Is buying a franchise profitable?

Is investing in a franchise better than starting a business from scratch? Here’s why investing in a proven small-business franchise concept may be your next best career move.

Buying a franchise seems like a straightforward way to start a business with a reasonable chance of generating a profit; after all, franchised brands tend to have significant consumer appeal already, and in some cases, thousands of franchise owners are already making money from the opportunity. It is, in many ways, less risky than starting a business from scratch based on an idea of your own, but does it truly offer the chance to make you independently wealthy?

Franchise Basics

Let’s start with a brief review on how franchising works. Every brand does things a little differently, but the basics are always the same. You’ll pay for the rights to open a business that bears the same name and/or sells the same products and services as the “parent” business. Most brands force you to follow certain policies for locations, pricing, hiring, and so on, but once the business is up and running, you’ll have some role in ongoing management and decision-making, and will be entitled to some or all of the profits generated by that location.

Long-Term Earning Potential

Franchisee success stories make it seem more than possible to build wealth with franchises; they make it seem normal, but it is hard work. There are thousands of franchise owners who have used their franchises to accumulate enough wealth to retire on (and retire very comfortably).

But of course, the real profitability figures suggest the possible outcomes are more diverse, and these businesses are complicated. According to data gathered from the Franchise Business Review, the average pre-tax income of a given franchise varies wildly depending on its industry. At the bottom of the list, with 1,571 survey respondents, was the travel and recreation industry, where franchises generated an average pre-tax income of $38,471. Near the top, with 200 respondents, was the automotive industry, where pre-tax income hit an average of $106,000. So to buy a franchise isn’t as easy as intial thought, a lot of money is involved and can be scary for those who don’t want to risk to fail. Getting advice from entrepreneurs could help make you more successful in your franchisor endeavours.

There are also outliers at various levels of investment and in various industries. The same report found businesses that cost $1 million or more to start that weren’t generating a profit, or were losing money. There are also businesses generating a mere $50,000 in gross sales, yet were returning a net profit of 50 percent.

It’s easy to imagine yourself as a positive outlier in this scene, generating massive net profits, but it’s more likely that you’ll be at the average level or lower, especially if you’re a new franchise investor. Making $106,500 a year isn’t bad (assuming you’re in the best possible industry, and doing an average amount of business), but it’s only going to make you rich if you can find a way to multiply that income, while living frugally. Opening more franchises could be the answer, or you could take the income and invest in conventional equities.

Barriers to Entry

Whilst an “average” franchise does seem to make it possible to generate wealth, however, there are a few barriers to entry that prevent most aspiring franchisees from getting to this point:

Franchise fees:

Buying a franchise requires you to pay an initial fee, as well as the costs of establishing a physical location, hiring workers, and so on. On top of that, you may need to pay royalties or ongoing monthly franchise fees to the main brand. Initial franchise fees alone may be as low as $10,000 or over $100,000, and together with the costs of opening a business, it could end up costing you hundreds of thousands to millions of dollars to get started. In other words, you may need to have a substantial level of wealth before you can even open a franchise.

Tight margins (and no wiggle room):

Many franchises have thin profit margins. Their goal is to generate as much visibility and customer appeal as possible, so they need to sell products and services for low costs. Depending on the rules and restrictions of the franchise, you may not have the power to increase these costs, even if your backend expenses increase. This makes it hard to generate a consistent profit, even if you’re seeing a suitable amount of revenue.

Entrepreneurial experience:

Solid business fundamentals are a requirement if you’re going to own a successful franchise. While the brand you’re buying into may already have customer appeal and revenue-generating potential, it’s still on you to choose the right location, hire the right leadership, follow the rules precisely, and keep your team attentive and provide training. If you’ve never owned or helped operate a business before, your risk rate of failure increases significantly.

The Bottom Line

The bottom line is that while a franchise can make you independently wealthy, it isn’t a guarantee. Choosing the right business in the right industry, and going in with preexisting entrepreneurial experience and/or existing wealth can help, but your income-generating potential may still be somewhat limited.

If you have been researching what makes a healthy and thriving franchise system – and as a potential franchisee, this is something you must understand before buying a franchise.

The research has uncovered three pillars which make a healthy/thriving franchise – relating to fabulous leadership, great systems and people and a determined eye on the future.

But across everything, the one critical success factor underpinning the healthy/thriving franchise is franchisee profitability. In extensive research, franchisee profitability was talked about repeatedly as the number one factor that will influence the future of franchising.

Educating yourself is a great place to start and reading as broadly as you can to really get a feel for what franchising is all about is invaluable. Keep up on any franchising news that could you generate more sales or have more marketing.

You may be wondering, how do I determine what makes a great franchise and one that makes it worthwhile to invest my hard-earned cash?

The first place to start for you, as an investor into a new franchise, is what will be the return on your investment and will you earn enough to support you and your family

Remember there are many options you have to invest your money: the bank, property, shares, superannuation. There are also a multitude of ways to be self-employed in the new economy: Airbnb your house, drive an Uber, or juice Lime Scooters. 

So buying a franchise needs to stack-up when looking at all of your options. Given the risk of investing potentially hundreds of thousands of dollars, will the returns be worth it? This is the question that should be your top priority when assessing your new business.

If you can get a 10% return in the share market, or 5% in the bank, keep these figures in mind as you assess your potential new business.

However, determining your potential returns is not an easy task, even for experienced business people.

What does a profitable franchise look like?

From the research, the general consensus is a profitable franchise provides enough profit to pay the working owner a wage (based on the wage of a manager of the store/service) PLUS at least 20% of their investment amount per annum in profit on top of the working owner’s wage (assuming a five-year agreement). Note that 20% is the minimum with 30% being a more comfortable figure.

This is also handy to have as a formula:

Profitable franchise formula:  MR = WOW + ROI > 20%

[Minimum Return = Working Owners Wage + Return on Investment of at least 20% (assuming a five-year franchise agreement].

As an example, assume a franchise has an entrance cost of $500,000. The return expected to the franchisee is a minimum of approximately $70,000 (wages) plus $100,000 (EBITDA) which is $170,000. Note that EBITDA is an accounting term which means earnings before interest, tax, depreciation and amortisation. In other words, it’s another term for your bottom-line profit.

An example is 7 eleven who have generated a lot of support over the years by expanding their franchise into a major convenience store becoming an established brand.

So how do you uncover the profitability of a franchise?

You start by looking at the disclosure document which will have some financial information for you to go on. This information can be quite broad and general so don’t stop there. My suggestion is that you seek out this information from current franchisees.  

Just this week, I had a detailed discussion with a franchisee from a major brand and he knew his return on investment and the margins of all of his products. He could also tell me about the level of support from the franchisor and if he’d recommend the franchise to others. This kind of information is invaluable for any new franchisee. Don’t be shy in seeking out this information – you and your family’s future livelihood is dependant on you making a decision based on the facts and hoping to not fail in this market of franchising.

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