How Franchisees Can Evaluate Their Future Net Profits

Investing in a franchise is a big decision. One of the biggest decisions a franchisee might ever have to make in a lifetime. With hundreds upon hundreds of different franchise concepts, it seems nearly impossible to sift through and find one that will check off all the desired boxes. Before deciding on a concept, franchisees have to look at different components including cost of real estate, royalties, investment range, and so on, with the goal that everything put together will answer one question – once all of the checks are signed, how much money will I be left with?

Calculating the net worth of different franchise concepts is no easy Algebra. That’s why 1851 Franchise sat down with franchise attorney Michael Boxerman of Marcus & Boxerman and multi-unit Great Clips* and Hand & Stone franchisee Sumit Bansal to get better insight on how to evaluate net profits and what red flags to look out for.

Utilize the Franchise Disclosure Document (FDD) as a Baseline

Before putting a large sum of money towards a franchise concept, most prospective franchisees do diligent research. It is important to study the FDD, a document provided by the franchisor that outlines the ins and outs of the concept in 23 items. While details like average P&L (profits and loss) are in the document, they should not be taken as an exact measurement.

“I always keep in mind that the numbers in the FDD are a baseline. While they give you a good indication of what the P&L should be, it’s not what you should expect in the first three years of business,” said Bansal. “For first time franchisees, I would reduce all of the numbers in the FDD by 20 percent. Then ask yourself, ‘If after performing 20 percent lower than the average owner, is my profit good enough to keep me happy?’ If the answer is ‘yes,’ then the franchise concept has a promising future.”

Note the Amount of Unit Closures

In the business world, when a location closes, it’s something to note. Was it poorly operated? Was it the product? Was the cost more than the gain? For prospective franchisees, the FDD can act as the first step in answering some of these questions.

“If you go to the FDD and see a lot of franchisees that have closed, I would assume net profits are low with that many people leaving the system,” said Boxerman.

Bansal noticed a similar red flag in his path to becoming a multi-unit owner.

“I always look at the number of stores that a franchisor has closed since they launched the concept,” said Bansal. “If you have a 100-unit franchise and 10 stores have closed – that’s a big red flag. The percentage of closings should be around one to two percent, and if you are seeing something in the five to 10 percent range, that typically means the net profits are low.”

Be Selective with Real Estate

It’s no shock to any one that a location in downtown Chicago, Illinois is more expensive than one in a surrounding suburb. However, it is a common misconception that having a high rent equates to low net worth.

“An expensive location does not mean low profits. But, if you are going to select real estate that is a bit pricier, be cautious of what your profits might be in case your store doesn’t perform as well as expected,” said Bansal. “I always tell first time franchisees not to choose expensive real estate until their third or fourth location, because with the first location, you want to ensure you are going to be successful.”

Utilize Existing Franchisees as the Experts

While the FDD provides baseline information, the existing franchisees within the system are the golden ticket for information.

“Before buying into a new concept, I contact various franchisees in different parts of the country to get a feel of how they are doing,” said Bansal. “I ask what the estimation of their profits are and take into consideration how long they have been with the brand and what area they are operating in.”

Boxerman has given similar advice to his prospective franchisee clients.

“We always encourage our clients to call as many current franchisees as possible and ask what their net profits are to get a better grasp on the numbers,” said Boxerman.

For prospective franchisees who are looking at putting a large sum of money towards a franchise concept, sometimes even their life savings, net profits are typically the biggest concern. Will I get back what I am putting into this? Unfortunately, the number is rarely cut and dry and can be extremely difficult to find.

While there is an FDD that lays out the general details, prospective franchisees have to take extra steps to get the answer they are looking for. Whether that means understanding what is noted in the FDD is not necessarily guaranteed, or asking existing franchisees for insight, these helpful steps can help candidates come to a decision.