A Business in Trouble
When a fledgling business begins to lose money, taking the wrong steps to “fix” things can make a bad situation worse.
If you’ve been following this column for the last two issues, you’re familiar with the story of “Mark,” who opened a 10,000-square-foot club with $100,000 of his own money and $400,000 in additional capital from a personal training client, his brother-in-law and his parents.
We pick up the story near the end of the second year of operation. In year one, Mark’s business lost money, despite a profitable first two months. In fact, an additional $45,000 of capital had to be invested in the business by the end of the first year just to break even! A far cry from Mark’s original dreams.
Mark had been right about some issues. The local “ma and pa” operation had gone out of business, but not before slashing prices in a last-ditch attempt to raise cash. At the same time that Mark’s first-year charter memberships were coming up for renewal (at $275, far lower than his operating expense per member), the ma and pa offered yearly prepaid memberships for $195! Mark lost over 100 renewals.
The area YMCA kept chugging along, and the local fitness chain franchise continued to sell a steady stream of memberships at $35 a month. The racquet club, due to its proximity to the ma and pa operation, gobbled up almost all of the latter facility’s memberships when it finally closed down.
After a midyear strategy meeting with his shareholders, Mark decided he had to do something to get sales up. So he hired a salesperson. Since Mark didn’t have any money to spare, he cut his own salary for the second time, gave the resulting money to the salesperson as a small base salary and offered a high commission (20 percent on all membership agreements).
Unfortunately, since Mark’s club continued to operate with a skeleton crew (his mother and sister helping out for no wages), he couldn’t offer much in the way of customer service, which he had counted on to differentiate his club from the competition. The saving grace of the club was that it was clean and modern.
The good news was that the new salesperson closed a high percentage of sales. The bad news was that to do so, he discounted the $79 joining fee to $19, so the club was losing $60 per new member.
To bring in some additional revenue, the dues for charter memberships were raised to $29 a month (at the investors’ demand, and against Mark’s protests), and the original $29-per-month memberships went up to $32. However, nonmembership revenue (from the juice bar, pro shop, personal training) dropped because there simply wasn’t enough staff to do everything. The group exercise program never really got off the ground; the few classes offered were not well attended.
Mark was now working almost 70 hours a week on average, his wife was concerned about their income, his mother and sister were beginning to grumble about working for nothing and the investors were unhappy. Although it looked like the club would be operating at a monthly breakeven by the end of the second year, there had been no return on investment for the stockholders, and there was no promise of any in the near future.
What should Mark have done differently? Let’s take a look at some basic guidelines. First, anyone who is even thinking about starting a club should ask the following questions:
- What is the goal for the business in five years? Ten years?
- What will your expenses be, and how much of your gross income will you need to reinvest in the business to meet your goals?
- What is needed in membership income to net a profit over and above your carrying costs?
What Mark should have figured out in the beginning was that to build a competitive 10,000-square-foot club, he should have been in the high end of monthly dues, not the low end! Had he started with $39 per month and refused to discount his joining fee, he would have had over $150,000 more in first-year income—and probably a totally different clientele. He would have established a profitable monthly operating base by the end of the first year, had enough staff to maintain a quality club, and been able to initiate the high-retention programs he had dreamed about.
In short, Mark would have differentiated his club in the marketplace by his pricing. All too often, clubs don’t charge what they need to charge to properly service customers. Membership becomes about price rather than value.
Mark not only failed to build value for his club, he failed to build valuation. Basically, clubs are measured for valuation in two ways. One way is by using the Net Asset Value (NAV) formula, which considers the actual current value of all equipment, furnishings and other assets (less debt) that “can be taken out on the front sidewalk and sold for cash.” The other way is by using the EBITDA formula, which calculates Earnings Before Interest, Taxes, Depreciation and Amortization.
To improve his valuation, Mark should have built his receivables base by concentrating on monthly dues. (Generally, monthly dues are considered an asset, whereas prepaid dues are considered a liability.)
Near the end of the second year, Mark and his investors realized they were going down a blind tunnel. He and his wife discussed the possibility of Mark selling out his interest and either going to work for the club as an employee, or leaving altogether and going back to another club where he could earn a decent living.
Mark called a meeting with his investors. He stated his concerns and suggested that perhaps he should sell his 22 percent interest, to the investors or somebody else. Everyone agreed that the first thing needed was a valuation of the business, so an industry consultant was hired to provide one.
What were the consultant’s conclusions? The current value, figured by using a combination of the NAV and EBITDA formulas, came in at slightly over $300,000. The investors were shocked. How could a business in which they had jointly invested over $500,000 be worth only two-thirds of that less than two years later? Mark was shocked. His buyout value would be under $70,000.
So what happened? Was there a way to sell the business (or Mark’s interest in the business), if that was determined to be the best thing? Could the investors ever see any predictable return?
In the final installment of this column, we will see what happened to this club and learn some valuable lessons about operating a fitness business.
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