The Franchise Buyer’s Guide: Value
Making money isn’t necessarily the most important thing in business, but a business that does not make money is not a very good business.
There is a common misconception that franchises—some of which are turn-key operations, and all of which come with a business playbook from head office—are easier to run than other small businesses or more reliably profitable. That is not necessarily the case.
There are certain advantages to purchasing a franchise over starting a business from the ground up, but those come at a cost. Whether that cost will be worth it will depend on a variety of factors that you’ll have to evaluate. These are a few of them.
The upfront costs
Most franchises have a standard set of financial requirements and payment structures for any prospective franchisee. Franchisors (the parent company) often make these numbers publicly available. They include:
- Franchise fee: Usually a one-time flat rate paid by the franchisee to the franchisor.
- Liquid capital requirement: A minimum cash requirement that the franchisee must prove in order to take on the franchise and cover the daily costs of running the business.
- Royalty fee: A percentage of gross sales that the franchisee is required to pay back to the franchisor.
- Ad levy: A percentage of gross sales that the franchisee is required to pay back to the franchisor, but which is earmarked for marketing the business.
The daily costs of running the business are additional and may include payroll, taxes, and material costs (ex. food franchisees are often required to purchase their ingredients from a designated supplier, which tend to come at a markup).
The rule of two-thirds
Some franchises have an initial price tag of over $1 million, so it’s reasonable to rely on financing. Franchise 101 proposes you stick to “The Rule of Two-Thirds.” How much cash you have to invest in a franchise, multiply it by three. That amount is the total initial investment within your capabilities. In order to be a profitable business, your franchise needs to be able to generate sufficient cash flow to comfortably service that debt (i.e. two-thirds of the initial cost) after covering all the other regular expenses. If it doesn’t look like it will be able to, it may make sense to extend the amortization period or reconsider the price tag.
The most important thing to understand about earnings are that there are no guarantees. While some franchisors will present you with historical earnings—such as an earnings claim statement or a sample unit income—those may be dependent on factors that may change under new management. It may be worth your time to interview other franchisees about their yearly earning and how they stack up against expenses.
It’s also important to recognize that, like all businesses, the start-up phase can be difficult financially on the new owner, even if the business is profitable. According to the Franchise Business Review, most business owners can’t take any money out of the business for the first few years, and it can take even longer for that owner to start paying themselves a salary.
But the payoff can be high, especially for food franchises which are known for their high initial costs. A survey conducted by the Franchise Business Review in 2018 and 2019 found that the average annual income reported by food and beverage franchise owners who had been in business at least two years is $120,000 annually.
However, when looking at all food franchises, owner earnings fluctuated much more drastically. Thirty-seven percent earned less than $50,000 per year—more than twice as many as those who earned more than $200,000. Those with multiple franchise units and those who had been in business longer tended to report higher earnings, but factors like brand recognition, location, management style and myriad others play a role.
McDonald’s is one of the oldest and most famous franchise opportunities anywhere, including Canada, and for that reason it has one of the highest barriers to entry. For the very limited number of franchises available, prospective franchisees must have a minimum of $700,000 in cash on hand, and will be required to pay 40% of the initial cost of the new franchise up front. If they are purchasing an existing restaurant, which tend to be more costly, that drops to 25%. In either case, the initial franchise fee is $45,000.
Taken together, initial investment for a McDonald’s can run as high as $2.3 million, after which franchisees will have to pay 4% of gross annual sales back to the franchisor as a royalty and an additional 4% as an ad levy.
But again, there is a reason for these high upfront costs. In 2019, Business Insider reported that the average McDonald’s restaurant does about $2.7 million in sales per year, and Fox Business reported that franchise owner annual profits come in at an average of about $150,000.
For a more modestly priced option that garners many of the same benefits as a franchising behemoth like McDonald’s, consider Pizza Pizza. It’s the largest takeout pizza chain in the Greater Toronto Area with widespread brand recognition.
Prospective franchisees much have a minimum of $125,000 in cash. The initial franchise fee is $30,000, and the total initial investment works out to around $350,000. Year over year, franchisees pay about 12% of gross sales back to Pizza Pizza, 6% as an ongoing royalty and 6% as an ad levy.
Average earnings were not immediately available, but comparable brands such as Dominos and Papa John’s report average franchisee earnings in excess of $100,000 per year.
Not all franchise opportunities come with such high start-up costs. Other sectors can have markedly lower costs with a potential to profit earlier in the start-up process.
Take Pro Fleet Care, for instance. It’s a rust proofing company that started in Canada in 1984 which developed a proprietary rust proofing solution that was more environmentally friendly and effective than tar or wax. But, most inventively, it was administered by a fleet of mobile franchisees.
While the franchise disclosure document is only provided to successful applicants, Pro Fleet care is notable because it claims to have “one of the lowest (start-up costs) in the industry”, low overhead (given that there is no storefront and no property taxes), and no royalties that need to be paid back to franchisor.
That, in combination with a diverse customer base that ranges from emergency vehicles to farm equipment to snow removal to public transportation, means profits for successful franchisees are apt to begin climbing earlier than other franchise opportunities.
BuyAndSellABusiness.com is also running a buyer’s workshop for those looking to purchase any small business—franchise or otherwise. It’s just 30 minutes long and completely free. You can register at our website.
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Opinions expressed here by Contributors are their own.