Chapter 30
Valuing and Buying a Business

IN This Chapter
Pros and cons of buying a business
Finding and analyzing a business
Business valuation
Negotiating price and terms
Franchising

Introduction
This chapter explains the advantages and disadvantages of buying a business rather than growing your existing business or starting a new one from scratch. Of course, these advantages only apply if you find the right business.
That’s why it’s so important to analyze the business before you buy. Profitability is essential, of course, as are location, the customer base and many other details. But it’s equally important to find a business that will fulfill you personally. Thus, this chapter encourages you to examine your own motives for buying, as well as the owner’s motives for selling.
Pros and Cons of Buying a Business
Some entrepreneurs choose to grow by buying an existing business that complements their products or services. For example, a marketing firm might purchase a direct-mail fulfillment house in order to expand its business. Others buy a new business in order to avoid some of the uncertainty of a startup operation. If you’ve always wanted to own your own bike shop and your favorite local store is for sale, you might decide to buy it in order to jumpstart your dream.
Advantages
Obviously, the biggest advantage of buying an existing business is that someone else has already gotten the ball rolling. Here are some more potential advantages:
Lower cost. It may be less expensive to buy a business than to start a new one.
Existing market share. You won’t have to create a presence in the market.
Clear capital needs. It’s usually easier to estimate costs for an existing business than it is for a startup.
Location. Buying a business in an ideal location can offer a crucial advantage. This location doesn’t have to be in your town; buyers often limit their search to businesses in the immediate area, which may cause them to miss out on excellent opportunities.
Personnel. An existing business may already have employees with the right skills and training.
Inventory. The seller should already have inventory on hand and a firm grasp of sales patterns. This reduces the risk of ordering unnecessary inventory.
Customers. An existing business should have an established customer base and brand image. Customer lists and social media followers can be particularly valuable assets.
Contracts and licenses. An established business should have all necessary licenses and permits. It may also have contracts with vendors and other supply chain partners.
Control systems. An established business should already have accounting, insurance, personnel, inventory and other control systems in place.
Credit. An established business should have good credit with vendors and bankers.
Disadvantages
Most of the advantages listed above can also be a disadvantage. For example, existing customers may have a negative image of the business, supplier contracts may be restrictive, and inventory control systems may be poorly designed or otherwise inadequate.
More generally, it’s an unfortunate fact that some sellers will misrepresent the condition of their businesses. This problem can be difficult to spot until after the purchase, so due diligence is essential.
This includes taking stock of market conditions. Is a new competitor moving into the area or coming online? Is the market shifting away from your product or business model? Will a massive construction project start next summer, resulting in months of traffic jams, noise and dust? Will new regulations take effect next year? Does the business have a lot of negative reviews online?
Unless you take the time to educate yourself on the industry, the business, the market and the neighborhood, you may not find out about serious problems like these until it’s too late.
…
I had spent nearly 15 years working for the county as a building inspector, and I was getting pretty sick of it. I wanted to go into business for myself, but I didn’t have any clear ideas. Something to do with food was the first thing that came to mind, but of course that didn’t narrow things down very much.
It wasn’t until the old health food market near my house went up for sale that I started thinking seriously about taking the plunge. They had a nice little deli area, and I felt like it had a lot of potential.
I knew Sue Flechsig, the owner. She’d started up about a decade ago, and it looked to me like she was doing alright for herself. She had a nice house, and it seemed like she bought a new car every year.
A couple of years ago, Dan Schreber started thinking about buying the local health food store in his hometown of Prairie Du Chien, Wisconsin. Dan’s wife, Sabine, had just inherited $50,000. Dan figured he could use that as a down payment on Sue’s $175,000 asking price. He’d have seven years to pay off the remaining $125,000.
Dan didn’t really know anything about health food, but how hard could it be to stock it and sell it? He’d read articles about how organic farming was the only growing sector of American agriculture. It seemed like everyone he knew was taking vitamins and herbal supplements. Plus, he’d heard about the importance of niche marketing to entrepreneurs, and there were no serious competitors within 75 miles.
Besides, he loved food, and he loved to cook. It seemed like a perfect opportunity!
…
Finding and Analyzing a Business
When deciding what type of business to buy, consider these questions:
What do you want to get out of the business?
Do you believe in the business? Will you enjoy it and take pride in it?
What is the business’s growth potential? Is it based on a current trend or an ongoing need?
How much capital can you raise? How much risk are you willing to take?
Do you have the right skills and experience? What skills do you lack?
What is the reputation of the business, locally, regionally and online?
Is this company the right size for you? How many employees will you need?
How many competitors does it have? (Remember to consider online competitors.)
Finding Businesses for Sale
Sources of information about businesses for sale include trade journals, real estate and business brokers, chambers of commerce, bankers and websites.
It’s a good idea to network among the private sources listed above. Let your banker, attorney, and accountant know that you’re interested in purchasing a business, and ask them to keep their eyes open for likely prospects. Don’t expect instant results—be patient and wait for the right opportunity.
Analyzing a Business
Once you’ve found a few businesses that fit your criteria, do a complete analysis of each to decide which of them are worthy of further consideration. This can be a daunting task; seeking expert help will make a tremendous difference.
Business Analysis Checklist
Although every business is different, here are some questions you should ask when assessing the health of a business:
Why does the owner want to sell?
What is the physical condition of the business (e.g., building, signage, equipment, inventory)?
Does the company own or lease its facilities? If it’s leasing, what are the current terms? Do the current owner and landlord plan to renew?
What is the financial condition of the business?
Who are the existing and prospective customers?
What is the competitive environment?
What laws and regulations apply? Is the company meeting them?
How is the company organized? Who owns it? Is it publicly or privately held?
How many employees does the company have? How long have they worked there?
What kind of accounting system is in place? What budgeting and expense controls are in place?
What do the company’s balance sheets, income statements, and cash flow statements show over a period of five years?
How does the company manage short- and long-term cash and investments? How much debt does it have?
Does the company have any unpaid taxes or lawsuits pending?
What type and amount of insurance coverage does the company have?
How solid are the company’s supplier and vendor relationships?
What sales and marketing activities is the company currently engaged in?
How much market share does the company control?
How does the company’s current pricing structure compare with competitors?
Does the company offer deep discounts to large-scale customers?
What is the company’s sales history during the past five years?
Does the company have an established distribution network and sales force?
Where is the business located? Near transportation and shipping lines (if manufacturing)? In a busy suburban mall (if retail)?
What sort of online presence does the business have? What percentage of its revenue comes from online sales? Does it have positive online reviews and enthusiastic social media followers?
How strong is the company’s manufacturing base?
How old is the company’s equipment? Does it own or lease the equipment?
Alternative Investments
As you search for a business to buy, you should also be looking at other things to do with your money, such as investing in the stock market, a money market fund, T-bills, a savings account, or other investment instruments. By thinking of the purchase of a business as an investment, you can evaluate all investment possibilities on the same terms and decide if buying this business offers the best return.
Investment choices can be passive or active. A passive investment is one in which you are not actively involved in generating money (e.g., a savings account or the stock market). An active investment is one in which you are actively involved in generating money (e.g., running a business).
If you can make a 10 percent return on a passive investment, does it make sense to buy a business that gives you less than a 10-percent return and requires your full-time attention? Always consider whether buying a business is a better investment than the other options available to you.
…
Sabine liked my idea in theory, but she was skeptical. I understood her attitude, but I felt a lot more positive about things. The store had been around for years, so I knew it was viable. It had plenty of loyal customers, too. Sue told me a lot of them came in every day.
That’s just what Sue would say, of course—I knew that much. But I also knew that it was important to get away from my job and do something for myself. I was 49, I’d been dreaming of going into business for years, and a great opportunity had dropped into my lap just when we happened to have an extra $50,000 lying around. How much more of a hint do you need that it’s time for a change?
Sabine knew Dan was ready for something new, and she liked the thought of him quitting his job. They’d talked about starting a business many times, and she couldn’t deny that things seemed to be lining up. Still, $50,000 was a lot of money.
Sabine knew that entrepreneurs are supposed to be enthusiastic, but she also knew that they have to be realistic. It was starting to look like she’d have to be realistic enough for both of them.
The first thing she wanted to know was why Sue was getting out of the business. Dan said, “She wants to move back to Minnesota.”
“Why now?” Sabine wondered.
She decided it was time to have a little heart-to-heart conversation with Sue. And her accountant.
…
Business Valuation
Once you’ve decided to buy a business, the next question is, “How much is this business worth?” The answer is always the same: “The business is worth whatever the buyer and seller agree it’s worth.”
The buyer and seller have different incentives for placing a price on a business. A seller who started a business from scratch and worked hard to make it grow may have an inflated estimate of its worth. A buyer will want to pay the lowest possible price, based on the costs of remodeling and any other necessary changes. The goal is to find a satisfactory middle ground.
Valuation Methods
There are numerous methods for valuing a business. And just to make things even more complicated, different terms are often used to describe the same method.
A full discussion of valuation models is beyond the scope of this book. However, understanding the pros and cons of the following three methods will make you a stronger negotiator when the time comes to discuss price. (Note: For a fee, a valuation firm will take on this task for you.)
Asset-based valuation is based on the company’s tangible and intangible assets (building, property, machinery, inventory, goodwill and so forth), minus any outstanding liabilities. Because it tends to ignore or undervalue earnings potential, it’s most commonly used for firms that are out of business or subject to liquidation. Common methods include book value (known as the balance sheet method); tangible book value; adjusted tangible book value; liquidation value; and excess earnings.
Income-based valuation derives the company’s value from its profits, earnings or cash flow (or their multiples or present values), which is then adjusted to reflect the desired rate of return as well as the risk of earning these returns. Typical methods include earnings multiplier valuation and capitalized earnings valuation.
Market-based valuation reflects what the business owner thinks the price should be, based on the selling price of other businesses (or, just as often, on a hunch). Common methods include fixed price and market value. These methods are often arbitrary, so you should avoid them if you can.
Cash Generation
A company’s assets are good for only two things: They can either be liquidated (sold for cash) or used to generate more cash.
Obviously, you can sell tangible assets such as equipment and inventory. And although they are more difficult to value, you can also sell intangible assets such as goodwill.
Alternatively, you can use these assets to generate cash. To illustrate this point, let’s look at Better Plastics, Inc., a manufacturer of ecofriendly auto parts. The company is currently up for sale, and its equipment and other assets have been valued at $100,000.
Scenario 1. Their financial records show a negative cash flow of $1,000 for each of the past three years. How much would you pay for the company?
Scenario 2. Their records show a positive cash flow of $50,000 for each of the past three years. How much would you pay for the company?
In Scenario 1, you probably asked yourself, “Why would I pay $100,000 for the privilege of losing $1,000 a year?” Maybe you could sell the equipment for $100,000, but then you haven’t really gained anything.
However, if this equipment could generate $50,000 in positive cash flow each year, as it does in Scenario 2, it would clearly be better to keep the equipment and use it to generate cash. That’s why valuation should focus not on how much a business’s assets are worth, but on how much cash they can generate.
…
Sabine got together with Sue and looked closely at revenues and expenses for the previous years. She took the data to her accountant, and together they considered the broad trends in the health food market, as well as specific issues like location, recognition, credit relationships, county services, taxes, insurance costs, neighborhood security, signage, and stock.
One of the things her accountant noticed was a downward trend of almost 9 percent over the previous year (ever since a vitamin and supplement chain opened a new store at the mall, in fact). She also noticed that Sue’s credit relationship with the biggest wholesaler in organic pharmaceuticals and beauty products was rather shaky. Among other things, Sue was no longer getting discounts for payment within 30 days.
That was food for thought. And there was more to come. For instance, Sabine asked Sue in passing if she’d gotten a good deal on her new Lexus, and Sue said, “Oh, I always lease.”
When Sabine got back from that meeting, I didn’t have to be a mindreader to figure out that she had some serious doubts about Sue’s “successful” business. Apart from questioning how much Sue was actually making, she wasn’t too impressed with the location.
She thought it was much too small and cramped, for starters. Also, the place next door had become a biker bar. There was a lot of broken glass and debris lying around. On the other side, there was an old diner with grease-spattered windows. It was one of those places that’s been there for as long as you can remember, but you don’t know a single person who’s ever eaten there.
I hadn’t really considered any of these problems. Now that Sabine had, I assumed that was the end of the road for my big idea.
But the amazing thing is, those problems actually gave her the determination to move ahead instead of pulling the plug. She thought about how unappealing the space was, and how nice it could be, and she started wanting to make it happen. She figured if we played our cards right, we could turn it into the nicest, cleanest, most pleasant store in town.
…
Using Cash Flow to Value a Business
To evaluate a business as an investment and place a dollar value on it, you must examine the company’s historical cash flows and estimate its future cash flows. The results determine the price you should pay.
Step 1: Historical Cash Flows
As the prospective owner, you need to know how profitable the company really is. Get historical cash flows for as many previous years as possible. It’s best to get records for at least the past three years. If the company is less than three years old, get as much of its financial information as you can.
Some small businesses will not make a cash flow statement available for inspection. However, most businesses do prepare a balance sheet and an income statement. If a cash flow statement isn’t available, your accountant can create one from the income statement and the last two ending-period balance sheets.
To get a true picture of cash flow, you must look carefully at the income statement. Normally, business owners try to make their income statement show as little profit as possible in order to reduce their tax burden. But when selling a business, they usually try to make the company look more profitable by hiding or understating expenses.
One area that sellers often manipulate is cost of goods sold; understating or overstating inventory costs significantly changes apparent profit or loss. You should insist on an independent inventory count to verify the owner’s estimate.
Many accountants use a technique called “recasting” or “reconstructing” to get a clearer picture of profitability. Essentially, they modify the cash flow to estimate the business’s profits if it had been run by the prospective buyer. In the case of an owner who tries to minimize profits, deductions for unnecessary items like first-class travel would be removed, or the cost of professional management would be substituted for the owner’s inflated salary. If an owner tries to inflate profits, the accountant will make sure that amounts listed for wages, taxes, accounting fees, supplies and other operating expenses are reasonable for a business of its type and size.
Step 2: Cash Flow Projections
Projecting future cash flows boils down to making an educated guess, with a strong emphasis on the word “educated.”
Table 1 shows you how to prepare a simple cash flow projection. However, it’s best to work with an accountant you trust to calculate an acceptable price range and the likely return on your investment.
Step 3: Use Historical and Projected Cash Flows to Value the Business
One problem with projecting cash flows is that due to the loss of purchasing power, dollars earned in the future are worth less than dollars earned today.
Therefore, future cash flows must be “discounted” to match today’s dollar value. By using a discount rate (i.e., an interest rate adjusted for risk), you can calculate a net present value that represents the dollar value of the business today, even though you may be looking at annual cash flows for as many as five years ahead.
There are four steps to calculating net present value.
1. Estimate Future Cash Flows
We’ve already discussed the basic process of estimating cash flow. But for negotiation purposes, it’s necessary to calculate two different kinds of cash flow:
Historical cash flow. Use historical cash flow to calculate the present growth rate, and then use this growth rate to project a conservative future cash flow. If past cash flow has grown at 10 percent per year, your estimate is that future cash flow will grow 10 percent or less per year. If the company has not grown in the past three years, or growth has been erratic, this becomes a negotiating tool for lowering the price. This estimate tells you the minimum you should pay.
Ideal cash flow. Next, calculate a realistic, best-case cash flow for your information only. This estimate tells you the maximum you should pay.
2. Determine The Discount Rate
The discount rate is essentially a risk-adjusted interest rate you would expect from a comparable investment. The risk adjustment is to compensate you for taking the risk of buying this business. The riskier a business is, the higher the discount rate should be.
Here’s an example: If investing in a government-guaranteed T-bill would safely earn you 7-percent interest, and a relatively low-risk business opportunity seems to justify a 2-percent premium, then your discount rate for valuing that business would be 9 percent.
But if the business seems risky, a risk premium of 10 percent might be assigned, resulting in a 17-percent discount rate. And in fact, most small businesses are assigned risk premiums between 5 and 10 percent. As a result, discount rates typically range between 12 and 22 percent.
Before you negotiate, it’s vital to understand how to set the discount rate, because you can use this as a negotiating point to lower the price of the business.
3. Determine a Reasonable Life Expectancy for The Business
Most experts agree that future cash flows should be estimated for three to five years. Estimates beyond five years are not reliable.
4. Determine the net present value
The value of the business is determined by calculating the net present value of the projected cash flows, based on your chosen discount rate. Using the data from the example on the facing page, a value can be calculated for Better Plastics, Inc. A growth rate of 10 percent per year is assumed for the data in the table.
Let’s review the table, and then calculate Better Plastics’ value by applying the four steps we just discussed.
1. Estimate Future Cash Flows
You have determined that the revenues and expenses for the next five years will be those in Table 1. Your evaluation of Better Plastics’ historical cash flows shows that they have been growing by 10 percent every year. Thus, the cash flows in Table 1 show an increase in revenues of 10 percent per year. Here are the cash flows you will use:
Year 1 - $ 8,050
Year 2 - $ 9,675
Year 3 - $11,972
Year 4 - $14,967
Year 5 - $18,796
2. Determine an Appropriate Discount Rate
Now, let’s assume your best investment alternative would earn you a 10-percent return. Let’s also assume that you believe Better Plastics is not very risky, so you assign a risk premium of 5 percent.
As we’ve seen, the discount rate is the sum of your best alternative investment rate (10 percent) and your risk premium (5 percent). In this case, that means you need a minimum annual return of 15 percent on your investment in this business.
3. Determine a Reasonable Life expectancy for the business
For this exercise, we’ll use five years of projected cash flows.
4. Determine the net present value
Using present value tables from a financial calculator or a computer spreadsheet, use the present value factors for your discount rate (15 percent). Multiply the present value factor by the cash flows for each year. The total of the discounted cash flows is the value of the business.
| A | B | C | D
1 | Year | Net Cash Flow | Present Value Factor | Today’s Value
2 | 1 | $8,050 | 0.8695 | $6,999
3 | 2 | $9,675 | 0.7561 | $7,315
4 | 3 | $11,972 | 0.6575 | $7,872
5 | 4 | $14,967 | 0.5717 | $8,557
6 | 5 | $18,796 | 0.4972 | $9,345
7 | Totals | $63,460 |  | $40,089
Here’s how to calculate net present value with an Excel spreadsheet.
| A | B
1 | Year | Cash Flow
2 | 1 | $8,050
3 | 2 | $9,675
4 | 3 | $11,972
5 | 4 | $14,967
6 | 5 | $18,796
7 | NPV | $40,089
Enter the cash flows for years 1 through 5 in cells B2 through B6. Then, type the following formula in cell B7: =NPV(15%,B2:B6)
Note that the discount rate of 15 percent is already entered in this formula. You can change the discount rate and cash flows to fit your situation.
The calculated value of Better Plastics, Inc. is $40,089. This means that if you buy the company today for $40,089, and the projected cash flow is accurate, you would realize a 15-percent annual rate of return on your investment over the next five years.
What We’ve Learned
Earlier, we said that this method of calculating a business’s value would allow you to answer two questions. Now, let’s look at the answers to those questions.
How does this investment compare with other investments available to me? At a price of $40,089, given all the assumptions made, your investment in this business will give you a 15-percent return. You can now compare that return with alternative investments.
How can I tell how much this business is worth? You have calculated that the business is worth $40,089. You now have a starting place for price negotiations.
…
Dan was amazed at how determined Sabine suddenly became. Because Sue didn’t own the building, Sabine talked to the landlord about the bar next door. She told him she was interested in leasing the space, but that she wanted an open wall of plants extending out between the two businesses. The landlord was willing, because the bar’s lease was coming due and he’d already had complaints from neighboring houses and businesses.
Next, Sabine considered the view from the highway and the way the neon Philly Cheese Steak sign hanging over the door of the diner seemed to intrude on the health food store and confuse the identities of the two businesses. Dan noted the gray-and-white window lettering that didn’t stand out at all, the skylight that had been painted over from the outside, and a strong smell of mice in the storeroom.
Dan made a list of all of these problems and started researching how much it would cost to get them fixed.
Once we had a reasonable estimate for all the renovations we had in mind, I took it to the landlord and said, “This is what it’ll cost to get ourselves settled in.” After that, we met with Sue and told her we were ready to buy. The only remaining sticking point was the price.
Sabine pointed out we’d be starting in a hole that Sue had dug with respect to her credit. And of course, we also had competition from the vitamin chain. Our goal wasn’t to squeeze her down so much as to arrive at a price that seemed fair given the facts.
In the end, we negotiated a $15,000 price reduction, along with a three-year extension on the lease.
…
Negotiating Price and Terms
The goal of the negotiation process should be for both sides to walk away feeling reasonably satisfied. As we learned in Chapter 23, Dealmaking and Contract Management, a win-win outcome creates goodwill on both sides. If it doesn’t seem possible to make both sides happy during the negotiations, consider looking for another business to buy.
Setting a Price Ceiling
Before you make an offer, you must establish a price ceiling—the top price you are willing to pay. This gives you considerable power in the negotiations.
Remember: The more you pay, the lower your rate of return. For example, if the price for Better Plastics were $46,204, your rate of return would only be 10 percent.
To set a price ceiling, choose your lowest acceptable rate of return and recalculate the net present values at that rate. The resulting number represents your highest acceptable price. Be prepared to walk away from negotiations if the seller will not accept it.
As stated earlier, you should also prepare a confidential cash flow that reflects revenue-increasing improvements you will make to the company. Using the net present value of the higher cash flows, recalculate the value of the company. This gives the company a higher value, meaning you may be willing to pay more than the historical cash flows justify. This can be risky, so weigh the evidence carefully before using this method.
Negotiating Price
Human nature dictates that when an initial asking price is accepted, sellers wonder if they could have gotten more out of the deal. Likewise, if the first counteroffer is accepted, buyers wonder if they could have gotten the business for less. To help avoid buyer/seller remorse, you should not offer your full asking price. Even if the asking price is well below your price ceiling, consider making a modest counteroffer.
Any counteroffer you make should be justifiable, however. If careful research indicates that cash flows will not support a certain price, you’re justified in asking for a lower price. Your research may also have made you aware of other factors that justify a lower price, such as outdated inventory or equipment. Always be on the lookout for these bargaining chips.
If the asking price is significantly above your price ceiling, counter with a price that can be supported by the cash flow (i.e., your price ceiling or lower). If that doesn’t leave you with enough negotiating room, you must either walk away or accept a higher price with more favorable terms.
Negotiating Terms
What’s more important to you: the price, or the terms of the agreement? If the seller’s price is firm, you should dictate the terms to your advantage. If terms are most important to the seller, you should dictate price.
As always, evaluate the deal in terms of the rate of return on your investment. Suppose your ceiling price for Better Plastics is $100,000, which would give you the 15-percent return you require. The seller refuses to go lower than $150,000, but is willing to carry the contract for 25 years with payments of $6,000 per year. Your original offer assumed you would need a $100,000 loan for five years at 10-percent interest, with payments of $25,488 per year. These new terms would increase your cash flow by more than $19,000 per year, which more than provides your 15-percent return. In this case, better terms clearly justify going above your ceiling price.
Franchising
A franchise is a legal relationship under which a franchisor grants a franchisee the right to sell the franchisor’s branded product under contractually specified rules. In essence, the franchisee pays a fee in order to reap the benefits of the franchisor’s brand, goodwill and efficient supply chain.
Most franchises fall into two categories:
Product franchises grant the franchisee the right to distribute goods under the franchisor’s name and trademark. Gas stations are a good example.
Business-format franchises provide franchisees with a standardized method of operations, including trade secrets and marketing materials (e.g., McDonald’s). These franchisors usually provide ongoing assistance to the franchisee.
One reason franchises are so popular is because statistics show that independent businesses are about six times more likely to fail in their first year than franchises.
Still, a franchise is not a sure thing. Like any other business, franchises require long hours, strong business skills and intense personal commitment. If you want to buy a franchise, you need to find one that suits your personal and professional goals, and you must also have good reason to believe it will remain profitable in your locale over the long term.
Advantages
The biggest advantage of franchising is that you can use the franchisor’s goodwill, quality standards, expertise, purchasing power, and other assets to compete with larger companies. These assets would take years to acquire independently.
The best franchisors aim for a win-win relationship with franchisees. They work to engender trust, provide educational opportunities, and give franchisees input into the system. Such relationships can be personally rewarding as well as profitable.
Disadvantages
Some franchisors will monitor and regulate virtually every aspect of your business. For example, they may require you to buy products, raw materials, fixtures, equipment and furniture only from approved suppliers.
Other franchisors are hands-off organizations that won’t be responsive to the problems you face as a startup. Think carefully about how much franchisor involvement is acceptable to you.
New franchisees often assume they’ll be profitable right away. However, the average franchise requires an initial investment of $100,000 to $250,000. It may take a year or two—or three—to make your franchise truly profitable, depending on your location, competition, fees and business skills.
Franchises and the Law
Corrupt franchising opportunities often target uninformed entrepreneurs, so due diligence is an absolute must for the potential franchisee.
The Federal Trade Commission’s Franchise and Business Opportunity Rule requires franchisors to provide you with a Franchise Disclosure Document (FDD) at least 14 business days before you pay any money or sign a contract. The FDD includes:
All costs, fees and royalties associated with starting and maintaining the business
A summary of contract terms and restrictions (including the length of the franchise agreement)
Copies of all required contracts, leases and agreements
The franchisor’s audited financial statements and litigation history
Background information on officers, managers, and other key personnel
Contact information for at least 100 previous franchisees in your area
Exit strategies, nonperformance penalties, and dispute resolution procedures
Some states also require franchisors to file an FDD with a state agency. In most of those states, it’s illegal to offer or sell a franchise until the FDD is filed. This doesn’t mean that the state has actually confirmed the information in the FDD; it’s up to you to check it for accuracy. You’ll need help from an experienced attorney and a trusted accountant.
Local Restrictions on Franchises
Some communities have voted to impose limits on franchises and other forms of “formula retail” in order to protect the local architecture and environment, or to nurture local businesses. In some cases, franchises may be required to forego their standard design in order to meet community standards. Other cities have limited the number of franchises that can operate within city limits at any one time.
If you’re in an area where these regulations are in force, or are being publicly discussed, take careful stock of local sentiments before proceeding with your franchise idea. Although the franchisor may be willing to fight such regulations in court, winning may do the franchisee very little good if angry citizens decide to avoid the business.
Researching and Applying for a Franchise
Before applying for a franchise, get a copy of the FDD and consider these questions:
Is the franchise new to your town or region? Is the business growing, stable or declining in other markets?
Can you visualize the franchise in your area? Do the demographics and economy of your area support it?
What do consumer groups like the Better Business Bureau say about the franchisor?
What is your break-even point, given the fees and royalties set forth in the FDD? Is it realistic? Will you have an adequate income in the meantime?
How do their fees stack up when compared to other franchises?
Is there a market for this franchise in your area?
Franchise trade shows will have booths explaining how to select and operate franchises. You may even be able to obtain FDDs from a large number of possible franchisors. Be careful, though: Many franchisors at these trade shows are small, disorganized operations.
Using a Franchise Broker
Franchise brokers advertise themselves as experts who can help you find appropriate, profitable franchises and walk you through the application process. Some brokers misrepresent their capabilities or affiliations, so always consider these questions:
Is the broker independent, or affiliated with a specific franchise or group of franchises? How many franchises does the broker represent?
Is the size of the broker’s commission tied to the franchise price? If so, the broker may recommend a bigger franchise than you can afford.
What local references does the broker have? Get their names and follow up.
The Application
After you’ve researched the franchise thoroughly and decided to apply, the franchisor will want to know some things about you, including your financial status, experience and ability to uphold the franchisor’s standards. Franchisors usually want a team player, not an independent-minded entrepreneur.
You may not like providing all this personal information. However, a franchisor that doesn’t ask for such information may not be careful enough about its business.
Deposit Agreement
Once your application is accepted, you’re typically requested to make a “good faith” deposit of $2,000 to $10,000. Review the deposit agreement, and make sure the money is refundable if you can’t strike a deal. Also, the deposit money should remain in escrow and reserve your franchise.
Examining the Franchisor
Once you’ve qualified, the franchisor should be willing to disclose its financial and operational details. You can expect to sign a nondisclosure agreement at this point. Examine this information carefully before signing the franchise agreement. If you negotiated your deposit agreement properly, you will be entitled to a refund if you don’t like what you see.
If the franchisor is reluctant to provide you with information, or is in a big hurry to sign you up, you should refrain from going forward with the deal.
Here are some questions to consider when assessing a franchisor:
Have you checked the franchisor’s standing with a credit rating service like Dun & Bradstreet? The state attorney general’s office? The FTC?
Does most of the franchisor’s income come from franchise fees (startup attempts) or from royalty payments (successful franchises)?
Are you permitted to interview any franchisees you wish?
Does the franchise location make sense?
Can you construct or maintain the type of store the franchisor requires?
What kind of help will the franchisor supply to a new or struggling franchise?
Are the training commitments adequate?
Will making purchase payments affect your short-term capital needs?
How many franchises have sold over the last five years? How many have failed?
Do franchisees collectively have a voice in management?
…
Today, we’re doing very well. In fact, we’re doing way better than I thought we would. I never expected to get into a growth business. I figured we’d get a steady, loyal clientele, but not much growth potential.
But I hadn’t counted on Sabine. She recognized right away that part of Sue’s problem had been her focus on vitamins and herbal remedies. That had been a good strategy when Sue started out, but since then a lot of competition had sprung up. Nowadays, even the drug chains sell herbs and supplements. Obviously, Sue couldn’t compete on a price basis with chains. And unfortunately, she really didn’t have too many other products to offer. Or at least, none that anyone wanted.
Sabine changed that, along with everything else about the store. She made it light, airy and bright, and turned it into the kind of place where people want to linger.
Dan and Sabine agreed that they didn’t want to run a “health food” store; that sounded too exclusive and had too many negative connotations. Instead, they chose to run a specialty and gourmet market, with lots of fresh local produce, interesting handmade products and green household supplies. There was a small deli with lunch and dinner options that Dan made fresh daily. The store was still organic, still healthy...but now it appealed to a much wider clientele.
Earlier this year, the diner next door went out of business. It was perfect timing. We’d just been talking about expanding our deli, which is one of the most popular parts of the store. The place next door was a complete mess, but I didn’t get too worried about it—Sabine had that determined look in her eyes again!
…
Understanding the Franchise Agreement
The franchise agreement legally defines the terms of your relationship with the franchisor. Unlike a traditional contract, franchise agreements often establish a relationship in which the franchisor can change policies and procedures without the franchisee’s knowledge or consent.
Don’t be afraid to ask the franchisor to explain why a particular term is fair or necessary; the agreement is negotiable even though it comes on a standard form. Remember: All your careful analysis is wasted if you agree to an unfair contract.
Seek legal counsel to help you negotiate a fair deal, and be prepared to walk away if you can’t achieve one.
Most franchise agreements will address the following issues:
Contract term and renewal. You may want a short initial term in case things don’t work out, but you may also want an automatic right to renew without additional fees. Also, note the type and length of renewal notice required. Many states regulate franchise extensions so that they can’t be cut off early.
Royalties can be based on net or gross sales. When is the royalty due? Is there a cap, or a declining percentage in your favor, as your sales go up?
Auditing. Make sure you understand all accounting and reporting requirements. Note that if your books are in error, you may be required to pay for an audit.
Territory. Is your territory exclusive or nonexclusive (i.e., can the franchisor grant other franchises in the area)? Are you required to open additional stores in the territory to maintain your exclusivity or your original franchise? Is the territory so large that it will overextend your resources, or so small that you must compete with another franchisee?
Sourcing. The franchisor may require you to buy raw materials, fixtures and other supplies from an approved vendor. In some cases, vendors may provide kickbacks to the franchisor in return for becoming a sole supplier. Look carefully at sourcing requirements.
Physical plant. Retail franchises usually require a standard physical appearance. Identify the extent to which the franchisor controls or assists you in locating a site, making improvements and furnishing the interior. Also, determine what rights the franchisor has to inspect your premises and operations.
Training. Your agreement should clearly state what training is offered, when and where, and at whose expense. Will your employees receive training from the franchisor, or is that your obligation?
Management assistance. Your contract should spell out what management assistance the franchisor will provide.
Marketing. What marketing or advertising programs does the franchisor undertake? Will you be required to spend a percentage of your gross sales on national or additional local advertising? What percentage of your royalty payment will go to area, regional and national marketing by the franchisor? Can you audit the franchisor’s books to make sure it’s meeting all marketing obligations?
Quality control. A bad product or sleazy business practice in one location will hurt all franchisees. The franchisor should hold all franchisees to the same quality standard and give you remedies if they fail to do so.
Trade secrets. A franchise agreement will often provide that every aspect of the business is a trade secret. The penalties for revealing or misusing this confidential information may be severe.
Noncompetition. You may be prohibited from competing against the franchisor when the franchise terminates, and from opening non-franchised outlets while the agreement is in place. Review these provisions carefully to avoid undue restrictions on your rights.
Transferability. At some point, you may wish to sell the business or pass it on to your children. However, the franchisor may want to review your buyer’s qualifications, just as it reviewed yours when it sold you the franchise. Alternatively, the franchisor may want to reacquire the franchise. It’s quite common to see options, or rights of first refusal, granted back to the franchisor.
Cure periods. Pay attention to the amount of time you and the franchisor have to “cure” contract defaults. Some agreements may grant the franchisor as many as 90 days to fix problems, while extending a much shorter grace period to the franchisee. A fair agreement will give both parties an equal cure period.
Termination. The termination provisions in a franchise agreement often favor the franchisor. However, you must have the ability to protect your investment, and to terminate or get damages if the franchisor fails to keep its promises. If the franchisor defaults and the agreement is terminated, can you recover some portion of your initial franchise fee? What about liquidated damages? What items must be returned to the franchisor? You will want a clear delineation of these matters, so you are not subjected to claims after termination.
Venue and legal fees. Some franchise agreements state that disputes must be litigated, arbitrated or mediated in the franchisor’s home state. Others require the franchisee to pay the franchisor’s legal fees if the franchisor wins the dispute, but don’t require the franchisor to pay if the franchisee wins. If the franchisor refuses to change such clauses, consider it a dealbreaker.
Conclusion
Buying a business is a great way to get started as an entrepreneur, and it can also facilitate faster growth for an existing business.
There are no hard and fast rules about valuing a business. A business is worth what the buyer and seller mutually decide it’s worth. The methods presented here merely serve as a starting place for negotiations.
Whether you’re buying a business or becoming a franchisee, you must calculate the rate of return you require, because this knowledge allows you to set a price ceiling. It’s essential to evaluate potential deals objectively, so you should always include a trusted accountant and attorney in your decision-making process.

Cererciat. Mendis re corate exped ut ullor sed ulluptia sime pa num et iume erchiliandae sam autecerae nimil ium dolo blam, conse vero

Table 1. BETTER PLASTICS, INC. Cash Flow
| 2015 | 2016 | 2017 | 2018 | 2019
REVENUE
Product 1 | 100,000 | 110,000 | 121,000 | 133,100 | 146,410
Product 2 | 100,000 | 110,000 | 121,000 | 133,100 | 146,410
Total Revenue | 200,000 | 220,000 | 242,000 | 266,200 | 292,820
EXPENSES
Cost of Product 1 | 50,000 | 55,000 | 60,500 | 66,550 | 73,205
Cost of Product 2 | 50,000 | 55,000 | 60,500 | 66,550 | 73,205
Wages | 25,000 | 27,500 | 30,250 | 33,275 | 36,603
Outside Services | 250 | 275 | 303 | 333 | 366
Office Supplies | 500 | 550 | 605 | 666 | 732
Repairs & Maintenance | 500 | 550 | 605 | 666 | 732
Advertising | 5,000 | 5,500 | 6,050 | 6,665 | 7,321
Car, Delivery, and Travel | 500 | 550 | 605 | 666 | 732
Accounting and Legal | 1,000 | 1,100 | 1,210 | 1,331 | 1,464
Rent | 6,000 | 6,000 | 6,000 | 6,000 | 6,000
Telephone | 2,000 | 2,000 | 2,000 | 2,000 | 2,000
Utilities | 1,200 | 1,200 | 1,200 | 1,200 | 1,200
Insurance | 1,000 | 1,000 | 1,000 | 1,000 | 1,000
Taxes | 1,000 | 1,100 | 1,200 | 1,331 | 1,464
Loan Repayment | 12,000 | 12,000 | 12,000 | 12,000 | 12,000
Miscellaneous Expenses | 1,000 | 1,000 | 1,000 | 1,000 | 1,000
Owner’s Withdrawal | 35,000 | 40,000 | 45,000 | 50,000 | 55,000
Total Expenses | 191,950 | 210,325 | 230,028 | 251,233 | 274,024
Net Cash Flow | 8,050 | 9,675 | 11,972 | 14,967 | 18,796

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