Franchising is a numbers game and thus it is the financial projections and the quality of the feasibility related to it that will determine whether the franchise will fly or fail. The feasibility study should be twofold:
- Can the franchisee make money after factoring in franchise fees?
- Is the franchisor entity viable based on the projected royalty fee income?
1) Franchisee feasibility
It is important to prove the financial viability of a unit or an outlet. In most instances you will have an existing successful business you wish to expand as a franchise. The use of franchising as an expansion mechanism should after all be based on a proven concept, and not just an “idea”.
Often this business has been running for some time and may be well established in its current location and the target market it serves. Imagine now opening an additional unit in a new location. What are the set up costs of the business? Considerations such as building costs, fixtures and fittings, signage, equipment, software and hardware, will have increased since your initial outlay and it is important to obtain new costs for these.
Once you have determined the updated set up cost of the business the next step would be to draw up unit projections over at least a three year period. Important considerations for this include questions such as: what are the revenue streams of the business; and what margins can be achieved? Remember these projections must be conservative and should be based on your experience in your existing business. In other words make sure they are realistic; and ensure that you factor in turnover trends and the typical expenses that are likely to be incurred on a month to month basis.
One of the most important aspects of the financial feasibility is determining the fees that they franchisees will have to pay and thus the income that the franchisor requires in order to build a sustainable network. Royalties, (otherwise known as Management Services Fees), charged to franchisees may be as a fixed fee or alternatively as a percentage of gross turnover. Currently, the industry best practice is to charge a percentage of gross turnover. This is largely because if fees are calculated in this way, then it is a win/win scenario. If the franchisees are successful then the franchisor’s business is usually successful by default. The term royalty implies a passive relationship or association. However, as the franchise relationship is an intimate one with a number of support responsibilities expected of the franchisor, the term “management service fee” is the more applicable term for the ongoing fees.
Your franchisee unit feasibility exercise should determine the following:
- Can the unit afford franchisee fees?
- Does the franchisee make a decent return on his investment?
- Is this an attractive opportunity?
2) Franchisor feasibility
It is a misperception that franchising is a “get rich quick scheme”. In reality a sobering thought is that a franchisor takes on average 3 to 5 years to breakeven which is much longer than it takes for an average franchisee to break even. The reason for this is that the franchisor incurs development costs prior to the expansion of its first franchise. These development costs may include legal fees, consulting fees, costs to advertise the opportunity, system development etc. Over and above this the franchisor requires an infrastructure to develop the franchise package and thereafter implement the roll out and effectively support franchisees.
It is important to consider at what point your franchise expansion will reach critical mass? This is the point at which your management service fee income exceeds the costs of expanding and supporting the network. This varies for each franchisor and is dependent on a number of factors.
A franchisor in most cases also charges an Upfront Franchise Fee (sometimes called an Initial Frnachise Fee or a Joining Fee) when a franchisee purchases the business. This contribution may tide the Franchisor over to the point of breakeven. However, it is not advisable to rely on the upfront fee contribution to cover the franchisor overheads for an extended period of time. This will put you under enormous pressure and is not sustainable on a long term basis. A point to remember is that the upfront fee typically comes from the unencumbered cash contribution of the franchisee. What does this mean? That it is not financed, simply because it is not an asset which can be recovered.
So the requirement for a franchisor that intends to offer business opportunities to third parties is to draw up franchisor financial projections plotting your upfront and ongoing fee income according to your proposed franchise expansion plan. It is important to add to this the infrastructure costs and other costs that will be required in order to support your franchise network.
Your franchisor feasibility exercise should determine the following:
- The cost to franchise your business?
- The critical mass / breakeven point of your franchise expansion plan?
Franchising requires an investment for long term gain. It is very important to make sure you thoroughly investigate the true financial potential of expanding your business as a franchise. It costs money to franchise whether you utilize franchise specialists or take the journey alone, ensure you have the financial means to see you through to critical mass. Always be realistic and conservative in your calculations.