Making the money work

Will your chosen franchise give you the right return on your investment? Tim Kilham, Partner at McLean Delmo  explains how the sums matter.

Almost any person who is thinking of buying a franchise considers what the franchise is going to cost, considers what the franchise is going to earn, and on this basis, amongst others, decides whether or not to buy the franchise. What a potential franchisee is doing in this calculation is working out return on investment (ROI), even though these may not be the words that come to mind when doing the sums.

So let's have a look at return on investment and what it means and how it should be calculated.

In its simplest form, return on investment is calculated by looking at the profit of a business in relation to the amount invested in a business. So if the profit is $120,000 and the investment is $300,000, this is a return on investment of 40 per cent (see box one). But how exactly should the investment amount be calculated. And what does profit include and not include?

How should the amount of the investment be calculated?

It is the total amount that you have to invest in order to run a business. It is not just the initial purchase price of a business. So if you buy a franchise for $300,000 but you also need working capital (for debtors and stock) of $50,000, your total investment for the purpose of the ROI calculation is $350,000.

If the rental bond you have to give to the landlord is $15,000, then that takes the investment up to $365,000. If other costs (legal and accounting advice on the purchase, costs of forming a company or trust) come to $5,000 then this increases the total investment to $370,000.

The investment for the purpose of the ROI calculation is therefore the total amount that you need to invest to acquire the business.

What about the profit? How is that calculated?

If you are going to work in the franchise - rather than put it under management - then the profit (return) must be calculated after allowing a fair salary for you working in the franchise. You need to be paid a fair salary for the work that you are doing in the franchise and you also need to get a return on your investment. You are investing your time, talent and your money in the franchise. If you chose a passive investment, you could invest $370,000 and still work and earn a salary. Alternatively, you can invest the $370,000 in the franchise and run the franchise. Therefore you need the franchise to provide you with a salary and to provide you with a fair return on the investment.

Profit should be calculated after allowing a fair salary for the job you are performing in the franchise. Note that what you should expect is a fair salary for the position you are performing in the franchise. If you are currently in a highly paid occupation, you can't expect to buy a franchise and for the franchise necessarily to provide a salary equal to what you could earn when you were employed, as well as provide a return on investment.

So, if you are acting as a manager of your franchise business and you would pay a salary of $45,000 on an arm's length basis for a person to do that job, then you should take an amount of $45,000 off the profit when calculating return on investment. Your adjusted profit - your return - is therefore now not $120,000 but $75,000 after allowing for a fair salary.

Another point to note is that any interest you are to pay on borrowings should be excluded in calculating the overall return on investment. You need to work out what your return on investment is going to be before interest, and then work out whether the return is fair and will cover your costs of borrowings and the risk you are taking. You can affect your return by gearing your investment, and this is covered later in this article.

So now the profit of the business (after allowing for a fair salary for you) is $75,000 and the total investment is $370,000. This is a return on investment of about 20 per cent (see box two).

What kind of return on investment should you expect?

This is a difficult question and three different advisors would probably give you three different answers. The most important factor affecting the return that you should expect is your perception of the risk of the investment. The higher the risk, the higher the return you should expect.

This is why the amount of interest you will earn on a fixed deposit from one of the four major banks is usually less than the rate of interest you would earn on a fixed deposit with one of the smaller financial institutions. This is why, all other things being equal, the return you would expect on an investment in a substantial and well-established franchise would be somewhat lower than the return you would expect from anew and less well-established franchise. There is always considerable risk involved in buying and running a business -somewhat less risk, hopefully, for a franchise business than for a non-franchise business, but a risk nonetheless. So what return on investment should you be looking for when you are buying a franchise business? In my personal opinion, you should be seeking a return on investment of between 20 and 40 percent, depending on the level of risk involved. In practice though, what I more commonly see with franchise businesses is a ROI range of between 15 and 30 per cent. In other words - and I stress this is a personal view - I think many people pay too much for businesses (or, expressed in another way, they don't demand a large enough return on investment).

You will sometimes see return on investment expressed as an earnings multiple. The earnings multiple is the inverse of the return on investment.

In other words, a return on investment of 25 per cent is equivalent to a four times earning multiple (100/25). A 33.5 per cent return on investment is equivalent to a three times multiple (100/33.5).

What other factors affect the return on investment calculation?

All franchises have a finite franchise period. You acquire the rights to become a franchisee for a certain term and often there are further terms set out in the franchise agreement. The franchise term may be three years with a three year option, or five years with two five year options or perhaps a much longer period.

Whatever the terms, the rights that a franchisee has at the completion of the initial term and of further terms will be specified in the franchise agreement, but in the most extreme case (which does not happen often) the franchisee has no further rights to operate the franchise, must cease trading and, indeed is restrained from operating a similar business for a defined period of time and within a defined area.

The return on investment analysis set out in this article assumes that the franchise has an indefinite period - in other words that the agreement will be renewed at the end of the franchise period. If this is not the case then you need to factor in a return that includes a capital return of the original investment.

For example, if you invest $370,000 on a 10 year fixed deposit, then you expect to get a return on the fixed deposit each year as well as the $370,000 principal back at the end of 10 years. If you are buying a franchise with a 10 year term, and you do not expect the franchise to be renewed, then there will be no return of the $370,000 at the end of 10 years.

If that is the case, then there needs to be an additional return of $37,000 per year for 10 years, on top of the profit that the franchise makes, to ensure a reasonable rate of return and to ensure your principal is returned to you.

In our example, if $75,000 is a fair return and you do not expect the franchise agreement to be renewed at the end of the term then you need a total annual return of £112,000 ($75,000 + $37,000).

You can also use leverage, or gearing, to dramatically affect your rate of return. In the example above the business made a return of £75,000 on an investment of $370,000. Assume that a bank will end $185,000 to the franchisee to buy the business. Assume the interest rate on the loan is 10 per cent. Now the investment of the franchisee's own capital is halved from $370,000 to $185,000. Interest on the bank loan will come to $18,500, so the return after interest will be $56,500. The franchisee now obtains a return of £56,500 on an investment of $185,000.

By using leverage, the return is now approximately 31 per cent this compares to a return on investment of 20 per cent without using leverage. Leverage helps to magnify returns while the profit being earned on the investment is greater than the interest paid on the borrowed funds. But beware - leverage works against you when the cost of the borrowing is greater than the return on the investment.

Return on investment calculations usually work best with the higher end franchises (those costing $300,000 or more). For franchises at the low end of the price scale, where people are often buying a job (and there is nothing wrong with this!), the calculation does often not make sense.

Take for example the case of a potential franchisee who has $150,000 to invest and who, for whatever reason, is unable to get a job. Assume that person can buy a franchise that will provide a return of $40,000, including a wage. If a fair wage for a franchisee working in a business is $50,000, conventional return on investment theory says that the franchisee should not buy the business, because there is a negative return after allowing for a fair wage. Why buy a business if there is no return on investment?

But as stated, if that franchisee cannot otherwise get a job it would make sense for the franchisee to buy the franchise and earn $40,000 rather than invest the $150,000 and get a return of perhaps $10,000 or $15,000 in interest or dividends. It is possible to live on $40,000, but not on $10,000 or $15,000.

In summary, if you are evaluating the purchase of a franchise, you should analyse it from a return on investment perspective. There should be a correlation between risk and return. You need to properly calculate your return on investment and assess whether it is reasonable. Failure to properly analyse your return on investment is likely to lead to a poor investment decision.

This article appears courtesy of Franchising Magazine