Is an investment in a franchise better than a passive investment?

January 31, 2017 Facebook Twitter LinkedIn Google+ Expert Advice,Raising Finance

franchise vs passive investment

return on investmentThe view of any franchisor is that franchises are only successful when the owner is permanently managing the business. Nonetheless, there are many franchisees running multiple stores who have decided that the rate of return on investment (ROI) in a franchise opportunity makes it worthwhile compared to other forms of investment.  However, these franchisees often have to employ large, high quality teams to ensure the success of each individual outlet.

For those who consider a franchise as an investment they can earn passive income from while continuing their own job, the investment must be compared less to a business than to comparable investments such as the JSE or a retirement annuity with a life insurance company.

You will still need to employ a full-time manager to stand in your stead while you carry on with a full-time job or other business interests on the side. The other option is to invest as a venture capital partner, with the objective of selling your shares eventually.

What factors need to be analysed in getting an answer?

When you invest in the stock market, you know exactly how much money you paid for the stock and your return (increase in the price of the shares or unit trust, plus dividend) is published in the daily newspaper. If you pay R1,000 for a unit trust that pays you a R50 dividend and then you sell the stock in one year for R1,100, you made a R100 total profit or a 10% ROI. If you buy a bond for R1,000 and it pays you an annual interest payment of R60, your ROI is 6%.

Such types of investments are referred to as passive: you are investing your Rands but not any significant passive investmentamount of your time. When investing, the more risky the investment the higher return you would expect to make. Over time, an annual return of 5% to 12% would be considered good, and anything higher than 12% excellent. The 12-month return on the JSE as at 12 December, 2016, is 5.1% for instance.  However, it must be noted that the stock market is experiencing a downturn after a few years of excellent growth.  Stock market investments are generally viewed as long term investments where “bad years” even out with better performing results over the long term. You can get 13% on a fixed bank deposit account at the moment.

Virtually all franchises assume that the owner will be investing at least some of their time and skill into the business, as well as their money. It is therefore reasonable to assume that an investment in a franchise should provide a return for both the money and a salary for the time invested in the business. That salary can be paid to yourself if you’re running the business, or to a manager if you’re not.

If you are viewing your purchase of a franchise as a pure investment, you need to factor in that most new businesses go through a startup phase where they lose money for a while, then break even and ultimately become profitable. For a typical business, this takes two to three years.

return on invested capitalAn evaluation of what is a reasonable return in a franchise should begin by looking at the return on invested capital. Starting any new business is considered a risky investment, so you should expect to earn a good return on your invested capital, say 15%. In other words, for every R1-million of your capital you invest, you should expect to make at least R150,000 a year ROI (after all expenses, including salary). Bear in mind, you can earn R130,000 a year at the current available rate on a fixed bank deposit account.

calculate reasonable salaryCalculating a reasonable salary is more difficult because of the variables involved. If you’re paying yourself a salary, then the franchise has to at least match that – or why bother? If it’s to be a manager’s salary, then you need to know the going rate. There are also of lot of ‘soft’ factors that are important to consider, but difficult to quantify. Your lifestyle may suffer if the franchise requires long hours, for instance.

evaluate investmentLet’s assume you are evaluating an investment in a franchise opportunity. Based on local assumptions by Franchising Plus, when you invest R2-million in a franchise business it would in the case of a very good franchise give you your money back after three years, after paying yourself a market-related salary. This is a return of R666,667 a year on R2-million. Assuming an average return of 12% on the JSE (or a retirement annuity) you would expect to earn about R240,000 a year as a fair return on the R2-million of invested capital. The franchise in this illustration therefore provides well over double the return on what the JSE would typically deliver. Even if there are no soft benefits to you whatsoever, that’s a pretty good deal.

variablesThere are many variables: when the business breaks even, and the cost of carrying that business to break-even point. Franchises also vary substantially in terms of their success potential, which is based on the brand and reputation of the franchisor, consumer support, location and quality of the operator/manager. The above figures are estimates and averages. Some franchises cost less than a million rand in upfront costs, and franchisors say owners can earn monthly salaries of R30,000 to R80,000 (depending on the amount of effort, skill and location). That is the beauty of a business over a passive investment – the opportunity to put your skill to the test and hugely increase that ROI.

Tsale pricehe real opportunity to create personal wealth occurs when a franchisee sells a well-established franchised outlet.  The sale price will also reflect the goodwill accumulated over the lifetime of the store, which could be substantial despite the fact that the sale of business will accrue capital gains tax.

*This article does not constitute financial or investment advice