So You Want To Buy A Fast Food Franchise?

HOW TO EVALUATE THE TRUE WORTH OF A BUSINESS
PART 14 of 21

"So You Want to Buy a Fast Food Franchise?"

By:  Willard Michlin

As an accountant for 30 years and a business broker for fifteen years, it is very disheartening to me when I see highly intelligent people who want to be free of corporate America, jump in to buying Franchises because of the name recognition these franchises have in the market place.  Well known is not an automatic ticket to success in business. In this article I would like to comprehensively address the subject.

WARNING! Buying a Franchise can be Dangerous to Your Health.

What You Need to Consider before Writing a Check.

In the last two weeks, I have talked to four food franchise owners who had wished they had never heard of the idea of fast food franchise. Let me tell you about them one at a time.

Amici Pizza Franchise: Sam is now sixty-six years old.  Last year, he retired from his lifetime occupation and after sitting at home for a month; he knew he needed to do something.  He got the idea that he would buy businesses.  And since he never owned a business before, he thought that a franchise would give him the security of success.  He also figured that by buying an existing operation that he would know exactly what he was getting for his money.  He bought an existing operation in a small town in Ventura County. (Name withheld to protect the unhappy).

He paid $150,000 for it, and it was expected to bring him an income of $5,000-8,000 per month.  He pays out of his sales, in addition to his normal operating expenses a 4% monthly franchise fee and a 2% co-op marketing fee.  He also spends his own money for single location advertising.  This is composed of discount coupons in the local paper. 

Two things happened that Sam didn't expect:

1. Sam found that his body was not used to being pushed around eight hours a day/seven days a week.
2. That his sales started dropping by 10% in the first quarter of 2007.

Of course whenever you start a new activity, your body must adapt to the new routine.  This is expected, but he never expected the higher level of activity that he found himself doing.  He did work with the seller for a month before buying the business, but this alone did not tell him what was in store for him.  Economic changes are a given, but enthusiastic buyers do not always realize that businesses have fluctuations-both up and down.  These fluctuations have to be prepared for and overcome.

Franchise buyers many times believe the franchisers will figure out how to overcome these market fluctuations, and sometimes they do; but not always.  As a result of the reduced sales his profit has dropped to $3,000 per month for his 50+ hour workweek.  The good news is that Sam is working on getting the local high school accounts that will increase his sales, but he does not know how much.  This owner will suffer only a small loss upon resale.  The reason being that he bought an existing store with most information known and disclosed.  When he does get out his buyer will pay close to the same price that the current owner did, which will make the loss tolerable even though not affordable.

Mexican Food Franchise: Paul is the owner of two Subway™ franchises that have been working well for him. He decided to open a Fast Food Taco franchise in a new center across the street from a big center with a major supermarket.  It is the only center for two miles in every direction. He sits in a center with a bagel shop, Quiznos™, and an Ice Cream store.  In the supermarket shopping center across the street there is a Subway™ and some other fast food stores.

This store, open for less than six months, is already doing $27,000 per month is sales, which is a very impressive number in my book.  The problem is that because of the rents, franchise fees, co-op advertising, food and labor costs the business is not making a profit yet.  Sam tells me has wants to sell now because of some medical condition, which prevents him from running this store.  The truth is that he doesn't run the store, his wife does and he has had this condition long before he contracted to buy this new location.  He tells me that he wants out of this store quickly and wants 80% of his investment back.  Unfortunately for Sam this probably will not happen.

Quiznos™: Charlie bought a new location and opened up one year ago.  His sales are also about $30,000 per month.  Quiznos™ for his first year of operations was requiring franchisees to buy all their food from the company at prices about 6% more then they could buy the same food elsewhere.  This caused Charlie to have to take cash out of his pocket to keep the operation going, as well as working the business full time.  The good news is that another company bought Quiznos™ and the food costs have been reduced to where they should be.  Charlie now estimates that the store will make a profit, from operations of $4,000.  Again he is still working the store full time.  He thought of hiring a manager but then the business will make even less money.

Quiznos™: Harry bought two locations, two years ago.  He thought that having them in the same town but at alternate ends would make good business sense for him.  Harry called me because Charlie told him that I had located three buyer prospects the first day.  Harry also wanted to sell his stores.  One of which is breaking even and the other, which lost him $30,000 last year.  Again the sales were around $30,000 per month for each store.  Harry doesn't work as many hours as Charlie but he does have to visit two stores.  Harry told me that every Quiznos™ in the county is listed for sale on the Quiznos™ corporate web site and that 20% of all Quiznos™ worldwide are available for sale.  Most of these Quiznos™ locations for sale all paid $240,000 for the franchise license and the location to be built-out $240,000.  A very large percentage of the Quiznos™ storeowners borrowed the money to purchase the store from their home or other assets.  A loan this size has a financing payment of at least $2,000 per month.  This financing payment takes a store making a small profit from operations and turns it into a life-threatening financial drain.  The resale market place for franchise sandwiches losing money is obviously not going to be anywhere near $240,000.  The truth is that it is closer to $100,000, or less. I know of some cases where the sandwich shop was an independent name and not a well-known franchise and finally sold for less than $25,000.

Why are Resale Prices So Low?

Resale prices are not always low.  They are a function of how successful the location is.  An existing location is worth what it produces in sales and/or profit, not what some franchise salesman has told a buyer the potential profit is before a store is open.  The buyer of an existing franchise location has the full knowledge of exactly what his sales and existing expenses are.  This allows a buyer to determine exactly what the location is worth to him.  A buyer might still buy a losing location, at the correct price because he knows what changes he will make to his local marketing, food costs, and labor costs.  He is willing to pay for exactly what he is getting, and if he still fails his loss is greatly reduced.

The point I am trying to make is that when you buy a new unopened location you are playing roulette with hundreds of thousands of dollars.  When you buy a resale you know exactly what you are getting.  If you pay $500,000 for a location, that cost $240,000 to open, you know why you are paying that much and you are happy to pay it.  Someone else took the risk.  Fast food sandwich shops, do not have full kitchens in them, therefore they cannot be changed into other types of food businesses.

If you wanted to sell hamburgers, Greek, Italian, Chinese or Middle Eastern food or any hot food that cannot be heated in a microwave or a deep fryer, you would have to buy a stove and a restaurant hood.  The purpose of a hood is to vent the heat from the fire.  Hoods, stoves and grills are expensive.

What are Food Franchises Selling For?

In recent years Subway™ has gone from a marginally profitable franchise to a booming company.  June 2007, the price to buy an individual location is now around eleven times the monthly sales amount.  In 1987 when I sold six Subways most were doing poorly and they sold for 30% of annual sales.  At that time, Quiznos™ was the new hot and up-coming business and they were selling at 50% of annual sales, even though they were not making a profit.  It was crazy.  Everyone expected Quiznos™ to overrun Subway™, so they paid more than the stores were worth, but never more than the original operator paid.  That of course is no longer true today with Quiznos™, where a lot of owners want to get out and cut their losses.  That may also change again with the new Quiznos™ management who has just cut costs from 33% of sales to 27% in my client's location.

If you asked, "What is the overall average for Fast Food franchises?" I would have to say that price is equal to 50% of the locations annual sales.  Of course these are averages and the exact price will vary from this based on how much money a location is making or loosing, and which franchise is the "Hot Deal" this year.  If I have convinced you to never buy a new location, then maybe I have done my job, but then again, maybe not.

Why Would You Take the Risk of Buying a New Location?

Everyone wants to buy a successful business.  People who own successful businesses do not want to sell them.  It may be impossible to find an existing location-good or bad.  When someone owns a successful franchise and wants to sell it, the other location owners of that franchise are right their to buy it.

The only McDonalds™, Burger King™, or Carl's Jr's™ you will ever see on the market is an overpriced looser.  The good ones, when sold, are sold within the company.  In smaller franchises this may not be completely true.

One of my clients, Benny, bought a profitable Johnny Rocket™ location through me six years ago.  Two years later he had me sell it, at a very substantial profit, and he went on to other things.  Six months later he wanted to buy another fast food franchise location, one making at least $150,000 net profit, per year.  He has now been looking for three years and cannot find one.  He now is suggesting we find an owner of multiple locations who would like to sell 50% ownership in their group of locations to Benny, who is willing to help run them.  As of today, I am still looking.

Some times you can only take a new location to get into the system, but remember that you can "eat crow."  I have on the market another Johnny Rocket™ location.  This location is in a food court in a big mall.  Because of the high rents charged by the mall and the competition from the other franchises in the mall the store makes the absentee owner $30,000.  If the owner worked the location, we estimate the profit at $80,000 per year.  The current owner paid $375,000 for this location.  I estimate that it is worth no more than $200,000.

It is my opinion that you should only play the new location game if you are willing to play "Red" at the tables for Double or Nothing.  $240,000 is a lot of money to bet in Las Vegas, but at least you know the answer in minutes not in months or years.

Willard Michlin is a Due Diligence and Business Evaluation Advisor.  He is also a California Business Broker and a California Real Estate Broker. He has published many articles and is in demand as a public speaker in the Southern California business community.