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Top Financial Breakthroughs of the Past 20 Years

The business of buying, selling and running a fitness center has changed a lot over the last 20 years.

The fitness industry has roots in the 1960s and 1970s, with two different antecedents. The gyms of that era were pure fitness offerings: small in physical plant and limited in the variety of equipment. Its business model focused on selling prepaid annual memberships for affordable prices and, in many cases, encouraging members to pay for three-year or even lifetime memberships at highly discounted prices. The key assumption in this sales-oriented atmosphere was that most members would not remain regular users after the first few months. The emphasis was always on sales and selling the next new joiner.

The other antecedent was the racquet-sport-based club. This may have been a pure indoor tennis club, a pure racquetball club or a combination. At the outset, there was no fitness component. The business model for these facilities was completely different, as it assumed the collection of a minimal membership fee and depended on usage fees. Usage fees were tied to court-time rental rates, with a range of prices that varied, based on the desirability of the time slot. Prime-time in the weekday evening would cost more than early-bird times (before 9 a.m.weekday mornings). The cost would be stated by the hour, so the participants (in groups of two or four) would split the cost among themselves. Racquet clubs also learned to develop their own packaged programs (lessons, clinics, round robins, leagues, tournaments, etc.) with a variety of pricing sets.

These two models came together in the early 1980s, and became part of a multi-sport club concept, with both racquet sports and fitness in the same building. There were many larger pure-fitness facilities developed, some with or without a few racquetball courts. The racquet-sport-based clubs often converted underused court space to a growing fitness component.

Beginning in the early 1980s, a number of financial changes developed as fitness centers changed in concept, started to reach out to greater audiences, began to develop a variety of programs and services, and started to mature as professionally run businesses. Ten major financial breakthroughs over the past 20 years can be noted.

The membership agreement

All clubs had some sort of membership agreement, even back in the earliest years. However, the 1980s saw the agreement as a major significant legal instrument that defined the individual's rights and obligations regarding the facility. Because of past abuses, individual states created specific healthclub laws to help protect the consumer. This contract highlighted the movement away from racquet-court-time as the major basis for revenue to a membership-fee-based scenario. The length of the contract varied, as some facilities offered one-, three-, six- and 12-month contracts. "Lifetime" contracts were now limited to a maximum of three years. Rights to cancel and various protections were built into the contracts by law. Multiple-club groups (or chains) offered rights and privileges to use all of the commonly owned clubs within a given geographical area. These contracts laid the basis for fitness centers to define basic facilities and services, and created the groundwork for future extra revenue opportunities (personal training, massage, food and beverage, leagues, lessons, special events, etc.).

EFT development

One of the major financial developments that took hold in the 1980s was the acceptance of membership billing on a monthly basis through the concept of EFT (electronic funds transfer), either via a member's authorization of a bank checking account or through a credit card. This became the norm for receiving funds. It involved little staff time and still allowed fitness centers to enter into contracts for 12 months or more, depending on how the facility chose to price its offerings. It simplified much of the mystery of running a fitness center, so outsiders (bankers, investors, potential buyers and even sophisticated Wall Street firms) could understand the business better. Often, they referred to this new financial model as analogous to a real estate owner's "rent roll." EFT allowed fitness facilities to charge higher prices, since the members would be committing to a higher price tag, but paid over many intervals. (Plus,the prepaid concept was encountering buyer objections.) It led to fewer accounts-receivable problems and minimal bad debts. It led to fewer dollars needed to go out for collection by third parties. Obviously, it led to predictable and timely payments. For upper-end clubs, house billing for extras (as in the country club model) was still available, but the core dollars from dues became automatic, once a month. The various state fitness facility laws often sanctioned this EFT concept.

Asset- and cash-flow-based lending

In the 1980s, the fitness center industry was immature, often with successful business professionals as key investors, with few having grown up within the industry. With no track records within the industry, and no data being published about the norms of this industry, bankers and lenders were ignorant about deals and their likelihood of success. Many start-ups went to their local banks for debt. Some tried to take advantage of Small Business Administration or other governmental agency guarantees, or even direct funding. Some developers went to regional banks or even national bank centers, as these institutions were regularly consolidating. The knee-jerk bank reaction was to always request a personal guarantee, at least for the key investors, as a second form of debt repayment in case the fitness center's cash flow was insufficient. EFT dues made the facility's revenue picture much more understandable.

As time went on, banks were willing to only seek limited guarantees or release the guarantees based on performance criteria. As multiple clubs were developed by the same organizations, fewer restrictions were demanded, as track records spoke for themselves. The use of independent market analyses provided some education about a future facility's likelihood of success. Appraisals were demanded, but ones based on the income approach started to gain acceptance. Sales of successful fitness centers were noted, as these yardsticks help convince bankers that an actual exit strategy did exist.

In the last 10 to 15 years, private equity firms became investors in the fitness center industry. They were interested in the larger, multi-club organizations, with the concept to grow the size of the business dramatically and then sell it or take it public. As part of their success formula, they wanted to leverage their equity dollars with debt from sophisticated lenders, or even the public debt markets. They were often able to borrow for club companies' total debt equal to four or five times the club's annual cash flow. This type of lending shifted away from pure assets (land, building or leasehold improvements, equipment and business) to a pure cash-flow basis.

Maintenance capital expenditures

One of the key lessons that fitness managers/owners have learned over time is to ignore the "depreciation" line on the income statement, as it is a non-cash item. Instead, they have accepted the tenet that, each year, they have to re-invest capital into their existing facilities (whether real estate was owned or leased). And this annual total bears no resemblance to depreciation calculations.

Owners/managers learned that they have to recarpet, repaint and redecorate once every certain number of years. Computer hardware and software has to be replaced or upgraded every few years. The space needs to be renovated (expanded or converted) from one use to another to meet changing demand. So, an underused racquetball court that was busy 10 years ago may today be a double-decked space housing a dedicated cycling studio and a Pilates studio -- both new concepts. Also, fitness equipment gets replaced regularly, and even added to as demand increases. On average, fitness centers spend 4 to 6 percent of their annual gross revenues, with some years as high as 10 to15 percent, for a major renovation. Maintenance capital expenditures, as distinguished from the original start-up capital expenditures, are accepted as a standard for all businesses in this industry; outsiders now accept this category as an industry norm.

Start-up funding

As the fitness facility industry has matured, even start-ups can obtain funding from various sources beyond friends and family. Today, real estate owners often seek out club operations as an acceptable use, and are willing to invest substantial capital to help pay for the fit-out of a fitness center, well beyond the plain vanilla shell. They are also willing to escalate the rent from no rent during construction to below-market levels as the facility ramps up its business.

Government funding is still an avenue used by many smaller start-ups. Bank funding is easier to obtain for an initial facility, as long as adequate equity is committed and a proper business plan with third-party documentation is provided.

Equipment leasing has become plentiful, especially with leasing companies either owned by or affiliated with the major fitness equipment manufacturers. Today, a good business idea, along with the proper homework, is more likely to get funded and created. The value of data from trade associations, such as IHRSA (International Health, Racquet & Sportsclub Association), has helped the funding process on all levels.

Valuations

As any industry matures, there becomes a need for valuing a business for every reason imaginable. Businesses and business owners typically will have the need, at some point, to sell the business or transfer some ownership stock as part of an estate plan, or will want to buy out one or more investors within the business. Unfortunately, the business also has to deal with stockholder divorce issues or even death of an investor. Or, the business may need to get financing/refinancing or protest its real estates taxes or defend its value for insurance purposes. In some cases, there may be a building owner/tenant dispute. For all of these purposes, fitness centers may need to obtain an independent valuation. Some appraisers have studied the industry, learned about the relevant and factual data, and determined the proper methodology. However, over the past 20 years, it has been more common to expect appraisers to be uninformed and to struggle to understand the nuances of the industry. Trade industry articles and publications have helped. The breakthrough in recent years has led to the acceptance of the income approach as the singular way to analyze fitness facilities, and the capitalized earnings method as the way to calculate it. This presumes accrual-based accounting and an adjusted financial statement from a recent representative period of time based on a third-party perspective.

Private equity investment

"Smart money" coming from private equity firms has found the industry over the last 10 to 15 years. These firms raise large funds, often with investments from pension funds, large financial institutions, insurance companies and some wealthy investors, and then leverage their equity with substantial debt. These are sometimes called LBOs (leverage buyout funds), where the intention is to grow these businesses and then have a capital event in five to seven years. This event may be a sale or an IPO (initial public offering) as the company goes public. The exit strategy is part of the initial plan. There are more than 10 club companies that are or have been backed by these private equity firms, with more such investment companies likely to invest in the industry in the future.

Industry vs. economic cyclicality

All sophisticated financial investors and analysts study an industry over the long term. They are concerned with how specific industries perform during weaker economic cycles, such as recessionary times. The fitness industry postulated that it did well during recessions in the early 1980s and 1990s, but it had no hard data. During the most recent recession, IHRSA created an index, where it collected financial and membership data on a sample of club companies from quarter to quarter. It then compared this data to the previous year to measure trends. The conclusion was that the fitness industry was recession-resilient, but not purely recession-proof. Revenue, memberships and earnings grew, but at a lesser pace than during pre-recession times. This data, which is still being regularly collected, has helped convince outsiders of the long-term viability of this industry.

Fitness center comparisons

As industries develop, there is a need to define common metrics that allow for comparisons between fitness centers and between companies. Several key metrics have begun to emerge, including revenue per member, revenue per square foot, revenue per FTE (full-time equivalent) staff, EBITDA percent (earnings before interest, taxes, depreciation and amortization), net membership growth, attrition rate, non-dues revenue percent, revenue growth, payroll percent of revenue, etc. These measures are valuable as an industry is studied by both outsiders and insiders, and create a common set of indicators for industry understanding.

Fair playing field

This industry has more than 60,000 fitness facilities, including all of those in apartments and condos, member-owned fitness centers, university facilities, parks and recreation centers, in-house corporate centers, military-based facilities, hospital-owned centers and non-profit facilities (such as YMCAs and JCCs). Many of those have non-profit status, which allows them more than a 30 percent cost advantage (due to the expense categories that are not charged or special rates that are given). Also, the capital cost structure is wholly different, as many receive donations for land or building, or benefit from below-market financing terms. The for-profit industry has tried to work with the non-profit organizations and government to ensure that there is a need for such new non-profits, and that they do not harm the equilibrium of the market by forcing existing for-profit fitness centers to fail. This has led to educating the government and the public about the real financials of the industry, and the real operating numbers neededto achieve survival and, later, success. This education process is ongoing, but one that attempts to protect the basic law of economics of supply vs. demand.
These 10 financial breakthroughs have been significant over the last 20 years, as all have watched the industry mature and develop its professionalism.
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