As a market researcher, one of the things people often ask me to research is for the best franchising opportunities. In fact, twice in the last month, have people asked me to research this for three very different businesses, and as I was trying to collect FDDs (Franchise Disclosure Documents) to answer their questions, various observations came to my mind
- The first is – companies are very weary of sharing FDD data which is weird, as it’s not super hard to find, and no one in their right minds will ever even consider investing without an FDD
- FDDs can be tricky. I have seen FDDs with a bunch of really detailed revenue data but without any profit data – which is kind of missing the whole point.
But I digress, as none of those things are the topic of this blog post. The real topic of this blog post and my true observation is this:
Franchises are built for people who care about NI (= money in their pocket at the end of the working day), not about ROI or NPV.
And to add a bit of a psychological / sociological flare, I would dare even say:
Franchises therefore are perfect for Americans as people who are educated from early childhood to live on debt (see “American credit system”)
This is a phenomena I saw over and over, looking at franchises and their profitability. At first my reaction was – why would anyone do this when a break even NPV is achieved in year 7 or 9 or 10 of the franchise’s life, but once I realized people don’t care about NPV it all became much clearer. As long as they can take home more money than came out of their own pockets – that’s all that really matters, on their way to use the profits to consume more debt through credit, mortgages and buy now – pay later schemes.
Alright, let’s do some math. Consider this as a classic example of a franchise – It doesn’t really matter which one.
Total Investment – $1M – this is a pretty average number, but I have seen franchises with 10X the investment and the same exact logic I will unfold here.
Build-up Time:1 year (0 revenue in this first year)
Time to ramp up to capacity – 2 years – or an additional year to the first, before the business gets to some kind of revenue optimization – if they do good on all operational fronts, which is not a given.
Revenue at optimized capacity but before growth = $500K with a 4% annual growth, thereafter, and a very generous 35% profit margin.
Note that these are not real numbers from any FDD I received, but they are also not very far off in their logic.
Now, assume our franchisee decides to finance this million by himself, here is what could happen
At some point in the life of this investment, in this case, in year 9, but sometimes it can be a little sooner – the NPV turns positive, a little before that, in this case in year 7, the franchisee has a cumulative positive net income (regardless of present value) – or in other words, that when they can start bringing money home.
Is this a good investment? It’s possible.
After all, if we consider the average duration of a franchise contract to be 10 years, this is a GREAT deal for the franchisor, even if not necessarily so for the franchisee – at the end of the 10 years, when extension is in question, the franchisee will have seen a positive NI and even a positive NPV just before the extension period and will want to continue their arrangement. Yes, it took them 7 years to make some kind of profit and 9 to return their investment, but so what? Carpe diem baby.
Would I make an investment that yields a positive NPV only in year 9? No, of course not, but that doesn’t mean others wouldn’t.
Now, let’s assume debt – which is the case in the majority of cases (although I have spoken to franchisors who insisted that most of their franchisees have millions and millions in their banks and don’t assume debt… I am not sure I believe that…). Let’s say our debt is at 7.5% with a 10 year term, 30 year amortization and that we finance 75% of the investment.
Oh well, in this case things look different.
Well, now things look very different. After 10 years the franchisee still didn’t recoup their investment and the NPV is negative (in fact, based on these assumptions, NPV becomes positive only at Year 12, or in other words – off the charts),
But who cares? They start making money right at year 4. Just on time to beat inflation tuition and those doctor bills.
Let’s have a name for our new defined KPI:
FPLV – Franchise pseudo Lifetime Value = Years to positive NPV vs. Years to positive cumulative NI
Without debt, this measure is 9-7 = 2.
With debt, this measure is 12-4 = 8
So while the KPI the franchisee cares about is:
First year with Cumulative Profit (=4)
The KPI he should be caring about is minimizing the franchise pseudo lifetime value or FPLV
And so what if in real money terms you make less money – As long as you can pay for stuff, isn’t that all that matters in a country that’s entire financial philosophy is based on one thing and one thing only – debt. Undoubtedly the thing that most Americans love most and can’t live without.
Let’s sum this up in a table:
| Years to Positive Cumulative NI | Years to positive NPV | FPLV | |
| Without debt | 7 | 9 | 2 |
| With debt | 4 | 12 | 8 |
And in a chart it would look like this:
I wish I had the sociological prowess to expand on the lunacy of this all, but then, who am I to judge. All I know is numbers.
And the numbers tell a very clear story.