With Borrowed Funds, Franchise Investors Can Maximize ROI and Build Wealth
The power of leverage is an essential financial concept many average franchisee candidates overlook. By understanding how to leverage debt effectively, future franchise owners can maximize their returns and build wealth more quickly. In this article, we will compare the return on investment (ROI) for two franchise investment scenarios to demonstrate the power of leverage and its impact on net profit.
What is Leverage in Franchising?
Leverage is using borrowed funds to increase the potential return on investment. In the context of franchises, leveraging means taking out a loan to finance a portion of the investment. This allows the investor to control a more significant asset with less of their own money. If managed correctly, leverage can amplify profits, but it’s crucial to remember that it can also increase losses if the investment goes south.
Comparing Leverage vs. No Leverage in a Franchise Investment
Scenario 1: $50,000 Investment with $150,000 Loan
In this scenario, an owner invests $50,000 of their own money and takes out a $150,000 loan to finance the remaining cost of the franchise investment. The total investment in this case is $200,000. The monthly loan payment is about $2,000, and the total amount to be paid over 10 years is (loan + interest) $238,000. Over the course of five years, the franchise generates a net profit of $1,000,000 and paid $120,000 in loan repayments.
We calculate the ROI by dividing the net profit by the initial investment: ROI = ($1,000,000 / $50,000) = 20. In this scenario, the investor’s ROI is 20 times their initial investment or 2,000%.
Scenario 2: $200,000 Investment without Loan
In the second scenario, an owner invests $200,000 to finance the entire franchise investment without taking out a loan. Over five years, the franchise generates a net profit of $1,120,000. This is the same net profit as the first investor plus all the loan payments the second investor isn’t paying.
To calculate the ROI, we divide the net profit by the initial investment: ROI = ($1,120,000 / $200,000) = 5.6. Here, the investor’s ROI is five times their initial investment or 560%.
Comparing the Scenarios
While the franchise owner in Scenario 2 has a higher net profit ($1,120,000 vs. $100,000), his ROI is significantly lower than the franchise owner in Scenario 1 (560% vs. 2,000%). By leveraging debt, the first owner is able to generate a higher ROI with a smaller initial investment. This allows him to free up capital for other investments, personal needs, or just to have more capital on hand in case something goes wrong. This is a significant advantage over the second investor, who must commit a larger sum of money.
How Does Leverage Affect the Exit Plan?
Let’s explore how leverage impacts both owners when they sell their businesses for $600,000.
For the franchise owner in Scenario 1, he needs to pay off the remaining balance on the loan, which is $120,000. After settling the debt, he’s left with the following: Proceeds from sale = ($600,000 – $120,000) = $480,000.
In Scenario 2, the investor has no outstanding loans, so he gets to keep the entire proceeds from the sale: Proceeds from sale = $600,000.
To evaluate the overall financial outcome, we need to consider both the net profit from operations and the proceeds from the sale.
Scenario 1: Total Earnings = (Net Profit from Operations + Proceeds from Sale) = ($1,000,000 + $480,000) = $1,480,000
Scenario 2: Total Earnings = (Net Profit from Operations + Proceeds from Sale) = ($1,120,000 + $600,000) = $1,720,000
Although the franchise owner in Scenario 2 has higher total earnings, it is essential to consider the ROI when comparing both scenarios. To calculate the ROI based on total earnings, we divide the total earnings by the initial investment:
ROI for Scenario 1 = ($1,480,000 / $50,000) = 29.6 (2,960%)
ROI for Scenario 2 = ($1,720,000 / $200,000) = 8.6 (860%)
Even after selling the business and paying off the remaining loan balance, the franchise owner in scenario 1 still achieves a significantly higher ROI than the owner in scenario 2. This example highlights the potential benefits of using leverage strategically to maximize investment returns, even when exiting the business.
The franchise owner in scenario 1 risks $50,000 + $240,000 = $290,000. $240,000 is the total repayment amount for the loan.
The franchise owner in scenario 2 risks $200,000. In this scenario, an additional $90,000 is risked to triple the ROI in 5 years.
The Power of Leverage
Leverage can be a powerful tool for franchise owners, allowing them to amplify their returns and make the most of their available capital. However, it’s essential to carefully consider the risks involved and ensure that the investment can support the additional debt.
By understanding the power of leverage and utilizing it strategically, franchise owners can maximize their ROI and build wealth more effectively, even when selling their businesses. In addition, the longer the owner waits to sell the business, the greater the ROI.
Remember that each investment opportunity is unique, and it’s important to consult with financial advisors to evaluate your circumstances and risk tolerance before making any decisions. Your particular franchise investment, return, and loan terms will be different than this example; however, the core tenants remain the same. You need to understand what you are risking in the short term (loan payments) and the long term (interest on the debt) and decide if the risk is worth the potential reward.
The above loan calculations use 10% interest amortized over 10 years which is the typical rate and amortization schedule for SBA loans. It also proves an excellent rate of return can be achieved even with double-digit interest rates as long as the cash flow can maintain the loan payment. It is recommended those currently considering investing in a franchise focus less on interest rates and more on the performance of the franchise through thorough validation and research.