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So you’ve decided to buy a franchise. You’ve done your research, and have narrowed it down to a short list of companies that excite you personally, are profitable, and have management teams you are willing to bank on.
Still, you haven’t answered the most important question: What can I earn?
Obviously, the main reason most people buy franchises is to earn money, but no good franchisor would ever answer that question directly. They would have far too much liability if they did. A franchisor should instead provide you with some guidance to help you make that estimate for yourself. The key to making that calculation starts with something called the “financial performance representation,” or FPR.
Where would you find the FPR? In many Franchise Disclosure Documents (FDDs), which a franchise will provide when you’re considering becoming a franchisee, you will find the FPR in Item 19. Almost always, the FPR focuses on historical results that have been achieved by the franchisor, its affiliates, its franchisees, or some combination of the three. The FPR may come in the form of an income statement, but more often, it will focus on some of the key variables that will dictate income (and will enable you to develop a pro forma income statement based on those variables). The format and utility of these FPRs vary from franchisor to franchisor.
Be aware that franchisors are not required to provide their franchisees with an FPR. In the early days of franchising, the use of an FPR (then called an earnings claim) was more the exception than the rule. In fact, in the late 1980s and early 1990s, less than 20% of franchisors provided one. Many were reluctant to share this data out of fear that it would result in litigation and were often warned against it by their lawyers. But over the past few decades, there has been a strong reversal of opinion on FPRs; by most estimates, the majority of franchisors provide at least some information in Item 19. In a 2018 study that looked at 1,497 FDDs, Rob Bond, president of the World Franchising Network, found that 61% included some kind of FPR.
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Why no FPR?
If a franchisor does not have an FPR, its absence will make it difficult for you to estimate your revenues and profits. And while the uncertainty of your projections will increase your risk, that does not necessarily mean you should immediately eliminate the franchise opportunity from consideration.
The (good and bad) reasons franchisors might not provide an FPR:
1. The franchisor may believe the units it could use for an FPR are, for some reason, not typical of what a franchisee might expect to make. In fact, it may believe its own performance will be stronger than the performance of the franchisee and may have avoided the FPR in order to be more conservative. For example, perhaps a given franchisor has a unique location or has been in business for decades serving one community where the brand has become iconic. Perhaps the franchisor is franchising only part of its current operation, based on the belief that the franchisee needs to start with a less complicated business (perhaps evolving later to a fuller line of products or services).
2. The franchisor may believe it will incur greater legal exposure by making an FPR (although this is probably not true, assuming the franchisor uses historical financial information as the basis for the FPR). Still, their attorneys may want the brand to approach the issue of financial disclosure with absolute, extreme caution.
3. The franchisor may not want to disclose unit-level financial information out of fear that its competitors could use that information to their advantage.
4. The franchisor (especially newer franchisors that have conducted most transactions at the unit level in cash) may historically have been understating its sales to the IRS to reduce its taxes, and now it cannot substantiate its actual levels of sales based on its own historical numbers.
5. A new franchisor may not have an adequate operating history on which to base an FPR. For example, its locations may have been open less than a full year.
6. The franchisor may have recently opened a new prototype that will be the basis for the franchise program, but it does not want to provide that information for fear of liability.
7. The franchisor may fear that its historical financial performance does not compare favorably with its competitors.
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Obviously, those last few reasons should be of some concern to you as a prospective franchisee, and you should add those questions to your list for further discussion with the franchisor if it does not provide an FPR.
But regardless of whether the franchisor supplies an FPR, your next job must be to develop an estimate of what you can expect to earn as a franchisee. This is your most important task before purchasing any franchise.
Use, but never rely exclusively on, an FPR.
When doing your research, nothing should make you happier than finding that a franchisor has provided an FPR. Generally, that means the company thinks it has something to brag about from a financial perspective. Moreover, it is making your job easier by telling you up front what kind of financial results some of the units in their system are achieving.
If a franchisor supplies an FPR, you should definitely use it as a starting point. Most FPRs will provide you with great information, and you (and your accountant) should read them very carefully to be sure you understand how to use them in your business planning.
However, as you go through this process, it’s worth keeping this old saying top of mind: “There are three kinds of lies: lies, damned lies, and statistics.” For example, there was one well-known franchisor that for years provided an FPR based exclusively on the performance of a handful of corporate locations. Those locations had far greater revenues and profits than the vast majority of franchisees in the system. But unless you read the footnotes closely, you might never know they were not a representative sample. While this kind of statistical juggling is no longer allowed under the new FPR rules, there are other methods (grouping by age, type of location, etc.) that could be used to give you unrealistic expectations (intentional or not).
Your first job, then, is to read the FPR thoroughly. Generally, it will have a load of disclaimers and footnotes. These are often as important as the financials themselves, so pay close attention. If, for example, the financials are based only on locations open longer than three years, you may want to ask yourself what the first two years looked like. If labor costs are reported, check whether those calculations include management as well as staff. Do some digging. And if you are not good with numbers, now is the time to get your accountant involved. (Either way, you will want them to look at your projections. More on that later.)
Also remember that no government agency has done any real due diligence on the document you are reading. It is up to you to be sure you are getting reliable information.
As you are reviewing the information in the FPR, note the format the franchisor uses to present the information. Franchisors in the same industry may present very similar information in slightly different formats — so carefully note those differences. As you may have noticed, there are hundreds of different ways in which earnings information can be presented.
Some franchisors include historical income statements — perhaps modified to incorporate line items for advertising fees, royalties, and other fees you may incur as a franchisee. These may be the best types of FPRs, as they allow you to compare the numbers you think you can earn with those that were historically achieved by the franchisor — but don’t rely on them too heavily in your planning, as your market conditions may be different.
Other franchisors are somewhat less forthcoming with their numbers. Some may choose to only disclose sales numbers. Some may limit it to average selling prices, average sales per square foot, average sales per salesperson, or any of a variety of other indicators. Fitness clubs may be broken out by number of members. Automotive franchises may focus on the number of vehicles serviced per day.
Restaurants may show food and labor costs but not occupancy (as this is often best determined on a market-by-market basis). Hotels often include occupancy rates in their FPRs to enable you to project revenue based on the size of your facility.
If a franchisor does use a historical FPR, you can ask to see “written substantiation for the financial performance representation” and the franchisor must provide it. So if you are not clear how the numbers were derived, ask.
Related: 3 Reasons Buying a Franchise Might Be Better Than Starting Your Own Business
Don’t do anything until you’ve crunched the numbers.
Regardless of whether the franchisor supplies an FPR, you must develop a pro forma statement of cash flows (which basically predicts how much revenue will come in and the expenses incurred during a given period, so you can understand your cash requirements and your profitability over time) for the franchise opportunity you are considering. In doing this, you should exclude some items you would normally find on an income statement, like depreciation, amortization, interest, and taxes, leaving you with a bottom line typically referred to as EBITDA (earnings before interest, taxes, depreciation, and amortization).
Let’s break down the elements of EBITDA and why they are excluded. Depreciation and amortization are non-cash entries that (other than reducing your taxes) will not impact your cash flow. We omit taxes from our analysis because most of your alternative investments are subject to tax in any event — so this allows us to better compare apples to apples. And we do not want to look at interest or debt service, as those numbers are a result of your deciding how to finance your business, not a function of which franchise you purchase.
This being said, your accountant may point out ways in which you can use a business to shelter otherwise taxable income. (Business necessities like the corporate Mercedes might fall into this category.) Finding these legal loopholes is worth the cost of hiring an accountant in the long run. Unless you have a background in finance and accounting, you should get your accountant involved early. And even if you do, you will want to have an accountant review your work before you finalize your decision.
As a first step, you should derive cash flow estimates for a “mature” franchise — one that is at least two to three years old. This will allow you to measure the long-term returns offered by the franchise, as many businesses (especially in the service sector) are not very profitable (if at all) in their first year or two of operations. Of course, you will have to estimate first-year cash flows separately when calculating your required investment to be sure you have adequate working capital.
Once you have these numbers, you will have a good idea of what you can expect to earn from your franchise. So let’s start crunching numbers. (Really. It’s not that bad.)
Deriving numbers when there is no FPR.
If a franchisor does not provide you with an FPR, you will need to get creative to accurately estimate the revenue your business can earn. But first, a word of caution: In virtually every business plan I have ever read, there is a tendency to overestimate sales and underestimate expenses. This can be disastrous! When franchise prospects make projections, they often gravitate toward the numbers achieved by the top performers in the system on the assumption that they are smarter, will work harder, and will work longer than the average franchisee. And while that might be true, I can assure you no one ever bought a franchise believing they would be on the lower half of the performance curve. Yet, by definition, half of all franchisees are.
Estimate low on revenues and high on expenses, and any surprises you receive will be happy ones. Expenses you should build estimates for include cost of goods sold, labor, rent, benefits and taxes, utilities, “plug” numbers (royalties, advertising assessments, or other ongoing fees charged by the franchisor), debt service, and other operating costs.
Now let’s talk about how to build those estimates. There are several different methods you can employ, and you should try all of them. Each method will result in a different figure. When making your final estimate, you should lean toward the methods that gave you the lower numbers, for the sake of being conservative.
Let’s look at some of these methods.
Ask someone who owns one.
This is perhaps the most important step in the entire process of making your decision. If the franchisor has existing franchisees, you should speak to as many of them as you reasonably can.
Every FDD must provide a list of current franchisees in the system, along with their names, addresses, and phone numbers. You’ll find this information in Item 20 of the FDD. It must also disclose contact information for franchisees who have been “terminated, canceled, not renewed, or otherwise voluntarily or involuntarily ceased to do business under the franchise agreement during the most recently completed fiscal year.” Call them!
Be sure you contact a large enough sample to give you a good cross-section of results. For example, speak to newer franchisees as well as those who are better established. Talk to franchisees who are located fairly close or in your target geographic market. Talk to happy franchisees (current ones, presumably) and unhappy franchisees (those involved in litigation or who have been terminated, for example). Speak to franchisees who are operating in a similar type of location (strip mall, street front, etc.). And as much as you can, target franchisees with a similar background (for example, if you have no industry-specific experience). The franchisor may be willing to provide you with enough background information to identify some of these people. From a statistical point of view, you will get the most reliable information if you keep your sample random and your sample size is larger — but do work in these subsets.
If you are speaking to a franchisee who failed, you will certainly want to know why, and they are equally certain to give a bad reference when asked about the franchise. You will have to decide whether their opinions have merit and whether you can envision yourself on their side of the fence someday. You will definitely need to take some of what they say with a grain of salt. I have never found a failed franchisee who attributed that failure to his lack of intelligence or hard work, although clearly some do fail through their own fault alone.
Of course, no business can ever guarantee success, even if a franchisee is a good fit. But a large number of failed franchisees may have implications for the franchisor’s support system, business model, or selection process. If that last one is systemic, it points to problems with quality control (too many dummies spoil the broth!) and future failures within the franchise system — maybe even your own. So be careful if every franchisee you speak with sounds as if they took one too many punches to the head.
When you do talk to these franchisees, ask specific questions. Ask them about their revenues — not just today, but when they started up. Ask them how long it took them to break even. Ask them about every cost element on the income statement. And, of course, ask them specific questions about the support provided by the franchisor. In particular, how helpful was the franchisor in the early stages of their business?
Stay away from generalities. Ask an easy question, get a meaningless answer. Try to avoid yes-or-no questions.
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Here are some sample questions to start out:
→ How long have you been a franchisee in this system?
→ What was your background before you joined as a franchisee? What factors led you to decide to become a franchisee of the brand?
→ Can you tell me about the support the franchisor provided prior to your opening? Site location, design assistance, construction assistance, and training? What did they do well, and where did they fall short?
→ Do you feel the franchisor’s consumer marketing efforts are productive? Why or why not?
→ How long did it take for you to become cash-flow positive in your business? Looking back, would you say the franchise was a good business investment for you? (If no, ask them why not.)
→ How many years did it take you to fully recover the investment you made in opening your franchise?
And that’s just the start. These questions are intentionally arranged to begin with broad, seemingly harmless generalities before moving to more specific questions at the end. This allows you to build trust with the franchisees before you start asking for details. And even if you do not get these latter questions answered, hopefully you will still have gotten some valuable information.
Remember, franchisees in general want you to join the system. When you enter the system, they gain advertising power and purchasing strength, as well as broader exposure of their brand name. But not all franchisees will be motivated to get you to join. For example, if you are speaking to a franchisee who wants to expand into the territory you’re interested in, they may not want to be helpful at all.
Moreover, franchisees want to reinforce the decision they themselves made. Once people decide to do something, they want to find reasons to support that decision. In psychology, it’s called rationalization. If we spend tens or perhaps hundreds of thousands of dollars, we don’t want to feel like we made a mistake. We may overlook minor flaws in our purchase and rationalize them with overstatements of its good qualities. So too with franchisees. Be careful of their responses. In general, however, you’ll find most franchisees are willing to share their honest experiences with you. And as you speak with more and more franchisees, you’ll begin to see commonalities in their responses, which is another reason to speak with as many franchisees (and former franchisees) as possible.
Their combined input will be the most valuable source of data in your due diligence process. Be sure to supplement your questions with others based on information in the FDD, what you have learned through your own research, and anything else that might be relevant to the franchise opportunity you are considering.
What about new franchisors who have not yet sold a franchise? If you are considering becoming a franchisor’s first franchisee, you need to satisfy yourself that the concept or the people behind it are ready for prime time — preferably both. And you need to exercise particular diligence when trying to estimate potential returns. If there are no franchisees you can call, you need to factor that into your risk calculation — and be certain the returns offered more than make up for that degree of risk. That’s not to say that being among the first franchisees in a system is a bad thing. Many franchisees have benefited from joining an emerging franchise system early in its development. It just requires an additional level of due diligence and a willingness to assume a higher level of risk in exchange for a greater anticipated return.
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Using the franchisor’s income statement
A second method of estimating revenues involves the use of the franchisor’s income statement, found in the FDD. While the franchisor will not disclose unit revenues in these statements, there are ways to make a guesstimate.
If the franchisor runs company-owned operations through the franchise company, there may be a revenue line in the statement reflecting revenue from corporate operations. If you can find it, simply divide that number by the number of units owned by the company to get average revenue per unit. This number will, of course, be influenced by any units that opened or closed during the period, but it will at least give you a rough estimate. Unfortunately for this method, most franchisors create a separate entity (or more than one) for corporate locations. This data is often not shown in the franchisor’s income statement.
If there are no company operations, some income statements have a separate line item detailing franchise royalties. Dividing that number by the number of franchises will yield the average royalty paid per franchise. Divide the average royalty by the royalty rate, and you have an estimate of average revenue per franchise. (For example, if the average royalties paid per store were $40,000 and the franchisor charged a 4% royalty, you would divide $40,000 by 0.04 to find an estimated average unit volume of $1 million.) There are a couple of dangers in these methods. Watch out for the following:
1. If company-owned units or franchises opened during the course of the year, both of these methods could understate anticipated revenues (since some units achieved less than a full year’s performance). If you can determine how many opened during the year, you can cut that number in half and add it to the number of units open for a full year to give you a rough estimate. Note: Generally speaking, the more “young” units a system contains, the more revenues will be understated, as these units will typically be at the early stages of their revenue growth curve.
2. Conversely, if franchisees ceased operation during the course of the year, chances are the number of franchisees would be accurately reflected in the disclosure document while the revenues might be inflated thanks to some income from these now-defunct franchisees. In this case, your estimate of your revenues could be overstated, since it would assume each existing franchise brought in more money than it actually did.
3. Read the notes to the financial statements extremely carefully. Some accountants may lump franchise fees, royalties, and other fees together under “franchise fees.” This will invalidate your analysis. Caution: Using numbers derived this way will overstate your anticipated revenues! Use these numbers only if you can back out all nonroyalty revenue.
4. Another thing you have to watch for, especially with franchisors who have been around for a while, is changes to the royalty structure. If the franchisor has increased its royalties, some older franchisees may still be paying the lower rate. Using the current royalty for all franchisees would understate your anticipated revenues.
5. If franchisees are not paying royalties (you can usually determine this by looking through the litigation section, if it has gone that far), revenues might be understated. Of course, you may have a larger problem to worry about.
6. Finally, be careful you are not dealing with one of the franchisors whose royalties are based on gross margins. If you are, as is sometimes found in the temporary help industry, you can use the same formula to determine gross margin. But if the franchisor charges a flat fee, you won’t be able to get any useful information, and if it derives its revenue from product sales, this method will not work. (You also need to watch out for franchisors charging a royalty or a flat fee, whichever is higher. When flat fees are paid in lieu of percentage royalties, estimated revenues will be overstated.)
Related: 6 Risk Factors You Need to Consider Before Purchasing a Franchise
Comparing Item 19 data from competitive franchise systems
If the franchise concept you’re considering has an Item 19 disclosure, you can obtain FDDs for their primary competitors and see if they disclose the same type of information. For example, most restaurant franchisors typically disclose revenues, cost of goods, and labor. If you’re considering a concept where the cost of goods is 32% and their direct competitors are all at 26% or less, that should raise a red flag. You should at least ask the franchisor why their cost of goods is so much higher than everyone else in the category. While there may be reasonable explanations for these variations (e.g., a franchisor may have a higher cost of goods because it uses better ingredients or intentionally charges lower prices), evaluating competitive FDDs will give you another point of comparison.
Using performance requirements
There may be other information in the FDD that can give you clues as to what the franchisor expects you to earn, often in the form of minimum performance requirements. If these exist, they would be disclosed in Items 6 and 12 of the FDD.
For example, the franchisor might have a performance requirement calling for a certain level of sales. Usually, franchisors with such a requirement use a relatively low estimate in the hopes that most franchisees would be able to meet it.
Many consumer service franchises (e.g., carpet cleaning, home inspections, etc.) require their franchisees to achieve minimum performance criteria to retain their franchise rights. If such requirements exist, they must be detailed in Item 12. For example, the franchisee may be required to achieve minimum revenues of $150,000 in their first year, $200,000 in their second year, and so on. Franchisors incorporate these requirements to assure themselves that an underperforming franchisee will not tie up a territory that should be generating much higher revenues (and royalties). If the franchise you’re investigating has such requirements, you may want to compare them to the competition. You can also ask the franchisor how many franchisees have failed to meet the minimum requirements, and how it has responded to that. Have they terminated franchisees on this issue alone? Have they allowed underperforming franchisees to remain in the system but reduced the size of the protected territory?
Some franchisors, instead of using a sales-based performance requirement, may require a minimum royalty, as opposed to a percentage royalty — for example, the contract might specify a monthly royalty of 6% or $2,000, whichever is greater. While this is not a performance requirement per se, it does provide guidance as to minimum revenue expectations.
When a franchisor sets a minimum royalty requirement, it is generally an attempt to minimize the royalty erosion that could take place if a franchisee were to underreport revenues or to offset the franchisor’s costs during the startup phase of a franchise. The franchisor’s reasoning usually goes something like this: Well, at a bare-bones minimum, every franchisee should be able to generate a minimum of $400,000 a year. At a 6% royalty, that would be $24,000 per year. So I’ll charge a $2,000-a-month minimum royalty.
Thus, if you want to derive that minimum sales number the franchisor had in mind when it set the minimum royalty, first annualize the minimum royalty payment by multiplying the monthly minimum by 12. Then divide the result by the royalty, as we did previously ($24,000 / 0.06 = $400,000), to get the franchisor’s idea of a required minimum level of sales.
The danger in this method is that the franchisor may have grossly underestimated or overestimated the level of sales you should achieve, either because it is too aggressive, too conservative, or simply doesn’t know any better. Thus, this methodology should be used more to confirm sales levels than to predict them.
Estimating based on observation
Another means of determining your estimated sales is through direct observation. While this may not work well for service-based franchises, where you can’t stand in the location and observe lines of customers, you should be able to get a good feel for the sales volume of retail stores and restaurants if you have the patience.
This method is simple but time-consuming. Just go to a unit and watch people spend money. Even from outside the unit, you can count the customers going in and make an estimate, based on the average prices, as to how much each one will spend. Multiply average daily expenditure estimates by the number of days the establishment is open, and voilà! You have your estimate.
The downside to this method, aside from the time required, is the statistical aberrations that can occur when doing a limited sample. If, just by chance, you observe the unit on several especially good or bad days, your estimate could be off significantly. Thus, this method works best when you observe multiple units over an extended period of time.
Several cautions are in order if you choose this method:
If the unit is location-sensitive or is affected by other variables you have not identified, your revenue estimate could be off. Try to observe units that are similar in most respects to the one you plan to open: similar locations, area demographics, size, etc. If it is a restaurant, the presence or absence of a drive-thru window could have a significant impact on revenues.
If a franchisee is running a promotion or advertising heavily, it may impact your projections. Factors like the weather may impact your observations. Watching a business in inclement weather may result in an estimate that is too low, while watching only during good weather could result in estimates that will be somewhat high.
Be careful about when you observe the unit. If you only go to a restaurant during the lunch hour, you may see a unit that is constantly busy, but only because you are observing during the rush. If you only watch it on the weekends, you may get a similar misimpression.
Watch out for seasonality! Some businesses, particularly those in malls, may do more than 40% of their annual sales volume in November and December. Others may be heavily skewed toward summer usage or particular holidays.
While estimation by observation can provide you with a good deal of insight, it should be used to supplement and verify your other estimation techniques, as the small number of units you can observe (and the various aberrations that will almost certainly creep into your analysis) will limit the reliability of your data.
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Estimating by the book
Another (perhaps less accurate) alternative is to use industry averages to give you an approximation of these numbers. For example, some industry associations like the National Restaurant Association or publications such as Nation’s Restaurant News publish periodic guides to operating statistics that allow you to estimate an “average” unit’s financial performance. Studies by the Risk Management Association, Dun & Bradstreet, and others can provide insight into a number of industries. And of course, the internet contains reams of information—some of which may or may not be accurate — to help you with this research.
The danger in using industry averages to estimate your performance is that you may not achieve it—either because your franchise does not perform as well as the industry as a whole or because you underperformed. Likewise, in doing this research, often the categories into which your statistics fall (e.g., full-service restaurants, fast-casual restaurants, etc.) may be too broad to be meaningful in deriving certain elements of your financial model. For example, McDonald’s and Subway might both be lumped into the fast-food category, but their unit economics have very little in common.
The last way to estimate revenue numbers is more direct — just ask. Even if the franchisor cannot answer your questions, others might. Try talking to the landlord for one of the system’s franchisees. If you approach them about renting a space to house a marginally related business, they might give you an idea of how that franchisee is doing.
Most importantly, you need to ask other franchisees. They can be your best resources for questions such as these and are absolutely essential to your research process.
Related: 5 Things to Consider Before Owning a Franchise
One last word of warning: Almost everyone you talk to has a hidden agenda, so everything they say should be treated with caution. A franchise salesperson wants you to buy a franchise. A landlord wants to impress you with how high the volume in their property is. Even other franchisees have a hidden agenda: When you join the system, you increase their advertising and buying power. And most people don’t want to admit it if they’ve made a bad decision. So be wary!
The bottom line in all of this: Do not buy a franchise until you’ve looked under every rock and investigated every possible problem. Before you make your final decision, you should be able to say you have done everything you could possibly do to investigate your choice. Because there is really no way to know how much you’ll earn — until you’re out there earning.