Lawrence Hall

I guess it's decision time," said Lawrence Hall to his wife, Danielle. By March 2, 1992, the Halls had spent two months investigating the purchase of Good Fotos Limited, a combination photographic supply store and film processor located in a shopping mall in Halifax, Nova Scotia. I think you're right," replied Danielle. "We've probably received the best offer that the present owner, Harry Mitchell, is going to make. We must now carefully review our personal financial situation, reexamine the company income statements and balance sheets provided by Mr. Mitchell, and reassess our personal goals in order to confirm this is what we really want. After the commitment is made, it will be too late to change our decision."

Background Information

Lawrence Hall was a self-employed photographer living in Dartmouth, Nova Scotia. His wife, Danielle, was a dental hygienist, working with a local dental practise. Lawrence had become a freelance photographer five years ago, following his


This case was prepared by Professor Wayne King of Memorial University of Newfoundland for the Atlantic Entrepreneurial Institute as a basis for classroom discussion, and is not meant to illustrate either effective or ineffective management. Some elements of this case have been disguised.

Copyright 1992, the Atlantic Entrepreneurial Institute. Reproduction of this case is allowed without permission for educational purposes, but all such reproduction must acknowledge the copyright. This permission does not include publication.


marriage. Prior to that, he had been a deep-sea diver. It was his interest in underwater photography, as well as a desire to find a less risky line of work, that prompted his career change. Lawrence found that freelance photography was a competitive business, with periods of intense activity alternating with slower periods. The family had often had to rely on Danielle's income to carry them through these slower periods. It was because of this that Lawrence, who had always enjoyed working for himself, decided to consider the purchase of a photographic store.

Good Fotos Limited was a franchised photo finisher/ retailer, owned by Harry Mitchell. Mr. Mitchell, a well-known local entrepreneur, was involved in several successful small businesses in the Halifax area. He had begun Good Fotos Limited about four years previously, mainly as a project for his wife, Roberta, to operate. Roberta had now decided that she was no longer interested in the store, and Harry, because of his other business commitments, did not have sufficient time to properly operate it. As a result, the store's financial performance had declined over the past several years. Exhibits 1 and 2 provide Income Statements and Balance Sheets for the past three years.

When the Halls first approached Mr. Mitchell about acquiring the store, his first reaction had been to investigate the cost of opening a similar store based on current prices. A copy of an opening balance sheet as required by the franchisor is shown in Exhibit 3. Under the franchise agreement, the term of the franchise would have to be restored to its original ten-year life as part of a change in franchisee. The new franchisee would pay $24,000 to the old franchisee and $16,000 to the franchisor. This meant that Harry would be entitled to a payment of $24,000. Harry felt that a reduction of 25% of the equipment and leasehold improvement values provided by the franchisor would be reasonable, considering that the Halls would be acquiring a four-year old, but well-known, location. Inventories would be sold at cost, which he estimated to be $15,000. The total selling price would be:

Inventory 15,000
Equipment 123,750
Leasehold improvements 56,250
Franchise 40,000
$235,000

 

The Halls spent about three weeks reviewing and discussing this offer. Finally, they decided to meet with Harry. Lawrence began the negotiations, "we feel that the price of $235,000, including inventory, is just too high. We've examined the equipment and found that it needs some repair work. Also, the store needs painting and minor changes. We are prepared to offer $180,000 plus inventories, but including the $16,000 payment to the franchisor. Don't forget, the store is losing money." "I agree that the store and equipment need some work done on them," responded Harry. "However, $180,000 plus inventories does not even return book value of the assets. Although the income statement indicates a loss for 1992, the store had been profitable previously, and there is a positive operating cash flow." After some additional discussion, both parties agreed that a price of $190,000 plus inventories would be acceptable. The Halls left the meeting satisfied with the deal they had negotiated, and made an appointment with their bank manager for the following morning. The revised values were:

Inventory 15,000
Equipment 103,000
Leasehold improvements 47,000
Franchise 40,000
$205,000

 

The Problem

Ralph Welsh, Manager of the Royal Bank of Canada's Dartmouth Shopping Center Branch, removed his glasses and looked thoughtfully across his desk at the Halls. "What you've just told me about the opportunity is certainly interesting," he said. "There are, however, some points that need clarification and some things about the bank's lending policies which you should understand. We would normally be prepared to lend 80% of the value of the fixed assets which are part of this package. However, in the event of default, the leasehold improvements would normally revert to the shopping center, and the franchise fee would not be transferable to us. Therefore, the bank would not be willing to advance funds to cover these items without additional security. We might be able to lend, as a working capital loan, 50% of the value of the inventory which you are acquiring. I would not advise you to use this money for that purpose, however, because you'll probably need some money to get started with, and you shouldn't use every available dollar in the acquisition. One of the most important things to clarify is whether this company can support the debt you are taking on and still provide an income for you. You've stated, for example, that you feel sales can be increased because you, Lawrence, will be working at the store and because of your contacts among professional photographers. I think that from your point of view, you should check on the competition from similar operations before making that type of assumption. I'll need a forecast income statement and balance sheet reflecting the acquisition and the changes you plan to make before I can proceed any further. In response to your earlier question, our term loans would normally extend for ten years, and our current interest rates average ten per cent."

Lawrence and Danielle were somewhat chastened after they left the bank. "I didn't think that the bank would lend us all the money we needed," said Danielle, "but I thought they would provide more than that. It appears that we can borrow only $82,000." One alternative for acquiring more money was to borrow $50,000 as an add-on mortgage on their home. They also had about $20,000 available as cash surrender value on life insurance policies which could be borrowed. "This will still leave us $53,000 short," said Lawrence. "I'll have to tell Harry that we can't finance the deal."

Harry, meanwhile, had also been thinking about the deal. He realized that his time constraints prevented him from operating the store effectively, and that the Halls were the most likely candidates to purchase it. When Lawrence finished outlining his problem, therefore, Harry was sympathetic. "Perhaps I can help with the financing," he offered. "Let's look at the inventory first. Instead of a total immediate payment of $15,000, pay me $5000 now, and the balance at the end of the first year. That win reduce your shortfall to $43,000. 1 can also defer that amount by taking a second mortgage on your home. Pay me $6000 at the end of each year. I can even make 50% of this amount interest-free, but I'll need a rate of 18% on the other half."

The Halls were very encouraged by Harry's offer, but Danielle still had some reservations. 'We still haven't determined whether there will be sufficient profit to provide you with a good salary and make all of these payments." 'Well," replied Lawrence, "I should be able to increase sales by at least 20% because of my connections in the photography business. I would, however have to increase my advertising by about $10,000 to do this. As you know, there is a new store opening in the same shopping centre as ours within a few weeks, but I don't think that this will affect my sales level. Being at the store regularly should enable me to restore the gross margin percentage back to about 61%. If I continue to do freelance photography I won't need much salary. In fact, I should be able to reduce wages expense by about $5000. Royalties will remain at eight percent of sales, and because we are assuming Harry's lease, which has five more years to run, rent will be unchanged. We'll have to recalculate depreciation and amortization, because I feel the equipment will also last five more years, and both interest charges will change. In fact, I think we won't need to borrow any working capital money"

Conclusion

Although Lawrence was confident that this was an excellent opportunity, Danielle was not so sure. "Don't forget," she said, "our real intention in pursuing this store is to increase our income stability and to provide some opportunity for advancement. I'm not so sure that this objective will be achieved."


Exhibit 1

Good Fotos Limited
Income Statements
For the Years Ended January 31, 1992, 1991, 1990

Exhibit 2

Good Fotos Limited
Balance Sheets
At January 31, 1992, 1991, 1990

Exhibit 3

Forecast opening balance sheet

Current assets
Inventory $10,000
Fixed assets
Equipment 165,000
Other assets
Franchise fee 40,000
Leasehold improvements 75,000
$290,000
Long-term liabilities
Bank term loan $232,000
Other liabilities
Shareholders' advances 58,000
$290,000
Note: Financing is the responsibility of the individual franchisee. The financial structure above is for illustrative purposes only