Buying a Franchise from an Existing Franchisee
By Michael Seid, Managing Director, MSA Worldwide
Established franchisee-owned businesses routinely come on the market and, if I were looking to become a franchisee today, those are the opportunities I personally would focus on first. But understanding why the existing franchisee wants to sell their business, understanding what that business is worth and, most importantly, understanding what you are actually buying is essential before you sign the purchase and sale agreement.
Often the seller has successfully operated the business for many years, and simply is looking to retire and move to a place where the sun shines every day. Possibly they don't have any children who want to take over the family business, or maybe they simply want to do something new. But not all businesses, including franchisee-owned businesses, are profitable – just because the purchase price is going to be lower than the cost of starting a new franchise, the franchise may not be a bargain.
The advantage of buying an existing and successful business is that it is already up and running. Compared to starting from scratch with a new location, you don’t have to choose a territory, find a site or go through the process of negotiating a lease, finding an architect, or hiring a contractor to build it out. If you are fortunate, your staff is already in place and trained. Your inventory is already in the store; all your vendor relationships are in place.
Most important is that the business has an existing customer base, an established and hopefully a great reputation in the community, and is profitable. The benefit of buying an existing franchise is that you can be up and running a lot sooner than if you had to start from scratch – and if you know what you are purchasing.
When you start a new franchise you don't know how well your business will do, even if the franchisor provides a Financial Performance Representation in their Franchise Disclosure Document (FDD). There is no guarantee your business will perform as well or better than the other locations in the system. But with an existing franchise, you have the opportunity to review the seller’s books and records and make a determination of future performance based on real numbers in an operating location. Those numbers tell you quite a bit, but in addition to the normal issues you want to look at in conducting due diligence for a new franchise, you should find out:
- Why is the franchisee leaving the business?
- Will the existing staff, especially the managers, be staying?
- Trends for the location – have they been continually strong or have they been on the decline?
- Are the neighborhood and its demographics beginning to change?
- Are there new competitors coming into the market that could affect future performance?
Look at the location as if you were starting fresh. If the business has been on a decline for the past several months or years, don't assume that you will work any harder or smarter than the seller. You need to understand your additional capital requirements if the franchisor requires you to bring the location up to then-current standards. If this is the case, understanding the cost of upgrading the location, the time you have to make the improvements, and whether or not you will need to close the location during the remodeling are essential for you to know in advance.
Although it's a new business to you, you also need to find out the terms of the agreement your franchisor is going to be willing to grant you. Don't assume that you are going to be able to assume the existing agreement that the seller has, and don't assume that assuming an existing agreement is even going to be beneficial for you.
The Franchise Agreement that you may be required to sign may be different from the seller’s, as the franchisor may require that you sign the same agreement they are currently offering to new franchisees. Your fees and other terms may be different than the seller has been operating under, and those changes may be material. You need to determine exactly what you're agreeing to before you settle on a purchase price.
Some franchisors will allow you to assume the seller’s franchise agreement. Others will require you to sign a new franchise agreement identical to the one they are offering to new franchisees. Still, others may require you to sign a new agreement but only provide you with the remaining term of the existing franchisee’s agreement.
Most franchisors won't require you to pay a new franchise fee, but many will still charge a transfer fee that either you or the selling franchisee will need to pay. Some franchisors will also charge the buyer for the initial training they will require.
You will be negotiating the purchase price with the selling franchisee. Don't be surprised if the franchisor wants to see how much you are paying for the business and how you plan on financing your purchase. Almost all franchise agreements give the franchisor the right of first refusal to purchase a franchise based on the same terms being offered by the buyer. Usually, they have 30 days or even longer to match your written offer, and some require you to put up an escrow payment for the business prior to them reviewing your application to become a franchisee, or before they review your offer to the buyer. It is a good idea to ask the franchisor in advance whether they are going to be interested in exercising their rights of first refusal before you spend too much time and money exploring the opportunity. Many franchisors will give you an answer; having that information in advance can save you money and of course disappointment later on. If the franchisor tells you that they are waiving their rights, it is important you get that in writing.
Another reason that most franchisors want to review the purchase price and understand how you plan to finance the business is that they simply want to see if you are overpaying and if the projected cash flow from the business is likely sufficient to allow you to meet your debt service. There is little advantage to any franchisor if you overpay for the business and then can’t service your debt and fail. Keep in mind that this can be a very difficult decision for franchisors to make. If they turn down the sale because the purchase price is too high, the selling franchisee will not be happy. However, if they let you invest in the business and you are not able to service your debt or achieve a return on your investment, you are not going to be happy. Make certain you discuss this with your legal counsel and they can address this with the franchisor.
Buying an existing franchise is a great way to become a franchise, and it has a host of significant benefits. However, just as with any investment, you need to do your homework, and you need to have qualified legal and business advisors working with you.