Risk in Franchising is a Measure of Certainty, Predictability, and Consistency of Return

 

When discussing franchise risk and the fears of starting a business, clients almost always discuss losing their money and failure. Since risk is traditionally thought of as the likelihood of loss or injury this makes sense. However, while those are risks, they can easily be mitigated with an introspective approach to franchise exploration and by conducting an effective due diligence process.

I would like to introduce a different methodology for understanding, calibrating, and assessing the true risks of franchise ownership. Risk and risk tolerance are often felt viscerally and are thus difficult to define. They possess a “know it when I see it” aspect that is often influenced by irrationality. By objectifying risk it can be understood intellectually and managed thoughtfully. Stated differently, a notion of risk that removes randomness is needed. As Einstein, speaking about quantum mechanics, said that “God does not play dice with the universe.”

Understanding Risk

So what if it was possible to better understand risk in franchising and reduce its uncertainty? This would empower people to better appreciate each franchise’s risk profile and drive improved decision-making.

As I conceive it, risk in franchising, is simply a measure of certainty, predictability, and consistency of return. In other words, lower variability in expected return correlates with reduced risk and the higher return variability connotes greater risk.

In this context, risk does not mean you will earn more money. Risk means that you have more certainty to perform at the levels of other franchisees. And, assuming the average return is sufficient for you that should be precisely what you are seeking.

To illuminate this idea, let’s look at two franchises, both of which have 100 franchisees and a mean franchisee net earnings of $250,000.

Franchise “A” has a tight earnings distribution. Eighty percent of the franchisees earn between $200,000 and $300,000. The balance of franchisees earn a little more or less than that range. Franchise “A” has low risk because the expected outcome is highly likely and predictable.

Franchise “B”, in contrast, has a highly distributed franchisee earnings profile. Forty percent of its franchisees earn between $200,000-$300,000. Thirty percent earn less than $100,000 and thirty percent earn more than $400,000. Franchise “B” has a highly “randomized” earnings distribution and therefore has significantly more risk.

For most people, franchise “A” is the right brand choice. For people with a higher acceptance of volatility and who are exceedingly comfortable with the business model’s match to their skill sets, franchise “B” may also be a good choice.

Why Distribution Matters

This is a foundational concept in understanding franchising. Mean, average, or median return is not nearly as relevant as the distribution that leads to those numbers. I review Item 19 financial representations and some are tightly distributed and others a truly scattershot and appear randomized.

Would you want to join a brand with a $300,000 average net earrings? Of course you would! How does your answer change when you learn that for every 10 franchisees 7 of them earned less than $100,000?

Distribution matters! You need to avoid franchises with haphazard earning distributions.

What causes the greater variability in performance within franchises? The truth is that not all franchises are created equal. Some have stronger business models, systems, marketing, support, and leaders than others.

Measuring Business Risk

As you conduct due diligence on a franchise, it is important to assess the FDD item 19. This is where franchisors can make a financial representation, and often share performance data by range, such as deciles or quartiles. In addition, when validating with franchisees you can explore the revenue and income distribution. Franchising success rates in general mean absolutely nothing to you. What matters is the success rate of the franchise brand you are considering joining. Some brands’ success rates significantly outstrip their peers, while others have staggering failure rates. Do your research in order to measure the business risk of a franchise, and match it to yours. Happy franchising!