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WILL IT MAKE MONEY?

by Robbie Gimblett,
last updated 23/07/2009

Robbie Gimblett examines the financial side of buying a franchise, and explains some of the processes that a potential franchisee must go through before deciding whether or not to buy a franchise.

The decision on whether to forego the safety of a regular salary or wage and step into the world of franchising is never an easy one. There are many aspects that a potential franchisee must consider when making the decision to buy a franchise. These include the time commitment of owning and operating your own business; your experience in the industry of the franchise in question; your skill or aptitude for business and your people skills.

This article focuses on the financial side of buying a franchise, to help you decide whether the opportunity is viable given your own particular assets and needs. It is divided into two parts.

The first part shows you how to examine your personal financial capabilities and allows you to evaluate the maximum price that you could afford to pay for a franchise. The second part helps you to evaluate various franchise opportunities from a financial perspective. A fictitious case study of a prospective franchisee called Roger Smith is used throughout the article to help illustrate the issues that arise.

1 Financial Capability

As a potential franchisee, before you even begin to evaluate franchise opportunities you must first examine your personal wealth. Most, if not all, franchises for sale require an up-front fee to be paid to the franchisor. This fee can vary from perhaps $10,000 for a home services franchise to, say, $700,000 for an internationally-recognised retail outlet in a prime location.

The first step is to establish the maximum amount that you will be able to invest into a franchise. To do this, you must prepare your personal statement of financial position. Simply list all of your large personal assets and subtract from those assets the debt you owe. This exercise will establish your personal net wealth. We suggest you only include assets valued at over $5,000.

In the example in figure 1, Roger Smith, our potential franchisee, has a house which has a current market value of $250,000, a car which has a current market value of $20,000, a redeemable life insurance policy with a current value of $10,000, and savings of $25,000 deposited at the bank. The only debt in this example is a $125,000 mortgage secured over the house. Subtracting the debt from the assets, the figures show that Roger has a net wealth of $180,000.

Fig 1

Fig 1

However, if Roger borrows money from a bank to help buy a franchise, then the bank will value his assets a little differently. Let us assume that the bank will allow a potential franchisee to re-finance to a level up to 80% of the house's value (see figure 2). The house has a current market value of $250,000. The bank's maximum figure will therefore be 80% of $250,000, which is $200,000. However, there is already a mortgage of $125,000 against the property, so from the bank's perspective the maximum additional amount that can be borrowed against the house is $75,000.

The $25,000 Roger has in savings would also be considered equity/personal funds available for purchasing a franchise. Let's say that, in this case, the car and the insurance policy are not taken into consideration for raising funds to assist with purchasing a franchise.

Hence, the total equity/personal funds that Roger has available for the purchase of a franchise is $100,000 (i.e. $75,000 + $25,000).

Fig 2B

Fig 2B

Many franchisors stipulate that potential franchisees must fund the business with at least 50% equity, rather than funding the majority of their purchase of the business with debt. Even if the franchisor does not make this a requirement, we believe the practice is sensible, as it means you are less likely to over-extend yourself. Many franchisees make the critical mistake of buying a business out of their reach and suffer accordingly.

Working capital is another important consideration. Unfortunately, many new businesses often find the first few months a struggle financially, and that often applies to franchises as well. Even with a strong brand and the support of a nationwide franchise system behind you, it can take time to establish your place in the market. For this reason, many franchisors also stipulate that franchisees must have adequate working capital available to help them ride out any tough times.

In our example, Roger Smith has $200,000 available to start his business. Bearing in mind the importance of the above, he has allowed $26,000 for working capital. The maximum price that he can afford to pay for a franchise is thus $174,000, as illustrated in figure 2b. The next step is for him to establish the minimum income he requires the franchise to generate to enable him to comfortably live day-to-day.

Income

Figure 3 illustrates the personal expenses that Roger expects to incur each year, based on current prices. This example also includes a provision to cover savings. When you perform this exercise for yourself, be realistic. Many potential franchisees underestimate the amount that they believe they can live on.

Roper's example includes interest and principal repayments that would be

due on the increased mortgage of $200,000. It shows that he requires a pre-tax income of, say, $61,500 each year to live comfortably day-to-day and repay his increased personal mortgage. For the purpose of this case study, we will assume that Roger currently earns $55,000 before tax per year.

fig 3

fig 3

Return On Investment

When evaluating a franchise, it is very important to factor into your calculations a return on investment. This return on investment should be over and above your income.

As with any investment, if you invest money you should expect an adequate return. This must be over and above the salary/wages you require, and represents the return which you should expect from investing your money in the business. We suggest that you aim for a return higher than that which you would get if you put the money in the bank, because there is more risk associated with investing in a private business. Accordingly, you should be compensated for taking this risk by receiving a higher return.

For the purpose of our example, we have used 15% as our required before tax rate of return. However, you may consider that a higher or lower rate would be more appropriate depending on your assessment of the level of risk involved.

If the prospective franchisee in our example did invest $100,000 into a franchise, then he should be looking for a return of approximately $15,000, which equates to 15% (i.e. $15,000/$100,000). This means Roger would want a business that will earn approximately $61,500 before tax in income, and a pre-tax profit of $15,000 over and above that income as a return on his investment.

Effort

It is worth bearing in mind that, in many franchises, it is necessary for the franchisee to work long hours to achieve an adequate return on their investment. Many retail franchises are open 7 days a week. For this reason, one of the major considerations when buying a franchise must always be the time and effort you are willing to put into the business, and whether the potential return justifies that effort.

2 Evaluating the Projections Provided by the Franchisor

Now you have determined the maximum amount that you can pay for a franchise, the salary or wages you require, and the return on investment that you consider appropriate, the next step is to evaluate potential franchise opportunities. One of the best places to start looking for franchise opportunities in New Zealand is this magazine: the Directory section helpfully lists opportunities and the level of investment they require (see page 75).

Once you have shown interest in a franchise system and reached a stage where you are seriously interested in buying into it, you should be presented with (or need to personally determine) projections that outline the profit that you could potentially achieve if you decide to buy.

Many franchisors have become somewhat reluctant to issue forecasts to potential franchisees because of recent litigation involving franchisees who did not make the profit that the franchisor projected. This is a difficult area for franchisors, as they are aware that if they do not supply financial information then potential franchisees will not be able to accurately assess the franchise opportunity and it will consequently be difficult to sell the franchise.

Most franchisors will therefore provide you with some indication of the profits you could potentially achieve based on actual results of pilot operations or other franchisees operating the same franchise system. However, these are not guarantees, and you should not rely upon them as such. We recommend you carry out your own research.

Figure 4 shows an example of an expected statement of financial performance for our prospective franchisee, Roger Smith, who is looking at investing into a fictitious specialist home/commercial cleaning services franchise.

Note that as all businesses have different costs and different types of costs, this statement of financial performance is applicable to this fictitious example only. For example, a retail franchise operating within a mall will have rent as a major expense as well as many other costs associated with operating a business within a mall that are not applicable to the example illustrated.

Regardless of whether projections are supplied by the franchisor, you should work through a similar model to that illustrated in figure 4. At least three scenarios should be prepared, including a pessimistic projection, a realistic projection and an optimistic projection. You cannot predict the future, but this format should allow you to better assess each franchise opportunity you evaluate.

It is very important that you don't just rely on the projections provided to you by the franchisor without doing your own assessment of the projections - preferably with the assistance of a qualified financial advisor. You are advised to work through every number in each projection and work out exactly what you believe you will spend on each expense. However, it is worth bearing in mind that an experienced franchisor should have a good knowledge of the real costs of running the business and should advise you accordingly.

Equally, you should think very carefully about the potential sales you believe you can achieve. Use the figures provided by the franchisor as a guide, but be aware that nobody can be sure how any business will fare in a new market.

For this reason, you should ask the franchisor some or all of the following questions (this is a general list, and you will also want to ask more questions relating to the specific franchise under consideration):

Questions To Ask The Franchisor:

  • Are the projections based on actual performances of other franchisees, or are they merely projections that you have calculated?
  • If they are based on actual performances of a franchisee, where was the franchisee located? Why do you believe that this experience is relevant to my planned location? If the franchisee was located in Auckland and you are based in Invercargill, then you should discount the sales figure shown for the volume of customers that can be achieved in Auckland in comparison to a smaller city.
  • If the projections are not based on actual performances of existing franchisees, how were they determined?
  • How long has the business been operating?
  • How realistic, given my location, is it for me to achieve the sales that you have predicted in the projections?
  • How successful are existing franchisees?
  • Can I discuss these projections with an existing franchisee?
  • Financially, why would I want to buy this franchise compared to other franchises available?
  • Why should I not just set up a similar business by myself?
  • Is the business seasonal? If so, which are the quiet times?
  • What ongoing fees will I be paying? Are these based on my turnover? If not, what are they based on?
  • What amount of working capital do I require? Is this working capital to be maintained throughout the life of the business or only in the start up? Is working capital included in the franchise price, or is it additional?
  • Do you plan to open any further outlets in my city/town/suburb? If so, how will this affect my profit?
  • Am I obliged to sell the franchise back to you, or can I sell the business to a third party?
  • Do I have to pay for uniforms, training and manuals separately, or are they included in the up front franchise fee that I will pay?

These are just some of the questions you should ask in relation to the financial aspects of the franchise. You will also need to ask many other questions in respect of training, operations, support of the franchise the franchise agreement and so on. To help you, Franchise New Zealand has a list of Questions You Should Ask - see the end of this article for details. The franchisor should be happy to answer all your questions, because it is in their best interests for you to make a well-informed decision that sets you up to succeed. If you succeed, so do they.

Decision Time

Although the review process shown above is by no means exhaustive or complete, Roger, our prospective franchisee, has now asked some of the questions that will help him to make the correct decision for his own personal circumstances.

The financial projections illustrated in figure 4 show three different scenarios of potential financial performance for the first year of Roger's new business. Please note that included in the projection is the remuneration (salary or wage) that Roger calculated earlier he would need to live comfortably and meet his increased mortgage payments.

The first scenario illustrates the profit he believes he will achieve if he has a very difficult first year. This shows that Roger would incur a loss of $20,000 after taking out his salary of $61,500.

The second scenario shows that he would make $Nil after tax profit. This is a return on investment of 0%, which is significantly below the return of 15% Roger is aiming to achieve.

The final scenario illustrates the profit he believes can be achieved if everything falls into place and he has some luck. This shows an after tax profit of $15,000 and a return on investment of 15% - equal to the return he is aiming to achieve.

If the figures shown in the example related to an established franchisee business, they would suggest that Roger should probably not invest in this franchise from a financial perspective unless he honestly believes that he can achieve the optimistic scenario. Other considerations (such as being made redundant but having the money to invest in buying a job, or the tax advantages of having a home office) could affect the decision process, but in our scenario Roger currently has a good job and is earning $55,000 per year. He should certainly question the wisdom of investing in this opportunity, given the level of borrowings he would need, because of the 0% return on investment expected under the 'realistic' scenario and the increased risk.

However, if these are only first year figures it would not be unreasonable to expect an increase in turnover in the second and subsequent years as the business becomes more established in its market. Consequently, the 'optimistic' scenario would become more 'realistic'. The franchisor should be able to demonstrate what level of growth has been achieved by existing franchisees or pilot operations, and Roger would be well advised to calculate figures for the second and perhaps the third years before making his decision.

One other element that Roger might also consider in making his decision is the potential profit he might make when he eventually comes to sell the business. The selling price will depend primarily upon the level of profit which the business is achieving at that time.

In Summary

To conclude, caveat emptor (Latin for 'buyer beware') applies to those buying a franchise as much as any other business. You must first consider your own financial position before thinking about buying a franchise. You must then establish the income that you require from the business, and add on a return on your investment. Finally, you must carefully consider the projections for the potential opportunity.

Make sure you prepare your own projections and don't just rely on the projections given to you by a franchisor. We would also strongly recommend that a business plan supporting the projections be prepared in conjunction with the franchisor before a final decision is made. Ensure that you can get adequate return on your investment over and above the salary or wages you earn from the business.

Lastly, seek the advice of a chartered accountant with experience in franchising. Expert advice will help you evaluate the opportunity, review the projections and provide you with a independent opinion. Although every successful franchisee will tell you that they are passionate about their business, it is not a good idea to get emotional when assessing a franchise. Wait until you are confident you are making the right decision before you put your time and effort, heart and soul into making your franchise the success you so richly deserve.

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