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The Power of Getting Started

“The secret of getting ahead is getting started”- Mark Twain

Financial and first time buyers are showing tremendous interest in the franchise space, yet as they are continually out bid for attractive opportunities, the frustration in entering certain systems may be at an all-time high. Why is this the case? One reason is because they typically will have to accept a below market return on their first deal in order to be competitive. This is also known as the price of first time entry, a key facet of doing deals known to industry insiders.

At the other end of the spectrum, we have seen consolidation in the big franchise systems in recent years, which has in turn created the “mega franchisee”. Why does it seem so easy for these massive franchise operators to continue to grow their holdings, while these other prospective, qualified  buyers struggle to gain entry?

Sitting in the position of a first time buyer or new entrant to a particular franchise concept can be a huge challenge. Not only do you have to prove you are capable of operating in a new business model, you also have to worry about making the right connections to earn the designation of “legitimate prospect”.

Let’s assume we have three hypothetical Buyers: Buyer A is a new entrant, Buyer B is a small to mid-size franchisee in the system, and Buyer C is a mega franchisee. Employing his business savvy, Buyer A made it onto the short list of potential buyers for our hypothetical franchise transaction. Why is it that this buyer is still at a disadvantage? Lack of Operating Leverage.  Because Buyer A doesn’t have an existing operating infrastructure to leverage in their favor, he enters the game down 2-0 from the start.

This is where Buyers B and C have a distinctive advantage.

Consider Buyer B. As a franchisee in the system in question, he has an immediate advantage over Buyer A. Buyer B is already familiar with how this franchise system functions and has the ability to leverage his existing infrastructure and business platform to operate additional stores at a lower cost than Buyer A.

Yet it is Buyer C that typically has the greatest advantage of all. Not only does Buyer C have the existing infrastructure and business platform to leverage, but he has also grown to a level of operational sophistication where he can operate the business at lower costs thereby producing higher profit margins enabling him to either pay a higher price or enjoy a higher return than Buyer A. This well-oiled machine of an entity has the ability to take on new stores with very little incremental costs associated with the acquisition. Buyer C has full confidence in exactly what action they will take to integrate the acquisition, as they have done it many times before.

These factors all heavily influence the purchasing power of Buyers A, B, and C. Buyer A, with no existing business platform to use to his advantage, has very little room to maneuver when submitting a bid to hit his targeted ROI.  He’s left in a position where he has to purchase the business including the seller’s infrastructure and platform of operations. As a result, his cost of infrastructure on this transaction will be higher than that of his deal competitors who can acquire the transaction with a far smaller incremental cost. This ultimately translates into Buyer A submitting a lower actual offer in order to achieve returns that are enjoyed by Buyers B or C.

The net effect is Buyers B and C can “overpay” by the standards of Buyer A because their forward multiple is much lower than the trailing twelve month multiple. Because of this, Buyer A needs to be prepared to pay a higher price to secure a market competitive deal. His other option is to consider buying a business that has more challenges and therefore less competitive but with additional risk.

At some point, Buyer A has to get started, and usually that means paying an above market multiple to acquire the ongoing business platform. It is once Buyer A completes this first acquisition that he will have put himself into a more competitive position amongst his peers, making the next deal he bids on work more to his advantage. This is the cost of entry in the restaurant industry, but it is important for Buyer A to remember that he has the potential to become Buyer B and even Buyer C in the future.