Franchise buyers: 7 things to learn from Warren Buffett

Years ago I worked in the business buyout world. Then, Warren Buffett, chairman of Berkshire Hathaway, was considered the most successful buyout master of the 20th century. Guess what? Buffett is still on top because of his seemingly risk-averse method of picking businesses that consistently produce profits instead of promises.

You could easily call him the Tiger Woods of business investing. He's that good.

Can prospective franchise buyers learn something from Buffett's investment practices? I think so. Like all other types of investing, some deals are worthwhile, while others generate heartbreaking losses. First-time franchise buyers, however, rarely have extra savings to easily absorb learners' mistakes. Thus, you need to set high standards for franchise selection.

Here are some tips to help you set these higher standards, the Buffet way.

1. Understand the business well.   Buffett doesn’t invest in businesses that he says he doesn’t understand. Just because something is complicated, doesn’t mean it’s worth your time and money. Fast-talking franchise sales reps should be your clue to run away … fast!
2. Business should be fun.   Be cautious about investing in a business operation that is different from your prior career experience. If, for example, you are considering a burger franchise, take at least six months to work in a similar food-service franchise. It's better to find out before investing if you don't like long hours, managing part-time staff, and the pervasive smell of fried food.
3. It's all about predictable, proven cash flow.   Buffett doesn't buy businesses that lose money. Neither should you. He also avoids less-predictable seasonal businesses and trendy businesses that may not hold up in five or 10 years as good investments. Buffett's history has favored investments in ordinary consumer categories such as razors, furniture, manufactured housing, candy, insurance, and underwear. A few of his name-brand investments include Geico auto insurance, Benjamin Moore, See's Candies, Dairy Queen, Fruit of the Loom, and Ben Bridge Jewelers.

   Here's another insider's tip from the business buyout world: Franchise organizations will present financial projections of a franchise opportunity that are based on a median or average franchise result. This means that their projections are always better than the worst-case scenario. Yet, the worst-case scenario is really what the nation's best investors use to separate winning investments from losing investments. Can you pay your business bills, pay down debt, pay yourself a salary, and make a profit each month based on the worst-case scenario? If not, move on to the next opportunity.

4. Seek critical advisers.   Successful business buyers don't just rely on their own judgment to select investments. To balance the natural tendency to be over-enthusiastic about an investment opportunity, hire a lawyer and business accountant to review all franchise documents. Instruct them to tell you all the reasons why you should not buy a particular franchise. It's what you don't know today about a business that can come back to haunt you.
5. Be patient.   Astute investors will review hundreds, even thousands of business plans and investment opportunities before making a move. At a minimum, buying a franchise only makes sense when you have the right location, a reasonable buy-in price, high confidence of fast and profitable cash-flow generation, and a franchise organization that is very well funded and managed. The more you compare deals, the better you will be able to learn how to uncover real investment value. In other words, don't buy into the first deal that comes your way.
6. Don't buy a salary.   It's hard to get ahead if the primary reason to buy into a franchise business is to replace a lost salary. Look at it this way. Over time, the U.S. stock market has historically delivered a 6 percent to 8 percent return to investors. Given the higher risk associated with investing in a single, relatively new business, rather than a "basket" of well-established publicly traded companies that often pay dividends, buyout investors seek an annualized return of 20 percent to 40 percent on their invested capital.

   Excluding your expected salary (and you should pay yourself if you work in the business), what level of revenues and profits must your franchise achieve in order to earn at least a 20 percent return? It's important to note that Buffett doesn't rely on the eventual sale of a business to make up for poor yearly sales and profitability performance. Maybe this is why he's a multibillionaire!

7. Invest money you can afford to lose.   Buffett is outspoken about businesses avoiding excessive debt. His success has come from managing and reducing risk wherever possible. In recent months, the franchise industry has been aggressive in encouraging prospective buyers to borrow from hard-to-replace 401(k) and other retirement savings accounts to buy franchises. Unless the franchise buyer is already wealthy, I believe this is a highly inappropriate solution for most middle-class households. It is true that many 401(k) plans have liberal borrowing rules; however, you must still pay back this money on schedule or face IRS cash penalties.

   Another concern is lack of liquidity. When retirement funds are invested in the stock market, investors can trade their shares and have money in the bank when they need it within about a week. Businesses, including franchise companies, are not so liquid. Businesses can be "up for sale" for months or years. Of course, the more desperate the seller is to cash out, the lower the purchase price.

Today, there are more than 3,000 different franchise companies that want to attract new franchise owners to their organizations. How can entrepreneurs make a wise choice? Let's turn to Buffett again. He believes that his money should only buy the best businesses. Every entrepreneur's savings deserves nothing but the best too. Insist on it.

About the author   Susan Schreter is a Seattle-area investment banker and venture-funding expert serving startup entrepreneurs and fast-growth company executives. She also teaches business financing and entrepreneurship at business schools, angel forums, and microfinance organizations in the United States and internationally. Write to Susan at susan@takecommand.org.