Question: I’ve been investigating a number of franchises and they don’t seem to be very consistent in terms of rate of return on investment. In fact it sometimes appears that there is very little correlation between the total investment and the amount of money I can make in the business. Is there a rule of thumb that applies to ROI in franchise opportunities?
Answer: This is a great topic because the real answer is so counter-intuitive for most people to accept. When you think of investing in real estate, the stock market or other somewhat passive investments, there is usually a fairly direct correlation between the amount invested and the total return. Returns of 10% to 15% per year on invested capital are normally considered very good.
Most people intuitively understand that the more you invest, the more you’ll get back. “Spend more, get more” is an accepted fact of life. The problem is that this “fact” just isn’t usually true in franchising.
The flaw in applying this same logic to franchising is that the investment is normally not passive. In addition to your capital, you are investing a fair amount of your time and management talent as well. You should be able to achieve a good return on both investments. Therefore, since you are making two investments, when you look at ROI in franchising, it should be considerably higher than what you can earn in a passive vehicle.
Returns in franchising vary all over the board. In most cases the return on capital (expressed as a percentage of the total investment) is usually smaller on high investment franchise opportunities than on low investment opportunities. The reason has everything to do with time leverage.
You make two types of investments in a franchise opportunity. The capital you invest is static and the returns you will earn on your invested capital are normally reasonable by passive investment standards. In other words, in most franchise businesses you will get very little leverage in relation to your capital investment. Even if you use debt to increase leverage, your debt service will dampen the overall net cash return produced by the business although can definitely increase ROI if used properly.
The real opportunity for leverage in franchising relates to the investment you’re making in your time and talent. This is where a great franchise system can utilize this asset to increase your returns dramatically.
The franchisor develops a system or method of operation that employs the franchisee’s time in a manner that drives the income from the business to levels that are not available from an investment of capital alone. These are the systems where a good operator can create annual incomes greater than 100% of the total initial franchise investment within a short period of time. Now that’s effective leverage, but still depends on your total time invested.
As a general rule of thumb, you should never invest in a franchise unless you believe (based on your own investigation) that the average annual income return on capital from the business will be equal to at least 30-50% per year of the total initial investment for the franchise unit. The total investment we’re referring to includes all debt and working capital reserves needed to start the business.
If the return isn’t at least this high, what are you working for? You’d be better off to keep your job and invest your capital passively. Another calculation is to compare your current or recent salary to the projected average cash flow from the franchise upon stabilization. If you’re making $100,000 per year but have to work full time in the new business to only make $50,000, even if this results in a return on invested capital of 100%, you won’t feel it’s a good investment.
So…how do you find a franchise with great returns? The first answer is not to immediately look at the most costly investments. You want to find the ones with great management leverage and/or semi-absentee business models. These can often be franchises with total investments of less than $200,000 and in some cases less than $50,000. Diamonds often come in small packages.
The next step is to carefully investigate the average earnings of a typical unit during the first three years of operation. Make sure you know what the average performance is, not just what the best units can achieve. If the business does not project to make the necessary returns by the third year at the latest, keep shopping. There are plenty of great opportunities out there that will meet or exceed this standard in a relatively short time frame.
Don’t be afraid to fully vet out multiple franchise business models to find the best combination of return on both time and capital invested to fit your goals and objectives. The best source is always to validate any claims by the franchisor with actual franchisees in the respective systems.
David Busker is a Franchise Consultant with FranChoice, the premier national network of franchise consultants. David helps candidates exploring business ownership through franchising to set their criteria and then matches them with the perfect franchise. You can learn more about David at FranChoice.
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