Why a guaranteed return on investment could kill off Australian franchising!

franchising guaranteed return investment
What will be the impact of a guaranteed ROI written in to the Franchising Code? (Source: Bigstock)

For those who do not understand the fundamentals of the franchise model a requirement that all franchise agreements must provide a reasonable opportunity for a franchisee to make a return on their investment sounds a fair thing. 

However, many Australian franchise systems will fail the ROI test.  If this requirement is introduced the golden goose of the franchise model that has underpinned Australia’s successful small business sector will be mortally wounded.

Understanding the problem

Most franchisees have never previously been in business when they acquire a franchise.  For nearly half of them, English is their second language.  Despite our multi-cultural society and workplace prioritisation of diversity these candidates are at a significant disadvantage in the Australian labour market.  Franchising provides them with the means to build financial independence and achieve a higher family income than via the workforce.

These franchisees are not buying themselves a job, but they are purchasing a combined income stream of wages and profits.  For them, return on investment is assessed on a total family basis.

Measuring ROI

This is not how ROI is measured under normal accounting principles or investment metrics, nor at law under the Franchising Code of Conduct.  ROI is assessed on net profit after all wages including the wages of the owners and family members. On this basis many Australian franchise systems would fail a pure ROI test and be exposed to substantial financial penalties under the Code.

The ROI provisions were inserted into the Code to address two specific concerns in the automotive industry:

  1. Short agreement terms for automotive dealers. Three years is common but some brands offered terms as short as 12 months.
  2. Allegations that some auto brands required high capital investment on lavish showrooms and vehicle inventory.

Neither of these factors is a feature of non-automotive franchising.  The average agreement term is 10 years and most franchise models require only essential initial capital expenditure.  Franchisors typically make little or no profit from the initial franchise set up, relying on the ongoing revenue stream from royalties.  Similarly, inventory costs are typically low.

Flicking the switch in the Code such that the current automotive ROI provisions apply to all franchise agreements is more than just flawed policy or a solution in need of a problem.  It will actually kill off or fundamentally threaten the viability of the many Australian franchise systems.

Franchise investment examples

Take the following two worked examples of a service and a retail franchise system. These are taken from real-life examples of satisfied franchisees content with their investment.

Mobile service business

ACME Mobile Services has a $70,000 investment cost.  Twenty per cent would be a reasonable return on an investment into a new business which carries normal business risk.  

Gross income$120,000
Less Operating costs$20,000
Less interest on $70,000$7,000$27,000
Less owner wages ($50 x 40 hours x 52 weeks assuming some work outside hours and inclusive of on-costs.

Net profit (Loss)($11,000)

Reasonable ROI is 20 per cent x $70,000 = $14,000.  To meet the reasonable ROI test the franchisee would need an additional $25,000 per annum in gross income. However the franchisee is quite satisfied with $93,000 current total return.  The franchisee receives a payback on the franchisee’s investment of $70,000 within around nine months. 

Yet viewed on the basis of traditional ROI the franchise never generates a positive ROI let alone the 20 per cent ROI calculated according to normal finance principles.

Food retail franchise

ACME Food Retail has a $500,000 investment cost that includes fixtures and fittings, equipment and an initial franchise fee.  It operates in a major shopping mall and trades well. Overheads are within industry norms as a percentage of turnover.

Gross income$1,000,000
Less: Cost of Goods Sold (33% of sales)$330,000
          Rent, outgoings, power (20%)$200,000
          Wages* (25%)$250,000
          Operating costs (10%)$100,000
          Interest (10% on $500,000)$50,000$930,000
Net profit (Loss)$70,000

*Wages includes owner wages of 60 hours x $40 x 52 weeks = $125,000 assuming some work outside hours and inclusive of on-costs.

The 20 per cent ROI benchmark would require net profit of $100,000, not $70,000, which would be a 14 per cent return.  However, owners receive a financial return of $195,000 or 39 per cent when measured on the basis of total dollar return.  The franchisee would receive its money back in around two and a half years on this basis.  However, the franchisee again fails to meet the ROI test.

These examples largely speak for themselves.  Other points to note include the capacity for a franchisee to reduce the ROI by working more hours as an employee or employing a family member.  Similarly, failure to hit benchmark figures or grow income, COGS, rent, wages and/or operating costs reducing profit and making ROI worse.  

More broadly, the proposal ignores the fact that many franchisors of franchise systems caught by the Code have no real involvement in the businesses of their franchisees.  And what happens if one franchisee sells to another?  Does the same ROI requirement apply?

The solution

If someone invests in a non-franchised small businesses or in a share portfolio with the hope of profit there are no investment guarantees.  

It is unprecedented and difficult to justify why there should be a statutory obligation on a franchisor (most likely to be an Australian owned small business itself) that is on one side of a commercial contract to provide a form of financial guarantee to another business.

If the government is reluctant to alter its policy position, “reasonable return on investment” should be measured by total owner returns not accounting profit.