How to buy a restaurant franchise, the Franchise Rule of Three

Posted by Eric Gagnon on Jun 15, 2010 1:14:00 PM

Why buyers looking for a franchise restaurant for sale should never be the first or second owner of a restaurant franchise if your goal is making money.

A well known and often cited study by H.G. Parsa, an Ohio State University hospitality-management professor determined that 61% of all start up restaurants fail in the first three years.  By contrast, 57% of all franchise restaurants fail before the end of three years.  That’s not a ringing endorsement for the security of a franchise. 

What does this mean for the would-be restaurant owner?  Buy restaurant history, experience and the business books and records. A restaurant with a three-year history in the same location with profitable books and records is a far safer bet than a franchise start-up. Over a decade of watching franchise start-ups come back onto the market for re-sale, we’ve developed the We Sell Restaurants Franchise Rule of Three.  Buyers that stick to these rules get the maximum benefit from buying an Atlanta restaurant franchise without over paying for it. 

Here’s the usual course of an Atlanta franchise restaurant.  The original owner invests $375,000-$400,000 in build out with stars in his eyes about how great this Atlanta franchise restaurant is going to be.  Forget the fact that he’s invested $400,000 in a unit that sells premium ice cream with an average ticket of $8.50 only busy in the summer months.  He’s convinced after the franchise boot camp that he’s got a winner on his hands.  He calls after a disappointing year of red ink and wants to know, who will give him what he has invested in his business.  The answer, sadly, is no one.  If the franchise is a hot concept in a pristine location, the next Buyer may be willing to pay as much as $99,000 to $149,000.  That’s over paying based on Seller’s Discretionary Earnings since at this point the restaurant is still losing money.   

The second owner more often than not ends up with a restaurant losing money for which he paid around $100,000.  Because his cost structure is lower (lower cost of capital to attain) and the sales line has matured, he may be able to get it out of red ink and into the black with franchise fees due and payable on every transaction.  He usually makes it through year one or two before he says, “Enough is enough.  I’m earning minimum wage here and working 50 hours a week in the store.  I have to get a job to feed my family.” That’s when the bargains kick in.  The franchise goes on the market as a mature concept for a multiple of earnings.  The third owner is the one who buys it right.  

The price has now decreased a third time. It’s listed and sold for no more than three times earnings on the books.  The expense is minimal and the sales line has had time to mature and catch up with fixed costs.  The buyer for a third generation franchise ultimately gets the best deal in the marketplace.  He gets a good brand, top line sales, limited earnings and a low (or fair) cost of entry.  The first guy is the one that takes the bath.  The second guy is a close second but number three is the winner.  That’s why we developed the We Sell Restaurants Rule of Three for buying a franchise.  

We Sell Restaurants Rule of Three for Buying a Franchise

1)      Make sure you’re the third owner of the franchise at that location if you want the best possible deal.

2)      Buy early in the third year of operation to maximize the long term earnings.  The business is still immature enough to see long term growth in sales but priced based on low current earnings. 

3)    Never pay more than three times earnings no matter how glamorous the franchise wants to paint the potential to be.  Remember that all other factors of valuation still apply whether or not you're buying a franchise.  

Topics: Buying a Restaurant

New call-to-action