Business Tools: Making the right franchise decision...
The decision of whether or not to invest in a franchise, or which franchise to choose from a range of options, is an important one. Tom Albrighton examines how investment decisions are made
Taking on a franchise will have a major impact on your career, your lifestyle and your finances. Franchises present excellent opportunities for making significant profits while maintaining control over your own work-life balance. However, the future is always uncertain so you naturally want to make the best possible choice. But how can you know what the best choice is?
To bring decisions into sharp focus, we can use the techniques of risk analysis. Imagine a game where you gamble £1 on the toss of a coin. Tails means you lose your £1, but heads wins you £2. Is the game worth playing? We might sense that it probably is, but we can confirm this by calculating the 'expected value' of the risk based on probabilities and impacts.
The probability of each possible outcome is 0.5 (2/1 in betting terminology). The negative value is -£1 (impact of losing) x 0.5 (probability of losing) = -50p, while the positive value is £2 (impact of winning) x 0.5 (probability of winning) = £1. Adding these together gives +50p: a positive value, indicating that the game is worth playing. If you could only win 50p on heads, or even 99p, the bet would have a negative expected value - a mug's game. Of course, people do play games with a negative expected value if the potential positive impact is big enough to eclipse its negligible probability in their minds - the National Lottery, for example.
There are many possible outcomes of taking on a franchise, but let's keep things simple and define the two most extreme: 'losing' and 'winning'. 'Losing' means losing your investment and walking away, while 'winning' means making a good profit. Let's say you're investing £10,000 with the chance to make £20,000. Now, you need to define the probability of each outcome in mathematical terms. Perhaps you decide that the chances of going bust are one in five (0.2), while you've got an even chance of hitting the jackpot (0.5). The expected value is -£10,000 x 0.2 + £20,000 x 0.5 = +£8,000, so the franchise is (in theory) a good bet.
Of course, the analysis depends on your estimate of probability. And how can you possibly know how likely you are to fail or succeed? Well, that's partly the point. Putting decisions in this rigorous framework highlights the things you don't - or can't - know about a situation, which is instructive in itself. It pushes you to get more information, and identify areas of risk.
There is another important point about downsides. Although they may be less likely than upsides, they can still happen, and you need to be sure they won't be 'fatal'. 'Fatal' means 'game over' within a particular sphere, such as your finances, so consider whether that risk is too great to put your investment sum on - can you afford to lose?
Mathematical risk analysis helps to put decisions on a rational footing. The reason this is so vital is that human beings, by their nature, are poor decision-makers. For all the talk of the brain as a 'computer', we're largely at the mercy of our emotions when it comes to decisions. Be aware of the following behaviours as you consider a franchise.
'Confirmation bias' is the tendency for us to seek out information that supports our position and ignore or play down anything that suggests it's a bad idea. Ostensibly gathering information 'to help us decide', we're really building a case for a choice we've already made.
Confirmation bias arises when there are too many complex factors for us to get a handle on the value of different options. If you suspect your choice of franchise was made too easily, seek out 'disconfirming information' - actively try to build a case against your choice and see if it holds up. Warren Buffett, the world's most successful investor, uses this technique.
'Risk aversion' refers to a tendency to avoid taking any course of action where the outcome is uncertain, even if the expected value is positive. A long-term investor who preferred a building society account to a FTSE-tracking ISA might be considered risk-averse. Trying to avoid uncertainty altogether is futile and just shuts off valuable opportunities. Be realistic about the chances of success as well as failure. Guard against overconfidence -becoming utterly convinced you're right. Get second opinions and, more importantly, listen to them. All franchisees need confidence to move forward, but overconfidence could take you into an opportunity that's just not right for you. Caution pays!
Finally, the 'endowment effect' refers to our preference for what we already have. We have a tendency to overvalue what already exists and irrationally fear what is new. Are you hanging back from taking on a franchise for fear of letting go of something - a job, perhaps? The test question is this: if you weren't already in your present situation, would you wish to create it?