Before you look at your financing options for an acquisition, it helps to understand how to determine the present value of the business. When it comes time to sell a franchise unit, both buyer and seller must agree on a market valuation. Determining that value often depends on how much cash flow the seller can prove through tax documentation and other financial statements.

If the seller can prove that his or her unit has predictable positive revenue trends, it will be much easier for a first-time buyer to finance the unit. If trends are negative, the seller may have to finance some of the deal in order for the transaction to move smoothly.

Understanding how franchises are valued

To get the most money from the sale of an existing franchise unit, the seller should prepare to spend two to three years controlling operating costs and creating clean financial records. Franchise owners that cannot or do not take the time to do so run the risk of losing money in the long run.

Sellers that can present clean tax returns and financial statements are in a better position to prove positive growth trends and ultimately increase the perceived value of their units. The seller should be able to demonstrate positive trends in gross sales and EBITDA because doing so will increase the value of the unit in question.

"Most businesses are sold on a multiple of proven cash flow, through EBITDA or seller's discretionary earnings (owner benefit items that have been expensed through the business). If you're going to sell, you want to eliminate as much seller discretionary earnings as you can because it creates a clean EBITDA multiple for the valuation," said Randy Jones, Head of Originations at ApplePie Capital.

The average range for cash flow multipliers is four to five times EBITDA. Therefore, if a business has clean tax returns showing $100,000 in EBITDA and an assumed five times cash flow multiplier, that business would be worth $500,000. However, if that same business could prove only $60,000 in EBITDA, and the multiplier remained the same, it would be worth $300,000.

Other financial considerations

If you are financing the purchase of an existing franchise unit, your lending partner will search for any liens on the business. If there are any other entities that have a right to the ownership of the business, you need to know that up front, as they could diminish your cash flow after acquisition. Buyers who aren't leveraging any financing options should consider hiring attorneys to run lien checks before making any purchasing decisions.

Similarly, real estate leases will have a significant impact on the value of a franchise unit.

"What the buyer has to do, as part of his or her due diligence, is check the leases that are in place and determine if there's going to be an escalation in the rent rate because that effectively decreases cash flow," said Randy.

A lender will want to see that lease rates are held steady for at least the length of the loan terms.

As part of this consideration, the buyer has the ability to go to the landlord and negotiate a lower rent rate. A landlord might lower the rent rate for several reasons. For example, if the building needs to be upgraded, the buyer could cover the cost of those additions and negotiate for a lower rent rate in lieu of a tenant improvement allowance. Additionally, if there are few buyers in the market, the landlord could agree to a lower rate rather than leave the building empty for an unknown period.

Finally, buyers who already own successful franchises have the option of refinancing their existing units to pay the down payment on new loans. For example, if you currently have a loan of $200,000 and you need $50,000 in cash, you could refinance at $250,000. This option is only available from a few lenders, including ApplePie Capital.