As a franchise consultant, I'm often surprised by the decisions made by demonstrably intelligent businesspeople. These are often businesspeople who've successfully grown businesses based on nothing more than their own ingenuity, talent and sweat--and yet some of their decisions almost defy explanation when it comes to franchising.

In analyzing some of those poor decisions over the years, I've come to the conclusion they're often a result of a lack of understanding of a very simple principle: the present value of a franchise.

Hardly a week goes by when I do not witness it: The business owner who pulls the plug on a successful broker program or advertising source because "it just isn't profitable" to sell franchises after paying broker fees. The franchise sales director who refuses to commission a franchise salesperson because "there is not enough margin in it after paying broker fees"--even though that strategy may result in lower broker closing rates. The hiring of less qualified staff or the failure to use a recruiter in order to save some salary--knowing that diminished sales production may be the result. Pulling the plug on advertising or a trade show because it didn't work the first time. Saving 20 cents a copy on a franchise marketing brochure by using a substandard paper stock, despite the less impressive message it may send to prospects.

Sure, some of these decisions are made based on necessity and short-term budget constraints. But often, it's simply cost cutting for the sake of cost cutting--without looking at the long-term consequences. And that's why one core principle we emphasize is understanding the present value of a franchise.

The concept of "net present value" (NPV) is borrowed from the world of finance. It means that a dollar paid to me today has a greater value than a dollar paid in the future. If I receive that dollar today, I can earn interest on it. And, of course, there's the uncertainty of not being paid at some point in the future. The present value of a future payment thus represents the amount that I would accept today in lieu of that dollar paid at some point in the future. If, instead of accepting a dollar one year from now, I would take 91 cents today, the difference is the "discount rate" (in that case, 10 percent) that I would apply to that payment. The discount rate represents a combination of the cost of capital (foregone interest) and the uncertainty of that income or income stream.

So what does that have to do with franchising?

Let's start with a basic premise. A franchise sale is more than a one-time sale. It is, at least from a financial perspective, an annuity that can last for decades. Franchisors will receive fees, royalties, advertising dollars, transfer fees, renewal fees, training fees, product margin, rebates and other sources of revenue over the term of each franchise relationship. And those fees--or the promise of those fees--represents a real value to the franchisor today--and will certainly have value to a prospective buyer who's looking to acquire the franchisor.

So how does one assess this value?

The first step is to understand the estimated life of a franchisee. A franchise, of course, represents a going concern. As long as it's open (even if it's sold), it continues to pay royalties and fees. So start by determining the anticipated life of the franchise. If you think your franchise offering will have an average failure rate of 5 percent in any given year, then you might anticipate the life of a franchise at 20 years (one divided by .05). If your historical or anticipated failure rate is higher or lower, modify that number using the same formula.

Next, estimate each franchisee's average profits. For many franchisors, this number increases over the years, so the best means of finding this number is to develop a financial model. The model should account for all revenues you anticipate from a franchisee over that franchisee's life, with one entry for each year for simplicity purposes.

Deduct any associated costs associated with bringing on a new franchisee. Factor in marketing, commissions, and other costs associated with the franchise sale. Also deduct any costs for goods sold to the franchisee. The tricky part comes when allocating expenses and overheads.

There are a number of ways to estimate expenses--and different methods are more relevant for different decisions. For most decision-making purposes, the most relevant way to conduct this analysis is to focus only on those costs directly associated with servicing that franchisee--not allocating overheads that you would incur regardless of whether a sale is made. For example, you might look at the costs of support-related travel as a variable cost. If you have one field rep for every 20 franchisees, allocate one-twentieth of his compensation. You wouldn't allocate a portion of the CEO's salary, as the addition of a new franchisee would not impact that expense.

Finally, you'd need to determine the discount rate. The higher the discount rate, the greater your uncertainty of a future stream of revenues. I've used a 20 percent discount rate below for the sake of illustration, and this number is generally considered a conservative number for such an analysis. To put that discount rate in perspective, a 20 percent discount rate is the equivalent of saying that you'd rather take $4,020 today than wait five years for $10,000.

This NPV calculation, in a highly simplified form, would look something like the following:

 

Lifetime of a Franchisee

  Year 0 Year 1 Year 2 Year 3 Year 4 Year
5 - 20
Revenue            
Franchise Fee $25,000          
Royalties   $20,000 $30,000 $30,000 $30,000 $30,000
Other Revenue $10,000 $10,000 $10,000 $10,000 $10,000 $10,000
Product Sales $40,000 $60,000 $60,000 $60,000 $60,000 $60,000
Total Revenue $25,000 $70,000 $100,000 $100,000 $100,000 $100,000
             
Variable Expenses            
Selling & Training Costs $35,000          
Cost of servicing one franchise   $19,500 $26,000 $26,000 $26,000 $26,000
Cost of Goods Sold     $28,000 $42,000 $42,000 $42,000
Total Expenses $35,000 $47,500 $68,000 $68,000 $68,000 $68,000
             
Net Revenue -$10,000   $22,500 $32,000 $32,000 $32,000
             
Discount Rate 20 percent
             
Net Present Value $137,910 Calculated based on 20 year life



Even when using a relatively high discount rate, as shown in the example, the lifetime value of a franchise can be well in excess of $100,000 even after losing $10,000 on the initial sale. This shows that, in the long run, it can actually pay handsomely to lose money on the franchise fees in return for the stream of income that each franchisee represents.

This particular analysis doesn't even account for the increase in the terminal value of your franchise company if you were to sell it. (More profits mean a higher selling price.) When we see franchisors reducing or waiving franchise fees to spur franchise sales in today's more difficult economy, that move may prove to be very wise long-term when considering the NPV.

While few franchisors can afford to lose money on every franchise sale, consider the short-term sacrifice for the potential long-term revenue.

Ask yourself these two questions:

  • Will this expenditure (on staffing, advertising, marketing materials, training, etc.) reasonably be responsible for one additional franchise sale?
  • Could this expenditure help lengthen the anticipated lifetime contribution of a franchisee (by increasing franchisee revenues, improving franchisee longevity, decreasing expenses, etc.), and if so, how would it impact the NPV?

Measure the cost of the expenditure vs. the impact of the decision. Remember, every franchisor will have a different NPV based on her anticipated fees, product sales, expenses, and franchisee longevity (as well as her estimate of an appropriate discount rate)--so a good decision for one franchisor may be a bad decision for another.

As this analysis illustrates, franchisors have a much greater need to balance short- and long-term considerations in their decision making than do other businesses. The NPV paradigm coupled with good short-term cash management will bring a long-term perspective that will ultimately improve your decision-making and your long-term profitability.