RISK REWARD

Philip Morrison has evaluated more franchises than most. Here he shares some of his experience

Whenever I tell anyone that I’m a specialist franchise accountant, I always get asked the same question: ‘What’s a good franchise to buy, then? You must know, you’ll have seen heaps.’

Well, yes, I have seen hundreds of different franchises, and I’ve seen thousands of different franchise buyers, too. And that’s why my answer is always rather unsatisfactory:

‘It depends.’

You see, what defines a ‘good’ franchise depends as much on the individual buyer as on the franchise itself. Everyone has different skills, everyone wants different things from a business, and everyone’s financial profile is unique to them. That means what works for one person may not work for another.

Benefits and drawbacks

Franchising offers a lot of potential benefits for a new business buyer. You’ll be selected for your ability to run the business; trained how to run it successfully; given proven systems to follow; benefit from group buying power and group marketing; and have ongoing support to help you maximise sales and profitability.

But at the same time, any business – franchised or not – has risks, and you have to evaluate those, too. You also have to be aware that franchises have some specific limitations: you can’t usually change the system or the products to suit your own desires, you may have a limited marketing area and, of course, you will have to pay ongoing fees in one way or another to fund that support.

Whether the advantages outweigh the disadvantages is something you need to weigh up with the help of an experienced professional advisor.

Unicorns don’t exist

Of course, what everybody is ideally looking for is a high reward, no-risk business. I’m sorry to tell you that, like unicorns, they don’t exist. If you want no risk, put your money in the bank or in government bonds, but be prepared to get a very low rate of return. As the old saying goes, ‘Without risk there is not, and cannot be, any reward.’

It’s therefore important that, when choosing a franchise, you have realistic expectations around risk and reward and can find a balance that you are comfortable with. As far as the risk side goes, there are two areas to consider: your own level of comfort with risk, and the risk profile of the business you are looking at.

Your appetite for risk

If you haven’t been self-employed before, moving from the ‘safe haven’ of a job to the excitement and uncertainty of owning your own business can involve a major leap of faith. It can be a time of great personal growth when you leave your comfort zone and put your trust in your own abilities. If you are buying a franchise, you are also putting your trust in the franchise system, people and process.

Buying a business is often the second-biggest financial decision you’ll make after buying a house – and it could be larger. So you need to apply a mix of logic (facts and figures) and emotion (fear, joy, anxiety, excitement) to your decision. You also need to be honest about your appetite for risk.

Someone with an extreme Risk Averse profile will look for a ‘no risk’ proposition where they can guarantee or control all of the elements in the business mix: elements that will work perfectly and generate predefined, predictable and stable financial rewards.

Someone with an extreme Risk Taker profile won’t worry about that – they will believe that they can cope with whatever happens and if it doesn’t work out, so what?

I just wish I’d listened

As an advisor, one of the most worrying things I hear is when someone says to me, ‘I thought I’d better get you to look over the figures, but my mind is pretty much made up and I’m going to buy this business anyway.’ That’s a reckless Risk Taker for sure – and, all too often, the outcome is a remorseful client saying, a while after, ‘I know you told me – I just wish I’d listened.’

But the opposite also happens. If someone proceeds in buying the franchise while still feeling extreme anxiety, their focus on the new business can be hampered by sleeplessness or health issues. That’s a tell-tale warning sign that not enough homework was done to mitigate their concerns.

Most people, of course, fall somewhere on the line between these two extremes. They are comfortable with a certain level of risk, but no more – and they also want a certain level of security. The trick is to ensure that you are comfortable with the level of risk involved, and have done the necessary homework (and taken the right advice) to have a clear picture of what the business involves and what you need to achieve over what timeframe in order to succeed.

How risky is the business?

New Zealanders have a big appetite for franchise businesses, both as franchisees and as customers. But not all franchise businesses are created equal. With new franchise systems coming on the market almost every week, there is an abundance of choice.

Some are new models from overseas; others are home-grown. Some suit owner-operators, others suit investors. Some are proven brands, others are new to the market. And even within a franchise network, some areas will perform better than others. Is that down to the location or the franchisee? It’s good to find that out before you buy, especially if you are purchasing an existing area. Could you do as well – or better?

A proper detailed analysis is required. Is it a viable proposition, will it make money, and what are the chances of losing your capital or getting your money out? These are important questions that a financial analysis or pre-purchase evaluation should cover. To do so, you will need to know what to look for, what questions to ask, and what the risk analysis and profile shows. That is where experienced franchise advisors are worth seeking out.

Sometimes, new franchise concepts genuinely are the ‘next big thing’ to come to market, and it will pay you to get in early and take the best locations while they are still available (and before the price goes up). Other times, they may involve a certain amount of wishful thinking, so getting help in evaluating the business risk is important.

What to look for

Here’s an example from when we evaluated a brand-new franchise system coming to market. They were recruiting their first franchisee, so our profiling identified that there was a potentially high risk that needed to be mitigated. What did we look for?

• The franchisor had invested in taking good advice from reputable industry advisors and lawyers in building the franchise – so it wasn’t a DIY franchise system cobbled together.

• The company had been in business over five years and was profitable – so it had a strong financial base. You could draw the conclusion that they were going to be resilient and in business for the long term.

• The franchise had taken time to run two pilot operations over two years to prove the business model in different locations before it started to recruit franchisees, so they weren’t testing it out on the first franchisee.

These factors provide some risk mitigation to potential franchise buyers, and give you a taste of the types of things you would consider when balancing risk versus reward. An existing brand with a proven track record would also demand analysis, but the questions are different. Is the brand still in a growth phase, or has it passed its peak? How well has it adapted to changes demanded by new technology or growing competition?

A good advisor will ask all these questions and a lot more. Don’t be tempted to cut corners on taking advice, and beware of buying a franchise on its reputation alone. A good reputation certainly helps, but any investment requires that you carry out proper financial due diligence.

A balanced scorecard

Getting the balance right between risk and reward is the tightrope you always walk when buying a business.

We call this having a balanced scorecard, and it comes from doing your homework, undertaking full due diligence, identifying risks and assessing possible rewards so that you can make a fully-informed decision. Some of the elements on your scorecard will be around the amount of risk capital you put up to purchase the franchise business versus the expected returns. You can never eliminate risk entirely, so the aim is to find a balance that matches your personal comfort level.

The following examples are in general terms to provide a rough guide. They are not comprehensive, and have been simplified to illustrate general concepts. A good advisor will include many more elements.

Example 1 (an established brand or business)

Risk Capital = $500,000 Return

Earnings to Owner = $50,000

Return on Funds Invested = 10%

This shows that risk capital of $500,000 is required and potentially generates a 10% return.

Typically, we would see a return of 10% as being at the lower end of the spectrum. You could say it’s just ‘buying a job’ and deem the returns too low for the capital invested; however this could be balanced by a reduced risk profile and/or marketplace evidence that businesses of this type are very saleable. In these circumstances, it may be that the increased likelihood of getting your money back or making a capital gain upon sale would offset the low returns.

Example 2 (a new start-up)

Risk Capital = $200,000 Return

Earnings to Owner = $50,000

Return on Funds Invested = 25%

This shows that risk capital of $200,000 is required and potentially generates a 25% return. Typically, we would see this level of return as being more attractive; however, there may be increased risk from a new brand or location.

Another factor that might reduce your appetite for the higher return is, for example, if this business worked anti-social hours and meant you never saw your family in the evenings or at weekends. Is that a trade-off you would be prepared to accept? This last point is important because it demonstrates that calculating risk versus reward isn’t just about money – it can be a mix of financial and non-financial measures.

Making the call

When weighing up the risk versus reward of a franchise business purchase, you can never eliminate risk completely. As the above shows, however, how much risk is acceptable to you depends on a range of variables.

If it’s your first time owning a business, then not knowing what you don’t know can increase that risk. Whether it’s a small home services franchise or a million-dollar restaurant, it will always pay to seek out help.

Experienced franchise advisors, accountants, lawyers and bankers are part of the process of creating a balanced scorecard for your assessment. After all, the less you worry about, the more time and energy you’ll have for building your new business and living the life you want. That’s what buying a franchise should be all about.

About the Author

Philip Morrison is principal of Franchise Accountants, a specialist accounting practice which has worked with over 250 different franchise brands throughout New Zealand.