Valuing a business is never just about a number – it’s about understanding the unique factors that drive that number and clearly explaining how it’s reached. This transparency is crucial for helping sellers achieve their goals and giving buyers the confidence to invest.
By Emma Bohan, Operations Manager, Franchise Resales
Understanding these metrics is essential for franchisors, as resale success directly impacts the strength of the network, brand reputation, and ability to attract new franchisees.
EBITDA multiples: A cornerstone of business valuation
For anyone buying or selling a business, EBITDA multiples offer a straightforward framework for determining value. Essentially, they indicate how much a buyer will pay for each pound of EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation).
For example, a franchised business generating £150,000 in EBITDA might sell at a 3x multiple, resulting in a valuation of £450,000. But why do franchised businesses often fall at the lower end of the multiple range?
Franchised businesses typically sell for 2x to 4x EBITDA due to a combination of factors:
- Royalty and marketing fees reduce profitability; for example, a 10% royalty on £500,000 annual revenue equates to £50,000, which directly impacts EBITDA.
- Franchise agreements often limit operational flexibility, making the business less appealing to buyers who value autonomy.
- Growth potential is also often capped by territorial boundaries, restricting scalability.
- Franchisees’ success is closely tied to the franchisor’s support and the overall brand, meaning any issues with the network can lower the resale value.
Independent businesses, on the other hand, achieve multiples of 4x to 7x EBITDA because they retain all profits, offer complete operational freedom, and lack territorial constraints.
Debt coverage: the financing hurdle
Most buyers rely on loans to purchase businesses, making debt service coverage a critical consideration. Banks use the Debt Service Coverage Ratio (DSCR) to evaluate a business’s ability to cover its debt obligations. A DSCR of 1.25 or higher is generally required, meaning the business needs to generate 25% more cash flow than is necessary for loan repayments.
Franchised businesses often struggle to meet this threshold due to reduced EBITDA from royalties and fees.
For example, a franchised business with an EBITDA of £150,000, selling at a 3x multiple for £450,000, might have an annual debt service of £108,000 over a five-year term at 7% interest. This would result in a DSCR of 1.39, which is acceptable. However, if the EBITDA were lower due to higher royalty fees, or the multiple higher, this ratio could easily fall below acceptable levels.
In comparison, an independent business with an EBITDA of £200,000, selling at a 5x multiple for £1,000,000, could struggle with a DSCR of 0.83, even without royalties, due to the larger loan amount. While both models can face DSCR challenges, franchised businesses often feel this pressure more acutely.
Why adjusted profit is better than net profit
When valuing a business, the term ‘adjusted profit’ often arises, especially in franchise resales. Adjusted profit, sometimes referred to as ‘seller’s discretionary earnings’, provides a more accurate picture of a business’s true earning potential for a new owner.
Net profit, while familiar, can be misleading because it often includes costs that are not directly tied to the ongoing operations of the business or that would not necessarily apply to a new owner. Adjusted profit removes these discrepancies and highlights the true financial benefit to a buyer.
For example, adjustments might include adding back the owner’s salary, personal expenses, and one-time costs such as legal fees or major equipment purchases. These adjustments reveal the business’s genuine earning potential, which is critical for prospective buyers and lenders alike.
Adjusted profit is also invaluable when comparing businesses, as it neutralises personal and discretionary expenses that vary from owner to owner. This makes it easier for franchisors and buyers to assess opportunities within a network on a level playing field.
Additionally, adjusted profit simplifies the financing process. It provides a clearer cash flow projection, which lenders prefer when evaluating loan applications. For franchised businesses, where DSCR is critical, presenting adjusted profit can make the difference between securing financing or losing a deal.
What franchisors can do to support resales
As a franchisor, supporting franchisees in the resale process is both a responsibility and an opportunity. Strong resale values enhance the network’s reputation, attract new franchisees, and maintain operational continuity.
Helping franchisees understand their financial performance is critical. Educating them on how EBITDA and adjusted profit impact valuation, encouraging them to maximise profitability, and eliminating discretionary expenses from financial statements can significantly improve their position.
Franchisees should also be supported in presenting their business attractively by adjusting financials to reflect true profitability and sharing benchmarks from across the network to provide context for valuation.
While franchised businesses may have lower multiples, they offer unique advantages to buyers. Established brands reduce marketing costs and attract customers, proven systems provide operational support, and the structured model appeals to risk-averse buyers by reducing failure rates. Highlighting these strengths can make a significant difference in the resale process.
Financing is another critical area where franchisors can help. Partnering with banks that understand the franchise model, as well as encouraging seller financing as an option to bridge funding gaps, can improve DSCR and make it easier for buyers to secure loans.
Additionally, developing a resale programme with resources, templates, and a network of potential buyers ensures franchisees are well-prepared and have access to the right support when the time comes to sell.
Whether you’re a franchisor looking to build a robust resale programme or a franchisee preparing to sell, we’re here to help support you on the journey.
Posted: 6th December, 2024