The Acid Test: Will Franchising Your Business Be Profitable or Not?

The Acid Test: Will Franchising Your Business Be Profitable or Not?

The acid test of franchising is return on investment. A franchise business must be profitable. But a profitable prototype is not enough. A franchise business must allow enough profit after a royalty (or any other fees or incremental product markups) for the franchisees to earn an acceptable return on their investment of time and money. So a business that offers an acceptable return to you as an entrepreneur may not provide adequate returns to your franchisee once you have assessed your fees as a franchisor.

Profitability, of course, is relative. A franchisee’s profitability — either as a stand-alone dollar amount or a percentage of sales — isn’t the relevant number. Profitability must be measured against the capital invested to provide a meaningful number. A franchisee who invested tens of millions in opening a hotel franchise might be very upset if they made a return of $200,000 a year, while a franchisee who invested $100,000 to open a service-based business would be thrilled.

To be competitive in today’s franchise marketplace, the iFranchise Group generally looks for the franchisee to achieve an ROI of at least 15 percent by the second to third year of operation. And if the franchisor is targeting area-development or multi-unit operators, it will need to provide a higher return at the unit level to offset the incremental overhead associated with multiple unit management.

It’s important to note that these returns must be calculated after deducting a market-rate salary for the owner-operator franchisee, since the franchisee’s alternative to buying your franchise is to invest his money and get a job. So he’s entitled to a return on both his money and his time.

The iFranchise Group’s version of franchisee ROI is calculated as the adjusted cash flow of a particular investment in a franchise, expressed as a percentage of that investment. To get to that percentage, one would divide the adjusted return by the estimated investment:

Adjusted Cash Flow ÷ Total Cost of Investment = ROI

The first thing we need to determine is what a franchisee will have to invest to obtain a particular franchise. The number should include all the costs incurred in starting an operation from the ground up, including any equipment, build-out, or inventory costs. You’ll also want to include an estimate of any initial franchise fee you’ll charge and any cash flow expenses the new franchisee will incur for initial advertising, personnel recruiting, training expenses, and the initial salaries and rent the franchisee will need to pay prior to achieving break even.

Once you’ve calculated your franchisee’s projected initial investment, you’ll need to make some adjustments to your current income statement to calculate a franchisee’s projected return. If you have multiple units in operation, start by looking at the unit or units you feel are the most representative of franchisee performance. You don’t want to look at a best-case scenario that franchisees aren’t likely to achieve consistently. Likewise, you don’t want to be overly conservative, as this will adversely affect your ultimate fee and royalty structure. The goal is to start with your best estimate of annual franchisee financial performance once a unit is mature, with the caveat that the franchisee will need to make their requisite return by year three or sooner.

You will then need to make some adjustments for franchising. The primary adjustments you should consider are:

Normalize the manager’s salary. If you as an owner-operator are taking a larger salary than you might pay a hired manager (or are paying longtime employees a higher-than-average salary and/or benefits), you would adjust that salary downward. Conversely, if you are not yet taking a salary (or taking a below-market salary), you would adjust it upward.

Adjust expense items. Look at each and every expense line item on your income statement to see if a franchisee’s expenses will vary from yours. For example, if the franchisee will own a single loca­tion, but your income statement shows the cost of a vehicle to move inventory between multiple locations, you should eliminate that line item.

If your franchisee will be buying equipment or goods from you at a markup, you need to increase their anticipated cost of goods sold line. If the franchisee will be paying more (or less) for rent, for example, you would need to take that into account.

Eliminate any expenses a franchisee will not incur. Franchisees will not, for example, have costs associated with a separate administrative office or field support team if you have those expenses allocated in your income statement. They will not incur certain legal expenses, such as trademark work, but you will want to include the expenses of incorporation or any locally required licensing or bonding.

Eliminate any one-time-only or investment expenses that show up as an expense item on your income statement.

Eliminate any financing expenses such as interest. Since you will be con­ducting this analysis on a cash-on-cash basis, it’s assumed that the franchisee will not need to finance anything.

Eliminate any non-cash expenses such as depreciation and amortization. These expenses help reduce taxes but do not alter the franchisee’s cash flow.

Eliminate any allocations for income taxes, as these taxes would need to be paid on any alternative ROI.

Confine expenses added to those pertaining to business operations.Do not include extraneous tax minimization strategies you may have employed for your personal benefit (automobiles, entertainment, insurance above an industry norm, etc.).

Add to your expense line an approximation of royalties, contributions to a system marketing fund, or other fees you will assess your franchisees.

Once you’ve made these adjustments, you’ll have an approximation of your franchisee’s adjusted return that can be used in the numerator when calculating ROI. With revenue and investment figured, you can now calculate the projected ROI.

In the vast majority of cases, if your business doesn’t meet these return criteria, don’t franchise. Period.

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