Worksheet to Evaluate Whether to Buy a Franchise
This spreadsheet analysis was created at the bequest of Michael Webster and Mr. Blue MauMau in order to benefit members of this community. In particular Mr. Blue MauMau spent hours correcting my fumbling attempts at presenting this in html, so give him a round of applause. The purpose of this spreadsheet is to demonstrate how you can use industry data and franchisor specific information from a UFOC to do a screening filter of a franchise opportunity. I believe this level of analysis is appropriate after you have done a ‘quick” screen of an opportunity. Stated differently, I would not bother to do this type of check on a first vetting pass, but rather perform it after I had performed quick concept screen and a macro trend analysis.
The numbers used in the spreadsheet are from the NOLN survey and Exhibit J. You can find links to these in the post entitled “Financial Sniff Test”. Additional details were taken from the UFOC, such as the build out cost and the duration of the franchise agreement.
The expected return for this franchise offering is $34,427.51.
If you examine the data from NOLN you will not that the average configuration is for 3 bays. In examining the UFOC, note that the initial investment is given as a range between $136,068 and $241,033 for 2 bays. The UFOC recommends that you add an additional 20-30% for the additional bay or 25% on average. Therefore the inital investment should be between $170,085 - $301,291 (see footnote #2 below).
The duration of the franchise agreement is 15 years. Conveniently, since 1926 there has not been any 15 year holding period for the S&P 500 that exhibited a loss. Historically, the S&P 500 has returned 10.33% (1926-1993) per year. Over the 15 year holding period of the franchise agreement you would anticipate an equivalent investment in the S&P 500 to return $4.37 for every dollar invested with no expectation of loss (see footnote #3 below).
The expected return for the franchise opportunity is $34,427.51.
In summary you are "investing" a figure that realistically exceeds 300K for an anticpated profit of 34K a year less franchise obligations, less your salary, and taking a 40% chance of either a total loss (depending on your financing) or working 15 years for no profit on your inital investment.
Footnotes:
#1 These numbers were extracted from a sample where 85% or more of the units were non-franchise. Therefore you would need to correct for the royalty and advertising fees. Stated differently, in a franchise, your anticipated profit would be less. In addition, these numbers assume an owner operator.
#2 Further investigation would reveal these numbers are very optimistic.
#3 As a passively managed portfolio using asset allocation you would anticipate a significantly higher return with less "risk". For example a simple 60/40 allocation between the S&P 500 and the Shearson Lehman total bond market would be anticipated to return 13.21 % as tested over a 20 year period. A more sophisticated asset allocation could provide an expected return in the 17% range with even less risk.
See the full spreadsheet here to download.
Related reading:
Franchise Worksheet Reality--Look at Brutal Truth
REALITY from FuwaFuwaIsagi as presented in the Lube Worksheet is brutal truth that is completely ignored because it is not investigated by most franchisees ---who are incapable of doing this kind of analysis on their own. (Brutal truth from experts who are more objective than compassionate is greatly appreciated.)
As Richard Solomon, Paul Steinberg, and Michael Webster, our resident Blue Mau Mau attorneys, always indicate ----only killer due diligence with an informed and highly knowledgable franchise attorney can give the "startupper," the first-owner franchisee, a real chance of success.
FuwaFuwaUsagi has indicated in many ways and on many occasions that the risk involved in the purchase and operation of a franchise is hardly ever justified by the rewards ----but "never underestimate the stupidity of people in large numbers." Franchising is growing in the US economy.
Oil Job- Three Tips
Tip 1: Fuwa's model is taken from industry data - people who have no interest one way or another in selling you a franchise. Use this type of objective data as a screen.
What if it is out of date? That is a difficult judgment call - is the industry better or worse since the data was selected? In this case, we can probably accept that the industry in 2008 was worse than in 2003/2004.
Tip 2: You have to focus on the average expected return: the sum of the probabilities of each state * the return. In this model, the expected return is around 35k. Way too low for the risk factor - 40% of losing your money- and the initial payment. You can fool around with this number, but it isn't going to make the expected return look any different.
Tip 3: Look at the chances of losing your entire investment, according to the industry data. 40%, according to the model. That is a big number, and unless you know something dramatically different, this is a losing bet.
Michael Webster PhD LLB
Franchise News
Not representative as it ignores gearing
Any analysis done on a prospective franchise by a prospective zee is good. However this analysis is far wide of the mark when viewed against how things happen in the real world. Very few zees buy a franchise cash so measuring a franchise return against the equivalent investment in the S&P is not helpful at all. Also of critical importance is the actual cost of startup the band given is broad ( as per the UFOC + the 3rd bay ) but that would definitley influence the investment decision . If for example you use the lower amount for 3 bay setup ( $170 085 ) vs the higher ( $301 291 ) the attractiveness of the investment varies greatly. But to show you why people do invest in franchises : An SBA loan for the lower amount would require an investment of $17100 ( 10% ) with the balance ( $152 985 ) financed over 10 years @ around 9% would cost $23 256 per year.
Now I would readily agree that $11 171 ( $34 427 expected return - $23256 loan repayment ) is not a lot of money to be left with HOWEVER it represents a return of 65% on the $17 100 invested and would be paid off after 10 years - ie. before the expiration of your 15 year time frame measurement. Does it mean that this particular opportunity is a good investment - maybe not . But like you I'm using it to show how and why people do invest in franchises using Gearing. The 65% return makes the S&P look pretty sick. And in the real world that's how people buy franchises - they borrow.
PizzaGuy
Expected Return and Lotteries
Pizzaguy: I have got an investment with a 75% return on investment. It only has a small downside risk, right around 40%. Meet me at the roulette table and bring plenty of cash - and I do mean plenty, we might be there a while.
Michael Webster PhD LLB
Franchise News
Great Analytical, more than most will do, not good enough!
Tip 1: Fuwa's model is taken from industry data - people who have no interest one way or another in selling you a franchise. Use this type of objective data as a screen.
I say: this data is from voluntary survey data and IS NOT verified by the National Oil and Lube news. I was in a lube franchise for over 17 years. You simply cannot rely on this data ALONE to make a decision on buying a quicklube franchise.
What if it is out of date? That is a difficult judgment call - is the industry better or worse since the data was selected? In this case, we can probably accept that the industry in 2008 was worse than in 2003/2004.
I say: The industry is changing so fast right now, that even if these numbers were audited and accurate, they do not adequately present the changes occurring in the industry, BUT you are correct that the industry is in a downturn, and has been for at least 7 years.
Tip 2: You have to focus on the average expected return: the sum of the probabilities of each state * the return. In this model, the expected return is around 35k. Way too low for the risk factor - 40% of losing your money- and the initial payment. You can fool around with this number, but it isn't going to make the expected return look any different.
I say: Without having a "buddy" that knows the buisness, and doing a ton of additional visitations and analysis, decisions to invest based on this analysis would be imprudent.
Tip 3: Look at the chances of losing your entire investment, according to the industry data. 40%, according to the model. That is a big number, and unless you know something dramatically different, this is a losing bet.
I say: Yes and no. It's like drowning in an AVERAGE of 2 feet of water.
The UPS Store And The Worksheet
If you want a really good laugh try this worksheet and UPS Store #'s...LOL...LOL...LOL...LOL...LOL...
It was written: The 65%
It was written:
The 65% return makes the S&P look pretty sick
My reply:
Not even slightly. At 65% you are still not being compensated for the risk ensued. It only makes it look sick if you do not understand risk adjusted rates of return.
And I am not trying to be rude, it may be how some people buy franchises in the real world, but it is also true that the record of success for those that do so is abysmal.
If you do not believe me check the statistics on the survival rate of small businesses.
Additionally you need to account for opportunity cost, which is to say you could be productively employed earning money that is all profit to you instead of laboring on this concept.
Just a nit here, but you would need to lower the expected return if you went with your lower start-up cost configuration, because the car counts were obtained mostly on 3 bays.
Lastly, I should point out that you could borrow to buy a portfolio, and many do.
And don’t even get me going on the damnable SBA. They should abolish that intrusion on the free markets.
But I must say, I actually really liked your post and I am glad you contributed to the thread. It was interesting.
FuwaFuwaUsagi
With all due respect...
With all due respect, I think you are missing the point. This is not meant as an analysis of a quick lube, but rather an example of analysis. The difference is this is simply showing a method. That is why it is done with old data and an old UFOC. It is not meant to be current or be relevant to the quick lube industry. I used NOLN because that is what I has available to me at no cost. On again, for clarity, this was attempting to illustrate how to use industry data as a screening process. The data used is irrelevant. This is not in depth analysis. This is a filter to see if you should invest the time in an in-depth analysis. It goes without saying that you want to use relevant, quality data.
These posts were an attempt to fill the knowledge void for prospective franchisees who have no idea how to vet the various franchise offerings. It was intended to be educational in nature.
To make this clear I would run an offering through a quick screen. Essentially I would looking to filter on the actual merit of the offering as a franchise and then as a business. If it passed through that filtering mechanism, I would then perform a macro analysis of the industry as a whole. If the industry looked good then I would compare my financial requirements, my capital , my temperament, desires etc to that of the offering and see if it was a good fit. If it was a match I would do this cursory financial examination using industry data and the actual concepts data If it passed this final filter, I would then spend the time on beginning due diligence of the opportunity which would include a detailed financial examination.
What this represents is only the cursory financial examination listed above. I hope that clarifies matters.
FuwaFuwaUsagi
Numbers tend to be given...
...much more credence than they rightfully deserve.
Any financial analyst will tell you that spreadsheets can cause peoples' critical thinking to shut down. It seems, people can use numbers to "prove" either side of an argument that they have already decided on (anchoring bias).
Numbers, even the ones that are based on extremely shakey assumptions, can be used improperly either intentionally or not.
Les Stewart MBA
20yearzee
20yearzee; you have entirely missed the point of this modelling. The model will never replace your decision making, it simply enhances it and points you to asking questions that you might not have thought of.
Fuwa intends this as an example of model making, and not as model to use. The features of the model are important - concentrate on those.
Let me respond to your detailed comments, which I fear are simply off the mark and may well indicate a ungrounded mistrust of model making.
20yearzee writes: I say: this data is from voluntary survey data and IS NOT verified by the National Oil and Lube news. I was in a lube franchise for over 17 years. You simply cannot rely on this data ALONE to make a decision on buying a quicklube franchise.
1. The data collection problems are inherent in any survey. Generally, the industry data is not going to be to date for your decision making. As for the voluntariness, why does this bias the data in anyone direction at all? You are not trying to use this data to predict your earnings, but rather to uncover some general features of the industry not apparent without analysis.
20yearzee writes: I say: Without having a "buddy" that knows the buisness, and doing a ton of additional visitations and analysis, decisions to invest based on this analysis would be imprudent.
2. This is one of the big myths debunked by modern decision making. Data is what counts and not individual stories. The Oakland A's in baseball have largely replaced their scouting staff with statistical analysis. Why? Because a scout going to see a player cannot evaluate the significance of what they have seen in such a short sample space. It is unlikely that you are going discover a la Kroc the McDonalds in California in the late 50's with line ups out the door. Now days the gold is in the data collected by the POS system. Start with that.
20yearzee writes: I say: Yes and no. It's like drowning in an AVERAGE of 2 feet of water.
3. Frankly, I don't think the you understand expected return models. While the expected return could be positive, this model is suggesting a long period of burning cash. Can you afford that.
Michael Webster PhD LLB
Franchise News
Business Risk
I certainly agree that it is the risk side of the franchise investment decision that is most critical. There may be a huge pot of gold but it is only fool's gold if you hit a "ladder" when playing the game.
The greatest obstacle to rational decision making (yet to be overcome through discussion on Blue MauMau, I might add) is the risk of post-sale over-reaching (franchisor opportunism).
Example: The assumptions underlying all models (quantitative or qualitative) are made instantly irrelevant when the head office turns the reins over to the "short-termers" (son/daughter/MBAs/etc.)
Substitute your own tyrant du jour; The means of cash flow-diversion (franchising opportunism) remains the same.
The industry elite can choose to eventually address this in a meaningful way. Or they can continue deny it.
But their lack of action does not alter the investors' uncalculatable business risk reality. (the don't "deny their denial" argument, lol)
Les Stewart MBA
Lotteries and Gambling
I think you'll find that your numbers are off on the roulette. If people practice due diligence as preached here starting a business need not be a lottery but will certainly remain a risk.
Risk however is part of being a life form on this carbon based planet.
You run the risk of contracting inumerable diseases, being victim of a natural disaster etc.
You pay money to beat the odds daily - you are betting against your life insurance underwriter, you are betting against your car insurance underwriter and you are betting against your medical insurance underwriter - the underlying statistical math is no different to your beloved roulette. Ask an actuary.
So save your cash and don't pay insurance - be done with pesky gambling.
PizzaGuy
No PHD or LLB
It was written 65% - Maybe more?
At 65% you may not be being compensated for the risk - but that would depend on the nature of the venture. I tried to restrict myself as much as possible to the framework of your example - because I understood what you were trying to highlight and I think any attempt to promote due diligence and real analysis is laudible.
I don't think that the record of succes of small business is due to gearing - I think that it is due to incomplete due diligence and analysis.
The companies which make up the S&P you refer to are geared - some more than others - likewise some enjoy much higher returns than others. Of course someone could borrow to invest in the S&P but unless they invest in an index fund they would have no way of buying into all of the companies which make up the S&P and could buy into the wrong companies. You can enter a franchise segment at the wrong time just as you can enter the stock market at the wrong time. If you had borrowed money and invested in the S&P on 1 Oct last year you would now be down by around 13% or if it was the first day of trading this year you would be down around 6.5%.
You are right about opportunity cost and that is normally balanced against a lifestyle choice. People choose to put in the hard work to be their own boss or because they may not be able to get the type of job they were accustomed to due to corporate downsizing etc. You could have a philosphical denate as to whether you are your own boss in a franchise but with the IRS and many other government agencies what is being your own boss? In the world of small business the entire profit of the business is viewed as return and owner compensation - different business brokerages have different names for it - owner cashlow , owner discretionary income etc. etc. and the value of an existing small business is usually calculated as a multiple of this.
Let me use a model that I'm more familiar with:
Startup investment including working capital - $220 000
Owner contribution - $22 000
Earnings before tax - $ 52 000 pa. ( after loan repayment )
Return on $ invested - 236%
Return on "sweat equity " - ??? - but 60 hour weeks are normal
If the SBA wasn't around then no small business lending would be happening now at all - banks won't even lend to each other at the moment.
I stick by my contention that gearing cannot be left out of the equation
Anyway - it's not often that I'm prompted to post anything and I've noted that your posts always have a lot of substance - probably what got me going. Thanks for getting me interested again. I hope your article prompts more people to do real number crunching before diving in head first.
PizzaGuy
With these caveats, FUWA, your modeling is a GREAT tool!
Agree with your entire posting titled "With all due respect".
Michael - I didn't really miss the point....
I was mainly interested in making another point, which was to be careful in using these numbers by themselves to make a decision. While I do understand that Fuwa was not intending anyone do this, the numbers used (2003's) are so off the mark, they are not relavent except to point out that the buisness is changing rapidly (yes, I know, this is also a good peice of information to have if you follow up on why it is happening...)
I have had many very fine consultants over the years that have been very valuable to me in making business decisions. These guys could whip together numbers in more ways than I could ever imagine. At times, they were even able to explain what the numbers meant, and how we might use them in decision making.
Let's just not have any new potential franchisees coming in thinking that if they formulate an analytical model (whether by a very smart consultant, or other source), then they don't have to undertake a huge additional amount of real life detective work before they invest.
About the NOLN survey data (which you call "industry data"), I make the following comment. The NOLN sends out a survey, which is quite involved, and asks operators to fill it out and send it back in. Whether the respondents use real data, or just make it up is not verified. I know from experience over many years that these numbers are all over the map, and I don't believe the response to the survey is statistically high. Having reliable data is, to me, very necessary to make good decisions. You could miss the mark by relying too heavily on this informal survey. The point is always start with reliable data.
So, without having that buddy I talked about, I am not sure where the data from the POS comes from. That's why you need to make a buddy out of some existing zees. The NOLN industry "estimates" are just an educated guess.
In my years in the business, we did extensive analytical analysis on sites we developed. I have to tell you that these numbers were wrong as much as they were right in our case. The best teacher, obviously, was experience, which new franchisees do not usually have.
I think the idea and concept of a model from FUWA is teriffic - I am not trying to be critical in any way - only expressing some caution in the overuse of the modeling process when investing one's life savings in a franchise. Too many other things outside of the numbers can affect the final return on investment - and those are only known after conversation and investigation.
Finally, buying a franchise is just simply not like picking the baseball player with the best stats. I'll bet that even when those scouts see the stats, they do some pretty intensive individual investigation of the player that is behind the stats before they invest in him.
Isn't the lesson to be learned here...
that you need to diligently conduct all of the DD components and analysis exercises?
If you skip any part, you are in for trouble.
However, if the numbers just don't add up, it is hard to argue in favor of proceeding...unless the decision is based more on lifestyle and less on income/ROI.
Lotteries and Gambling
If you are suggesting that buying a franchise is like the toss of a coin, I agree with you. If you read the statistics on small business failure, you understand that franchising is just a method for the franchisor to beat those odds by using the franchisee as a resourse who absorbs the great risk.
It is truly gambling but the odds should be posted on the ZOR'S board for ZEES to see.
Gobbledy Gook
If you are about to invest in a business, you had better figure out a way to pay keen attention to numbers. If you are not comfortable with numbers, you can believe the writer's gobbledy gook above, then later blame the franchisor for outwitting you when you fail.
Notice how the spreadsheet is a worksheet in which the numbers and even categories can be modified to fit your particular circumstance. It looks like it uses the time value of money - future value, present value, rate of return with the cost of capital factored in, and the risk factor broken down. It's a good template / example.
This is the first I've seen such an investment tool in franchising. Franchise developers and investors almost always incorrectly focus on the month of break-even-point for the store / unit.
As you can see from the comments, you will argue back and forth on what numbers are the most realistic. That's healthy. You should develop a scenario plan of worst, good and best cases.
--
dw
Counting
Pizzaguy, it doesn't surprise me that you missed the point.
The expected value of playing red/black at roulette is negative. However, if I can sell you this lottery ticket claiming that it has 75% gain, with only a 40% chance of loss - I will make money and you will lose.
The observation that we run risks daily is mundane: a more useful observation would be to show us how to calculate better, based on some reasonably articulated theory.
Michael Webster PhD LLB
Franchise News
Return on Capital versus Return of Capital
Pizzaguy writes: "Return on $ invested - 236%"
Interestingly when the SEC did a study of individuals who had been defrauded they found that there was a common thread.
The investors were more knowledgeable than ordinary investors: except in one area. They had no ability to understand risk//reward ratio, let alone the difference between return on capital and return of capital.
Pizzaguy if you sell franchises using the above type of model, you have the heart of a shill.
Michael Webster PhD LLB
Franchise News
The Fuwa Model
Every decision we make is based upon a model, usually completed unarticulated. I am as guilty of this as anyone - some of my most major decisions were based upon what turned out to be air. Air that I could have easily discerned. And I probably will continue, unfortunately, to act on air.
But, the worst offenders are those who believe that they aren't acting in accordance with some mental model.
Our intuitions about economic choices ought to be informed by, challenged and sometimes changed entirely by models. This was the benefit of the Fuwa model.
It is a very nice little filter: don't pass this model, don't collect $200 and go directly to economic jail.
I apologize for being a bit harsh, 20yearzee, but we live in an age in which our collective mathematical illiteracy now matters.
Numbers do lie, but models challenge.
We need to rise to those challenges.
Michael Webster PhD LLB
Franchise News
Odds are you will lose your life savings with a franchise
Zors are the only winners just look at thousands upon thousands of zee failures.
Hope for Success and have a plan for failure
Darnelle Says "As you can see from the comments, you will argue back and forth on what numbers are the most realistic. That's healthy. You should develop a scenario plan of worst, good and best cases"
You are right on target, in my book, and I would add that when you look at that worst case, you figure out what will happen if you have to exit the investment.
This will take you into areas that will open your eyes to the downside of a zee failure.
Do this exersize before you sign the franchise agreement!
Perfectly rational, Mostly irrelevant
By all means, build your sand castle quant models.
But contrast them with...
...the granite mountain of business risk that makes franchised small businesses unique among entrepreneurial activity.
If you can't name 10 uncontrollable, lose-your-life-saving post-signing opportunism franchisor behaviors right now, you will be somebody's lunch.
To the blind, everything is sudden.
Les Stewart MBA
Understanding Franchising
Of returns and shills
Must get lonely up there, being so aloof.
The crux of my discourse with Fuwasagi was to higlight the effect of gearing as this is actually how most people buy or start businesses - with borrowings. I went to some length to explain that due diligence ( taking the utmost care to minimize risk ) was extremely important. Whilst large companies have varying methods of calculating ROI - some charge themselves internal hurdle rates based on their unique cost of capital situation or their own required returns based on undertakings to shareholders - this is not how small business typically operates.
Gearing is how the average person makes a return on housing as well.
The return was shown after the repayment of the loan for the year ( ie. short term portion of long term loan ). You can't realistically calculate the total ROI without having the business appraised once operating - it has a value and this could equal or exceed the setup cost. If you have a look at some of the larger business broking sites profitable franchised outlets are selling for about four times owner cash flow. Thus the value of the going concern in my example would be around $208 000.
Over time this enterprise value would stay the same or increase if annual owner cash flow increased and the amount owed on the setup loan would decrease. The total ROI could only be calculated if the owner exited the business and paid offthe outstanding loan, adding any net proceeds into the calculation.
There are many models for calculating returns and there are many models for placing a value on businesses. You cannot leave the intrinsic value of the business out of the mix.
PizzaGuy
No PhD or LLB ( Got Heart ).
PS. I don't sell franchises
If you buy any franchise you are doomed to poverty
Zors will take all your money and you cannot win.
Gearing
Please define gearing, is this what has been called leverage by another name, or is there something more that I missed?
Gearing Nonsense
Yes, borrowing increases the return on capital invested.
The accepted term is "leverage".
Leverage increases risk.
There was nothing in your reply to Fuwa about risk adjusted due diligence, just a serious error about how to calculate an expected return, in which you glossed over return on capital with return of capital.
Do you understand the point I am making?
Michael Webster PhD LLB
Franchise News
Gearing - No Nonsense
I didn't gloss over anything - I listed the return on $ invested to highlight a return. I specified what the return was on. I didn't attempt to state that it was a return on total capital employed at any time. As I explained in the later posting you need to take into account the intrinsic value of the entity in order to do do so.
You may be shocked to learn that just because you may not be familiar with something it doesn't mean that it doesn't exist or is not accepted. Gearing is a perfectly acceptable term for financial leverage.
http://www.investopedia.com/terms/g/gearing.asp
Investopedia is part of a fringe organization called FORBES - that may be why gearing is such obscure terminology for you.
PizzaGuy
More Nonsense
Pizzaguy writes: "You may be shocked to learn that just because you may not be familiar with something it doesn't mean that it doesn't exist or is not accepted. Gearing is a perfectly acceptable term for financial leverage."
You are correct, I should have looked up the term first.
But, you are still wrong about your example. The "return" you championed may have contained a return of capital and had no reference to a risk adjusted rate.
For these errors, or misdirections, I said that you had "the heart of a shill."
Your postings doing nothing to change that impression.
Michael Webster PhD LLB
Franchise News