Q:
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?
A:
This is a great topic, because the real answer is so
counterintuitive 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
20 percent 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.
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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 (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
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
simply decrease the overall net cash return produced by the
business.
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 percent of the
total initial franchise investment within a short period of time.
That's effective leverage!
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 from the business will be equal to
at least 30 to 50 percent 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.
So how do you find a franchise with great returns? The first
answer is not to look at the most expensive opportunities. You want
to find the ones with great management leverage. These are often
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 is not making the 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.
Jeff Elgin has almost 20 years of experience in franchising,
both as a franchisee and senior franchise company executive. He is
currently the CEO of FranChoice
Inc., a company that provides free consulting to consumers
looking for a franchise that best matches their needs. He can be
reached at jelgin@FranChoice.com.
The opinions expressed in this column are those
of the author, not of Entrepreneur.com. All answers are intended to
be general in nature, without regard to specific geographical areas
or circumstances, and should only be relied upon after consulting
an appropriate expert, such as an attorney or
accountant.