There are many definitions about what constitutes an investment, but most often it boils down to the utilization of money in the expectation of future returns in the form of income or capital gain. In calculating an investment return on a franchise opportunity, the potential franchisee needs to be very aware of both aspects of the investment return, that is, income and capital gain.

Here is a formula to help you with calculating the potential investment return provided by a franchise.

• First, calculate how much cash you need to invest to open the doors of the franchise. Those who have been reading my blog, or who have heard me speak, know that I encourage potential franchisees to pay all cash for their first franchise. Let's say the franchise is going to require a $150,000 cash outlay.
• Next, the prospective franchisee needs to analyze how much they could make working a full-time or even part-time job in the marketplace, and compare that to the income they could expect from the franchise operations. Most franchises require full-time attention by the franchisee in the early years. Let's say you are in middle management in corporate America making $65,000 per year, plus vacation, plus benefits, the value of which adds up to $80K per year.
• The next step is to calculate the return that a safe investment would yield on the cash required. Let's assume the average investor can make 8% per year over the long run, or $12K per year on the principal. In our example, this is $12K.
• Therefore, the return that a $150K franchise would need to produce to break even with working a job and investing the capital is $92K ($80K + $12K). Since most franchises sell for 2.5 to 3.0 times net income, the expected income would be $60-$75K, or a net opportunity loss of $15K-$28K per year.

Now, let's look at the prospects for a capital gain on your investment in a franchise. This is where buying a new location is frequently the worst financial decision a franchisee can make. The cost of building a new location must include the build-out time that the franchisee must invest in project management, plus the cost of the build-out, including any rents paid prior to the doors swinging open for business. In addition, it generally takes 1-2 years before the full earnings potential of the location are realized. The likelihood of achieving a capital gain on any new location is very slim.

The only way this makes any investment sense is if the franchise can be purchased for about 1.5x net income, or if the income prospects for the franchisee are less than $48K per year.