor access to an established business with complete infrastructure, possibly at a bargain basement price and offers the opportunity to turn it into a viable operation within a relatively short period of time.
Some of the potential pitfalls investors should be mindful of are:
- Lack of business potential;
- Onerous liabilities attached to the purchase of the business;
- Problems within the franchise network itself;
- The investment required.
We’ll now look at these in some detail…
Lack of business potential
This can mean several things, including that the product targets a shrinking or highly competitive market, or the location is wrong. And even if the location is a bustling shopping centre, almost every centre has some blind spots, areas where foot traffic is low to non-existent. Human nature being what it is, the seller is unlikely to point out the negatives. The onus is on you to undertake an in-depth investigation, and this necessitates a lot of leg work. You need to look at the seller’s books, certainly, but this in itself is insufficient. The experts coined a fancy word for investigating the business – they call it “due diligence” – but especially in the case of a small business, where creative accounting prevails, it often tells only half the story.
You need to investigate the business and its market. For this to be meaningful, you need to talk to the business’s existing customers, suppliers and staff. If at all possible, you should spend a few days at the business to get a real feel for it before you commit to anything other than signing a confidentiality undertaking.
Keep in mind, too, that while the seller’s main concern will be to bank your cheque and provided that it clears you may never see him or her again, the franchisor will be on your side, for better or worse. The earlier you strike up a working relationship with the brand’s representatives the better – but see our comments at the end of the article.
What many investors fail to understand is that if they acquire a business as a going concern, they purchase the whole basket – good and bad. If the business has a legal persona of its own (as is the case with a Close Corporation or Limited Company), any outstanding contractual or statutory obligations become the new owner’s responsibility. Examples are unpaid bills, outstanding tax liabilities and obligations arising from employment contracts.
Unfortunately, the opposite is not always true. If, for example, the business holds a lease over premises, a change in ownership could trigger its premature termination. And even if the lease can be transferred, it may come up for renewal within a relatively short period. This could place you into a vulnerable position because you have a business but no premises from which to operate it from, prompting the landlord to push up costs. In larger networks, unions will also claim a say in the transaction. Issues of this nature should be clarified and satisfactory arrangements made before you sign the purchase agreement.
Problems within the franchise network itself
Keep in mind that by investing in a second-hand franchise, you conduct two legal transactions that are separate yet closely intertwined. Chances are that the existing franchise agreement contains a clause to the effect that the franchisee cannot sell the business without the franchisor’s approval. This approval will usually hinge upon you meeting the network’s admission criteria for new franchisees and being willing to accept prevailing terms and conditions.
This calls for an in-depth investigation of a different kind. You need to find out whether the network is sound, and whether you stand to benefit from joining it. Standard guidelines for assessing a franchise opportunity apply. Use whichfranchise to help with this process.
The investment required
It stands to reason that a business with a profit history has a higher price tag attached to it than a newly established business with no on-site track record. Although the goodwill of the business is linked to the brand, which is the property of the franchisor, the outgoing franchisee will expect to make a capital profit. Moreover, the franchisor may charge you an initial fee for being admitted to the network, and to cover the cost of initial training. There is nothing inherently wrong with that but you need to take it into account when you assess the viability of the deal.
If, on the other hand, the business has been trading badly in the past but you are confident that you can turn it around, you are in a strong position to negotiate a favourable deal. The franchisor will be happy to have someone nurse an ailing unit back to health. The landlord and others who are in a contractual relationship with the business will probably feel the same way. And if the seller is in financial difficulties, he or she has little choice but to accept the offer you make. You can rest assured that turning a business around will be hard work so make the best of it!
Professional assistance is needed
To invest in a second-hand franchise could be the best decision you’ll ever make but it could also become a veritable nightmare. Take off your rose-tinted glasses and approach the transaction for what it really is, namely a complex business deal that requires careful scrutiny of all salient facts. To do this on your own because you want to save on professional fees would be unwise.
You can do the initial legwork yourself but once you have assembled all the facts and are ready to move ahead with the deal, you should seek the help of professionals with proven experience in the areas of business acquisition and franchising. Keep in mind, too, that the large commercial banks maintain small business units that are dedicated to the funding of small businesses and franchises. For example, far from just offering funding, Absa Franchising has the expertise to guide you through many of the pitfalls that await the unwary.
In closing, one more word of caution: Don’t be taken in by the “wink-wink, nudge-nudge” approach of an eager seller. He or she may say that to reduce their tax liability, they understated profits. Even if this is true, it would raise problems of its own, including the possibility of claims made by SARS at a later stage.
Unless you are encouraged to meet with franchisor representatives early on and you and your professional advisors are given access to all salient documentation before you sign a binding agreement, we’d advise you to terminate negotiations. The “once-in-a-lifetime” opportunity is usually a myth. In our experience, if you walk away form a deal, others will present themselves soon enough but if you make the wrong investment, the implications could be long-lasting and severe.
The street smart guide to investing in a second-hand franchise
The following is a summary of the most salient aspects of the deal you need to scrutinise:
- Will you pass the network’s admission criteria for new franchisees? If so, will the franchisor charge an upfront or training fee and/or insist on an upgrade of the store? You need to consider the financial implications of these obligations.
- Is the lease transferable? If so, for how long will it run? Is the owner of the premises prepared to extend the lease or enter into a new lease with you over a reasonable period? What are the financial implications (total rentals and escalation clause)?
- What is the foot traffic around the store location like? Check especially developments around the entrance closest to the store. (Changes in tenant mix can draw shoppers to other parts of the centre – the centre may be thriving but your location may be virtually dead.)
- What are the business’s outstanding contractual liabilities, with specific reference to finance agreements, payments to creditors and statutory payments (UIF, taxes etc.)? It is best to get confirmation from potential creditors that everything is paid up to date.
- What are the ongoing contractual obligations arising from the employment of staff, for instance termination pay that may become due to an employee who has been with the business for many years but leaves shortly after the take-over? And, given that dismissing staff is no longer a simple matter, you should also check for deadwood in the existing staff complement.