A fresh paradigm for decision making helps franchisors see short-term expenses because of their long-term worth.
As a franchise consultant, I’m often surprised by the decisions created by demonstrably intelligent businesspeople. They are often businesspeople who’ve successfully grown businesses predicated on only their own ingenuity, talent and sweat–and yet a few of their decisions almost defy explanation in terms of franchising.
In analyzing some of these poor decisions through the years, I’ve come to the final outcome they’re often a consequence of a lack of knowledge of a simple principle: today’s value of a franchise.
Hardly weekly goes by when I really do not witness it: The business enterprise owner who pulls the plug on an effective broker program or advertising source because "it seriously isn’t profitable" to market franchises right after paying broker fees. The franchise sales director who won’t commission a franchise salesperson because "there isn’t enough margin in it right after paying broker fees"–even though that strategy may bring about lower broker closing rates. The hiring of less qualified staff or the failure to employ a recruiter to conserve some salary–knowing that diminished sales production could be the result. Pulling the plug on advertising or a trade show since it didn’t work the 1st time. Saving 20 cents a copy on a franchise marketing brochure with a substandard paper stock, regardless of the less impressive message it could send to prospects.
Sure, many of these decisions are made predicated on necessity and short-term budget constraints. But often, it’s simply cost cutting with regard to cost cutting–without looking at the long-term consequences. So in retrospect one core principle we emphasize is understanding today’s value of a franchise.
The idea of "net present value" (NPV) is borrowed from the world of finance. This means a dollar paid if you ask me today includes a greater value when compared to a dollar paid later on. EASILY receive that dollar today, I could earn interest onto it. And, of course, there’s the uncertainty of not being paid sooner or later in the future. Today’s value of another payment thus represents the total amount that I’d accept today instead of that dollar paid sooner or later in the foreseeable future. If, rather than accepting a dollar twelve months from now, I’d take 91 cents today, the difference may be the "discount rate" (if so, ten percent) that I’d connect with that payment. The discount rate represents a combined mix of the expense of capital (foregone interest) and the uncertainty of this income or income stream.
Just what exactly does that have related to franchising?
Let’s focus on a simple premise. A franchise sale is greater than a one-time sale. It really is, at least from a financial perspective, an annuity that may last for many years. Franchisors will receive fees, royalties, advertising dollars, transfer fees, renewal fees, training fees, product margin, rebates and other resources of revenue over the word of every franchise relationship. And the ones fees–or the promise of these fees–represents a genuine value to the franchisor today–and will surely have value to a prospective buyer who’s seeking to find the franchisor.
Just how does one assess this value?
The initial step is to comprehend the estimated life of a franchisee. A franchise, of course, represents a going concern. Given that it’s open (even whether it’s sold), it continues to pay royalties and fees. So begin by determining the anticipated life of the franchise. If you feel your franchise offering could have the average failure rate of 5 percent in virtually any given year, you then might anticipate the life span of a franchise at twenty years (one divided by .05). If your historical or anticipated failure rate is higher or lower, modify that number using the same formula.
Next, estimate each franchisee’s average profits. For most franchisors, this number increases through the years, so the best method of finding this number is to build up a financial model. The model should take into account all revenues you anticipate from a franchisee over that franchisee’s life, with one entry for every year for simplicity purposes.
Deduct any associated costs connected with bringing on a fresh franchisee. Element in marketing, commissions, and other costs from the franchise sale. Also deduct any charges for goods sold to the franchisee. The tricky part comes when allocating expenses and overheads.
There are a variety of methods to estimate expenses–and different methods are more relevant for different decisions. For some decision-making purposes, the most relevant way to conduct this analysis is to target only on those costs directly connected with servicing that franchisee–not allocating overheads that you’ll incur whether or not a sale is manufactured. For example, you may consider the costs of support-related travel as a variable cost. For those who have one field rep for each and every 20 franchisees, allocate one-twentieth of his compensation. You wouldn’t allocate some of the CEO’s salary, as the addition of a fresh franchisee wouldn’t normally impact that expense.
Finally, you’d have to determine the discount rate. The bigger the discount rate, the higher your uncertainty of another blast of revenues. I’ve used a 20 percent discount rate below with regard to illustration, which number is normally considered a conservative number for this analysis. To place that discount rate in perspective, a 20 percent discount rate may be the exact carbon copy of saying that you’d like to take $4,020 today than wait five years for $10,000.
This NPV calculation, in an extremely simplified form, would look something similar to the next:
Duration of a Franchisee
|Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 – 20 Revenue Franchise Fee||20 percent||Calculated predicated on 20 year life|
Even when utilizing a relatively high discount rate, as shown in the example, the lifetime value of a franchise could be well more than $100,000 even after losing $10,000 on the original sale. This implies that, over time, it could actually pay handsomely to reduce money on the franchise fees in substitution for the blast of income that all franchisee represents.
This specific analysis doesn’t even take into account the upsurge in the terminal value of your franchise company in the event that you were to market it. (More profits mean an increased selling price.) Whenever we see franchisors reducing or waiving franchise fees to spur franchise sales in the current more challenging economy, that move may end up being very wise long-term when contemplating the NPV.
While few franchisors are able to reduce money on every franchise sale, consider the short-term sacrifice for the potential long-term revenue.
Ask yourself both of these questions:
- Will this expenditure (on staffing, advertising, marketing materials, training, etc.) reasonably lead to one additional franchise sale?
- Could this expenditure help lengthen the anticipated lifetime contribution of a franchisee (by increasing franchisee revenues, improving franchisee longevity, decreasing expenses, etc.), and if so, how would it not impact the NPV?
Gauge the cost of the expenditure vs. the impact of your choice. Remember, every franchisor could have a different NPV predicated on her anticipated fees, revenue, expenses, and franchisee longevity (along with her estimate of a proper discount rate)–so an excellent decision for just one franchisor could be a bad decision for another.
As this analysis illustrates, franchisors have a much greater have to balance short- and long-term considerations within their decision making than do other businesses. The NPV paradigm in conjunction with good short-term cash management provides a long-term perspective which will ultimately improve your decision-making as well as your long-term profitability.