Buying a franchise is one of the most significant financial decisions you'll make. It's natural to approach a business opportunity with optimism and enthusiasm. However, if the business doesn't produce the financial results you're counting on, you could face years of financial stress working long hours for little income or find yourself unable to repay your investment before the franchise term ends.
Owning a franchise always involves financial risk. A wise buyer takes action to understand and reduce that risk before signing.
Understanding the risk means recognising some hard truths: you'll only be able to pay yourself if the business makes a surplus after covering operating costs and staff wages. To repay your investment, the business must generate enough profit to cover all costs including your own wages. And here's the critical point: if you can't repay your investment within the franchise term, you face the real possibility that the business will close with debt still owing to yourself or a bank.
Now to the question of how to reduce the financial risk associated with buying a franchise. This is the financial due diligence stage of buying a franchise.
The first step in financial due diligence is to answer three questions:
- What will the annual operating costs of the business be? These should include your own wages and interest on any borrowings.
- How much profit does the business need to make over the initial franchise term to repay the upfront investment?
- What annual sales are needed to cover the operating costs, repay the initial investment, and provide a return on your investment of your own money?
Working out these answers requires detailed financial modeling that accounts for dozens of variables and their interactions. Most franchise buyers benefit from working with an experienced advisor or accountant who specialises in franchise businesses. Here's what this process typically involves:
Estimate Your Operating Costs
Work out the likely operating costs for the first year you'll own the business. You'll need to estimate three types of cost:Fixed costs of operation - costs you'll incur regardless of your sales level. These include rent, insurance (general and workers' compensation), vehicle costs, utilities, software subscriptions, professional fees like accounting, and ongoing franchise fees if they're a set monthly amount rather than based on sales.
Variable costs - expenses that only occur when you make a sale. In a café, these include coffee, milk, food ingredients, and packaging. The franchisor should provide a target range, typically expressed as a percentage like 29-32% of sales. Franchise royalties calculated as a percentage of sales are also variable costs.
Annual wages cost, including superannuation - This can be tricky to estimate because while every business has a minimum staffing requirement, higher sales usually demand more staff. A good starting point is the cost of the recommended staffing level for the first year, or if you're purchasing an existing business, use the current staff costs as a guide.
Calculate Your Breakeven Point
Once you know these costs, you can calculate your breakeven point - the minimum sales needed just to cover costs.
Here's how: First, work out your contribution margin (this is simply 100% minus your variable costs percentage). So, if your café's food costs are 30% and royalty is 9%, your contribution margin is 61% - meaning 61 cents of every dollar in sales is available to cover fixed costs.
Then divide your total fixed costs and wages by this contribution margin. For example, if your fixed costs and wages total $300,000 and your contribution margin is 61%, you need sales of $491,803 just to break even.
But breaking even isn't enough - you also need to repay your initial investment. To factor this in, add another annual cost: your total upfront investment divided by the number of years in your franchise term. A $400,000 investment in a 10-year franchise term means you need an additional $40,000 in profit each year just to get your money back.
Once you've completed these steps, you'll have a reasonable estimate of the target sales for your first year. You can extend this analysis to cover three or four years to get a financial picture of the business over a longer term.
Do the financials stack up?
Once you’ve got the financial model worked out, it’s time to turn to the big question: “How confident am I that the business can operate within this cost structure and generate the target level of sales?”
This opens up another part of the due diligence process: looking for evidence that your assumptions are reasonable. To do this, you'll need to ask questions of the franchisor and the existing franchisees.
This is where experienced guidance becomes invaluable. A specialist franchise accountant can help you test your assumptions against real franchisee data, identify red flags in the financial model, and ask the tough questions that might save you from a costly mistake. They've seen what works and what doesn't across hundreds of franchise systems, and can spot the difference between a genuine opportunity and one that looks good on paper but struggles in practice.
The time and cost of professional advice during due diligence is small compared to the risk of buying the wrong franchise. Done properly, this financial analysis gives you either the confidence to proceed or the wisdom to walk away - both are valuable outcomes.
Kate Groom - Short Franchising Bio
Kate Groom is Co-Founder and Director of Franchise Accounting & Tax, an accounting and advisory firm which helps franchise owners with financial management, tax, and accounting.. Kate has a keen interest in financial and business education and has developed and run many courses for business owners. Since starting her working life in audit with Coopers and Lybrand in the UK, Kate has worked in a variety of management and leadership roles in accounting, insolvency, and franchising.
