Financial modeling is not new to business planning. It is attempted in one form or another, crude and sophisticated.

The pro forma in every franchise investor's business plan is an example of crude, incompetent financial modeling.

Many Item 19 FDD presentations are incompetent or deliberately misleading attempts at financial modeling. In decisions to franchise businesses, pie in the sky financial modeling is the delusional mind expansion medium that caused many doomed franchise attempts to be initiated. In this article we will discuss them all.

Anyone who has ever contemplated turning their established successful business into a franchise operation has gone from the anecdotal "This would make a great franchise" suggestion from friends and customers, to contact with a franchise consultant whose sales pitch enthuses the mark with suggestions of revenue streams capable of slaking the greatest thirsts.

A hundred sold franchises at $ 25,000 initial fees provides $ 2.5 million - never mentioning that most new franchises never attain that number ever.

A hundred franchised stores generating $ 500,000 a year in gross sales represents at 6% of sales $ 3 million a year in royalty revenue and, at 2% of sales, another $ 1 million a year in advertising revenue that can be used for all sorts of yummy venture functions.

Four and a half million a year plus initial fee income makes many otherwise rational people delusional.

But, reality may be seen in my article Why New Franchisors Fail The new franchisor field is strewn with the wreckage of misled business owners who were successful at what they did and lost everything in the world to unscrupulous franchise consultants.

In my opinion, in addition to all the failure causes dealt with in that article, there is the matter of failing to model with financial competence the business that the franchisee will be operating.

If there is no competent success financial model for the franchisee's business, you cannot arrive at a decision that your business is franchisable.

More importantly, franchise investors have no ability without focused specialist assistance to sort out the incompetent and misleading information presented. Consequently, the field is also strewn with the financial corpses of duped franchisees who thought they understood what was set before them. 

Constructing a competent franchisee's business model is an exercise in multivariate regression analysis. That isn't as complex as that fancy name suggests, but it must be honestly done if a reasonable financial model is to result.

(Using wishful thinking financial modeling causes incompetent financial planning in the franchisor model and in the information that will end up in your Item 19 Earnings Claim calculated to enthuse franchisee investors to buy into your system.

Then only litigators will make money on your franchise and you will spend years in misery funding nightmare dispute resolution instead of sipping good single malt on the fan deck of your yacht.  Examples of this are Cuppy's and Java Joe coffee; 1-2-3 Fit; Curves; Dagwood Sandwiches; and many others that are on the brink of collapse but not quite yet in the tank.)

Boiled down to a very simple statement, financial modeling is an exercise in which you establish a chart of accounts that your franchisee's business will use and then populate the chart with the numbers/ranges of numbers that you can identify as reliable.

That will leave a number of line items that you have no current reliable data to corroborate, where you have to provide an estimate for each category.

How you do that is to repeatedly, ad nauseam, ask "What if..." questions until you believe you have probably exhausted the range of expectable events that could influence the number than goes into each line.

Actually, you also do "What if..." analysis on the lines where you are fairly certain you already know the appropriate number, discounting for learning curve impact and discounting further to arrive at an imputed value for unidentifiable risk. What's that, you ask.

Unidentified risk includes such things as the extent to which others may not be as adept as you are in the operation of your kind of business; or that it may take quite a while for them to get the hang of it while you fine tune your franchisee training program; or the vicissitudes of any geographic market (or the market as a whole) for your products or services; or "gambler's ruin" - poor estimating of the time required to achieve break even/positive cash flow (which may not result in "free" cash); and several more such categories.

Asked simply, the question you would be trying to answer is "Can a franchisee, using my business format, have a reasonable potential to achieve a good return on his investment if he operates my type of business competently in another geographic area and had to carry, in addition to all other expenses, the costs required in order for him to be a franchisee?" These costs include more than simply the initial fee, the royalties and the advertising fund contributions.

For example, if you believe you will confine your franchisees' purchase of supplies/inventory to vendors designated by you, and that those vendors will be paying you for your approval to be vendors to your franchisees, the franchisees will incur an opportunity cost of not having access to competitively priced vendors and the cost of their having to pay you for the privilege of being designated vendors.

Inasmuch as there will be opportunities for you to impose other expense categories from which you will intend to derive extraneous revenue, these will also be franchise relationship carrying costs.

The "What if..." analysis is a lengthy exercise if you intend to come up with a reasonable financial model of what your franchisee will encounter.

For more of Richard Solomon's articles, please click here.

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