Chantal: Why would club owners need to use a third party in that sales process?
Rick: Sure. And just to follow on, I said earlier that I think sometimes the worst negotiator in a club is the owner. He’s too close to it, he needs to stand back. For instance, if I were the owner and someone said to me, going back to that example of, “I want a million dollars as my bottom line,” and said, “You know I think I’ll … Based on my early information about the club, and I haven’t done my full analysis yet, but I think … I’m prepared to offer you a $600,000.” And the many times the owner would respond by … With some epithets and some language that might not be … Might be very colourful and not very polite.
But an intermediary would say something instead such as, “You know I appreciate your spending time looking at this club. Let me tell you what I know. The owners would probably not want to have you spend any further time looking at this club if that really is your best offer. If you’re suggesting that as a starting point, and you’re really willing to go much higher, then we should have another conversation. But if you’re telling that that’s where you’re coming out then I think we ought to close off our communication at this point because it’s so far away from any kind of bottom line that I think they would consider. And certainly as you know, they’ve told you what they’re asking price is,” let’s say it was $2 million, “And so far away from that that I don’t think it’s in our best interest, yours or mine, for us to continue the conversation.”
Very polite, very business-like, no emotion, and finally says, “Well actually I would go up much higher but I thought I’d start there.” And he said, “Well I appreciate that. Let me suggest that I’m not going to take that information back to the owners. Why don’t you think about what you can do and consider going up much higher because it’s so far away from that $2 million asking price that it really is not in your best interest or mind to really have that communicated.” And they said, “Okay. I get it.” But it was a nice business like conversation, no emotions, and they get a flavour of how to interpret it and they can go from there.
So what I do with a third party, who may not be expert in the club industry to start with, is I encourage club owners to either find a business friend of theirs who’s local, or a local business broker or real estate broker who may not know the industry at all, or their local accountant or a local business oriented corporate lawyer type, or a CEO of a local business who is a personal friend. And what we would do is, in effect, orient them. Give them some coaching and five things. One we tell them how to implement the marketing. So if we’re going to place an ad in the Wall Street Journal local edition, or if we’re going to write individual letters or make phone calls to owners of clubs we’ve designated not necessarily in the immediate area, we would have that information and rehearsed them as to how to go about that.
We would tell them how to screen responses, number two. And this critical to make sure that people don’t get access to information if they’re serious and don’t meet the criteria. And he would ask what their financial resources were to make sure that they really could afford to buy the club properly. And then we would have them sign a nondisclosure agreement and make a big deal that anyone they brought in as an adviser, or consultant, or architect, or an engineer, or an accountant would also have to abide by the nondisclosure otherwise there’d be real consequences. So we make a big deal of that. The third thing we teach them is how to arrange for site visits because we don’t want them to come in on their own and have control.
Sometimes club owners have said, “We don’t want them to come in while the business is actually active. They have to come in on a Sunday night after 10 o’clock when we’re closed and I’ll have a night maintenance person take them around that doesn’t know anything about the club.” Or other kinds of situations where we really control their access to the club. We also have this person as the fourth thing they do is disseminate club materials. Remember we talked about my suggestion of putting together materials in advance and we either would put them online in a controlled environment, or we put them in a data room perhaps at our accountant or lawyer’s office or the businessman’s office where they go into a conference room and can look at the materials. They can’t take them away.
And finally they would facilitate the negotiations just as I said earlier. They would have discussions, then talk to the owners, go back to the would be buyer, and go back and forth and serve as a communicator along the way. So that’s part of what a third party would do. And in many cases, not necessarily an expert in the club industry but we can give them enough coaching to make them be very successful in that role for this purpose.
Chantal: Rick do you think that you can perhaps step us through some of the challenges that we may face in selling a club?
Rick: Sure. One of the things that we do is obviously want to minimise the rumour. So the first thing we want to do is obviously have a game plan of how we’re going to deal with rumours. The second is to create an auction. We want two people to be interested at the same time because that’s helpful for two reasons. One, it means that people know there’s someone else looking so they’re going to behave differently. They’re going to be timelier, and they’re going to probably get closer to their higher price they’re willing to pay earlier than they would if they thought they were the only person in the lineup.
Doing proper marketing, depending on which groups we’re talking about, and screening who should be contacted from the club industry as well as creating a marketing plan for outsiders, has to be done and many cases people don’t do it or know how to do that. Preparing all the relevant materials ahead of time has made a big deal of that and I just want to reiterate that again. That’s a challenge because people kind of wing it and respond rather than really be preemptive and have it already organised and have the third party ready to hand it over when asked. They also, a challenge for most individuals is to have enough patience for a lengthy process. No matter what I say, I’ll say it’ll take three to four months. If it takes five, they may not have the wherewithal to stick with it and say, “You know I’m going to pull the club off the market. It’s taking too long. It’s too disruptive. I’ve lost my patience.” So the challenge is to make them understand what the process is before they start, and then have them understand along the way how it’s going every step of the way.
Another challenge is to run your business properly at the same time. There’s nothing worse than having your business start to decline and people getting current information and finding out that they were going to pay this much, but now they’re going to deduct because right now the club is not operating where it was a year ago, or six months ago because someone has taken their eye off the ball. And then just one last point. [inaudible 00:07:40] I was owning and operating a personal training studio. In many cases the business is you. The principle. So if you want to stay and just be a personal training instructor only, it may have some value. But if you want to leave, often the intrinsic business without you may be worth less, or be actually worthless because you were the business. And so we really have to understand what it is that’s realistic when we do that evaluation and understand how we’re presenting that to third parties.
So those are, frankly, a variety of the challenges.
Chantal: Rick, I’d like to dive into some detail on this next area, and I’m hoping you can tell us all around, all about the evaluation process.
Rick: Sure. It’s one of my favourite topics and I do a lot of them for the industry of all types and I’ve learned a lot because if you’ve done now 400, which I think is the number I’m up to, I’m a lot better than I was when I did my first ten of them years and years ago. But generally speaking, if you got to an evaluation company or any outsider, they all will tell the three general approaches to evaluation. But two of them are rejected in this industry. The rejected ones are the cost approach, and the sales comparable approach partly because no two clubs are really comparable.
So the one approach that is acceptable is the income approach only. And there’s one method of the different types of income approach methodology, and that’s the capitalised earnings method which is based on the most recent historical information as the norm. And then what you do with that is obviously use that as a base and use industry information to figure out, based on those particular earnings, what the proper value would be. But then there are lots of adjustments that have to be made because there’s no simple formula or shortcut in our industry. So what we have to do is start with the basic evaluation, but then deviate and make adjustments for things that are unique to your facility which could be positives or it could be negatives, but they need adjustments.
Most owners unfortunately have a highly inflated view of their club’s net worth. If a club happened to own their real estate, at some point they probably had to hire what is called an MAI, which stands for Managerial Appraisal Institute. These are the licenced appraisers. And the reason for that is that if they went to a bank for financing or refinancing the bank would have their own favourite list of evaluation experts, and they’d tell you that you can pick one. And in almost every case, they have little to no club industry experience specifically. So what they end up with are values that are overstated. This is good news actually for the club because they can get a higher level of financing or refinancing, but the overall value is overstated.
So as a result, if a club owner were thinking that that’s what it’s really worth and now is going to somehow sell up for resale, he would find himself being really delusional in the sense that an actual savvy buyer would pay that much. So it’s critical that the club owner initially, for stage one of the five phases I talked about, get an independent evaluation at the outset to get that reality check. And so I make a big deal of the fact that we can waste the whole process if we’re not realistic about the value right at the outset.
Chantal: Rick do you think that you could give us a definition of EBITDA?
Rick: Sure. It sounds so guttural, and I’ve learned how to say that and pronounce that. But in the old days we had a thing called net operating income. NOI. And that got replaced by EBITDA. So in order to use the income approach that the process involves a calculation of EBITDA, which stands for Earnings, the E, Before Interest, Taxes, the I and the T, Interest, Taxes … And that’s corporate taxes by the way. D for Depreciation, and A for Amorization. So it’s Earnings Before Interest Taxes Depreciate and Amorization. The evaluation company makes lots of adjustments to the basic EBITDA because it’s not a case where you’re applying a cap rate or a multiple to EBITDA. It’s to an adjusted EBITDA.
So you start with the actual raw calculation EBITDA, and then you make adjustments. But it’s a starting point and it’s the way people talk to each other both in the industry and outside because often EBITDA is a measure used by lots of different industries to figure out what the guts of the business is throwing off, and then they obviously make some adjustment to knowing either with a multiple or dividing by a fraction, they’re the same number, of what the value would be using EBITDA as the first starting point.
Chantal: You know quite often when we’re discussing this topic Rick, we hear the term due diligence. Can you help us understand that term?
Rick: Sure. This is a term that’s often used after a seller, and a potential buyer, agree on some basic terms of a deal, maybe even with some conditions involved. And then what the potential buyer is allowed to do is go through a process to verify the information the seller has provided. So now he gets into the detail, looks at the financials, and see how your financials were presented and might ask for backup information where he wants to verify that your account did actually do the calculations properly, and wants to verify and maybe do some sampling that your memberships are accurate and you’re really collecting what you say you are by looking at your month EFT, Electronics Fund Transfer, sheet that tells them how many people were billed at what amount, et cetera. And they might look at some expiration dates to find out if people have closed them contracts when they’re ending because they don’t want to assume that if someone is, in effect, has an expiration date one month after the potential closing date, it’s not clear they’re going to have continuing dollars from that person.
So they have to be realistic and understand that. And they’ll look at the lease details and find out what kind of renewal periods you have and what kind of increases in rates of any are in the agreement. And they’ll look at the adequacy of physical plan. They bring in some engineers to inspect them and see how well your heating, ventilation, air conditioning systems or electrical systems are adequate. Especially if they want to intensify the use of the physical plant. And they’ll look at your insular revenue and see what you’re really paying your instructors, and how many people are not just in it right now but how many people are in those activities regularly. And then they’re going to study each of the cost of doing business. So they’ll look at a lot of the line items for your expenses.
You get the idea. It’s a whole process, and what they’re trying to do is take time, sometimes several weeks to try and verify what you’ve put out there as being representative of the business, and make sure that that is in fact true. And what it does for them is allow them to know at a baseline, what they’re buying into so if they want to then project what their next year or two of their business as they see it, with whatever changes they want to make, they now have confidence that they’re starting point is accurate. So due diligence is really important for many buyers just to be able to make sure that they know what they’re getting if they do close on the deal.
Chantal: We talked earlier about the challenges in selling a club. Tell us this, what are the challenges of selling a studio?
Rick: Well let me highlight … I think there are lots. First is, as much like a club, you want to create an auction. You really want two people involved or more who are interested in buying the business at the same time, and this will create a higher price obviously and more urgency amongst the prospective buyers. The timing of the entire process is a challenge because again it’s not clear, especially in the studio world, that there’s any timeframe of a buyer depending on the individual situation, and we may not have any clear threat that if they don’t buy it by a certain time, that the price will change or the business will be affected. The ability a buyer, in some cases to get his financing, may be an issue. So if they’re trying to find both equity and debt, it may … And debt might involve the SBA along the way. There could be delays. Could be various things from the time they say they’ll do the deal to the ability to actually close on it and make it happen, may create some real time loss.
And so I’m thinking of a friend of mine right now who’s trying to sell one of his clubs, and they’re going through SBA financing and a bank and both of them are taking a longer time than the individual who’s seeking their financing thought. And therefore, the process of buying the club from my friend has taken much longer than either side expected because the financing seems to be a work in progress, and not clear when they’ll have a due date of completion. The other thing sometimes, especially in a studio situation, is the landlord has to approve the new tenant. And they may want to do some homework and do some diligence into making sure the tenant is adequate, at least as adequate if not more than the previous tenant. And at the same time the new tenant, the buyer coming in, may want to change some of the lease terms and want to negotiate.
So there could be a landlord process that goes on as part of this. And then the last couple things would be, while this is going on, the would be buyer wants to make sure the basic business does not decrease in value during the process as I said earlier. And again, for a sole owner who’s trying to run a business and perhaps sell and doesn’t have the best third party to help him, this could in effect hurt him and hurt the business because he’s spending too much time being distracted, he would use the word, by the process of selling. And then finally we need owners to have a reality check first with evaluation, and maybe they didn’t get an evaluation so they’re going with their gut and maybe not with reality. And then with the whole sale process which I mentioned several times now can be unwieldy, lengthy, difficult, and frustrating. And so when you’re a small business in particular, in some cases you let emotions or your personal feelings creep into this and it may not lead to a proper objective process.
Chantal: Rick I have to take advantage of having you on this show and I have to ask you this question. Can you share your thoughts with us about the future of our industry?
Rick: I can, but I probably will focus mostly on the US for a moment and assume that maybe some of my comments will also lend themselves to some of your audience in other countries. But the US continues to see the number of overall members of health clubs grow by about 2% to 3% for the country each year. So it’s growing. It’s not growing as fast as we’d like, but it’s growing. The second thing that’s growing is competition. There’s always been an ease of entry of new competitors coming in and that’s a given. We can’t stop them, we can’t go to the landlord and prevent them from coming in. We just have to assume that there’s going to be more competition, some of whom are going to be good competitors, some of whom may not be great competitors. And they can shake up a market because they may not be the most logical when it comes to being competitive.
Third, for our industry, is the large club companies of our industry continue to grow, but are no longer acquirers. They’ve decided they prefer to build anew. So 24 Hour Fitness, LA Fitness, Lifetime Fitness, Equinox, all in different segments are deciding that what they want to do is grow, but grow by new builds. By doing their own new facilities and not acquiring others. So therefore, where they did acquire in the past, they stopped doing that and so we need, if we’re looking for other large companies to acquire, many of them have taken themselves out of the lineup in that regard.
Some of the large club companies, just to remind ourselves, are going to stay large or grow fast with their new builds because they have access to capital, they have access to new deals because real estate people find them and come to them. Especially some of the largest real estate developers in the country. They have expertise so they know how to grow their company systematically. They have in many cases people trained to be the next manager of a facility. They know how to do real estate well. They know how to do construction well. They know how to organise and staff well. They know how to pre-sell or early sell a facility well. They know how to use their systems and in effect adapt them to a new place. So they have a lot of things going for them, and that will lead them to obviously continued growth, and maybe predictably having some good successes early on in the new facilities.
The other thing that’s the other side of the equation is the franchise companies are also growing and growing well. Especially some of the key names such as Planet Fitness and the HVLP, High Volume Low Price segment. More in theory, in the clearly high intensity interval training studio segment. Anytime Fitness and Snap Fitness in the 24 hour all access categories. Barry’s Bootcamp, Pure Barre, all of these are poised to have faster growth because they’re all well positioned, they’re well financed, and they’re having private equity firm backing them. So as a result they’re able to grow faster and more logically than those who are looking to their own resources.
Regional club companies are growing, but generally by one new club every 12 to 18 months. So if I have six or eight clubs in a region, you can assume at this point I’m going to continue to grow but it might be one every 12 months or one every 12 to 18 months depending on resources, depending on my focus, depending on finding a new good site to buy, et cetera. And then the other challenge is for the industry, we have some that are stuck. That is especially those in the middle where they’re in the middle both in terms of size and pricing. And they’re positioning is not unique. And for those, the challenge is all over the place. Will they stabilise, will they kind of inch up and grow a little bit. Will they now face perhaps some pressures and now see their bottom line decrease a little bit. Not clear, but they’re going to be the most challenged.
So those are some thoughts about the industry. I’m sure we can talk all day about it but those are some quick thoughts.
Chantal: Thank you so much for you insights on that Rick. Now to finish off today, can you share with us a couple of tips to understanding club financials?
Rick: Yeah, I’d be happy to. And I’ve spend a lot of time kind of learning financials, although I have an MBA, what really I did was I needed to understand, and had accounting courses, and corporate finance courses. I really needed to understand accounting and small business. So one of the things I’d urge people to do is to study an accounting course. That is take a course, even if they do it online, or get in depth coaching over several hours, not just a question or two, but over several hours by a club experienced person who would be someone that could really coach them and explain to them how to read financial statements, how to really create budgets, how to interpret various analysis. Things where you’re comparing budget against what the actuals are.
Or spending time with your club’s own accountant and ask him questions. “Well why is depreciate getting handled this way? And how did we handle the fact that we brought some new money in from debt or equity? And how did that go through our club? And how do we account for that. And why is this treated in a certain way?” So being a great questioner goes a long way. The second thing for club financials is I always, as I just said, ask for backup information and how we define each item on the financial statement, and become what I call a relentless questioner. I think my accounting firm probably would have a different nickname for me. I’d like to think it was relentless questioner. But I continued each month to literally go to their doorstep and say, “I don’t understand why you did this?” And when we had eight clubs, I had eight sets of questions because the clubs were all different and different stages of their life cycle, and different things going on.
And so I went and said, “Well okay we want to grow this one, and we want to expand, what are the ways we can do that in terms of financially? How do we do that? We have investors and we have bank debt. And do we refinance? But aren’t there penalties?” And all of those kind of questions came up and sometimes with a what if kind of format. But I was a really good questioner and frankly got the patience of people like accountants who spent the time to teach me and answer all those questions.
The third thing in terms of a tip would be to understand the legal structure of the club, how it was financed, including the specific terms, what rights the perhaps investors have including some investors that may be in different categories. What kind of financing have I done, and what rights they have. And how can I perhaps revise or change the financing to refinance. How do I, in effect, present my story to a third party so if I did want to sell. What do I need to know and what are the questions they’re going to ask so I can be ready for them. So I would ask a lot of questions to really understand my numbers well of people that I respect and would give me the … And have the patience to, in effect spend time and answer them.
Chantal: Rick I just want to say thank you so so much for being incredibly generous today with your knowledge, and with your time. I’m personally just blown away. It’s been an absolute honour having you on the show today.
Rick: Well I’ve enjoyed it and I appreciate your contacting me and allowing me to hopefully be helpful to your listeners.
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