Understanding Franchisee Return on Investment

What Are We Measuring, and How?

Measuring Franchisee Return on Investment (ROI) is a key part of determining if a business is feasible for franchising. There are several components to measuring a franchisee’s potential ROI, however, and several different ways to measure.

Measure Them Not You

First, to illustrate the importance of measuring franchisee ROI (vs your ROI when you started your business), lets imagine your business is manager ran and takes very little of your time. Lets assume your numbers look like this:

Initial Investment $200,000
Revenue $500,000
That’s a solid business model! Without being owner-operated, you are returning 50% per year on your investment. Now let’s franchise it. You are going to want to collect a franchise fee; lets assume that is $50,000. Your franchisee will incur additional costs for travel for training, legal review of the FDD and legal costs for entity formation; let’s assume that is $10,000. Finally, as a franchisor you will want to maintain brand standards; your franchisee will likely incur additional costs for signage, paint, and build-out fixtures you require for this purpose. Let’s put that number at $15,000. Your franchisee will likely have additional ongoing costs, as well. Lets assume you charge your franchisee a royalty (8%), a National Advertising Contribution (2%), and a $300/month technology fee. Lets assume you also require your franchisee to attend conference every year, which has a fee of $1,000 and additional costs (including hotel, travel, etc.) is $3,000. If we stop there for simplicity sake, lets do the numbers again:

Initial Investment $275,000
Revenue $500,000
EBITA Profit $42,400
($100,000- $40,000(8%*$500,00)-$10,000(2%*$500,000)-3600 ($300*12)- $1000-$3000)
Your franchisee owns a manager-ran franchise that returns 15% on their investment, assuming they execute on all other facets of the business model at least as well as you, the founder, did.

How To Measure

You must also decide if your business should be looked at based on an investment ROI, or a cash-on-cash ROI. Again, allow me to illustrate. If our hypothetical franchisee above took a standard small business loan, and was able to finance the normal 70% of the investment (the SBA typically requires a franchisee to invest 30% of their own money, give or take), then theoretically they could get into this franchised business for $82,500 ($275,000*30%) out of their own pocket. If their $42,400 profit was after making a loan payment, then their ROI on a cash-on-cash basis would be ~50%. That is a much more palatable number! Stick with me for just a minute longer and I’ll show you where this becomes really important. Let’s start with a clean scenario. Imagine two franchisees, one takes a loan and one doesn’t, and the overall investment is $350,000. Assume the franchisee that does take a loan does so for 10 years @ 8%. Finally, lets give these franchisees $600,000 in top-line revenue with a 10% EBITA margin.

Franchisee A Franchisee B
Initial Investment $105,000 Initial Investment $350,000
Revenue $600,000 Revenue $600,000
EBITA Profit $60,000 EBITA profit $60,000
Debit Service $35,000 Debit Service $0
EBITA Profit after debit service $25,000 EBITA Profit after debit service $60,000
Cash-on-Cash ROI 24% Cash-on-Cash ROI 17%

The General Rules of Thumb

What is an “acceptable” investment is 100% up to the investor. However, there is an oft-repeated rule of thumb that, after the second full year in business, a franchisee should be realistically able to anticipate a 15- 20% per year ROI plus an equitable salary for whatever work they do in the business. Should you measure this as Investment ROI or Cash-on-Cash? What method a franchisee is using to invest, for example banking borrowing, using their own cash, or some other means, is likely to be the determining factor on how they view ROI. Franchisees for example, investing in a business in the mid seven-figures or higher which has a significant real estate component, are likely to be looking at cash-on-cash ROI measure. Likewise, franchisees looking at a fully-passive investment while maintaining gainful employment will be looking at the same. Conversely, franchisees that are looking at 100% of their own cash (likely a lower-priced investment) or using some sort of retirement funds, may be measuring against investment total. This is why its so important to understand up front who your target owner is. Do you need help with that? Check out our Franchisor Preparation Services, where we help you, among other things, determine who your target franchisee is.