Franchising ROI: What's Reasonable? How to determine whether a franchise investment makes financial sense
By Jeff Elgin
Opinions expressed by Entrepreneur contributors are their own.
What is a reasonable rate of return on investment in a franchise opportunity? Though the question seems simple, it is still an important one, so let's analyze the factors involved in getting an answer.
Usually computing the return on an investment is a fairly straightforward and intuitive process. When you invest in the stock market, for example, you know exactly how much money you paid for the stock. Your return usually consists of a combination of dividends paid to you while you owned the stock plus any appreciation in the stock value when you sell it. If you pay $100 for a stock that pays you a $5 dividend and then you sell the stock in one year for $105, you made a $10 total profit, a 10 percent return on your investment. If you buy a bond for $100 and it pays you an annual interest payment of $6, your return on investment is 6 percent.
Those types of investments are referred to as passive, which means that you are investing your dollars but not any significant amount of your time. With passive investments, the more risky the investment the higher average return you expect to make, and the more money you invest the higher your total investment earnings will usually be. Most people would agree that, over time, an average annual return of 5 to 12 percent on your passive investment dollars is good, and anything higher than 12 percent is excellent.
But a franchise is almost never a passive investment. Virtually all franchises assume that the owner will be investing at least some of their time and talent in the business in addition to their money. So it is reasonable to assume that an investment in a franchise should provide a return for both the money and the time that is being invested in the business; hence the complication in the ROI calculations. This also means that we expect the return to be significantly higher for a franchise than for a passive investment. Otherwise what's the point of investing your time?
Most new businesses go through a startup phase where they lose money for a while, then break even and ultimately become profitable. The curve of this initial growth phase is usually fairly sharp in the beginning, and then the business stabilizes and begins experiencing a more normal growth rate as it matures. For an average business, this process takes about two to three years. For this reason, when we look at the monetary return for a franchise, we usually look at what our income expectations are based on the business being in its third year of operation.
When evaluating what is a reasonable return in a franchise, begin by looking at the return on invested capital. Since starting any business is considered a relatively risky investment, you should be able to earn a very good return on your invested capital, let's say in the neighborhood of 15 percent. In other words, for every $100,000 of your capital you invest, you should expect to make at least $15,000 per year in return on the investment.
Calculating a reasonable return on your investment of time is more difficult because of the variables involved. Start by asking yourself what your time is worth in general terms. How much are you used to earning in exchange for your work hours? If you can fairly easily trade your time for $60,000 in yearly income, then you can assume that is a reasonable value for a full time investment of your work hours into a business. So at the very least, you're going to be looking for a business that can provide you with some increase in this standard return for the value of your time
The analysis gets a bit more complicated, though, when you factor in lifestyle changes that can come with owning your own business. For example, let's say that the business will provide you with a great deal of schedule flexibility or that it does not require any out-of-town travel. That may mean that you'll never again miss a child's birthday party or that you'll finally be able to coach a soccer team like you've always wanted. As another example, let's say that the $60,000 job you currently have involves doing tasks every day that you really dislike, or that you've got a boss that you can't stand working for. Getting away from those factors and into a situation where they don't apply may have a great deal of non-monetary value to you. These types of "soft" factors are undoubtedly important to consider, but they are difficult to quantify with a fixed monetary value that we can use to compute a return on investment.
Let's say that you are evaluating an investment in a franchise opportunity. Based on your research, you determine that the total monetary investment in the franchise is going to be $200,000. You further determine that the average income (before any owner compensation) produced by this type of franchise in the third year is $150,000. From the expected income of $150,000, you subtract $60,000, which represents the fair market compensation for your time. This leaves you with $90,000 as a return on the investment of both your money and your time. You would expect to earn at least $30,000 per year as a fair return on the $200,000 of invested capital, so the franchise in this example provides an additional $60,000 as a return on your invested time. That equates to a 100 percent return on the investment of your time. Even if there are no soft benefits to you whatsoever, this sounds like a pretty good deal.
If, on the other hand, the typical third year gross income is only $90,000 instead of $150,000, you would clear the same return on the capital you invested but the ROI on your time investment would be zero. With an ROI like that, the obvious question is why take the risk? Unless there are compelling soft benefits for you, it would be better to keep looking for a different business with higher returns while you stay in your current job.
As a final note, look for opportunities that grow to mature profitable levels much faster than the standard of three years. There are a few companies that reach this level within a few months and those businesses are much safer opportunities in a recessionary economy like we have been experiencing for the past couple of years. It may take extra effort to find them, but the time will be well spent.
