The iFranchise Group Acid Test

1. Begin with the profitability of the prototype operation. Adjust for changes in gross margin (if you will be selling product to your franchisees at a mark-up).
2. Add to that number any investments made during the year (e.g., new signage, remodeling, etc.)
3. Add any non-recurring expenses (e.g., litigation, funding costs, etc.)
4. Add any expenses the franchisee will not incur (e.g., trademark registration, logo development costs, franchise registration, consulting fees, etc.)
5. Add the cost of any excess benefits taken by the owner or other tax minimization strategies you may have utilized (e.g., life insurance, automobile, country club membership, etc.).
6. Add any excess compensation (above the market rate) you may have taken. If you took a salary that was less than the market rate for the position you held, subtract that amount.  Note:  The purpose here is to include an “average” compensation package for the franchisee who acts as a manager.  Remember, the franchisee is entitled to a return both on their time (salary) and on their investment.
7. Add back depreciation and amortization.
8. Add back interest paid (If you are working off of a cash flow analysis, add back debt service in its entirety.)
9. Deduct a royalty payment based on comparable franchises — usually between 4% and 6% of gross revenues.
10. The resulting number is your franchisee’s projected adjusted net income.
11. Estimate your total investment. Be sure you estimate using full costs in today’s dollars. Assume you pay cash for everything — no financing at all.
12. Divide the franchisee’s projected adjusted net income by your estimate of the total investment. The result will be the franchisee’s projected Return on Investment. The franchisee’s ROI should be at least .15 (15%) or higher for owner-operators or .20 (20%) for area developers. (Important: many businesses mature over the course of one or two years; when making this calculation, take into account earnings at year three, or sooner, if the business reaches profitability more quickly.)

Note: This model can also be done as a Return on Equity model. In that case, reduce your anticipated investment to the equity portion alone, and deduct debt service from the franchisee’s anticipated net profit.