Investment vs. Return
By Steve Hockett
Question: 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?
Answer: This is a great topic because the real answer is so
counter-intuitive 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 15% per year on invested capital are normally
considered to be 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.
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%
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 30-50% 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, for what are you working? 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.