By Christo Weideman
Christo Weideman is a seasoned banker with extensive franchise experience. He is also a Business Associate at Global Business Holdings and a member of the South African Council for the Property Valuers Profession.
It is widely accepted that when the Greek philosopher Plato (427-347 B.C.), coined the phrase “Beauty is in the eyes of the beholder”.it was in a different form and meaning. It’s another way of saying that beauty is subjective.
The same can be said about value. Value can be subjective. There could be countless interpretations of the value of a business by the seller, the buyer, the agent, the bank, the accountant and the business consultant. In franchising, this becomes important when the franchisor wants to sell the franchised business or when a franchisee wants to sell his/her franchise. In the current climate, there could be a lot of opportunities for buying or selling a business and it’s important to understand valuation methods. It’s usually at the point of sale that the seller has the opportunity to realise the value and create personal wealth, subject to some of the conditions mentioned in this article.
From a franchisor’s point of view, it’s advisable to recommend a valuation method to franchisees and to include this in the franchise agreement to avoid confusion later on. Also, it’s very important that the franchisor includes first right of refusal and the ability to approve any buyer of a franchise business as conditions in the franchise agreement.
What is value or often referred to as the market value of a business?
According to the International Valuation Standards Council (IVSC)
“Market Value is the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgeably, prudently and without compulsion”
This article will have some basic departure points and a focus on the concept of a business or what is often referred to as a “going concern”.
Basis of value
There are a number of departure points in valuation or reasons why a value has to be determined. These are:
- Market value
- Equitable value
- Investment value
- Synergistic value
- Liquidation value
- Fair value
All of the calculations of value above are done for different stakeholders and there could be differences. The role of a qualified Valuer is to firstly discuss the reason for requiring a value and for each of the bases there are differing calculations and circumstances. The points to consider when value is determined are:
- Purpose of valuation
- Valuation date
- What was valued
- Who did the valuation
- Compliance with other standards
Entity specific factors
- Specific value created such as the business is sold as a “going concern”. If a business is sold as a going concern, there is intrinsic additional value that could be added such as goodwill. This is applicable to a well-established franchise brand. For example, a business sells meat prepared in a certain way but is a stand-alone business. Right next door there is a well-known franchise brand also preparing the meat in a certain way. If turnover numbers are exactly the same, there will still be a difference in value if both are offered for sale. A large contributing factor to this is the fact that the franchise is more likely to have brand value and benefits associated with the business from being part of a franchise network.
- The connection between the assets and the business. If assets are used in production or to run the operation, there should be value. If a business is not a going concern and the assets are valued in isolation, the approach will change into a forced sale environment where the assets are sold off individually or collectively. This would have an influence on the value as factors such as current use and goodwill will be excluded.
- Legal rights and restrictions on the business will have an influence on the value.
- If a franchise is sold as a going concern, there may be restrictions imposed by the franchisor. This will include the right of first refusal by the franchisor. Even if there is a willing buyer, the franchisor has the right to refuse the sale and buy the business as a company-owned outlet.
- Let’s say the franchisor is willing to allow the sale, but does not approve of the proposed buyer as a franchisee, chances are that the sale will not be concluded.
- Another constraint could be the rental agreement or lease. If a landlord is not willing to negotiate a new lease/rental agreement with the proposed buyer, it could prevent the sale from taking place.
- Tax benefits or tax burdens on the current entity could also have an influence on the sale.
A very important fact to be bear in mind is the concept of “going concern” as referenced earlier.
If a business is trading and considered to be a “going concern”, the following should be evident.
- There are customers frequenting the business and spending money, hence an income is generated by the business.
- There are staff who interact with customers and suppliers to keep the business going in their respective roles.
- There are assets required to run the business and most often liabilities linked to these assets.
- There are premises with a lease or some form of ownership linked to the premises.
- There is a type of “stock” in trade unless it is a “service-linked” business.
- An important point to consider is whether the business is making a profit.
- The ultimate point is however that the entity will remain in business for the foreseeable future.
Age and life stage of the business
All businesses require some form of revamping/refurbishment at a certain point in time. This would be required as a norm in the franchise space and a buyer of an existing franchise may be required to revamp the outlet. If the business is a stand-alone business, it is the owners’ prerogative whether they want to keep the store the same or give it a fresh look. If a business is in dire need of a revamp/refresh, it would have an influence on the value of the business as the buyer will have to consider the cost of the revamps during negotiations.
How reliant is the business on the owner
Many experts will tell you that the art of running a business is formed around relationships. Basic customer service, in general, revolves around customer needs and there will be an interaction between staff, managers and owners with customers. There are however businesses that are entirely built around relationships with a service offering. If the business is valued as a going concern, attention should be paid on how the owner interacts with customers and suppliers. In these cases, a business could realize a value in the open market. However, if sold, the turnover generated may decline due to the fact that the customers and suppliers prefer to only deal with the specific person. This is a form of goodwill, but to attach a value to these relationships is nearly impossible.
External influences over which there are little control could lead to a price adjustment. These could include the question of “What is the current state of the economy”? Other dynamics include – international events, economic growth, productivity levels, employment levels and local regional events and influences. It could take into account mining and farming activity in rural areas, urbanisation and a multitude of other issues that could have an influence on the value. Hence the expression “a buyer’s market” during periods of economic upheaval.
The word location is used and repeated by many business consultants. It is due to the fact that it is the starting point of all businesses. Let’s demonstrate with geography in terms of business type and location of the business. Two businesses exist with the exact size, look and feel, stock levels, trained staff and a willing and able entrepreneur. The one is in a small farmers’ town and the other in a high street shopping centre. They both sell upmarket fashion garments. Which one will be worth more on day one? Which one will be worth more after one year of trade? Let’s add more factors. Let’s say, the business in the high street shopping centre has more than a handful of competitors in a few hundred square metres. The one in the small farmers’ town is the only of such businesses in a few hundred square kilometres and frequented by all the wealthy farmers in the area. This changes all the perspectives. So in order to get to a value, much more info will be required.
Remember, you are buying future profits
When buying a going concern, it is crucial to take the following into account:
- Analyse the income – how it is paid, when received and the cost of getting it into the bank.
- The cost of sales – what stock cost, how is it received and paid for.
- The gross profit realised.
- Verify the expenses – read the lease agreement and look for hidden costs and increases, franchise fees, salaries, marketing expenses and all related operational expenses.
- After all, expenses are paid, consider the profits left. In accounting terms, this is called earnings before interest, tax, depreciation and amortisation (EBITDA). This is often where the equation stops when calculating a business value. However…
- The bank and the taxman still need to be paid.
- Lastly, the owner is entitled to draw a salary.
- After all of the expenses were paid, then the net profit is realised.
Please bear all of this in mind when you value a business. If you need assistance with valuation of an existing business, contact us. Next month we will take a look at specific valuation methods.