Business Valuation does not equal Purchase Price. Why?
In this article we look at why the valuation and selling price may differ and the reasons behind the adjustments.
By Kobus Oosthuizen
The valuation of any business, franchised or not, is primarily driven by assumptions regarding future profitability and a certain probability that the numbers are achievable. Even so, the actual amount paid will in all likelihood differ from the valuation.
For the purposes of this discussion we will make reference to a typical franchised business.
The matter of urgency, and the reason for the sale:
“Why are you selling?” is the first question any purchaser should be asking. The motive for selling will have an impact on the valuation method applied and is the primary indicator of the risks attached to the transaction.
Always keep in mind that “good businesses” are seldom up for sale and if they do end up in the market there is usually a substantial amount of goodwill attached to the valuation. Profitable businesses are very seldom sold for reasons attached to the actual business, but rather because of circumstances relating to the stakeholders of the business. Examples of this could be:
- The remaining term of the franchise and/or lease agreement
When a business valuation is based on future profits, it is assumed that the business will have access to its primary resources for the valuation period and beyond. Two of the key resources of a franchised business are, the premises from which the business operates, especially a retail business, and the use of the franchisor’s business system.
The remaining period of the lease and franchise agreements must at least be equal to the period used as earnings multiple in calculating the valuation. If, for example, 36 months was used as the earnings multiple, the remaining period of the current lease and franchise agreements cannot be less than that.
If the purchaser requires a loan to fund the transaction, financial institutions will only grant payment terms equal to the lesser period remaining on either the franchise or lease agreement.
For this reason it is suggested that the purchaser, assisted by the seller, attempt to negotiate an option to renew with both the landlord and the franchisor, on terms on par with the valuation model.
If such options cannot be negotiated, the valuation price of the business should be discounted accordingly.
- An obligation to refurbish or upgrade
The obligation to upgrade or refurbish a franchised outlet is normally contracted in terms of the franchise agreement and it is usually specified when refurbishments will take place.
When buying an existing business, the obligation to refurbish will fall to the new franchisee. The estimated cost of such a refurbishment should be taken into account when adjusting the purchase price downward.
The seller will probably argue that the refurbishment will increase turnover and therefore profitability, and that it is therefore not reasonable to adjust the valuation by the full cost of the refurbishment. In such an instance, it is suggested that the parties refer to the franchisor for their view on how much the turnover is expected to increase, and based thereon to determine the extent to which the purchase price should be adjusted.
- The equity position of the purchaser
“Cash is king” is the essence of this argument and suggests that, if the purchaser is in a position to buy the business without having to procure funding, the seller should be prepared to discount his price.
If the purchaser is obliged to apply for funding chances are that the sale will be delayed and may never take place should the funder not be comfortable with the valuation of the business or the profile of the buyer.
Cash buyers are not common and when approached with an offer from a cash buyer, sellers should certainly consider discounting the valuation accordingly.
Next month we will provide some pointers on what to take into account when conducting a due diligence in preparation of making an offer on a business.
By Kobus Oosthuizen
The valuation of any business, franchised or not, is primarily driven by assumptions regarding future profitability and a certain probability that the numbers are achievable. Even so, the actual amount paid will in all likelihood differ from the valuation.
For the purposes of this discussion we will make reference to a typical franchised business.
The matter of urgency, and the reason for the sale:
“Why are you selling?” is the first question any purchaser should be asking. The motive for selling will have an impact on the valuation method applied and is the primary indicator of the risks attached to the transaction.
Always keep in mind that “good businesses” are seldom up for sale and if they do end up in the market there is usually a substantial amount of goodwill attached to the valuation. Profitable businesses are very seldom sold for reasons attached to the actual business, but rather because of circumstances relating to the stakeholders of the business. Examples of this could be:
- The remaining term of the franchise and/or lease agreement
When a business valuation is based on future profits, it is assumed that the business will have access to its primary resources for the valuation period and beyond. Two of the key resources of a franchised business are, the premises from which the business operates, especially a retail business, and the use of the franchisor’s business system.
The remaining period of the lease and franchise agreements must at least be equal to the period used as earnings multiple in calculating the valuation. If, for example, 36 months was used as the earnings multiple, the remaining period of the current lease and franchise agreements cannot be less than that.
If the purchaser requires a loan to fund the transaction, financial institutions will only grant payment terms equal to the lesser period remaining on either the franchise or lease agreement.
For this reason it is suggested that the purchaser, assisted by the seller, attempt to negotiate an option to renew with both the landlord and the franchisor, on terms on par with the valuation model.
If such options cannot be negotiated, the valuation price of the business should be discounted accordingly.
- An obligation to refurbish or upgrade
The obligation to upgrade or refurbish a franchised outlet is normally contracted in terms of the franchise agreement and it is usually specified when refurbishments will take place.
When buying an existing business, the obligation to refurbish will fall to the new franchisee. The estimated cost of such a refurbishment should be taken into account when adjusting the purchase price downward.
The seller will probably argue that the refurbishment will increase turnover and therefore profitability, and that it is therefore not reasonable to adjust the valuation by the full cost of the refurbishment. In such an instance, it is suggested that the parties refer to the franchisor for their view on how much the turnover is expected to increase, and based thereon to determine the extent to which the purchase price should be adjusted.
- The equity position of the purchaser
“Cash is king” is the essence of this argument and suggests that, if the purchaser is in a position to buy the business without having to procure funding, the seller should be prepared to discount his price.
If the purchaser is obliged to apply for funding chances are that the sale will be delayed and may never take place should the funder not be comfortable with the valuation of the business or the profile of the buyer.
Cash buyers are not common and when approached with an offer from a cash buyer, sellers should certainly consider discounting the valuation accordingly.
Next month we will provide some pointers on what to take into account when conducting a due diligence in preparation of making an offer on a business.
Well, If you starting a business then It will be really very careful that what kind of franchisee you want and what is the strategy you behind it.
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