You might have noticed that when researching franchises, there isn’t a consistent pattern when it comes to the rate of return on your investment. Sometimes, it feels like there's no clear connection between the total investment and the potential earnings.
Many franchise candidates have asked me: Is there a rule of thumb for understanding ROI in franchising?
The answer might challenge your initial assumptions.
“Spend More, Get More” Doesn’t Always Apply in Franchising
When you consider traditional investments like real estate or the stock market, there's typically a straightforward relationship between the amount you invest and your eventual return. Earning a solid 10% to 15% annual return on invested capital is often considered a success.
For most of us, it's common sense that if you put in more money, you should expect to get more in return. "Spend more, get more" is a mantra we live by. However, here's where it gets intriguing: this principle doesn't necessarily hold true in the world of franchising.
The reason behind this seeming contradiction is that franchise investments are typically not passive. In addition to your financial investment, you're also dedicating a significant amount of your time and management skills.
Here's the key: You should be able to achieve a satisfying return on both of these investments. Since you're essentially making two investments – financial and personal – the return on investment in the franchise realm should ideally surpass what you can expect from a passive vehicle.
ROI in High-Investment Franchises vs Low-Investment Franchises
Returns in the franchise industry are quite diverse. In many cases, the return (expressed as a percentage of the total investment) tends to be smaller for high-investment franchise opportunities compared to low-investment ones.
The primary driver behind this phenomenon is leverage.
In franchising, you make two distinct investments:
- The capital you invest
- The investment of your time and management expertise
The returns you earn on your capital investment typically align with passive investment standards.
The real potential for leverage in the world of franchising lies in the investment you make with your time and talent. This is where a well-structured franchise system can truly capitalize on this asset, leading to a significant boost in your returns.
The Problem with Most Franchise Businesses
Most franchise businesses offer limited leverage in relation to your capital investment. Even if you choose to use debt to amplify your leverage, the debt service may merely offset the overall net cash return your business generates.
What Successful Franchises Do Differently
A forward-thinking franchisor develops a method of operation that optimizes the franchisee's time, channeling it in a way that drives the business's income to levels that transcend what you could achieve through capital investment alone.
These are the systems where a savvy operator can swiftly generate annual incomes surpassing 100% of the initial franchise investment. That's the power of effective leverage!
My Rule of Thumb for a Good ROI
As a fundamental rule of thumb, never venture into a franchise investment unless your thorough investigation suggests that the average annual income return from the business will equal at least 30-50% per year of the total initial investment for the franchise unit.
This total investment encompasses all debt and working capital reserves required to kickstart the business.
If the return doesn't meet this benchmark, it is likely wiser to retain your current job and passively invest your capital elsewhere.
Focus on Leverage
So, the burning question remains: How do you identify a franchise with exceptional returns? Surprisingly, it's not about fixating on the most expensive opportunities. Instead, focus on those with remarkable management leverage.
Often, these are franchises with total investments of less than $200,000, and in some cases, less than $50,000. As the saying goes, diamonds can indeed come in small packages.
The next crucial step is to meticulously investigate the average earnings of a typical unit during its first three years of operation. Don't just look at what the best-performing units achieve; it’s key to understand average performance.
If the business isn't delivering the expected returns by the end of its third year, it's time to continue your search. Rest assured, there are numerous opportunities that can meet or exceed this standard.