Starting a Franchise? Here’s What You Need to Know about Initial Investment and EBITDA
As you prepare to franchise your business, one of the most important things you need to do is put yourself in the shoes of a prospective franchisee. Investing in a brand new franchise can be daunting. Will this new franchise survive or is it a fad? How much time will I need to devote in to get the business up and running? What kind of support will I receive? But one of the biggest questions looming over franchisee prospects is: What kind of return on my investment can I expect?
As a franchisor, you must provide prospects with an accurate assessment of the health of your business – and it needs to be healthy. The numbers must have an adequate return on the franchisee’s initial investment in comparison to other investments they could make with their money. If they do not, your prospects will likely choose those other investments, which may include your competitors.
EBITDA for Calculating Return
A common valuation measure of a company’s operating performance is earnings before interest, tax, depreciation and amortization, or EBITDA. EBITDA is based on operating decisions to determine profitability and is useful when comparing similar companies. The non-operating decisions vary from company to company and do not lend themselves well to an apples-to-apples comparison.
By knowing your company’s EBITDA, prospective franchisees can determine when they might expect to see a return on their initial investment and if it’s worth the risk. Since getting a franchise location up and running requires considerable effort, this information will help them determine if investing is worth the proverbial blood, sweat and tears. Since franchising is an “active investment,” whereby the candidate will likely be engaged in the business, Winmark Franchise Partners recommends providing a 30 percent or more pretax return in order to be competitive with other franchise investment concepts in the market. Given the higher level of risk and requirements for franchisees, the investment must provide a much higher rate of return than a passive investment, like buying stocks, which typically yield a return in the 4 to 8 percent range.
Anything below 25 percent is too low to consider franchising, in our estimation, as the return for the risk taken by the franchisee is simply not there. In those cases, we would recommend that a potential franchisor defer from franchising their business until they can get their corporate and affiliate units up to a level that will provide that type of return.
How to Measure EBITDA without Franchise Units
As a new franchisor without any franchise locations, you should use your corporate or affiliate locations as your benchmark. Add in the additional expenses a franchisee will incur, including a royalty rate or continuing fees, as well as a national ad fund fee, before calculating the new ROI. With the additional expenses layered in, a franchise will want to project a 25 to 35 percent rate of return at a pre-tax level on paper. This would provide a three-year return on investment to the franchisee candidate.
Budding franchisors can also share with potential franchisees the corporate and affiliate information in Item 19 of their Franchise Disclosure Document (FDD), and note below the information the additional expenses a franchisee can expect to incur. Or, perhaps even more transparently, include the additional expenses in the profit and loss statement of their corporate and affiliate locations, noting that those items have been added to the Item 19 to reflect a comparative bottom line result.
Entrepreneurs interested in investing in a franchise can use a simple formula for determining their pre-tax return and when they can expect to recoup it: EBITDA divided by initial investment. This will give potential franchisees a percentage answer. Typically, they should expect to get back 30 percent of whatever that amount was each year that they perform against the company’s benchmark – assuming that they can hit those numbers.
With more than 30 years of experience, Winmark Franchise Partners can help business owners prepare to become franchisors with a strong EBITDA valuation and help determine whether they are able to provide a strong ROI to franchisees. We have the capacity to work in any number of ways with our franchise clients. If you are interested in putting your company on the track toward franchise growth, contact us here or at (844) 452-4600.