At my core, I am a pretty simple guy who understands things better if I can break a complex puzzle into smaller pieces and then build it back up into a whole. That is how I think about investing in a business. There is a total investment that can be very confusing in aggregate. But, if you break the whole investment into smaller pieces, it is far simpler to understand.
When I evaluate franchise investments, I find it useful to break down the total investment in to 5 smaller elements:
- Franchise fee
- Build-out required for facility (office/store/studio)
- Initial equipment and inventory
- Expected working capital
- Oops money
The first component to understand is the initial, one-time franchise fee. As you plan your investment, this will be the first major cash expenditure for your franchise investment. The franchise fee is the investment you are making to secure rights to operate that franchise business in a particular territory/market. If you desire to operate multiple locations, you will need to pay a franchise fee for each location, in advance, to secure the exclusive rights to those locations/markets.
The amount of the Franchise Fee as well as any discounts associated with securing multiple locations will be detailed in Item 5 of the Franchise Disclosure Document (FDD).
The second category has enormous variability attached to it. If you are investing in a services based franchise, the required investment for location build out may be small or zero (for a home based franchise). But, if you are starting a Dunkin (still my favorite franchise!) with a drive through, the facility investment will be very substantial.
The franchisor estimate of the required investment will be outlined in Item 7 with varying levels of detail. It is crucial that you study this disclosure, including the footnotes, and then seek detailed validation of the numbers through your validation discussions with other franchise owners.
Initial Equipment and Inventory
The next investment grouping includes all of the equipment and initial inventory needed to start the business successfully. This is a disclosure that is typically more straight forward and has a smaller range of variability. Most franchise systems have a standardized list of initial equipment and inventory that are required for startup. These items generally have a standardized cost and a known initial investment.
This information is disclosed as a part of Item 7 in the FDD. You may need to gather additional details on these items through conversations with the franchisor and existing franchise owners.
Expected Working Capital
The most overlooked and misunderstood financial investment requirements in a franchise system relate to “working capital”. In my way of looking at business investments, “working capital” is the amount of money you require to operate the business and pay the bills starting with opening day and ending when the business is producing positive income.
The working capital investment is used for a multitude of individual expenses that can include: rent payments, prepayments of insurance, payroll and employee benefit expenses, supplies, utilities and many other categories.
In every business plan that I have ever created, I have mis-estimated on nearly every line item. In some cases, I underestimated the expenses. In a few instances, revenues were higher than I had anticipated. But, nearly always, I was shorter than expected on revenue and higher on expenses. Oops.
A business mentor of mine reminded me that I would always have errors in business planning but would not have any idea where they would arise. Thus, the need for the “Miscellaneous” line item in my business plan. By building in the business model a margin for error, it offers more flexibility and prevents downstream problems.
From my experience, breaking a total franchise investment into these 5 component parts will allow you to develop a more accurate understanding of the business and also help you to build the appropriate financing plan for your business. All of these elements are incorporated in a franchise investment in different amounts. In a home based, services franchise, the total investment may be less than $75,000. For a brick & mortar based, product heavy company, the investment level may easily exceed $500,000. One business is not universally better than the other. Instead, each investment will be right for a different type of investor.
If you want to discuss this, or any other franchise related topic, I encourage you to visit my website at www.chriscynkar.com to see these related articles:
- Ask These Money Questions Before You Buy a Franchise
- Franchise Investment Levels
- How to Finance Your Franchise Investment… Psst, it’s Easier Thank You Think!