Want to buy a franchise? Track record is only a guide to the future, it doesn’t underwrite it. Dennis Mattiske explains pitfalls and options, and how to research, plan, and find the best mix for financing the venture.
A company considering expansion by franchising needs more than a strong business track record. It must also have a carefully considered business plan, covering worst and best case scenarios, and access to funding for both.
Without adequate provision for funding, even a business with the best possible franchising opportunities can fail. And success brings increased funding needs. The sale of franchises can be expected to have a significant effect on the turnover of a business. An operation with, say, three company-owned retail outlets that sells three franchises, potentially doubles its business. Thirty franchises potentially represents a ten-fold increase, or even more.
A franchisor requires capital to cover expansion expenses such as:
• increase in production capacity (machinery and premises)
• increase in stock holdings
• computerised management reporting systems
• increased sales support and administration
• training of franchisees
• advertising and marketing.
Finance Options
Quite often the driver for expansion through franchising can be current spare production capacity. So, at first, any increase in output may only have a minimal increase in fixed costs. But a plan needs to be in place to manage the impact of further demands on capacity in all areas, including production, distribution, marketing, and management.
Additional equipment and larger premises will need a medium to long-term financing commitment, which is often provided by a bank, especially for a property purchase. As much of the financing required is long term, franchisors should seek lower interest rates, either on an interest-only basis or on a long-term principal and interest plan.
Leasing machinery and renting premises are alternatives. Even in these scenarios, sufficient finance is needed to cover relocation and set-up costs, as well as carrying spare capacity to meet future growth. Expansion of management information systems, increased administration and support staff, and the cost of training and advertising, add to the working capital requirements of the business.
Looking at ways of using growth to manage costs should also be considered. For example, projected increases in sales and stock holdings can be used to negotiate extended credit terms and lower prices with suppliers. Extended supplier credit terms can help finance a large proportion of expected stock increases, but only if good business plans and projections are available.
Financing options include extension of basic overdraft facilities, an increase in long-term finance facilities (to cover increased working capital requirements), or consideration of alternatives such as debtor/invoice financing. Debtor/invoice finance may not be appropriate in all cases, and was once considered to be high cost financing. While it does have some benefits and is worth exploring, it should be compared carefully with other options.
A basic business overdraft usually has a higher interest and fee structure than longer-term business loans secured by real estate, and so it is important to get the right mix of finance in place.
If financing is beyond the means of the franchisor, a venture capitalist or some other investor may be an option. Venture capitalists may take a minor interest in the business if it has a good track record and there is a strong business plan to support expected growth. Venture capitalists will always want an exit strategy, and this needs to be discussed to ensure that it is consistent with the owner’s future plans and strategies. Often a business owner’s accountant will have connections with people who can provide this type of finance, or they will be aware of other investors.
While a good business plan is usually an essential part of a successful business, it is even more essential if seeking an investor such as a venture capitalist. A business plan is a vital part of the communication required with investors. Usually some form of participation at a director level will also be expected.
Buyers’ Guide
The profile of many people who consider buying a business franchise is that of someone buying themselves a job. It is very important that any would-be franchise purchaser understands it is much more than this.
The purchase of a business franchise has all the inherent risks of purchasing any kind of business. The expected sales may not eventuate; working hours may be required that conflict with lifestyle and family commitments; and, most importantly from a finance perspective, the finance required may be beyond the resources of the prospective buyer. It may take some time to establish the business before it pays the owner a worthwhile income.
If the franchise is well-known with a proven track record, it will often command a premium and the price will reflect the commensurate lower risk. But there still is a risk and it is important to do the due diligence to find out where the business is in the overall product life cycle. Past performance is only a guide to the future, it does not underwrite it. A franchise for a product that is going out of fashion clearly is not a good proposition, and it is up to the franchisee to do the research.
There are several advantages in buying a franchise that largely revolves around the franchise being a tried and proven business, usually with a good degree of accuracy in sales projections, working capital and fixed capital requirements. Again, research is necessary.
The Franchising Code of Conduct governed by the Australian Competition and Consumer Commission (ACCC) shows the information that must be provided by the franchisor in respect of the franchise agreement. Much of the information is in respect of the business operations, franchise territory limits, and the financial strength of the franchisor. Some of it influences the financial considerations of the franchisee, such as the details of goods and services to be acquired from the franchisor, including restrictions on where they are bought, monies to be paid before signing the franchise agreement, details of establishment costs and financing arrangements with the franchisor.
When buying an established franchise business, there will usually be a payment to the vendor for goodwill and equipment acquired. However, the total finance required will be more than this, and includes stock and other working capital. This must be factored in to the funding requirements. With equipment it is important to find out whether it actually belongs to the current franchisee (and can be sold to you) or is leased from the franchisor and remains their property.
As mentioned earlier, with any business finance it is important to get the mix of longer term and working capital finance right. Most of the large banks have finance products focused on franchise businesses and are a good source of information—for example, the National Australia Bank has a franchise guide. Banks like being associated with strong franchise businesses because of the lower risk associated with good franchise history.
It is usually easier to obtain finance to buy a franchised business because banks often already have financial information supporting the business. But they will still want security and, especially for long-term business loans for capital and goodwill, will require real estate as security. Business overdrafts should be used only for short-term working capital that is often required in a monthly or seasonal selling cycle, and equipment leasing can be an option.
Sometimes the franchisor may offer finance, especially with pre-arranged leasing. This can be a convenient alternative to a bank but the cost of finance should be carefully checked. It can be more expensive, especially if it is sourced from a third party finance provider, as is usual, and commissions may be involved.
*Dennis Mattiske is a partner with accountants and business advisers HLB Mann Judd, Sydney.
