Franchising Classroom Lesson 6: Making the right choice.
 
There is a required 10-business-day waiting period after receiving the offering circular during which no money can change hands. There is more analysis to do.
 
Franchising as an investment. If you want to start your own business, you need to view it as an investment and should evaluate business franchises based on the estimated return you can expect to get out of it.
 
Evaluating the risk. The higher the risk, the higher the return you should expect. How can you measure the risk of a franchising investment? Usually, if a business franchise system has been around for awhile and has multiple units, it has proven itself in a variety of markets-and some degree of risk has been taken out. You should also determine if the franchisor has recently sold units. If there aren't very many sales, is it because the franchisor is very discriminating when it comes to selecting franchisees? Or is it because individuals looking to own a franchise have found the business franchise system to be undesirable?
 
Secondly, check the percentage of failed franchisees. Using the generally accepted 5%-per-year closure rate of franchises as a general rule of thumb, determine if the franchisor's failure rate is higher or lower.
 
More risk equals more (expected return). At the higher end of the risk scale, things aren't quite as clear-cut as outlined above. For example, you might find a business franchise system that has higher-than-average failure rates, but whose general concept and business system you judge to be very solid. This might be a good, worthwhile risk, you deduce, and you may still want to own a franchise in this system. You could then perhaps seek to buy out an established but struggling franchisee of this business franchise, perhaps at much less than it would cost to buy a new outlet. And, if the only reasons the previous franchisee failed is that he or she lacked good individual management skills or wasn't using the right approach for his or her individual market, you might be able to make a much more successful go at it-and realize a hefty return on your investment in the process. But of course there is risk involved. What if the reason the business franchise was failing was the basic concept and system weren't as solid as you thought? That's where the risk lies-in determining if a business franchise is going to be successful. And the higher the risk, the higher estimated return you should expect to achieve before you decide to own a franchise in that system.
 
Estimating your worth as an employee. Before you can determine your potential return on an investment in a franchise, you must consider an important concept that you may have overlooked or may not have properly assessed. Namely, you should be fairly compensated for the time you spend acting as a manager of your business franchise on a day-to-day basis. (A fair rate to pay yourself is the amount you would pay someone else to do the same job.)
 
Estimating return. There is more risk in investing in a franchise than in for example, Treasury notes. And, on this higher risk end of the spectrum, you need to look for higher rates of return to make things worth your time and investment.
 
Generally, you should look for at least 1-2.5 times the risk-free rate of return on capital for most sorts of franchise investments. That is to say that if you could get 8% risk-free (as we noted above), you should expect to get 12-16%, depending upon the risk involved (i.e., 16% for the riskiest, down to around 12% for less risky-but still not "blue chip"-franchises). And how much can you expect to make on a blue chip franchise, such as a McDonald's? About the middle of the range is a good expectation--the average return is about 13-14%. All of these figures are standards to give you an idea of what to expect; as with any venture involving some amount of risk, the actual percentages may vary within these ranges.
 
Two figures are important to understand when fully analyzing the financial end of franchising: the amount of the initial franchise fee and the percentage of the ongoing royalty, both of which are paid to the franchisor.
 
Franchise fees. The general rule of thumb for initial fees is: The greater the amount of the total initial investment, the lower the franchising fee should be as a percentage of the investment. This rule pertains only to single business frnachise units. The reason is franchisors don't want to create an impediment (through the imposition of gouging financial requirements) to people wanting to own a franchise.
 
The flip side of this equation is that in service-type franchises (such as cleaning services or professional consultants), the fee may be half or more of the total investment. These are generally not capital-intensive businesses- franchisees usually don't have to buy land or building or extensive in-plant equipment. Therefore, the fee is much higher in comparison to the other costs.
 
In short, you should try to determine if the initial franchising fee seems fair, but you should not put overriding importance on this figure. Instead, you must look at the entire investment and what you can expect in return.
 
The ongoing royalty percentage. If franchisees are not paying a capricious initiation fee to the business franchise system, neither are they paying a permanent percentage of their income to the business franchise system just for being allowed to operate. That royalty pays for support, advice, research and development, and, above all else, a proven business system and the expertise to successfully operate it.
 
Once the general overall benefits of the royalty have been determined, next you have to look at the specific figure and what you can expect to get for it. It is important not to judge a royalty simply by its gross amount-that is, don't look at the situation as follows: The XYZ Company charges 8%, but the ABC Company only charges 6%. You have to examine it in terms of what it will cost you in real dollars and what it gets you as an investor.
 
You have to expect that the franchisor should realize a financial return for establishing you in business and for providing you with their proven franchising expertise. So don't look at a royalty as a negative and don't begrudge the franchisor that money-it is merely part of the cost to own a franchise.