While doing your due diligence as a prospective franchisee, what are some first steps you can take to help determine your would-be unit’s average income?
If you want to open a franchise as a franchisee, you want to make money by default because businesses have to make money to survive on their own. And more than make money, you want to make a profit. You don’t want to waste your time and especially not your money on becoming an unprofitable franchisee and have to close your shop. So how do you know how much money you can make opening up a franchise unit?
To start, it helps to know a few definitions. The most obvious is what is “income” and what does “average” mean. “Average” is an easier concept to understand than “income.” Average is just “mean, median, or mode” as most of us learned at some point in math. Any of these is fine in this evaluation. It doesn’t make much of a difference (at this point); the overall concept being “what am I generally going to make?” The time period to which the average refers to is the most important. Year one of opening a franchise is most likely going to be different than the second year and the fifth year. Evaluating the average from year to year will be important. Ideally, in business, income is going up from year to year. The old adage “up or out” is generally true in business.
Second, the word “income.” It’s very important to distinguish between “income” and “net income.” In a financial statement presentation, “income” is the very first number presented, while “net income” is the very last number presented. So it’s quite important to know the difference between the two in evaluating what your “average income” will be!
In talking, in presentations, in newspapers, the word “income,” without using the word “net” in front of it, generally refers to sales. Sales and income are in some ways presented as one and the same. You get income from your sale of services or sale of products; both sources of income. The franchisor gets income from royalties you pay as a franchisee. A franchisor also gets income from the franchise fee they charge you as an upfront cost of being a franchisee. So, the lesson learned is that “income” in this sense is the money received before you incur any expenses. If you charge $20 for a haircut, you have $20 in sales of a service, or $20 in income. This income amount doesn’t include the money you had to pay the hairdresser, the build out for your location, the cost of the chair and scissors, etc.
The bottom line number, or NET income, is much more exciting. This number represents your bottom line, or how much money you are taking home. The number is your sales, or income, less your expenses. Therefore, net income is the net amount of money you gain after your expenses and can put in your pocket or reinvest in your business. So, in the example above, if you charge $20 for a haircut, that is your income. If you spend $15 in servicing that haircut, then your net income is $5. If the amount of money that you spend over a period of time is greater than that of which you earn over a period of time, then net number is not net income, it is a “net loss.” So in the example above, if you charge $20 for a haircut, but you spend $25 servicing that haircut, then your net loss is $5. You can see that it’s very important to know the difference when a franchisor refers to its income versus its net income!
Using the FDD
Now that the above definitions have been explained, how does a potential franchisee evaluate what his or her average income will be? First of all, knowing that revenue, or income, is definitely not the same as bottom line net income, we can back into the fact that it’s more compelling and easier to know or calculate our top line number to be able to get to our bottom line number. To get an idea of what these numbers can be, the most realistic place to look first is to the franchisor’s Franchise Disclosure Document (FDD). Once you have applied to become a franchisee, you can request this FDD at any point, and the sooner the better. In some states, the FDD is automatically available online, so looking for the FDD in a disclosure state may get a version of it in your hands before you have to apply.
Item 19 gives financial information about average unit-level earnings claims. You can find information here, if provided (it’s optional) at the unit level. Second, Item 21 will provide financial statements for the brand as a whole. Even if the unit-level economics are good, you want to be part of a system that is healthy as well. These items can be a starting point at which to look at indicators of the system’s overall situation. If you employ an attorney or accountant, he or she can help you use this information to do more complicated analysis.
Beyond the FDD
The FDD is only one, albeit very important, source of determining what your average income can be as a franchisee. But it has limits. Tommy Lee, Partner-in-Charge of Retail, Franchise & Hospitality at Aprio, gives the following advice to potential franchisees who seek his financial counsel:
I encourage them to do as much research as possible. FDD’s are a guide or at best an educated guess with a certain set of ideal assumptions. So I offer some suggestions as follows.
1. Seek out other franchisees in the system and see if they will share some of their actual cost information with you. You’ll be surprised how transparent other franchisees will be.
2. During this process, try to ask specific questions; not just general ones. For instance, if you want to find out what your real dry goods spend is, ask; you will normally get farther with specific questions versus asking to see their whole P&L [Profit & Loss Statement].
So you can see that it’s a combination of getting all you can get from the financial statements on your own, perhaps with some added professional help, and then using your own grit to do some sleuthing for the rest.
You need to do as much research as possible in gathering and analyzing company records that are available, but know that they don’t give a complete picture. Notes CEO of No Limit Agency Nick Powills, “While franchisor’s use of Item 19 is more prevalent than ever before, if I were buying a franchise, I would not want to simply be average. I would want to be the best. If you are looking at a brand and wanting to know what you ‘could’ make, you are looking at it wrong. The system put in place will create an average, but if you invest properly in your team and your marketing, the sky's the limit.”
The support of your accountant and attorney can be a major value-add at this stage, especially if you have a limited financial background. Lastly, have grit and seek as much information as you can from other sources. Don’t be shy to seek out franchisees who might talk and also put you in touch with others who can help. By doing your prospective franchisee due diligence, you can better control your risk and make a more informed choice about the franchise opportunity you seek out.