Be Diligent With Your Due Diligence

This article appeared in Issue 3#2 (January/February 2009) of Business Franchise Australia & New Zealand

In the current economic climate, businesses of all sizes across every industry and sector, are being urged to heed caution; and franchising is no exception.  

Although our domestic franchising industry is relatively strong and expected to show some resilience against broader financial market woes, existing franchisees are compressing costs and prospective franchisees are being encouraged to make every effort possible to undertake thorough due diligence across the entire business.

Diligent preparation and planning are core to finding, funding and running a successful franchise, and in the current environment, it is even more imperative to go above and beyond to ensure the business is a sound investment.

Why due diligence?

Doing thorough groundwork prior to purchasing a franchise business will help to lay the foundations for its success.  The process can be time consuming, but it is essential and covers everything from reviewing the business’ track record, system growth strategy, cash flow projections and capital requirements, through to assessing the customer base and competitors, researching the locality and clarifying any legal obligations.

Ultimately, the due diligence process will give prospective franchisees the information required to develop a comprehensive business plan and help them secure the financing for the venture from a bank.  It will also help them formulate a sound strategy to ensure they get the most out of the business from day one.

Assess the franchisor

Where to begin?  A good place to start is to spend time with the franchisor.  Getting to really understand the business is a must for any prospective franchisee.  Clarify the terms and conditions of the franchise agreement at the outset and don’t be afraid to ask the franchisor for guidance along the way.

The franchisor should also be able to share the system’s operating manuals that will provide a detailed insight into the system format and its value.

Look closely at the credentials of the franchise.  In particular, it’s size, growth strategy, reputation and the strength of its brand.  All of these factors will impact the day-to-day running of the business, help identify potential challenges and opportunities and provide some insight into established networks and processes.

There is also a new online resource that can offer independent reviews of Australia’s top franchise systems, DC Strategy Research’s website www.dcsreport.com. The site offers in-depth research into each system, providing franchisees with a valuable source of information to reference during the due diligence process.

Consult experts

Before buying into a franchise system, it’s imperative to source professional advice and consult a wide range of people with different skills and experience.

Aside from the franchisor, there are a wealth of experts within, and associated with the system who should be consulted for advice and support.

Speaking with existing franchisees from within and outside the franchising model is invaluable – especially if you are new to franchising.  They can help you understand the processes, demands of the business, and introduce you to key individuals across the industry.

Don’t be afraid to pick their brains about what they have found to be the critical factors for success – they live and breathe the business day-in-day-out, so it pays to build relationships and a support network early on.

Enlisting the assistance of a specialist franchise banker right from the start will help to better ensure the financial security of the business venture.  A franchise banker will bring a wealth of industry knowledge to the table, coupled with a complete package of the financial tools that can help get you on the right track to securing financing, and putting the business on solid financial ground from the very beginning.

Even after securing the initial financing, it’s advisable for franchisees to maintain a good relationship with their banker as they can help with the ongoing day-to-day financial management and working capital requirements of the business.

All franchise systems operate under varied models and similarly, the financial and legal requirements of a franchisee will differ depending on the franchise.  Consult a lawyer before any contracts are signed to ensure you fully understand what is required of you and of the franchisor – this will help to ensure you don’t come across any unexpected surprises along the way.

Analyse the market

A franchise’s performance depends heavily on the market and environment in which it operates.  There are many factors to consider including the size of the industry, maturity, seasonality, trends and key differentiators of the business.

It’s also important to consider the proximity of other franchisees in the same system and assess the impact you expect to have on each other and on competitors.  A good understanding of competitors is also critical – understanding the unique selling points of your business in its local context will be fundamental to its success.

Know the business costs

Perhaps the most important considerations from the outset are the immediate and long-term financial requirements and prospects of the business.  Failure to understand this in the due diligence phase can result in major financial short-falls down the line.

The value of the franchise is dependent on many factors, including the system to which it belongs, its size and location, cash flow performance and projections and also its ongoing working capital requirements.

Understanding the cash flow drivers of the business is crucial and will play a significant role in the development of the business plan – an important document that is required by banks or financiers to consider any form of investment.  A financier will expect a clear and detailed overview of the cash flow projections required to protect their investment.

Remember to be as realistic as possible as ill informed projections can result in reduced funding or even funding refusal.  Also, as part of the loan application process, the bank will undertake its own due diligence and has the ability to compare projections with the performance of other franchisees in the system.

In the longer-term, poorly projected cash flows will lead to under-capitalisation of the business – a potentially fatal, but avoidable, error.  Always allow for surplus cash where possible in the budgeting process and have a plan in place to source additional funds if required.  Franchisees need to have sufficient reserves, or a plan to manage personal cash flow, should things not go as well as expected.

The Business Plan

Conducting thorough due diligence will enable prospective franchisees to create a strong and informed business plan.  Initially, this plan will be required to secure funding from a financier, but can also be a living, breathing document that acts as the blueprint for the business.

This document should reflect the goals and objectives of the business; detail the product and service offering; market position and the overall business strategy.  Even after funding has been secured, this plan should be continually updated and maintained during the entire lifecycle of the business.

Find the right fit

It may seem obvious, but ensuring you are entering into a system and a sector that you are really passionate about is essential.  Many people often forget to stop and think about how the business will fit in with their lifestyle and interests.

When you buy a franchise business it becomes part of your life and requires a certain level of commitment and energy, so it’s important to have a passion for the product or service.

Also consider whether a particular franchise system will suit your lifestyle.  For example, a young family may not want a business with extended trading hours and a bakery is probably not the best option for people who aren’t naturally early risers.

A plan from start to finish

Franchisees too often get caught up in the start up phase of the business, such as financing arrangements for the business loan and the practicalities of actually doing business, and don’t think far enough beyond opening the doors to the business.

It is a good idea to have an exit plan; or even a five to 10 year plan in place before buying the business, as this may affect the buying decision in terms of whether you opt for a new or old outlet and which system you buy into.

Buyers looking at a franchise as a short-term investment with an exit planned within five to 10 years may be better suited to an existing franchise, whereas buyers wanting to build up their own business who are willing to take the time to do this will probably be looking for a new outlet.

The Commonwealth Bank has a dedicated team of franchising specialists who can assist prospective franchisees in financially managing their purchase decision.  To speak with a franchising specialist from the Bank, call Rod Nuttall on 0420 946 013.