As a franchise consultant, I am often surprised at the decision-making processes employed by demonstrably intelligent business people. These are often business people who have successfully grown businesses based on nothing more than their own ingenuity, talent, and sweat – and yet some of their decision-making almost defies explanation when it comes to franchising.
In analyzing some of those poor decisions over the years, I have come to the conclusion that they are often a result of a lack of understanding of a very simple principle: the present value of a franchise.
Hardly a week goes by when I do not witness it. The business owner who pulls the plug on a successful broker program or advertising source because “it just isn’t profitable” to sell franchises after paying broker fees. The franchise sales director who refuses to commission a franchise salesperson for a broker sale because “there is not enough margin in it after paying broker fees” – even though that strategy may result in lower broker closing rates. The hiring of less qualified staff or the failure to use a recruiter in order to save some salary – knowing that diminished sales production may be the result. Pulling the plug on advertising or a trade show because it did not work the first time it was used. Saving 20 cents a copy on a franchise marketing brochure by using a substandard paper stock, despite the less impressive message it may send to prospects.
Sure, some of these decisions are made based on necessity and short-term budget constraints. But often, it is simply a cost cutting for the sake of cost cutting – without looking at the long-term consequences. And that is why one of the core principles that we espouse is an understanding of the present value of a franchise.
The concept of “Net Present Value” is borrowed from the world of finance. In that world, there is an understanding that a dollar paid to me today has a greater value than a dollar paid in the future. If I received that dollar today, I could earn interest on it. And, of course, there is the uncertainty of not being paid at some point in the future. The Present Value of a future payment thus represents the amount that I would accept today in lieu of that dollar paid at some point in the future. If, instead of accepting a dollar one year from now, I would take 91 cents today, the difference is the “discount rate” (in that case, 10%) that I would apply to that payment. The discount rate thus represents a combination of the cost of capital (foregone interest) and the uncertainty of that income or income stream.
So what does that have to do with franchising?
Let’s start with a basic premise. A franchise sale is more than a one time sale. It is, at least from a financial perspective, an annuity that can last for decades. Franchisors will receive fees, royalties, advertising dollars, transfer fees, renewal fees, training fees, product margin, rebates, and other sources of revenue over the term of each franchise relationship. And those fees – or the promise of those fees – represents a real value to the franchisor today – and will certainly have value to a prospective buyer who is looking to acquire the franchisor.
So how does one assess this value?
The first step is to understand the estimated life of a franchisee. A franchise, of course, represents a going concern. As long as it is open (even if it is sold), it continues to pay royalties and fees. So start by determining the anticipated life of the franchise. If you anticipate that your franchise offering will have an average failure rate of 5% in any given year, then you might anticipate the life of a franchise at twenty years (one divided by .05). If your historical or anticipated failure rate is higher or lower, of course, you would need to modify that number using the same formula.
You would then need to estimate the average net revenue per franchisee. For many franchisors, this number increases over the years, so the best means of finding this number is to develop a financial model. The model itself should account for all revenues that you would anticipate from a franchisee over that anticipated life, with one entry for each year for simplicity purposes.
Next, you would deduct any associated costs associated with bringing on a new franchisee. Marketing, commissions, and other costs associated with the franchise sale would be deducted from the initial fee. You would, of course, need to deduct any costs for goods sold to the franchisee. The tricky part comes when allocating expenses and overheads.
There are a number of ways to estimate expenses – and different methods may be more relevant for different decisions. But for most decision-making purposes, the most relevant way to conduct this analysis is to look strictly at the variable costs associated with an incremental franchisee plus an allocation of directly attributable overhead. Thus, you might look at the costs of support related travel as a variable cost. If you typically have one field rep for every 20 franchisees, you might allocate 1/20th of their fully loaded compensation as directly attributable overhead. But you would not allocate a portion of the CEO’s salary, as the addition of a new franchisee would not impact that expense.
Finally, you would need to determine the discount rate. The higher the discount rate, the greater your uncertainty of a future stream of revenues. I have used a 20% discount rate below for the sake of illustration, and this number is generally considered a conservative number for such an analysis. To put that discount rate in perspective, a 20% discount rate is the equivalent of saying that you would rather take $4,020 today than wait five years for $10,000.
This NPV calculation, in a highly simplified form, would look something like the following:
As one can readily observe from this example, even when using a relatively high discount rate, the lifetime value of a franchise can be well in excess of $100,000 even after losing $10,000 on the initial sale. This example illustrates that, in the long run, it can actually pay handsomely to lose money on the franchise fees in return for the stream of income that each franchisee represents. And this particular analysis does not even account for the increase in the terminal value of your franchise company if you were to sell it (more profits means a greater selling price). So, for example, when we see franchisors reducing or waiving franchise fees to spur franchise sales in today’s more difficult economy, that move may prove to be a very wise long-term move when considering the Present Value of a Franchise.
It goes without saying that very few franchisors can afford to lose money on every franchise sale – cash flow considerations simply would not allow it. But you get the idea. Far too many decisions in franchising are taken based exclusively on short term considerations – without regard to the potential sacrifice of long term revenue.
So when making any buying decision, ask yourself these two questions:
- Will this expenditure (on staffing, advertising, marketing materials, training, etc.) reasonably be responsible for one additional franchise sale?
- Could this expenditure help lengthen the anticipated lifetime contribution of a franchisee (by increasing franchisee revenues, improving franchisee longevity, decreasing expenses, etc.), and if so, how would it impact the NPV?
Then measure the cost of the expenditure versus the impact of the decision. Remember, every franchisor will have a different Net Present Value based on their anticipated fees, product sales, expenses, and franchisee longevity (as well as their estimate of an appropriate discount rate) – so a good decision for one franchisor may be a bad decision for another.
But as this analysis illustrates, franchisors have a much greater need to balance short and long term considerations in their decision making than do other businesses. Thus, the use of the NPV paradigm – in conjunction with good short-term cash management – will bring a long term perspective that will ultimately improve your decision-making and your long-term profitability.
Article republished with permission.