Doing Due Diligence when Buying an existing Franchise

Buying an existing franchise means you will be hitting the ground running. But, just like when buying a new franchise, success is not guaranteed. For this reason it is imperative to undertake the same due diligence (reviewing and verifying all the relevant information about the business), as you would when buying a new franchise. You must, therefore, scrutinise all aspects of the business and put the same time and effort into researching it as you would if buying a new franchise.

And a major benefit of buying an existing franchise is that you will be able to review the deal in much greater detail, and have in-depth discussions with the current franchisee and the staff. You will also be able to analyse past and current accounts and be able to see first-hand how well the business is doing, which will enable you to value it accurately.

Advantages

  • An existing franchise will have brand awareness and an established reputation in the local area. This means it will have an established customer base and you won’t need to spend a lot of time initially trying to create a market and find customers.
  • It will be easier to obtain financing, provided the business has a good profit history. Bankers and investors generally feel more comfortable dealing with a business that already has a proven track record.
  • Operations can commence immediately and current inventory can be sold to produce immediate cash flow.
  • The business will also have an established relationship with suppliers.
  • Existing staff will be familiar with all aspects of the business and may have a good relationship with your customers and suppliers.
  • You will be buying an operation that’s already generating cash flow and profits.
  • You may get valuable legal rights with the purchase, such as patents or copyrights, which can prove very profitable.

Disadvantages 

  • The cost may be higher than starting from scratch, as you are also buying ‘goodwill’.
  • Existing problems can remain hidden until after the sale, which means you could get stuck with obsolete inventory, uncooperative employees, outdated distribution methods, or equipment that are faulty.

A closer look

To make sure you get the best deal, follow these steps:

Put together an ‘acquisition team’ consisting of your banker, accountant and attorney. These advisors are essential to conducting due diligence.

Start your preliminary analysis with some basic questions:

  • Why is this business for sale?
  • What is the general perception in the marketplace of the franchise company and this franchise in particular?
  • What is the outlook for the future?
  • Does the business have enough market-share to remain profitable?
  • Are the raw materials used in the production or manufacture of products abundantly available?
  • How have the franchise’s product or service lines changed over time?

To assess the company’s reputation and the strength of its business relationships, you need to talk to existing customers, suppliers and vendors. You should also, contact industry associations (Franchise Association of South Africa, etc.), as well as credit agencies to ascertain whether any complaints have been made against the business.

If the franchise still looks promising after your preliminary analysis, your acquisition team should start examining the potential returns of the business as well as its asking price. Whatever method you use to determine a fair market price, your assessment should take into account the financial health of the business, its earnings history and growth potential, along with its intangible assets (for example, brand name and market position).

To get an idea of the company’s anticipated returns and future financial needs, examine projected financial statements. In this regard balance sheets, income statements, cash flow statements, footnotes and tax returns for the past three years are all key indicators of a business’s health. Conducting a thorough financial analysis will highlight any underlying problems and provide a closer look at a wide range of less tangible information.

DUE DILIGENCE CHECKLIST

This is a checklist of the information and documents you should review:

  1. Stipulate that the seller must put in writing and certify every essential part of the business, including:
    • That the financial statements are true and correct.
    • That there are no hidden liabilities of any kind (tax claims, lawsuits, or supplier bills).
    • A complete list of everything being purchased such as: leases, contracts, amounts owed to suppliers, amounts owed by customers, inventory, fixtures, equipment, signs, computer hardware and software, as well as anything else that will contribute to the success of the business.
  2. If the financial statements have not been audited by a certified auditor, you must have it done.
  3. Try to obtain a set of financials from a similar business from an industry body or a company that does business valuations, to compare to those of the business you’re planning to purchase.
  4. You have to understand that if you are paying more for the business than the value of its assets, you are buying ‘goodwill’ – an intangible asset that can be amortised over 15 years.
  5. Determine why the seller is selling the business.
  6. Determine whether there are factors that could lead to the termination of the business, such as a material threat to the business location (a new road being built, etc.).
  7. Speak to the landlord if there is a lease in place to ensure that the terms of the lease will remain the same. I would also be an ideal time to negotiate terms for renewal and termination of the lease.
  8. Consider working in the business before making the final decision to buy. This is the best way to judge whether the volume of business is satisfactory, and whether you will enjoy working in the business and whether there are any problems that needs to be addressed before the sale is finalised.
  9. The success of a business is often directly linked to the personality of the owner. You, therefore, have to determine whether you will be able to make the business successful based on your personality.
  10. Ensure that the seller signs an agreement not to compete with you for at least 10 years, especially if you believe his or her personality was the reason for the success of the business.
  11. Speak to other neighborhood businesses that are not direct competitors, to learn more about business growth in the area, problems for the future, and their impressions of the franchise you’re buying.
  12. Do credit checks on both the seller and the business itself.
  13. Check with suppliers whether the inventory you are buying is valued correctly.
  14. Talk to all employees to determine whether they will remain if you buy the business. Also try to get any other information they are willing to share.
  15. Talk to some of the customers to learn whether they are satisfied with the business the way it is currently.
  16. Visit every competitor in the area to ascertain if the franchise’s prices are competitive and to gather information about potential changes, which the industry may face in the future.
  17. Also check any licensing issues, environmental requirements, zoning regulations, and whether the business has any outstanding taxes.

Conclusion

It is also important that all human resource issues and benefits such as accrued leave and any other benefits for those employees, who will be retained, be specified. Any sale’s agreement should identify which employees will be retained, as well as the salaries and benefits they will receive.

The seller should also be required to indemnify the buyer against any unforeseen liabilities that may crop up after the deal is closed. It is often a good idea to hold a part of the purchase price in trust for a period of time, as a safeguard against unpleasant surprises.