What makes a franchise financially viable?

This article appeared in Issue 3#4 (May/June 2009) of Business Franchise Australia & New Zealand

Rod Nuttall from the CBA discusses financial strategies to maximise return on investment.

On face value, buying a franchise can seem like a sure way of taking charge of your financial future and earning a healthy profit, with the added bonus of becoming your own boss.  Proven business models, established brand names, popular products and access to training programs form a comprehensive framework which can leave potential franchisees asking – How could I go wrong?

While the framework often provides great assistance for owners to maximise their initial investment, there are a number of key factors that must be considered to ensure a franchise operation takes full advantage of the selected business model, and eventually turns in a healthy profit for its owners.  Some of these include:

• capitalisation – avoiding the trap of under-capitalising the business;
• getting the right fit – choosing a franchise system that is aligned with the interests and passions of a franchisee;
• undertaking due diligence – thoroughly researching the investment and preparing a detailed business plan that will help to secure the required funding, and;
• exit strategies – considering where, when and how the business can be sold.

Taking the time to understand the franchise system is crucial.  Franchisees must be honest and realistic in assessing opportunities and make sure that they select a system that suits their lifestyle and aligns with their interests.  

Australia is one of the world’s most franchised countries per capita. With so many systems out there to choose from, it’s vital for prospective franchisees to gather as much information as possible during the due diligence phase, to ensure they’re investing into a business that they believe in and fits their long-term ambitions. 

A key risk for any franchisee when entering into a franchise agreement is the depth of understanding they have of the business they are considering investing their capital into. 

The franchisee should not only seek information from the prospective franchisor but also from reliable independent sources for both advice and information. 

DC Strategy Research, a specialist research firm focused on providing quality business analysis for key decision makers, has undertaken a venture whereby they are constructing well researched independent business reports on individual franchise systems. 

These reports will allow prospective franchisees to more easily identify the highest quality franchise systems in Australia. As a result, those prospective franchisees now have a trusted and independent source of information to help them make a fully informed decision about which franchise to purchase.

Commonwealth Bank’s Franchising Banking business is partnering DC Strategy in this initiative due to the growing need for better educated franchisees on their capital investment.  

Once the best fit has been found, franchisees also need to be realistic about the level of risk they are prepared to take.   Higher risk can potentially reap higher returns, but the franchisee must be comfortable and willing to accept the challenges that this may bring.  

Choosing to buy a brand-new store, for example, may be considered a higher risk option than investing into one already established with proven cash flows. Whilst it may be cheaper to purchase a new franchise, you will need to create and build up a customer base and initiate personal relationships with suppliers; and there is no proven return on investment to track against.  There are benefits and pitfalls with both options, neither right nor wrong – it ultimately depends on the level of risk that the franchisee and their financier is prepared to take.

A successful franchise is always one that has been fully researched, diligently planned and properly financed from the outset.  Under-capitalisation is one of the easiest and most fatal mistakes a new franchisee can make and generally stems from unrealistic, incomplete or misguided planning.  

To help avoid falling into the trap of under-capitalising the business, a prospective franchisee would be well advised to seek out the services of an experienced accountant or financial advisor with knowledge of the specific franchising system and an understanding of its working capital structure.  Getting the right advice up-front will help to ensure a smooth transaction and start-up process, setting the business up for a successful launch and potentially healthy returns. Your franchise system will also encourage this even though many also have consultants for system specific advice.  

The right accountant or financial advisor with specific franchising experience will be invaluable in the due diligence process.  They can help a new franchisee produce realistic and viable business plans, reducing the chance of initial under-capitalisation. They can also offer invaluable insights into the industry, making even first-time franchisees appear well versed and sophisticated to the bank or financier, which is vital when trying to secure funding.  

It really can’t be stressed enough how crucial this initial research and planning phase is for a prospective franchisee.  Put simply, failing to plan effectively and under-capitalising the business from the outset will lead to a slowing of the cash flow cycle, a short fall in projected sales and limited return on investment.  Once these factors come in to play, it is an up-hill battle to get the business back on a level ground. 

Unless a franchisee is able to finance the franchise with his or her own funds, a bank or financier must be engaged to arrange a loan.  In order to secure the financing required, a well researched, comprehensive business plan must be prepared, including goals and objectives, market position, business strategies and projected turnover.  

This document shouldn’t just be viewed as a means to securing finance. A business plan is a blueprint for the business and should be a regularly updated working document that enables franchisees to identify the strengths and weakness of their business.  The more detailed this plan is and the more knowledgeable franchisees are of their selected system and store, the more likely they are to secure the financing they are seeking.

If the bank or financier agrees to lend only part of the requested amount, it is vital to step back and reassess the viability of the entire business plan.  There will be valid reasons why they are agreeing to only partial funding and it is crucial to understand what those are to ensure they are addressed and amended.  Without making a solid case about the implications of under-funding to your banker or financier and simply ploughing ahead with too little initial capital, the likelihood of running into financial problems further down the road is almost guaranteed.

Also, always be up-front with your banker or lender.  If the business plan requires a loan of $250,000 for the franchise to succeed, either secure $250,000 or re-plan.  Failure to do so can make a moderately successful business look like a failing one when compared back to its original business plan.

The other major factor to consider, and one that is frequently ignored, is the exit strategy for the business.  Franchise agreements are generally for a specified fixed-term and having a plan about how to exit the business will not only provide additional reassurance to the bank or financer that the business plan has been carefully considered, but also an exit plan of how and when to sell the business will ensure that the eventual returns are maximised.   

It is important to remember that buying into a franchise system is a lifestyle change and will be very different to a typical PAYE job.  As the franchise typically has a finite life expectancy it is in the interest of the franchisee to consider all aspects of the running of and ultimately the selling of the business.  These not only include keeping a current and thorough set of financial records, but also giving some thought to not only where and when the franchisee will sell, but also how.  It doesn’t need to be fully scoped, but consideration of an exit strategy from the outset is strongly recommended.

Ultimately, reaping a good return on investment underpins the running of a franchise.  With the right due diligence and a well thought out and thorough business plan capturing as much information as possible about the site itself:  goals and objectives; business strategies; projections and exit plans; prospective franchisees should be able to secure the required funding and ultimately have the foundations to run a prosperous business.  

Franchise specialists will be vital throughout every phase of the set up and a franchise specialist banker can help to ease the process.  

To speak with a franchising specialist at the Commonwealth Bank, call Rod Nuttall on 0420 946 013.

DC Strategy reports are available for purchase through www.dcstrategy.com – the reports will cover key details and information on the organisation, key management, franchise system structure, performance, industry commentary, re-sale activity, history of disputes and current franchisee feedback. The reports range in price from $350 – $700 + GST depending on the detail in the report.