When buying a franchise, understanding ROI is critical to making an informed decision. ROI, or Return on Investment, is a mathematical calculation that shows how much the original investment pays the investor after a specified period of time. Usually this is based on an annual term (one fiscal year). ROI is calculated by dividing the buyer’s original cost of the franchise into the projected net income after one complete year of operations. However, if the transfer of a pre-existing franchise will require bank financing, the payments on the loan that increase the owner’s actual equity should be included within the net income.
The reason is very simple. Let’s say, hypothetically that a buyer of a franchise re-sale invests $150,000 and $100,000 is financed by a bank. During the first year, let’s assume the new owner projects $100,000 net income, but before having made payments back to the bank. Now the owner plans to pay the bank back $75,000 that same year, increasing the owner’s equity by $60,000 after interest payments have been deducted. Without including the equity, the projected net income would only be $25,000. $150,000 divided into $25,000 shows, inaccurately, an ROI of 16.7%. The real ROI would be found by adding back the $60,000 to the $25,000, for $85,000. Dividing $150,000 into $85,000 shows a completely different picture. This accurate ROI of 57% after interest payments reflects a very acceptable return for the first year.
What exactly is an acceptable ROI for a buyer of a franchise on resale? A number of factors must be considered. For example, each industry has a different level of acceptable profits per year. The key is to first evaluate the specific industry of that franchise to learn what the average net income is for the past few years within the same geographical area. Net income projections must be obtained before ROI can be calculated.
The second consideration is to research what the best franchise within the same brand and general area is earning? This provides a net income as a benchmark for what is possible within the same company brand. By visiting and then comparing that franchise’s operations and location to the re-sale under consideration, the buyer can begin to get an understanding of what the potential ROI might be. This can be simplified also by requesting to review the franchisor’s Franchise Disclosure Document (FDD), and looking at any earnings claims made in item 19 of the document.
One big advantage to buying a resale involves faster ROI. For most business owners opening a new franchise, there is a period of maturation that limits the full potential earnings power for 2-3 years. In contrast, the buyer of a re-sale can begin earning a mature level of profits within a relatively short period of time, if not immediately, because the business is already a fully operational franchise. In addition, the FDD commonly provides the average earnings of the specific franchise over three years, which would lessen the difficulty of future projections tremendously.
The third point to consider is the difference between a passive investment and a franchise investment. A bank CD and a stock traded on the New York Stock Exchange are considered passive investments because little time or expertise is expended by the investor to obtain those earnings. They are passively accrued over time. In contrast, profits obtained from the investment of a franchise are earned through the hard work and management skills of the franchisee, in addition to the risk involved in the actual dollar investment. Whereas a stock investment would be considered adequate by providing an ROI of 10-15%, this would not suffice for a franchise.
The reason is that the buyer must consider the monetary value of his or her time. If a buyer of a re-sale ordinarily earns $50,000 in annual salary working for someone else, this amount must be included in the projected ROI from any business operations resulting from the purchase of the franchise. This is a must because the owner is no longer able to work for someone else, and is now self-employed.
In addition, the risk of the actual dollars has a time value. If the franchisee had not invested the money into a business, that money could have potentially earned a passive income of 10-15% in stocks. This passive return is precluded from occurring because the money was alternatively invested in the franchise. Therefore, it should be included in the projected ROI of a business acquisition to offset the capital gains that could have been earned otherwise.
Thus, as stated earlier, in calculating an appropriate ROI for a franchise re-sale, the buyer does not have to build projections out to the third year of operations. Instead, the prospective franchisee would base the projected profits on historical data of the re-sale and expect those returns within the first or second year. After researching to obtain such a figure, the buyer could then reach an informed ROI.
This could be accomplished a couple of different ways mathematically. Some people just divide the projected earnings by the total cost of the purchase price, as described above. This is a total ROI. However, this does not account for the values of time the buyer spends away from other income-generating employment working for someone else. For that reason, a more accurate calculation compares an ROI to a standard, passive investment. This is calculated by subtracting the potential buyer’s normal annual income from the projected franchise income and dividing the difference by the total cost to purchase the franchise. If the percent figure were higher than 15%, the buyer would be making a good ROI on the franchise, because earning a passive income above 15% in today’s economy is very difficult.
One final consideration involves the price itself. Potential franchisees should be leery of agreeing to a price above market value that the seller bases on projected sales increases. Projections are never certain. Basing a buy on facts rather than speculation will increase the likelihood for success. And if the buyer of a re-sale franchise institutes management strategies that increase the ROI then that expertise will be rewarded immediately and proportionately. After all, the seller could have kept doing business, and especially with a re-sale there is commonly a number of opportunities (i.e., past litigation, bad customer service) for increasing profits and ROI overall.