When you’re contemplating franchise ownership, evaluating ROI (Return on Investment) figures is an important part of the process. You’re probably wondering what to expect from a franchising ROI. Is it different than that of an independent businesses? The answer is a little complicated. Many factors come into play.
ROI demystified
Usually computing an ROI is straightforward and intuitive. When you invest in the stock market, you know the amount of money you paid for the stock. Your return is usually a combination of dividends you receive while holding the stock, plus any appreciation of the stock at the time you sell it.
Example: If you invest $100 in a stock that pays a $5 dividend, and sell the stock one year later for $105, your profit will be $10. This equals a 10% return on your investment. If you buy a bond for $100 and it pays you $6 in annual interest, your annual ROI will be 6%.
These examples are passive investments, where you invest money but not any significant amount of your time. In a passive investment, the ROI you hope to see rises with the amount of money you invest and the risk of the investment vehicle. Most people would agree that over time, a strong annual rate of return on a passive investment would be 5-12%. An ROI of more than 12% for a passive investment is usually considered excellent.
How is a Franchising ROI different?
Buying a franchise business is rarely a passive investment. Nearly all franchises require their owners to invest time and talent in the business in addition to their funds. Thus, a franchising ROI is more difficult to calculate because that portion of the initial investment (time/effort) can’t be quantified. And because franchise owners are investing time and effort plus money, they should expect a higher ROI than they would for a passive investment vehicle. Otherwise, why bother investing your time?
Most new businesses go through a startup phase. During this period, they lose money for a while before breaking even and ultimately becoming profitable. This initial growth curve is usually fairly steep. For most businesses, it takes 2-3 years for the business to mature. For this reason, when we look at a franchising ROI, we analyze income figures beginning with the third year of operation. This helps us more accurately measure the average annual return the business is likely to produce.
Calculating and evaluating a Franchising ROI
Begin by looking at the return on invested capital. Because starting a business of any kind is considered relatively risky, you should be able to earn a very good return on your invested capital. Look for an ROI on your capital investment that falls in the neighborhood of 15%. In other words, for every $100,000 of capital you invest, look to make at least $15,000 per year in returns.
Calculating a reasonable return on your investment of time is more difficult, because many variables are involved. Start by assigning a value to your time. How much are you accustomed to earning in exchange for your work hours? For example, if you can fairly easily trade your time for $60,000 per year in wages/income, that’s reasonable way to value your full-time time/effort investment. Look for a business that can provide you with some increase in the return on this investment of your time.
Considering lifestyle benefits when calculating a Franchising ROI
Before you wrap up your analysis, factor in lifestyle attributes the business will provide you. For example, will the business provide you with more flexibility in your schedule and/or enable you to avoid out-of-town travel? These “soft” lifestyle benefits may mean that you’ll now be able to attend your children’s birthday parties or coach the soccer team. And let’s say that the $60,000 job you currently have involves doing daily tasks that you detest or that you’ve got a boss who makes your time at work extremely unpleasant. Getting away from that job and into a better situation may have a great deal of value to you. These soft factors may be valuable considerations for you, but they are hard to quantify and assign a fixed dollar value.
Example: Let’s evaluate a franchise that will require a total investment of $200,000 and produce an average income (before any owner compensation) of $150,000 in the third year. To evaluate the ROI, we subtract $60,000 (representing the fair market compensation for your time) from $150,000. This leaves us with $90,000 as a return on the investment of both your money and your time. A reasonable ROI on your invested capital would be 15% ($30,000 per year). So, in this example, your invested time earns you an additional $60,000. And this $60,000 means you’re getting an 100% ROI on the investment of your time. Even if there are no soft benefits, this sounds like a strong ROI!
What if in this same example, the third-year typical gross income was only $90,000? In that case, you would clear the same return on the capital you invested, but the ROI on your time investment would be zero. Then, the obvious question would be: why take the risk? Unless there are compelling soft benefits, it would be better to keep looking for a different business with higher returns while you remain in your current job.
Looking ahead
As a final note, look for opportunities that grow to mature, profitable levels in a shorter time frame than the standard three years. There are a few companies that reach this level within a few months! It may take extra effort to find them, but your time will be well spent!