Number one is the investment amount. You’re generally gonna find the investment range to open up a franchise, including the franchise fee, working capital, any real estate expenses in the franchise disclosure document, also called the FDD.
Another important item is the revenues. How much money are you making from this franchise in terms of how much money comes into the franchise location? Sales, revenue, outside of the U.S., they call it turnover. Sixty percent of franchises disclose financial information, generally at least the sales information in Item 19 of the FDD. If the franchisor does not disclose sales information, it’s very important that you consult directly with multiple franchisees. We recommend you speak to at least five franchisees to better understand the financial information.
Leading into the third point, how much money does it make in terms of net income, owner’s benefit? How much are you making from the business to benefit you and your family? Very important. Oftentimes it’s disclosed in the franchise disclosure document. However, you need to talk to franchisees to better understand how much they’re making in Year 1, Year 2, Year 3, and what the general trend is for income generation for that set franchise.
Number four, the franchise failure rate. You need to know how many franchises are closing down. How many franchises are not extending after the initial 10-year term? How many franchises broke their agreement with the franchisor and basically the relationship didn’t make sense? You need to understand what the franchise failure rate is. This can range anywhere in a 3-year period from as low as 0% up to 20% plus. Some big names like Subway have a franchise failure rate above 15% over a rolling 3-year period. That’s definitely a big red flag.
Another important figure, number five is the franchise sales rate, basically the transfer rate, as well as the franchisor buying back locations from franchisees. This is important as it can indicate that people don’t want to continue to grow with the franchise system and they prefer to move on to some other entrepreneurial venture. Again, going to Subway, the transfer rate’s above 15% on a 3-year rolling basis. That’s pretty high. That basically for every 100 franchises, 15 of them are getting out of the system.
Number six, the franchise success ratio. We’ve coined this term looking at hundreds of thousands of small business administration loans that have been issued to franchisees throughout the United States. So, we look at the ratio as this, for every, say, 10 loans that were paid in full, where the franchisee was able to pay back the loan totally to the bank, maybe one defaulted. So, that would be a 10 to 1 loan success ratio for that set franchise.
Another important point to consider, we have the data for that given franchise. We also have how that industry does as a whole. So looking at food and beverage, for example, say, for franchise over the last 10 years, our analysts have calculated that for every 9 restaurant franchises that pay a loan back in full, 1 defaulted. Where you look at some other industries like healthcare, real estate, education, the default rate is lower. So, it’s very important to look at the industry figures and a key indicator for that is the success rate of those that have taken out a loan to open up a business and/or franchise in that industry.
Eight, working capital. How much additional capital do you need invested in the business until you break even and you’re able to start taking dividends out of the business or even paying yourself? So, many franchisors will disclose in Item 7 all the expenses, including working capital or additional capital. Some choose to be conservative and really give an estimate of whether it’s six months, nine months for how much capital you need to sustain the business on average on when their franchisees broke even. Other franchisors will just list three months of working capital, which according to our research at Vetted Biz is not enough time to break even, and you’re probably gonna have to inject additional capital.
Besides working capital, and this plays into the next point is how many hours do franchisees work in the business? Because that’s gonna affect a lot of items like income, the return on your time invested in the business. Not just the capital you’ve deployed in the business. So, it’s really important you get this information directly from multiple franchisees.
I mentioned the transfer rate of some large franchisors is high. Over a 3-year period, 15%, 20%, 30% of franchises are changing hands. So, you need to prepare for that eventual exit. It might be in 5 years, 10 years, but you should know what the average resale value or the range is for that franchise. So, we have the industry data at Vetted Biz. And it’s important that you ask the franchisor for recent resales of franchises that have recently left the system. And to give an example of a business, a technology cell phone repair business. Maybe you invest $120k, $130k to start the business, and then after 2 years, you could sell the business for $250,000.
There are many food franchises where I don’t see how you’re gonna get your capital back. Where you invest $500k, $600k, but recent resell data is more like $300,000, $400,000. So that’s a big red flag. On your invested capital, you should seek at least a two times return when you have that eventual exit. So, again, if you invested $100,000, when you sell the business after 3 years, 5 years, 10 years. You should be getting at least $200,000 when you sell that business.
Now, obviously, these are not all the metrics to look at when you’re evaluating and investing in a franchise. These are some of the ones that are readily accessible through our database at Vetted Biz. Also through the franchise disclosure documents that we extract information from conversations with franchisors and franchisees. In our next articles, we’re gonna go through the top 10 questions that you need to ask franchisees before buying a franchise. As well as the top 10 questions you need to ask franchisors before buying their franchise.
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