Good for the goose

Whenever Dragons' Den or American Inventor appears, I think back to my first business venture, begun at the tender age of 21.

My friend Max was a wizard engineer but still failed to fully secure the 60-ton press as he left the shop floor for lunch. During his absence the press suddenly revolved, crushing a worker's fingers.

After a career of 40 years, Max chose to resign. Shattered by the turn of events and with no job or income, he retreated to his garage. His home resounded to the sound of metal being hammered and drilled. 

After six weeks he rang and asked me to call. In his garage stood a machine whose purpose eluded me. The only similarity to Chitty Chitty Bang Bang was that it sported four wheels. It was loosely based on the remains of his lawn mower, with additional parts scavenged from his childhood Meccano set.

Max picked up a length of aluminium rod, pushed it into the machine innards and pulled on a long handle. The wheels revolved and into a wicker clothes basket dropped a fully formed boy's catapult.

You were probably one of the thousands of kids across the country who saved their 75p to buy his 'Acme' thumb bruiser catapult. Max pulled and pushed the handle, making 50 pence profit each time. The faster he worked the faster he made money. The machine cost Max £210 and was an instant money-maker.

After three years I offered Max £21,000, bought his business, cleared my garage and pulled the handle ever faster. Max used my money to pay for surgery on the workers injured hand, proposed to her, then retired with his new wife to a perfect seaside bungalow in Norfolk and never worked again.

Max and his wife were happy, I was happy, thousands of kids were happy. The only one unconvinced was my father, who could never understand why I would pay 100 times the asset value for a business with no premises, hardly any stock, one machine and a long list of customers.

How come was I more than happy to pay £20,790 for the goodwill? Few prospective business owners fully understand the principle behind the goodwill element of an operating franchise.

It might help if we take the fairy tale of the Goose which lays the Golden Egg. If we assume that every egg would sell for £5000, then we need to ask what is the actual value of the goose.

As a means of producing an income of £260,000 a year, what price would you be willing to offer the owner?

You would need to have a number of questions answered.

How old is Goosy Goosy Gander? Is she in rude good health? Has she always laid a Golden Egg every single day? How long will she live?          

What does she cost to keep?

You will then make a guess at the number of eggs you may expect to produce and offer the owner a share of that future income to purchase the asset.

Goodwill is defined as the premium offered by the buyer, above the actual 'book' value of the assets.

So what's an existing franchise worth?

The truth is that a franchise, like any other business, is worth only what someone is willing to pay. My home is worth £250,000 in its quiet Worcestershire lane - but would command £7 million if located on that London lane that runs between Hyde Park Corner and Grosvenor Gate. Where, when, and how the business operates determines the value.  

When buying any business, you are not just investing in what you can see, touch, or hold. What you are really into is buying the parts of a 'machine' that will produce a healthy return on your investment.     

When buying a franchise ask to see a copy of the previous profit and loss account and balance sheet. In general the 'goodwill' cost of a franchise, would probably calculate out at 1.5 times the pre-tax profits.

Let's imagine that you are considering buying a franchise which generates a net profit of £36,000 each year. Using the formulae of 1.5 times net profits, you would be prepared to offer up to £54,000. If the equipment, fixtures and fittings you are buying are worth £32,000 then the goodwill premium is £22,000. 

However, at best, this goodwill figure is only an estimate. The fixtures and fittings are always worth more as a going concern, than their scrap value. The whole is worth more than the sum of the parts.

At 1.5 times the assets, you are set to make a return of 66 per cent on your investment. Broad smiles all around - but think on.

You have ignored your salary, or rather the salary you could expect if you worked your socks off for someone else.

£36,000 net profit - less your average salary of £21,000. You are now making only £15,000 net profit. Borrow money at 8 per cent interest and you could well be down to a negative return on your investment. Survive this and repay your loan in three years, and your investment once more returns to being a moneyspinner.

Does it hang together?

We all examine the sales turnover figures of the franchise to gain an idea of the value. Most of your customers will come from within 10 miles of your location, so it is a simple matter to calculate the potential population who are expected to provide you with a living.

Does it seem that every single resident will have to buy from you to reach these figures? Do you and your family purchase a similar amount?

The family income and expenditure survey available from H.M. Stationary Office, or your local library will provide actual expenditure.

Try and look at the accounts over a few years. Is the sales figure being window dressed? Could it be that the prices have been lowered to increase the turnover? There's nothing that someone in the world cannot make a little worse, and sell a little cheaper.

Many sellers hint that the true sales could be higher, or the potential is greater than the accounts show. Remember that put simply it is still cheating, and that by accepting, you are party to fraud. Penalties will exist for VAT and unpaid Tax. It should be apparent that a person is prepared to cheat once - may cheat again - and this time it could be you on the receiving end.

Take the chance to look through the purchase side of the franchise. Unless the business is complicated the purchases are a guide to the sales. Purchases will evidence if the sales are accurate. Usually a franchise will be dealing with one main supplier (often the franchisor) making the task easier.

Want to get a franchise of your own?

Who doesn't? The system works. But the most difficult decision is which franchise to choose.

'I'm a good cook,' you think. 'I could take to fast food franchising.'

Despite pygmies never wanting to dip their arrows in your chilli, it is not enough reason to consider a food service franchise.

Fast food is about speed of preparation, and always having sufficient stocks to meet demand. It's about portion control, waste reduction, and keeping strictly to hygiene standards. It's all about staff control and management of assets. It's about quality standards and customer service. Fast food is not about cooking. A production engineer stands a better chance than a chef, when it comes to franchised fast food.

So what's the best way to find out which franchise suits you. Want to find out what it's like to franchise a Burger Queen?  Get a job behind the counter and see if you enjoy it enough to carry on.

More worries?

Don't be fooled by those who say: 'You can sell this, and make a mark-up of 100 per cent.' The prospective franchisee's eyes open wide. A frown creases their brow. 'G.. G... G...Granville. What's a mark-up?'

It's simple. You buy the product for £5 - you mark it up by 100 per cent. The product now sells for £10. But the margin - the bit you get is only 50 per cent. Time to get a calculator.

In the case of a product marked up from £1 to £1.50 - a 50 per cent mark-up, but your margin is now down to 33 per cent. 

Fiddle factors

Cash flow forecasts are demanded by banks before allowing a business loan. Taught on every new franchise course, and intended to show the inflow and outflow of cash into the franchise. All too easy to simply adjust the figures if there appears to be insufficient income to repay the loan. Once again ask to see actual audited figures from the last tax year.

The good news

For most entrants franchising has an enviable track record. Successes will continue to outweigh the small number of failures, but too many still arrive at the door of a franchising opportunity without a clear understanding of what precisely they are buying with their investment. 

Most common is the lack of understanding of financial information and operating ratios. Bankers are also aware that the weakest area of business knowledge is control and operation of the money.

Few businesses fail through lack of sales - most fail through lack of financial control and budgeting. The day of the 'bean counter' has finally arrived. The accountant will reign supreme.