Financial hints for buying a franchise business
By Tim Kilham, Head of Franchising, Lanyon Partners
You are reading this article, and therefore you are thinking of buying a franchise. That can be a scary prospect. For some of you, the purchase of a business (franchised or not) will be the single biggest purchase you ever make in your life, or perhaps the second biggest after your house. For others, the purchase might involve a relatively small sum. However, whether it is a small or large purchase, it is your money and it is important that you make a wise investment decision.
We have had many years experience in advising prospective franchisees to purchase (and not to purchase!) franchises. In this article we will try to give you some helpful financial hints in relation to the purchase of a franchise.
1. Understand the Legislation Governing Franchising
Whether it is a small or large purchase, it is your money and it is important that you make a wise investment decision
Franchising in Australia is governed by a Code of Conduct which is administered by the Australian Competition and Consumer Commission. This Code of Conduct is compulsory and must therefore be followed by all franchisors. It applies to all businesses which fit within the definition of a franchise under the legislation, irrespective of whether or not the business opportunity is called a franchise. Some people will call the businesses they have for sale franchises, some will call them licences, some will simply call them business opportunities – but if that opportunity or licence falls within the definition of a franchise, it is a franchise and the Code must be complied with.
2. Review the Disclosure Document Carefully
The Code provides you, the prospective purchaser, with some protection, and you should be aware of what this protection is. From a financial perspective, there will be useful information available to you in the Disclosure Document. A Disclosure Document is a document which must be given by franchisors to intending franchisees at least 14 days before you sign the Franchise Agreement. It contains much useful information about the franchise system and its owners, and you cannot properly evaluate a franchise without reviewing that document. In relation to financial issues, it will include
- Details of the franchisor’s estimate of the initial costs involved in acquiring the franchise.
- Details of ongoing fees payable to the franchisor.
- Possibly, sales and expenses and likely profit for a model franchisee. Alternatively, the franchisor can simply state in the Disclosure Document that it does not provide any earnings information.
- The most recent profit and loss and balance sheet for the franchisor (or alternatively, a statement by the directors of the franchisor, and verified by a registered company auditor, that the franchisor is able to meet its debts as and when they fall due).
3. Educate Yourself
Before you get too far into the process of purchasing a franchise, educate yourself about business and about franchising. There are plenty of resources for example,
- There are publications available from newsagents and the Franchise Council of Australia.
- Go to the website of the Franchise Council of Australia (www.franchise.org.au) and review the material available there.
- Small business corporations in most states run seminars on franchising and business.
- Various organisations (including the authors’ firm) run regular free seminars on buying a franchise.
- An appropriate search of the internet will generate a vast amount of information. But be selective in your research on the internet – the information there is not always reliable.
4. Know Your Borrowing Capacity
All of the major banks and other major lenders to franchises have an accreditation system for franchises. If a franchise system is accredited with a lender, then you will have to supply a portion of the finance – usually between 30% and 50% (either in cash or in the form of security against the property) and the lender will supply the remaining 50% to 70% with the only security being the business itself. Conversely, if the system is not accredited, you will have to put in cash to buy the business, or borrow money from a lender against security of a property, but the lender will not usually provide any loan against the business itself.
As a practical example, assume you own a house worth $300,000 and you do not have a mortgage. If you wish to buy a franchise, and the franchise is not accredited with one of the lenders, then you have the ability to buy a franchise for up to $240,000, because the lender will normally make a loan to you of up to 80% of the value of your house ($300,000 x 80% = $240,000).
On the other hand, if the system is accredited, and the lender is prepared to lend up to 60% against the business itself, then you have a borrowing capacity of $600,000 – the lender will lend you 80% of the value of the house ($240,000) and it will also lend to you a further 60% of the total purchase price against the business itself (another $360,000).
It should therefore be apparent that your borrowing capacity is significantly greater when you are buying a franchise in a system that is accredited with one of the major lenders. You should be aware that the terms of any loan that is secured against the business itself will be significantly different to the terms of the loan that is secured over a property. In particular, the loan secured against the business will have a higher rate of interest and a shorter repayment period.
5. Choose the Right Business Structure
Choosing the appropriate business structure for you is of paramount importance if you wish to protect your assets, minimise your ongoing income tax liabilities and have flexibility in distributing income in a tax effective manner.
The structures available to you in Australia are a sole proprietorship, partnership, company and trust, or a combination of these. The structure that will best suit you will depend on your circumstances and an advisor experienced in franchising will be able to advise you which structure suits you best.
For example, if you want to keep the business as simple as possible, if income splitting is of no benefit to you and you are not concerned about asset protection, then a sole proprietorship may be best for you. In a sole proprietorship, you include in your personal tax return the profits of the business and pay whatever taxes are due.
If you wish to achieve some income splitting, but are not too concerned about flexibility or protection of assets, then it may suit you to go into partnership with your spouse or another person. You then include in your tax return your share of the partnership profits.
A company alone, or a trust with a company as trustee, is a more complicated structure and more expensive to set up – the set-up costs could be in excess of $2,000 for a trust and company, whereas the cost to set up as a sole proprietor may be as little as $70 (the cost of the registration of a business name). However, the use of a company will provide you with the benefit of limited liability – that is, help you keep your personal assets separate from your business assets and limit the chance of you losing your personal assets in the event of the business becoming insolvent. Further, with a discretionary trust you may legitimately distribute income to beneficiaries (yourself, your spouse, your children and possibly other family members) in a tax effective manner each year – that is,distribute the income to people in such a way that income tax is minimised each year. Get advice on a suitable structure for you from an experienced advisor before you enter into the purchase of a franchise. Good advice will reap huge benefits.
6. Understand GST on the Initial Purchase
There may or there may not be GST on the initial purchase of a business. You should clearly understand whether or not there is any GST as this will significantly affect the price that you pay.
If you buy a business for, say, $110,000 and the purchase price includes GST, then in the first Business Activity Statement that you lodge after purchasing the business (which will be within three months of you purchasing the business), you will get back 1/11th of the purchase price, ie $10,000. So your net purchase cost is $100,000. If, however, the purchase price does not include GST, then you will get nothing back when you lodge your first Business Activity Statement and the net cost of the business is $110,000.
So when will there be GST included in purchase price and when will there not be? The answer is that if the sale is a sale of a going concern as defined in GST legislation, if both buyer and seller are registered for GST, and if the appropriate clauses are written into the contract, then there will be no GST included in the transaction. This means that the purchaser cannot claim any GST on the purchase price and the seller does not have to pay any GST on the selling price.
7. Prepare Your Own Financial Projections
It is likely that in the purchase of a franchise you will be given some financial projections. They may be included in the disclosure document. They may possibly not be included in the disclosure document but be given separately to you by the franchisor or its agent. You should, if you are buying an existing business from an existing franchisee, obtain copies of that franchisee’s most recent financial statements.
None of this financial information is of itself sufficient for you to make an informed decision as to whether you should purchase the franchise. From a financial point of view, you have two decisions to make – do you want to purchase the franchise and how much do you want to pay. The only way that you can make these decisions is by preparing your own financial projections. You need to prepare detailed monthly sales and expenses and profit projections for the first twelve months for your business. The information provided to you by others is only a guide – it is historical, not prospective, and it is coming from people who have a vested interest in you buying the business. You need to prepare your own projections using your own assumptions and information that you have gathered. Only then can you make the decision as to whether it is worthwhile to purchase the business, and how much you should pay for it.
One particular word of warning – if there are projections provided in a Disclosure Document for a model franchisee, these will nearly always require amendment by you. The model projections may not include depreciation, they will not normally include interest (because the franchisor does not know how much money you will be borrowing), will often not include an owner’s wage (because the amount of the owner’s wage will be at the discretion of you, the owner), etc etc. The figures in the disclosure document will therefore usually not provide a realistic basis for you to make a decision about a business.
8. Don’t Pay Too Much
It never fails to amaze us when we come across people who will put considerable thought (and rightly so) into spending $2,000 on, say, a new television set but who will spend $200,000 on a business based on a glossy brochure and some brief conversations with a franchise broker. Do your homework and plan the purchase properly.
When you are buying an existing business from an existing franchisee, the price is nearly always negotiable. Just as when you are buying a house the price the vendor will accept is usually somewhat less than the initial asking price, so it is with the purchase of a business. Do not simply pay the asking price. Be prepared to put in a much lower offer and find out what the vendor really wants.
When you are buying a new franchise from an existing franchisor, there is often less room to negotiate the price. However, there is usually still some room to negotiate.
Do not assume that because you know of another franchisee in a particular system that has done well, that you will automatically also do well in that system. Within all franchise systems, there will be a vast range of franchisee performances. There will be good and there will be bad and there will be indifferent franchises. To some extent this will depend on the operator (you!) but it will also depend on the location, demographics of your catchment area, etc. Do your homework, do your financial projections and pay the right price – if you pay too much, you may never be able to make a success of your franchise no matter how well you run it.
9. Plan Now to Minimise Capital Gains Tax
Capital Gains Tax is something that you pay on the sale of a business. Why, therefore, you may be wondering, does this article, which is about the purchase of a franchise, deal with tax on the sale of the business? The answer lies in the fact that your choice of business structure now may significantly influence the Capital Gains Tax that you pay on the sale of your business.
For example, most taxpayers who sell an asset that has been held for more than one year, receive a 50% discount – that is, they only have to pay tax on half of the capital gain. However, if a capital gain is made by a company a company does not get that concession. For this reason, many franchisees will choose not to own their franchise through a company.
For many franchisees a further 50% concession (the Active Asset Concession) is available. In practice, what this means is that for many franchisees, every $1 in capital gain can be reduced to 50 cents (by claiming the 50% discount) and then to 25 cents (by claiming the Active Asset Exemption). You can then choose to pay tax on that 25 cents, or avoid tax by either buying replacement active assets or by rolling the money over into a superannuation fund. So for many people selling businesses it is quite possible to avoid paying any tax on the capital gain on the sale of a business. However, the ability to do this is dependent on choosing the correct business structure at the time you buy the franchise.
This area is too complicated to cover in any detail in this article, but it is crucial that you consult an experienced adviser who will ensure that your structure not only minimises your ongoing Income Tax liabilities, but also the Capital Gains Tax payable on the sale of the business.
About the author
Tim Kilham is a director of Lanyon Partners Chartered Accountants and heads up the franchising area of that division. He can be contacted on:
phone: 03 9861 6100