June 28, 2024
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Want to know if a franchise will actually make you money?
Most buyers fall in love with a brand first. They see the logo design, the bustling outlets and the glossy brochure, and then they sign.
Here's the problem: none of that tells you if the numbers add up. And as someone buying a franchise for the first time, the numbers are all you should care about before you hand over your life savings.
The good news? You don't need a degree in finance to figure this out. You simply need a simple spreadsheet, the franchise disclosure document (FDD) and one afternoon of focused work.
Franchising is expanding. The IFA predicts that there will be over 12,000 new franchised businesses launched this year.
That is a lot of new owners, and a lot of them are going to find out the hard way that a great brand does not guarantee great profits.
A financial model is your safety net. It tells you how much the business needs to earn, how quickly you need to earn it and how much cash you need to bridge the gap.
Think about it. Would you purchase a home without researching the price, the mortgage repayments and your monthly budget? Never. Do not do the same with a franchise.
This is where having the right advice really helps. Many first-time franchise buyers are unaware of which costs to scrutinise, which fees to model or which brands have poor unit economics. By working with a seasoned franchise consultant like Paul Schlanger, you can compare franchise deals side by side and identify issues with the numbers before you invest.
Whether you seek assistance or not, you still need to learn how it works. Here is how to do it.
Every franchise model comes down to three things:
Get these right and everything else falls into place.
Royalties are the continuous payment made to the franchisor, typically a percentage of your gross sales. Most brands charge between 6% and 10% of gross sales.
That might not sound like much. But here is the kicker: royalties are calculated off your sales, not your profit. If your store makes $500,000 in sales annually and your royalty is 7%, you pay $35,000, even if you do not make any money that year.
And royalties are rarely the only fee. Most systems also charge:
Total them all up. It is this "fee stack" that is the true number to model, not the headline royalty.
Revenue is vanity. Margin is what pays your bills.
Your gross margin is what remains after the cost of goods or services sold. Your net margin is what remains after everything else: rent, wages, royalties, insurance and loan payments.
Say two franchises each sell $600,000 worth of product. One keeps 15% of the sales. The other keeps 5%.
That is the difference between a healthy business and an expensive job.
Tip: always model your margins after the entire fee stack. A brand that has a low royalty but very thin product margins could actually be worse for you than a brand that has a higher royalty but fatter margins.
Breakeven is reached when your monthly sales equal all of your monthly expenses. You are no longer operating at a loss, but you have not yet recouped any of your investment.
The basic formula is simple:
Breakeven sales = Fixed costs ÷ Contribution margin %
Contribution margin is essentially what remains from each sale after paying for variable costs such as stock, card fees, royalties and marketing fees. Royalties count as a variable cost because they increase with your sales.
Let us say you have $20,000 a month in fixed costs, and you keep 40% of each dollar after paying your variable costs. You will need $50,000 a month in sales to break even. Pretty simple, right?
Now it is time to put it all together.
Begin with the franchise disclosure document. Item 7 presents your estimated initial investment. Item 6 details your ongoing fees and Item 19 (provided the brand discloses it) details how current units are doing.
Not all franchisors provide Item 19. If yours does not, consider that a huge red flag and ask why not.
The FDD just scratches the surface. Item 20 provides a list of current and former franchisees, so make the calls. Ask them:
Call at least 5 owners and make sure to include some who have exited the system. They will gladly tell you what the brochure will not.
Never build just one model. Build three:
Most novice franchise buyers only forecast the best case scenario. This is why good people find themselves out of cash in month eight.
Your model is only useful if it can handle bad news.
Consider your worst case scenario and ask yourself some tough questions. What if rent increases by 10%? What if you need an additional staff member? What if it takes you 18 months to break even rather than 12?
If the business survives, you are fine. If tweaking one little thing causes it to fail, let it go.
Here is something most people forget: you will need working capital in addition to your initial investment. This funds your losses until you reach breakeven, as well as personal living expenses until your business gets established. Use the longest breakeven timeframe reported by current franchisees, not the shortest.
Why? Because going broke is one of the quickest ways to lose a franchise that could have succeeded with just a little patience.
Franchise modelling is not hard. All it takes is a little discipline. Before you spend one red cent, make sure you:
Follow this advice and you will enter your franchise with eyes wide open. Ignore it and you are gambling your nest egg on a logo.
The numbers do not lie. Just make sure you check them first.
Most brands charge between 6% and 10% of gross sales. The headline rate matters less than the full fee stack, which also includes marketing, technology, training and renewal fees.
Divide your monthly fixed costs by your contribution margin percentage. With $20,000 of fixed costs and a 40% contribution margin, breakeven sales are $50,000 a month.
Item 19 is where a franchisor discloses how current units are performing financially. If a brand does not provide it, ask why not and treat it as a red flag.
Call at least 5 owners from the list in Item 20, and include some who have left the system. They will give you a more honest view of costs and time to breakeven.
Enough to cover losses and your personal living expenses until you reach breakeven. Plan around the longest breakeven timeframe current franchisees report, not the shortest.
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