Of the 3,800 concepts that are currently franchising, over 25% have 0 franchised units. Going up to the next tier of 1-25 units, you’ll find another 36% of franchised concepts. A report by FranchiseGrade further shows that after two years of trying to franchise, 65% of concepts sell no locations.
It shouldn’t come as a surprise that I have many conversations with owners of franchise systems who are frustrated with the lack of growth. Most are left to wonder if their business is worth franchising. In fact, this August alone, I had three different conversations with owners who asked me to take a look at their financial statements and give my “honest assessment” if it was worth continuing.
The struggle to franchise hits owners hard. Many are left with no answers. Most have tried franchise sales consultants with no luck.
I have had more than my fair share of conversations with owners who tell me they will have 100 units in the next three years. I often don’t have the heart to tell them their chances of that happening are around 1%.
There are many different reasons that the struggle is felt by many so owners trying to build their systems. This article is not meant to go into them (get me on the phone, and I am happy to discuss them with you). Instead, this article is meant to give a franchise owner a few steps to quickly analyze whether their business is financially suitable to franchise.
Below I am going to give you a quick process to identify if your system has financial issues that need to be addressed. Please keep in mind, this is only meant to be a quick exercise to show you any glaring issues. While this is valuable, I often recommend a much more in-depth modeling exercise before making too many changes to your system.
Step 1 – Project your Income Statement for a “Average” Franchisee
The first step I take is to get two years’ of income statements for the operating unit, hopefully in Microsoft Excel. Once recieved, I start to dive into each line item and figure out what is the true expense of the business.
When I say true expense, I mean the expense that an average owner would expect to incur. For instance, many financial statements show expenses such as legal expenses for the franchise included. A typical owner would not incur these expenses.
Another example of an expense to examine is rent. Do you expect your average franchisee to pay as much or even more rent than your current location? Are you in an area of the country where rent is low or high?
All expenses must be examined and normalized.
In addition, what expenses might a franchisee incur that you don’t currently incur? For instance, do you pay yourself royalties? Do you pay yourself a marketing fee? Odds are you don’t, so you will need to include these.
Step 2 – Normalize your Revenue
Your unit will most likely produce more revenue than a franchised unit. While some of your franchisees may produce more revenue eventually, most will not. You need to examine your revenue and determine if your location’s top line needs to be adjusted.
Here is an example. I was talking with an owner whose business was located in an area where it was able to be operated year-round. However, this might not be true if the business were in a colder location. As a result, revenue would need to be altered for this concept if the owner wanted to sell into certain climates.
There is plenty of financial modeling and analysis exercises you could undertake to get to a much more precise number for your revenue. However, if you are already pushing your Excel and financial skills, I wouldn’t recommend going down that road yourself.
One final recommendation would be to start with your revenue, and then start decreasing it by 5%. Using this method, you can see where the threshold is for what minimum revenue would need to be for a franchise to eventually achieve the results they need to.
A Quick Check-In
Before we go any further, let’s recap what you should now have. You should have an excel sheet that has four columns. The first column shows your expense and revenue categories. The next two columns show actual results for your operating unit. The last column is your projected revenue and expenses.
At the bottom, you should have net income for each of the actual years and your projections.
If you want extra credit, for each year, show what percentage of total revenue each expense item represents. Doing this will make step 2 easier.
Step 3 – Computing Cash Flow to Owner
Now that you have figured out your average franchisee’s projected net income (if its a projected loss, then you have an issue), its time to determine the potential return on investment.
For our purposes, I am going to exclude taxes. While taxes are an expense a franchisee should take into account, they are overkill for our simple exercise.
When a new franchisee opens, they will most likely need a loan. This loan will have monthly payments as a result of this debt. In this step, you need to estimate a few key variables:
- What is the estimated start-up costs (these should be consistent with your FDD)?
- What are the terms of the financing? Specifically –
- Interest rate – You can find on the internet the current SBA loan rates.
- Loan Term – Assuming an SBA loan, it is safe to assume 10 years
- Down payment – Again, assuming an SBA loan, this will be between 25-40%. I like to use 30%
On your spreadsheet, document each of these assumptions. Now is the time to figure out what their yearly loan payments will be. To do that, use a payment formula. I am going to refer you to this article on how exactly to use that formula.
Using this formula, you will come up with the total debt payments for a year. Deduct this entire amount from the net income of your projected average income statement year.
Once you have completed this step, you will have computed the approximate amount of cash flow that an average owner will make from their investment in your franchise.
Step 4 – Compute Return on Investment (ROI)
The last step is to compute what your average owner’s return on investment will be. Return on investment is the ratio of net profit compared to cost of the investment.
For the cost of investment, we will use the down payment required for the investor. We would have calculated this in Step 3.
Now, you can divide cash flow to the owner by the cost of investment to open your franchised unit. This will give you a percentage amount. Your next, and essential question should be “What is a good ROI”? The answer is not straight forward.
An acceptable ROI will be different to many. However, here are a few hints. If you invest in a simple S&P 500 index fund, your average return would be 10%. If you have an ROI of less than 10%, your franchise is going to be hard to sell.
Typically, where you want to see your ROI is at a minimum of 15%. Ideally, you want it to be even higher (think 20%) plus. But, at 15%, you can start to make some tweaks to your model to drive earnings for your owners.
Conclusion
If your head hurts because of all of the math and Excel we just went through, then give me a call. I am happy to spend an hour with owners going through this exercise.
However, the power of knowledge an owner gains from this exercise in too valuable not to do it. Let’s recap some of the questions that a franchise owner can answer:
- How do you need to change my concept in the future to create more value?
- Where should you spend my time and money concentrating on setting up a better system?
- How much will your owners make? Answering this question is powerful for your sales process.
- What factors are environmental that must be addressed? For instance, do you need to figure out to sell your concept in colder weather environments?
- Where should you concentrate your sales efforts? Do you need to look for lower rent areas or can you support higher rent areas?
These are just a few of the questions you can start to dig into. What you are doing now is starting to set a strategy for your business going forward? Finance turns into a powerful tool and can quickly become the brains behind your operation.
Remember those scary statistics I quoted at the beginning? Those that plan, strategize, and have the most knowledge are the ones that succeed.
About Krieger Analytics
My name is Matt Krieger, and I am the founder of Krieger Analytics, an accounting and advisory partner for small businesses and franchisors. Our goal is to completely outsource your accounting department from bookkeeping and taxes to CFO advisory services. I am also the owner and franchisor of a concept called Monkey Bizness, in Denver, Colorado.
As a small business owner with a background in finance and strategy, I realized the benefits that a CFO could bring to smaller organizations. Most franchisors and small business owners don’t have a need (or budget) for a full-time CFO or bookkeeper. To better fit my clients, Krieger Analytics is a part-time resource. While most think of CFO’s being involved in finance and accounting (we are), we are also involved in much more. We partner with clients by coaching, giving them clarity into their business, and creating growth strategies. Conversations are free, so don’t hesitate to reach out to me at [email protected].