Capitalization Strategies to Finance a Franchise System
Rick Chittley-Young , Partner
FranchiseVoice
Dec 2009
The concept of growing a business through franchising appeals to many entrepreneurs because they can leverage the enthusiasm and investments of franchisees to finance a successful franchise system.
Sometimes.
Franchising often attracts entrepreneurs who have ambitious expansion plans for their business but lack access to capital. Franchising is typically viewed as a conduit to grow a business model without having to assume significant debt, sacrifice significant equity or when traditional financing is unavailable.
After all, franchising can generate funding from numerous sources: franchisees pay an initial franchise fee, plus an annual franchise license renewal fee. Franchisors also receive revenue by selling goods and services to franchisees. As well, goods or services that are proprietary generate a mark-up of 10 to 20%. Franchisees also share operating expenses – while the franchisor assumes expenses for research and development, creating and distributing products and managing the franchising corporation, franchisees assume all of the capital expenditures and operating expenses for their own outlets. These include leasehold improvements, fixtures, inventory, equipment, pre-opening expenses and working capital. Franchisees also pay the franchisor monthly royalties ranging from 5% to 8% on gross sales. And many franchisors require franchisees to provide an additional 1% of gross sales to cover the cost of national advertising and promotions.
While this all sounds profitable and low risk, many budding franchisors have indeed faltered because they failed to adequately capitalize their franchise systems in the early stages of development. It’s not uncommon for new franchisors to underestimate the capital they need and the amount of time it takes to set up the system, get it running smoothly and start generating profits. Knowing what to expect and planning appropriately, however, can enable aspiring franchisors to avoid serious financial setbacks.
To begin, it’s important to realize that prospective franchisors need more than a preliminary business model and a strong belief they can quickly spin this into a franchise system. They should have an established, profitable business in order to reduce the risk of a financial calamity in the event that new franchisees are unable to meet their financial obligations to the franchisor.
In order to properly test a business model, a company generally needs to be operating for a few years. This also allows the prospective franchisor the time needed to document the necessary processes and operational requirements, to develop appropriate management, control and reporting systems, to refine marketing and to devise training programs for franchisees. Thus every prospective franchisor needs to ensure sufficient capitalization to cover the costs of refining the existing business and building the necessary system to franchise it.
Plan for Expenses
Establishing a sellable franchise model with formal systems and documented operations can require months, or even years, including a substantial investment in the following expenses.
- A franchise plan detailing how the franchise system will be developed and expanded. This includes management, territory development, franchise support services, franchise compliance systems, sales and marketing plans and financial projections. The assistance of an experienced accountant may be needed to assist in developing a viable financial model and to prepare appropriate financial projections and statements. To assess the feasibility of the overall plan, the expertise of an experienced franchise consultant may also be required.
- Relevant legal documentation, including registration of the franchise, a franchise agreement and disclosure documents. Franchisors must also secure rights to intellectual property associated with the business in order to enable franchisees to use the franchise brand name, operational system and trademarks. This requires the assistance of a lawyer.
- An operations manual to provide franchisees with the information they require to run their franchises and for franchisors to maintain quality control. This manual typically covers systems, policies, procedures, forms and agreements for pre-opening, staffing, training, daily operations, sales/pricing, insurance, trademarks, marketing and more.
- Depending upon the complexity of the franchise operation, a training manual, separate from the operations manual, may be required. This generally provides franchisees with a complete orientation to franchise operations, management and accounting. Franchisors also have to factor in costs for providing new franchisees with hands-on training. It’s important that new franchisors involved in labour-intensive operations do not underestimate the costs of supervision and training to properly support franchisees.
- A marketing plan to attract franchisees, plus sales strategies and materials. These may include ads, collateral materials, a website, trade show participation, and so on. Preparing the plan and developing the materials may require the support of a franchise marketing specialist.
While pulling all of these elements together, a prospective franchisor must also be able to finance the development, testing and refining of the franchise pilot(s), staffing and office expenses to support marketing, accounting, training for franchisees, and also travel costs.
Before selling a single franchise, a prospective franchisor may therefore have to invest anywhere from $50,000 to $250,000 to develop the franchise system. Attempting to finance the cash flow needed to get a new franchise system on its feet through down payments from new franchisees could jeopardize support for new unit openings. Instead, franchisors need to be have sufficient capitalization to support this early stage of development for their franchise system.
Source sufficient capital
This begs the question: how can prospective franchisors capitalize the launch and early maintenance of a franchise system?
First, they need a realistic estimate of the total investment required to get the system up and running. This includes working capital until the business is capable of generating sufficient revenue. Thus owners should have adequate funds to cover monthly overhead and personal living expenses for six to 12 months – the period of time required for the franchise system to begin generating enough revenue for owners to draw remuneration. An accountant experienced with franchises can assist in preparing detailed projections.
Banks are generally unwilling to finance businesses that lack history or a debt-to-equity ratio of about 2:1, indicating a healthy level of retained earnings. This means new franchisors must often rely on family, friends and/or private investors as sources of financing.
Still, when it comes to financing any new business venture, the buck stops first with the owner. Every ambitious prospective franchisor must be prepared to self-finance a significant portion of those ambitions. To attract investors, this generally means contributing at least 50% of the total financing.
With this financial foundation, family, friends and private investors are more likely to contribute the remainder of the financing required. These arrangements are typically structured as non-interest bearing, non-arm’s length loans with favourable terms of repayment, or as an exchange for shares in the franchise corporation. Private equity investors are usually attracted to companies with ambitious growth plans since they typically expect returns of 12% to 20%.
Whether they are close family or friends or strangers, investors will expect to recoup their investment within two to three years. Thus they will want to see a business plan that outlines why this franchise model is a wise investment. This requires preparing cash flow forecasts and projected income statements (monthly forecasts for the first year and quarterly for the following two years) so investors can assess the expected payback period for their investments.
Launching a franchise is obviously a demanding undertaking. When ambitious franchisors are realistic, informed, and well prepared, however, payback can be timely and rewarding – both for franchisors as well as the investors who support their dreams.
Rick Chittley-Young is a principal of BDO Dunwoody LLP (www.bdo.ca). BDO is one of Canada’s leading accounting and advisory firms, which helps entrepreneurs, family businesses, franchisors and franchisees succeed. You can reach Rick in the Oakville office at (905) 844-3206 or rchittley@bdo.ca.
