Don't believe the franchisor who promises you a 12-month payback

Don't believe the franchisor who promises you a 12-month payback

By SirGerardThe1st | Franchise matters | 12 Aug 2020


Sometimes there is news that makes me angry. Because I consider myself a franchising fundamentalist and it makes me very bad that some of the players, who call themselves "professionals", sell lies.

When I read in a "technical sheet" that a franchise paybacks in 12 months, I wonder if the one who says that knows how to calculate the return on an investment or if he is simply deceiving the one who reads it, with the only purpose of selling him/her a franchise, and thus getting out the photo with the new franchisees.

I want to explain my rationale, and unfortunately I'm going to have to get technical for a few minutes and use a much more mathematical language than what a true franchise project needs.

First I am going to define the initial investment. It is the sum of several items, among which are the initial fee, real estate expenses for accessing the premises, building work, decoration, equipment, launch event, working capital to face the first months of operation, and purchase of initial merchandise calculated by the franchisor.

The Excel model that defines the franchise operation will have at the end an income statement during the 5 years that a contract usually lasts. The formula is simple:

 

revenues - expenses - annual investment = profit before tax - income tax = profit after tax

(That is when you do not have to subtract loan interest and other taxes that correspond to the activity)

 

What is the annual investment? Something that many franchisors "forget" to talk to their potential franchisees. Every business has to invest every month to maintain its competitive position. If not, the spaces you leave will be quickly filled by your competitors. Therefore, the franchisee is also going to have to invest in his/her business, and this, regardless of whether the franchisor is charging him/her a percentage of his turnover as an advertising contribution. Even so, you will have to invest, mainly in marketing.

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Then comes one of the key elements to calculate the return on an investment of this type, which is what is called "maximum financial exposure". It can be considered a very good franchise operation, if at the end of the first year the equilibrium point was reached and the business is already in a steady state, and there is no need to keep pouring money down. But according to statistics, that happens in 50% of the cases. In the event that the break-even point has not been reached, then there will be a negative result at the end of the first year of operation, which is money that must be poured in, because otherwise the business cannot continue operating. And so on in the second year and ... hopefully the second is the last. Then we must add to the initial investment, the negative cash flows that we have when we calculate the projected income statement, and, in this way, we obtain the maximum financial exposure.

So it turns out that, in cases where the maximum financial exposure is greater than the initial investment, the maximum financial exposure will be the figure to be "recovered".

What does it mean to recover? Simply get back the money you put in, be it the initial investment or the maximum financial exposure.

And how do you know how much money did the business get? Adding the free cash flows, that is, the earnings after taxes for each year. But be careful, here you have to incorporate a new technicality that has to do with the "time value" of money.

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A million dollars today is not the same as a million dollars in a year or two years from now. These cash flows must be discounted with a rate that will be set according to some criteria, which will have to do with the mood of the markets when making the Excel model. That is, the profit after tax in year 2 will have to be discounted with that rate squared, and the profit after tax in year 3 will have to be discounted with that rate cubed. And so on until the 5th year.

Adding these discounted free cash flows, the famous recovery is obtained when that sum equals the maximum financial exposure.

As is well known, there is no Excel that does not show extraordinary results for the franchisee. But let's take a simple example for a typical food business and we will see that recovery in the first year (the promised 12 months) is far from practical reality.

Suppose the initial investment equals the maximum financial exposure and is $1.5 million. If the profit after taxes is an average 10%, then the turnover of that business in the first year should be $15 million, in order to obtain a profit of $1.5 million, and so recover what was invested in those first 12 months. This then implies an average monthly billing of $1.25 million. If you work 30 days per month, that means a daily turnover of approximately $42,000. If you work 10 hours per day, that implies an average billing of $4,200 per hour. If we have an average ticket of $30, then we have to do an average 140 tickets per hour, that is, an average 2.3 tickets per minute.

A good figure, right?

Especially if one takes into account that during the first year it will be necessary to go through the winding paths of the learning curve, which greatly lowers revenues for a period of no less than six months.

I am not saying in any way that these are unattainable figures. What I say is that they are not achievable in the first 12 months of operation, with which, it is not true that the investment will be recovered in 12 months. Not to mention if the brand is not well known. And if to arrive at these figures it is necessary to make investments that were not contemplated (more personnel, more equipment, more communication), then we are modifying the structure of the model and in the same way, the investment recovery is going to extend over time.

So, beyond the numbers, I repeat once again that what is needed is, on the part of the franchisor, a very important investment for a long time, destined to the construction of a robust and attractive brand, and on the part of the franchisee , a push of maximum energy to be excellent and less concerned for the payback periods set in the technical sheets, which are always calculated with false or at least erroneous premises, with the aim of attracting investors who think more about the financial speculation than in being excellent in their territories with top-of-the-line brands.

Franchisor and franchisee must invest in each other for a long time.

What we need, those of us who love the franchise industry, is more investment by franchisors before going out to sell franchises of unknown brands, more energy to be excellent at serving customers in the territory by the franchisee, and less quackery by unscrupulous operators who litter the industry with their mistakes or false sales pitches.

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Thank you for reading!

You can check out my other posts here: https://www.publish0x.com/franchise-matters

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If you have any questions or comments, please feel free to leave them down below.

You can also contact me at gerardo.saporosi@gmail.com.

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SirGerardThe1st
SirGerardThe1st

Franchise veteran, Dapps developer, DeFi evangelizer, Bitcoin and Ether since a long time


Franchise matters
Franchise matters

Reflections of a franchise industry's "Old Wolf", after 30 years in the international franchise business. All opinions are mine, and cover aspects that serve both franchisors and franchisees. Love for brands and entrepreneurs around the world.

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