Attention Franchisors and Franchisees: A Successful Franchise Shouldn’t Require Extraordinary Performance

by Ed Teixeira

In a prior article I presented a number of reasons why some franchisees fail. One of the reasons for the failure of a particular franchise was that the franchise program was flawed. The following article attempts to explain how franchisors and franchisees can address this specific issue.

In the article I wrote several months ago entitled “Understanding Why Franchisees Fail Will Help your Evaluation Process”, my objective was to educate prospective franchisees and existing franchisors as to how to better relate to the factors that lead to franchisee failures. This article expands on one of these factors. An excerpt from that article: “The franchise program is flawed shows a situation, where the sales and/or gross margin dollars needed to meet expenses, including paying royalties may be difficult to achieve. It may require extraordinary performance to be profitable.” This can eliminate franchisees that do a good job but not an extraordinary job. This situation can be corrected by the franchisor.

The Franchisor: A franchisor should structure their franchise program in such a way that franchisees can earn a fair return on their investment based upon good performance. If it’s a start-up franchise program there should be a proto-type or model operation that the franchise is based on. Then the sales and gross margin necessary to achieve profitability would flow from this model. The royalty and ad fund contributions should reflect the aforementioned fact. To take this a step further; if the business model for the franchise was well managed and profitable, then the franchisor should understand how much added expense in the form of royalties and fees the new franchise can absorb. Unfortunately, in some cases a 5-6% royalty and 2% ad fund contribution is added on with the expectation that the franchisee can generate additional sales and/or gross margin to cover this added 7% plus earn a profit.

If the business model earned 20% pre-tax and a new franchisee did just as well as the founder then their pre-tax income would be 13% after fees.  Franchisors have to take a realistic approach when it comes to the level of performance their franchisees can be expected to achieve.

The Prospective Franchisee: An individual looking to purchase a new franchise needs to perform comprehensive due diligence. A critical part of this process involves constructing a pro-forma income statement that provides a financial model of the franchise. The inputs for this model will come from the franchisor, existing franchisees and information contained in the Franchise Disclosure Document. Developing a pro-forma is a way to determine if the sales and gross margin results will require reasonable effort. Simply put; does the pro-forma indicate that the franchisee must achieve a top sales number to reach break-even and earn a profit? I cannot over state the importance of this activity. Many prospective franchisees become overly optimistic in their sales projections which can lead to a shortfall in their future profits.

Both franchisors and prospective franchisees need to recognize whether future franchisee profits will require extraordinary performance. Franchisees that follow the franchise program execute correctly and achieve good results should earn a reasonable return on their investment.

© 2010 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow, LLC. He can be reached at franchiseknowhow@gmail.com