Tips for valuing a franchise
If you are considering investing in a business, these tips for valuing a franchise should help you avoid financial mistakes that can torpedo your investment returns.
Is the price right?
The price you pay - your investment - is usually determined by what that business needs to get off the ground. This includes an initial franchise fee, and everything else that must be paid for - the ‘three p’s’ of property, products, and people:
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Property includes the building and equipment needed to operate your business
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Buying the products or raw materials that your business needs to create revenue
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Hiring and training the people needed by your business
In other words, the price you pay includes the costs that you would pay regardless of whether you are a franchisee, or own the business outright.
The question is, how do you measure the value of a franchise? And what makes a franchise expensive?
Tip #1: More expensive doesn’t mean a better franchise
Don’t think a more expensive franchise is better than a lower-cost franchise. Paying more doesn’t mean you get better value. The important element is the return your franchise business is likely to create - this is the measurement of financial value to you.
Tip #2: Price is different to value
Price is what you pay. Value is what you receive. So said Warren Buffett, who knows a thing or two about investing.
Here’s why developing a formula to calculate value is so difficult. Value has a different meaning to different investors, especially when investing in a business.
If you plan to invest in a franchise instead of investing in, say, the stock market (or real estate or a 401(K), for example), you’ll want to target a greater return from passive income and growth than you are likely to achieve by investing in the stock market.
If you are considering buying a franchise to actively run as a business, it may also be that you value filling your time with a new challenge, or get huge enjoyment from owning and managing a specific type of business.
So, value is as subjective as it is objective.
Tip #3: Understand the components of price
When you invest in a franchise, the price you pay is decided by reference to several components. These might include premises and equipment – items with a real value. It’s relatively easy to price these accurately, and you’ll know if you are investing at the right valuation.
You will also need to consider the initial fees and running costs (royalties or commissions).
· Initial franchise fee
You will probably pay an initial franchise fee to become a franchisee. This may be as low as a few thousand dollars, but can be far higher. Look on this as paying for your membership of the franchise.
The initial franchise fee is really a payment based on the goodwill of the brand. It’s assessed by the franchisor. You’ll need to factor this into your calculation of value.
· Ongoing royalties
Ongoing fees include royalties, usually a percentage of your sales, though it may also be a fixed amount each month. The lower the royalties, the more of the profit you get to keep.
· Purchase of products
Some franchisors require you to buy your raw materials, products, and services from them. In most cases, this means that you will benefit from economies of scale and lower purchase prices than if you were a non-franchisee and buying your products and raw materials wholesale or retail independently.
Tip #4: Don’t focus on gross profit
Numbers can be misleading. For example, if I asked you which of these two franchises represent better value over a 10-year period, which would you say:
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Franchise A, which delivers $100,000 profit each year pre-royalties and other costs
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Franchise B, which delivers $200,000 profit each year pre-royalties and other costs
It looks like Franchise B, until you then factor in other costs:
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Franchise A requires an initial fee of $100,000
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Franchise B requires an initial fee of $200,000
Still, franchise B, right? Because over 10 years, B delivers $1.8 million for the initial investment compared to $900,000 on A.
But hold on. We now need to consider royalties.
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Franchise A has a revenue of $500,000 each year, and the franchisee must pay 5% royalties on this
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Franchise B has a revenue of $1,000,000 each year, and the franchisee must pay 10% royalties on this
After royalties, Franchisee A is making a profit of $75,000. Franchisee B is making a profit of $100,000.
Is Franchise B still the better value?
Despite making $25,000 per year more than Franchisee A, Franchisee B’s return over 10 years on the initial fee is $800,000 – or 400%. Meanwhile, Franchisee A’s $650,000 profits have yielded a gross return of 650% on the initial investment.
In short, your initial cost is a line item of the cost of buying the franchise, and royalties is a line item within the costs of running your franchise business. Understanding how this interacts with your gross revenues to deliver net profits is important when measuring a franchise opportunity’s value to you.
Tip #5: Don’t ever go it alone
Investing in a franchise can be the best investment you ever make. But the above illustration – which we’ve purposely kept simple – demonstrates that price and value are quite different. More expensive franchises aren’t necessarily the best value for your investment.
When calculating the value of a franchise and figuring out if the price is right for you, you must take into account all the components of price, as well as the subjective value – the other, non-financial reasons you might want to invest. You shouldn’t do this without help. Valuing a franchise is more complicated than many would have you believe. If you get it wrong, you could end up paying a price that destroys the franchise’s value to you.
Your franchise success depends upon the help and advice you receive. Book a 30-minute free consultation, and let’s get the ball rolling.