Financial Modeling in Franchising a Business: The Good, The Bad & The Ugly
In decisions to franchise businesses, pie in the sky financial modeling is the delusional mind expansion medium that has launched many doomed franchise attempts. Yet, financial modeling is not new to business planning. It is attempted in one form or another, both crude and sophisticated. The pro forma in every franchise investor’s business plan is an example of crude, incompetent financial modeling. Many Item 9 franchise disclosure document presentations are incompetent or deliberately misleading attempts at financial modeling.
Anyone who has ever contemplated turning their established successful business into a franchise operation has gone from the anecdotal “This would make a great franchise” suggestion from friends and customers, to contact with a franchise consultant whose sales pitch enthuses the mark with suggestions of revenue streams capable of slaking the greatest thirsts. A hundred sold franchises at $ 25,000 initial fees provides $ 2.5 million – never mentioning that most new franchises never attain that number ever. A hundred franchised stores generating $ 500,000 a year in gross sales represents at 6% of sales $ 3 million a year in royalty revenue and, at 2% of sales, another $ 1 million a year in advertising revenue that can be used for all sorts of yummy venture functions. Four and a half million a year plus initial fee income makes many otherwise rational people delusional.
Reality may be seen in my article Why New Franchisors Fail. The new franchisor field is strewn with the wreckage of misled business owners who were successful at what they did and lost everything in the world to unscrupulous franchise consultants.
In my opinion, in addition to all the failure causes dealt with in that article, there is the matter of failing to model with financial competence the business that the franchisee will be operating. If there is no competent success financial model for the franchisee’s business, you cannot arrive at a decision that your business is franchisable. More importantly, franchise investors have no ability without focused specialist assistance to sort out the incompetent and misleading information presented. Consequently, the field is also strewn with the financial corpses of duped franchisees who thought they understood what was set before them.
Constructing a competent franchisee’s business model is an exercise in multivariate regression analysis. That isn’t as complex as that fancy name suggests, but it must be honestly done if a reasonable financial model is to result. Using wishful thinking financial modeling causes incompetent financial planning in the franchisor model and in the information that will end up in your Item 9 Earnings Claim calculated to enthuse franchisee investors to buy into your system. Then only litigators will make money on your franchise and you will spend years in misery funding nightmare dispute resolution instead of sipping good single malt on the fan deck of your yacht. Examples of this are Cuppy’s and Java Joe coffee; 1-2-3 Fit; Curves; Dagwood Sandwiches; and many others that are on the brink of collapse but not quite yet in the tank.
Boiled down to a very simple statement, financial modeling is an exercise in which you establish a chart of accounts that your franchisee’s business will use and then populate the chart with the numbers/ranges of numbers that you can identify as reliable. That will leave a number of line items that you have no current reliable data to corroborate, where you have to provide an estimate for each category. How you do that is to repeatedly, ad nauseam, ask “What if…” questions until you believe you have probably exhausted the range of expectable events that could influence the number than goes into each line. Actually, you also do “What if…” analysis on the lines where you are fairly certain you already know the appropriate number, discounting for learning curve impact and discounting further to arrive at an imputed value for unidentifiable risk. What’s that, you ask.
Unidentified risk includes such things as the extent to which others may not be as adept as you are in the operation of your kind of business; or that it may take quite a while for them to get the hang of it while you fine tune your franchisee training program; or the vicissitudes of any geographic market (or the market as a whole) for your products or services; or “gambler’s ruin” – poor estimating of the time required to achieve break even/positive cash flow (which may not result in “free” cash); and several more such categories.
Asked simply, the question you would be trying to answer is “Can a franchisee, using my business format, have a reasonable potential to achieve a good return on his investment if he operates my type of business competently in another geographic area and had to carry, in addition to all other expenses, the costs required in order for him to be a franchisee?” These costs include more than simply the initial fee, the royalties and the advertising fund contributions.
Illustratively, if you believe you will confine your franchisees’ purchase of supplies/inventory to vendors designated by you, and that those vendors will be paying you for your approval to be vendors to your franchisees, the franchisees will incur an opportunity cost of not having access to competitively priced vendors and the cost of their having to pay you for the privilege of being designated vendors. Inasmuch as there will be opportunities for you to impose other expense categories from which you will intend to derive extraneous revenue, these will also be franchise relationship carrying costs. The “What if…” analysis is a lengthy exercise if you intend to come up with a reasonable financial model of what your franchisee will encounter.
Franchise sales people understand that franchisee investor prospects believe themselves to be highly risk averse. The sales presentation is calculated to reassure the investor that, due to “proven system” claims and the touting of high quality training and continuing support from the franchisor (none of which is ever provided for with any specificity in any franchise agreement), the risk of investing in this franchise is really quite low. It is always a delusion in the case of newer franchises. In fact the risk is enormous. Franchised start ups are not less risky than independent start ups. They never have been, and the franchise industry’s claim that they are less risky was always based upon an utterly incompetent, trumped up “survey” done by the U.S. Department of Commerce. Now even the IFA disclaims that nonsense, but newer franchise companies continue to make that false assertion.
The claims cannot be based upon any possibly constructed reliable data for the reason than in a newer franchise there is no experience history to provide the data. Franchise investors, no matter what their other business experience, have no ability to appreciate what is happening to them.
Therefore, if you want your franchised opportunity actually to be less risky, you have to engage in financial modeling in your decision to franchise. If, when you are done with this exercise, the franchisee financial model does not yield positive prospects for investment returns, you will decide not to franchise or you will be just another vehicle for bankrupting investors by making representations about risk that are totally without foundation.
One of the unrecognized facts that make franchise investment a higher unsystematic risk is that there is no way for a franchisee, having signed the franchise contract, to achieve diversification to systematize the risk. He is tied in to a very stringent, no right to deviate from the plan, regimen. He cannot use any vendors he likes. He cannot without consent diversify the products or services he offers in his business, and he cannot change location to go to a better area. Systematic risk arises only when the investor can diversify through increasing the scope of his “portfolio”. In franchising the “portfolio” is limited by the terms of very tightly written contracts. In that perspective, franchise investing is much riskier than any investor recognizes.
The bottom line here is that your risk in deciding to franchise your business really is a function of the degree to which you can provide workable financial models for your franchisees. If you make the franchising decision without financial modeling, you aren’t planning anything. You are just rolling dice.
I have encountered very few new franchisors who ever gave this any serious thought. Traditionally, the good old franchises and the few good new franchises managed to provide good livings for their franchisees through being early in the business segment (McDonalds in hamburgers; Little Caesars and Pizza Hut in pizza; Colonel Sanders in fried chicken; Brinker International in Chili’s, Maggiano’s Little Italy and others; Panera Bread in pastry café restaurants) without financial modeling or with very crude financial modeling. They simply assumed that their franchisees would be successful enough to pay the freight, and they were.
Today, with new franchise concepts entering already heavily populated business segments and heavy price promotion the rule, those assumptions are not reliable. One could posit however that some rudimentary form of pseudo financial modeling was probably provided to franchise investors by someone, even if only on a cocktail napkin. The most sought after answer to pre investment questions is how much the investment is likely to return. Your sales people will answer that question in some fashion – usually inappropriate – so you would do well to provide something reliably competent. Your lawyers will provide you with all sorts of contract language disclaimers that will sometimes work and sometimes not. Since franchise salesmen are never wealthy, you can expect to pay for the consequences of everything they do.
A form of modeling is always to be found in the pro forma that goes with the franchisee’s business plan in support of a start up loan application. Either all the financial information in that pro forma came directly from the franchisor, or bits of it came from the franchisor (probably contained in Item 19 of the FDD) with the franchisee estimating the rest and then being told by the franchisor that his pro forma was within the normal range of what the franchised stores are doing. Often the franchise investor spoke with other franchisees about financial performance. This was once thought to be a responsible source of information, but it is not. Every failed franchisee in every system spoke to other franchisees before deciding to invest. Many times the investor was steered to specific franchisees known to be willing to cheer lead for the deal. Sometimes these shills actually get paid commissions on each deal where they touted the investment. Franchise sales people believe that if they steer a prospect to a “fixed” franchisee reference, this is not their actually making an earnings claim. That is wrong. Many believe that this charade somehow is not an actual earnings claim. They are wrong.
Important, however, is the fact that in almost every instance, the pro forma is way off the mark from reality. Item 19 of the FDD has numerous disclaimers about how line item numbers are averages of some stores meeting certain selection criteria. The more blank spaces in the Item 19 materials, the more likely it is that the Item 19 information is misleading. Illustratively, where an Item 19 earnings claim omits royalties and makes some excuse for doing that, it is always that the stores used to compile the Item 19 earnings claim do not have the same royalty and other obligations as the model business that the prospective franchisee will experience. What is omitted is often the telltale mark of fraudulent and misleading presentation of information. In one instance I know about personally, the Item 19 stores were operated by insiders and paid no royalties at all. They had not even signed franchise agreements, and had many other distinguishing attributes that were not disclosed.
No matter how professional an Item 19 earnings claim may appear, whether it is a competent franchise business financial model can only be determined by very aggressive due diligence analysis. Most of the time it is not anything at all like a competent financial model, and after signing the franchise agreement, the franchisee learns to his detriment that he lacked competent disclosure upon which to base an investment decision.
That he used the information in his business plan and presented it to a lender means nothing, as lenders don’t read business plans anyway, especially in SBA guaranteed loan situations where the government picks up the pieces if the loan fails . They are merely file stuffers in case a bank examiner comes around to see the loan underwriting files. It is a charade.
There is an ongoing debate about whether competent Item 19 financial modeling should be required in every FDD. The franchisor community, speaking through the IFA, flatly opposes that. They claim it cannot be competently done. That is not true. The reality is that they don’t wish it to be done. Were it to be done competently, they fear that only the most obviously successful franchisor in any given business segment would be able to sell franchises. No one would compare the information of all competitors in any segment and deliberately select some inferior model for his investment. Comparison shopping is one of the great evils that are not to be provided to franchise investors.
While it may seem at first blush to be contrary to open market niceties, it is great for those practitioners who offer killer pre investment due diligence services. I suppose I should be grateful and not mention it. There was a legislative charade several years ago called the LaFalce (how appropriate) hearings, supposedly relating to the adoption of something called the Small Business Franchise Act – a fairness and touchy feely construct calculated to protect the public from rogue franchisors. As predicted, it produced nothing but a venting opportunity for those who spend their time lamenting the ambient circumstances instead of actually doing something about it. It is easier to whine about any situation than it is to acquire the ability/buy the ability possessed by someone else to overcome the difficulty. Testimony was provided by various chipmunk chatter groups that offer their services as professional mourners at the financial funerals of wasted franchisees.
Stripped of the legalistic mumbo jumbo, it is very clear to me that if a franchisor has a business model that works financially, the facts that show that to be true are available and can be provided. Why are investors left out there having to guess whether the artful dodger quality of current financial disclosure hides a predatory franchisor’s intent to fleece him? It is not that any law prohibits the disclosure. It is just that the law requires that financial disclosures have a tangible data base to substantiate them. If that is a given – which it is – due diligence could be made less art form and more metric. What should the investor reaction be if the franchisor declines to provide written answers to financial performance questions? Obviously the most secure reaction is simply to refuse to invest in that franchisor’s proposition.
Unreliable financial performance information is now clothed with claims of proven systems – competent training – start up cost savings (always false) – greater chances for success than an independent start up (always false also) – buying power (rarely true and when it is it is the franchisor who gets the benefit of it, not the franchisees) – and other mesmerizing mantras that convince people who have never in their lives vetted small business investment opportunities to sign contracts with draconian terms.
Only later. After signing the contracts they cannot escape from, these zombies learn that without killer pre investment due diligence resources (that are not free), they walked into bankruptcy and not into a life of business success. Would that it were not so, but in today’s franchising market the scoundrels represent a huge majority of the franchise offerings. The real franchisors seem to have no interest in policing the scoundrels, and the IFA will take membership money from and provide code of ethics logo use permission to any crook with a membership fee check. With investment quality and disclosure quality this low, the field is wide open for good franchises to be more dynamic about what it is that they have that the bad guys don’t have. How that is done is the issue, and quality control through regression analysis is the key. The dependent variables reduce in number as the quality of the deal itself improves. What more incentive could anyone ask for?
Where does all of this leave us? Here is the bottom line.
First, if you are considering franchising your own business that you have already operated with financial success, with more than just one store, for at least three years – hopefully several more than that – you can begin to construct a model of what your franchising business will be like financially. You will definitely want to establish a separate business entity to be the franchisor, saving your own operating business apart from the franchise operations.
You can franchise using an opening certified financial statement, as your franchising company will have no actual franchise operating experience. If you are located in a state that has a franchise investment statute, or intend to sell franchises into states that have such laws, you will have to escrow initial fees for a while pursuant to those statutes. The initial fees can come out of escrow once your franchisees sign off on your having provided to them the services you promised in connection with their training and store opening assistance. This is done with thinly financed franchisors, and you should plan for this so that you don’t run out of money because of this requirement if it applies to you.
In the establishment of a capital budget for your franchising company, and in creating a pro forma for resources needed and revenues to be anticipated, you should consider the following. You can do it a lot more expensively than I am depicting here, but if you were working with me you should expect at least the following.
You will need a name. You already have a name for your local business. Whether that name is feasible for a franchise company, however, is another question. You will want to do a deep search of the name to see who else may be using it or any similar names and in what kinds of businesses and locations. Since use trumps registrations in trademark and service mark law, you may indeed have the right to the name where you now are, but lack the ability to exclude others from using it or a similar name elsewhere. You will also need to evaluate whether the name you use is essentially descriptive of the nature of your business. The more descriptive it is, the less likely you will be able to defend it against potential infringers. Illustratively, many years ago Computer Land Corporation – a rather descriptive name (it identified a business in which computers and related products and services were sold) – sued Business Land for infringing its name. Computer Land lost. The court found the names not to be confusingly similar, and that Computer Land was descriptive and therefore not the strongest mark.
If your name is descriptive, you will wish to consider finding a more distinctive name before making a large investment in it in a wider geographic area where people are investing in your franchises based in part upon the present and future value of the name as the identifier of their business. Franchisors who have name difficulty invite revolts and large scale departures by their franchisees, accompanied of course with quite expensive litigation. Budget at least $ 7,000 for trademark work under the best of circumstances.
The accounting work will amount to at least another $ 5,000 for opening certified financials.
If you have not yet created an effective operating manual that can be the text for your franchisee training as well as the operations manual for your franchisees to use in connection with finding everything they will need in operating their franchisees, you can start working on one now or you can buy one from a company that provides generic operations manuals that you can then fine tune to make it fit your specific concept and terms.
You will have to establish an advertising and franchise marketing budget to promote franchise sales. You can do this with your local advert agency or you may decide to hire a professional franchise marketing firm that will do the work and charge you appropriately, including listing your franchise with them as your sales arm. Selling will be compensated by commissions on franchises sold. The other work will probably be fee based.
This could be much longer, but you get the picture. You should accept the likelihood that you will spend upwards of $ 100,000 before you see your first franchise sale. If you budget for that, and if you are correct in your belief that you do in fact have a franchisable concept in this current market environment, you are pretty certain that your surprises, if any, will be pleasant ones. This is very conservative. If anyone tells you that you can do it for less, be very wary. This will give you the outline for the franchisor business financial model.
As for the role of financial modeling for the franchisee’s business, it is unlikely that you can build a reliable financial model for a franchised business where there is no base of significant experience of actual franchisees operating the franchised model for at least three years. Where new/recent franchisors have used earnings claims, they are extremely unreliable and probably just outright false. Most recently I have encountered a recent franchisor whose beginning Item 19 earnings claims were based upon stores operated by family members of the owner that signed no franchise agreements; had no similar risk profiles; and that paid no royalties at all. That is what you can expect with new franchisor earnings claims.
If you in fact have a successful franchise concept that your franchisees are operating and making decent return with, you should definitely consider financial modeling for your Item 19 earnings claims section. A profitable franchise concept can use that positive experience base as a sales tool in its FDD.
If I were such a franchisor, I would use a very conservative financial model in Item 19, carefully footnoted and fully documented so that I could with ease pony up the supporting data without fear that it would show I was fudging. I would know at what sales level my franchisees were hitting break even and how long it took them to get there. That would also tell me whether my working capital requirement information in Item 7 was responsible. Most working capital figures given today are ridiculously low, resulting in many instances of “gambler’s ruin” going broke because there isn’t enough working capital to finance the way to profitability. I would have scrupulously gathered the tax returns of my franchisees as is provided for in every franchise agreement, as that is the most conservative statement of how the franchises are performing financially. I would also carefully monitor what my franchising competitors were saying about their systems in their Item 19 earnings claims. If, using that quality information I was better than they were, I would be a fool not to use financial modeling in Item 19 as a sales tool.
With electronic information management today, tax returns do not represent warehouses full of old paper taking up expensive space. It is only a matter of programming for that information to be organized to produce for you variables based upon geography, seasonality, age of the franchised unit reporting, metro or out county market stores, time to break even by all those categories, cash flows and working capital requirements, identifying non productive expenditures (as in for example advert costs as percentage of sales) and all sorts of other delicious info candy. There are line item expenses that include non cash charges that will be handled separately and included in only certain kinds of measurements. There are other line items having to do with all the forms of owner compensation that would present confusing information were it not for the fact that your franchise agreement allows you to require reporting of financial information in any supplemental manner that you may find useful.
These are for your determination and may be changed as you decide other formats to be more useful to you. These are the other things typically pointed out to claim that comparability is not available. Nothing could be farther from the truth when you use the system I am describing. With your standard franchise agreement language you can require any business information that may be useful to you in any electronic format. You simply change the format of the pdf forms on which the franchisees report. If your stores were company owned instead of being franchised you would be doing this as a matter of competent market research. The more successful your franchise system becomes, the more useful doing this financial modeling will be. Ultimately, the world’s largest retailer does this at an extremely sophisticated level and saves tens of millions for doing it .
Now, of course, if your franchise concept is a bozo concept, it will show that too. This is only for franchise systems that have positive prospects.
Will some franchisees fail no matter what? Sure. Might I get sued by one or more failed franchisees for doing that? Possibly. But if the quality of the financial model is very high, I would not be likely to incur liability, and I would sell a lot more franchises.
Will a lot of people simply decline to accept that risk profile and just let their sales people provide bozo earnings claims on cocktail napkins as they always do (even if not on an actual cocktail napkin)? Of course. They will have the same rate of failure, and the results of disputes may – depending on disclaimers and pre closing questionnaires – be adversely greater than responsible financial model earnings claims. It all depends on the quality level of how you do it. You can be bullet proof and use financial modeling in your own Item 19.
This could be a much longer article, but I think it will suffice at least to give you insight into how to engage in a longer discussion of the use of financial modeling in the franchise industry with whoever you choose to work with in franchising your own business. It should also serve to enhance franchisee investor awareness of the many pitfalls out there and of the fact that, no matter what their prior business backgrounds may have been, they do not know how to vet small business investment opportunities.