RISK VERSUS REWARD

Every year, like clockwork, books and magazines will publish their franchise rankings. We've all seen the listings. And like Spring follows Winter, the franchisors who make these rankings will tout their position and reprint the articles that called them the best franchise in their category. Case closed. Stop your research and fill out the application.

Of course, if there truly were a single best franchise, everyone would buy it to the exclusion of all others. But no test, no matter how well constructed, can provide you an answer to the single most important question: "What is the best franchise for me?" That's because even the best rating system leaves you out of the equation.

Several things must go into your personal buying decision. How do you feel about what you will be doing? Does it seem like fun? Do you think you would be good at it? Can you see yourself doing this for the next ten to twenty years? Beyond the lifestyle aspects of a franchise, however, most of us look at franchise ownership as a means to achieving our financial goals.

Ultimately, when we make any investment, the two most important factors are risk and return. But unlike other investment opportunities, the franchise investment is among the most difficult to assess in terms of both risk and return. Everyone wants a low risk franchise that offers high returns. But there is no such animal. The key lies in finding the franchise that offers the highest return for the amount of risk that you are willing to take.

Complicating matters is the fact that most buying decisions are emotional. Did you purchase your last home after researching neighborhood price appreciation, construction materials, and energy efficiency? Or did you start with some general criteria (schools, neighborhood, and costs) and look for that house you fell in love with? How about your last car? Were fuel efficiency, insurance rates, and safety your only concerns? The problem is that we will often let these emotions influence our rational thought. After all, that new Corvette does get fairly good mileage for a sports car...

The purchase of a franchise is probably the biggest financial decision you will ever make, and perhaps the most emotional. Not only are you going to invest your life's savings, but you may well live in that business for the next twenty years. And unlike the purchase of a car or a house, the purchase of a franchise is a decision that can be extremely difficult to un-make.

Yet, a franchise has risks that are, in many instances, higher than other investment vehicles. To make this investment worth your while, it must compensate you for that incremental risk by offering an incremental return. Perhaps more than any other investment, the franchise you buy deserves a level of cold-eyed scrutiny far beyond the emotional first blush.

Assessing Risk
With over 4,000 franchises in the U.S. franchise universe, the first thing that you should do is narrow the field. A good place to start cutting is based on your likes and dislikes. Chances are, that if a business doesn't sound appealing to you, you shouldn't be in it. Next, eliminate businesses that you can't afford. Once you have limited your choices to a manageable number, you need to rate the remaining candidates based on risk.

Risk, ultimately, involves your assessment of whether a specific franchise might fail (or might fail to live up to expectations).

Some of the risk-oriented factors that that you should examine include financial performance, longevity, size, turnover, management, litigation history, support, and contract terms. Taken as a whole, these provide excellent measures of risk.

Where do you find this information? Directories like those found in Successful Franchising are a good place to start. But once you get serious about your candidates, you need to start collecting Uniform Franchise Offering Circulars (UFOCs). Every franchisor must provide you with this document at the first face-to-face meeting at which the sale of a franchise is discussed (these documents are also available for a minimal fee from state agencies governing franchising). The contents of an Offering Circular are strictly governed, and all of these issues are included.

But the UFOC is not the only place to find this information, and you certainly shouldn't rely on it alone. Remember, in most states, no one other than the franchisor and his attorney review the Offering Circular. So talk to franchisees. Suppliers. Talk to your banker. Hire experts. CPAs. Attorneys familiar with franchising. Do your homework.

One thing that I often recommend is for the prospective franchisee to assign a numerical value to each element of risk for each franchise. If you are examining ten franchises, which has the lowest franchise turnover level? The smallest ratio of lawsuits? The most experience? Then total these elements up. This exercise should provide you with some insight as to where on the risk spectrum a specific franchise can be found.

Finally, determine your tolerance for risk. Remember that risk is relative. It is relative to who you are. It is relative to your age and your ability to recover from a loss. It is relative to the risks posed by other similar franchise investments. Draw a risk line in the sand and eliminate the franchises that stepped over it. Then, once you have eliminated franchises that pose too great a risk, choose among them by assessing return.

Measuring Return
While some of the historical measures of risk are mandated disclosures, information on return is much harder to obtain. Under FTC Rule 436, franchisors are not currently required to provide prospective franchisees with information on unit level performance or earnings in their UFOC. And, in fact, approximately 80% of franchisors choose not to make these "earnings claims." Unfortunately, that leaves franchise buyers in the dark.

But all is not lost. There are a number of ways that you can measure return.

Again, start by talking to franchisees. Ask specific questions. Very specific. Remember, If you ask a franchisee how much profit they made last year, they may be embarrassed at their lack of earnings. Or they may prefer not to disclose this information. Some franchisees may be sheltering their income to avoid taxes, and thus may provide you with information that is artifically low.

So to avoid these kinds of issues, ask more specific questions. What were your gross sales? How would you describe your location? What were your cost of goods sold? What were your labor costs? What do you pay in rent? How big is your location? How much inventory to you maintain? What kind of inventory turnover do you achieve? In short, ask questions that will allow you to create your own pro forma rather than looking for a pat answer that may or may not be misleading.

And don't stop with franchisees. Speak to landlords in your own area. What locations are available? At what costs? Speak to the franchisor's designated suppliers.

Once you feel comfortable that you have created an accurate analysis of what your franchise can return, the final step is to measure this return in a consistent manner. To do this, you must avoid the temptation of measuring your projected income. Instead, measure return on investment. In essence, what you are asking here is "How much return can I get for each dollar I invest?"

In order to do this, you need to first obtain one additional number -- start-up costs. The good news here is that start-up costs are a required disclosure. The bad news, however, is that franchisors may use different assumptions in determining these costs. Your best bet is to make an educated guess as to what these costs will be on a case-by-case basis after doing your homework. If you are uncomfortable with that, ask your CPA to help you here. And remember, it will always cost you more than you think, so be conservative in your analysis.

Look at your projected income statement for year two or year three (year one is really your start-up year). Be sure that your pro forma income statement accounts for a reasonable salary for the unit manager (you, if you will fill that role) and does not reflect debt service, depreciation or taxes.* Then divide your projected earnings by your start-up costs to figure your return.

Low risk franchises should be able to conservatively offer you consistent returns of at least 15%. Higher risk franchises should offer greater rewards, or they are not worth the incremental risk.

How much higher?

That one is up to you.