Financing your Franchise
How to finance your franchise
For most franchisees, finance is going to be a necessary requirement in their life as a small business owner. Whether you are just about to commit to buying your first franchise business or you are a seasoned franchisee opening your tenth location, securing finance is probably going to be a critical step in your journey. Having a greater understanding of finance will put you in a better position and make securing finance a less stressful process.
What type of finance do you need?
You can broadly categorise all types of funding into two categories – equity and debt.
Equity finance is using funds in exchange for a share in the ownership of your franchise, and includes your own cash savings that you will be putting towards the cost of the business. Equity partners become an owner along with you and will enjoy the potential upside through profits and capital growth, but they will also suffer the potential downsides should the business fail. Sources of equity funding may include cash savings, business angels, family and friends, venture capitalists or even crowdfunding. In the case of an existing business it may also include your retained earnings.
Debt finance is typically made up of funds borrowed from a source outside of the business and will be paid back with interest over time. It usually comes from banks and other financial institutions, or it could come from family or friends, and in some cases vendor finance with the franchisor. It would be quite rare for a franchise to be completely funded with only equity or only debt, it is usually a mix of both. Let’s delve more into debt finance.
Have realistic expectations
From time to time I see franchisees expecting to be able to debt finance 100 per cent of their business. In some very rare cases this might be a reasonable proposition, but generally this is a recipe for disaster. Being overburdened with debt is one of the fastest ways to becoming another business failure statistic. Working out what a safe and responsible level of debt to employ in your business doesn’t have to be a guessing game. We will cover this shortly, but essentially the key message here is have a realistic expectation of what the right mix of debt and equity should be in your business. If you don’t have enough to contribute on the equity side, then maybe you should be looking at a franchise with a lower cost of entry, or sourcing more equity partners.
Before you start the formal process of applying to banks and other financial institutions it’s a great idea to get some professional advice. This may include accountants, lawyers and business advisors who can assist with determining what structure you own and operate the business in, understanding your obligations as a business owner, reviewing agreements, tax planning, GST obligations, pointing out the potential risks and helping with business plans to name a few.
There are also various state government departments that provide small business assistance at no charge. Consider making an appointment with one of these agencies to see how they can assist you.
Getting the right advice before you start your business can save you a lot of stress and money in the future and save you from making mistakes that you may not have even considered.
Applying for Finance
This is where we need to get organised. Not understanding what lenders want to see and not being well prepared can potentially kill your chances of securing funding. Lenders want to support sound and viable businesses.
Showing a lender why you are or will be a sound and viable business, and how you are going to repay the debt is critical to a successful application. What you need to provide to a finance company is also going to differ from lender to lender, and based on the amount of funding you are applying for.
The requirements for a $50,000 application are going to be different than applying for $250,000. And the requirements from a specialist equipment finance company is going to be different to what a bank will require.
After your initial application, you should ensure you get a very clear indication from your lender of what supporting information they want to see, then set about to provide exactly what has been requested. Not only does this ensure a smooth application process, but it should mean you get your approval in a more timely manner.
The most common requirements from lenders may include:
- Application Form
- Forms of Identification
- Trust Deed if you operate through a trust
- Business Plan
- Personal Asset & Liability Statement
- Commitment Schedule
- Financial Projections
- Accountant Prepared Financial Statements
- ATO Portal and / or Business Activity Statements
- Personal and / or Company Tax Returns
- ATO Notice of Assessment.
Whatever information you are asked to provide, it is important that you make sure it is accurate. If there are errors in your information it can quickly erode your credibility. On the other hand, providing information and records that are all up to date will enhance your application. Let’s go into a little more detail on a few items from the list above.
A lot of franchisees underestimate the value of a great business plan. They think that because they are joining a franchise that a business plan is not relevant. Whilst the lender may have a good understanding of the franchise system, the business plan is your opportunity to sell yourself.
A good business plan has many aspects, including:
- Explaining the critical functions of the business and how these functions will ensure you succeed.
- Communicating all the objectives of the business to financiers, business partners, investors and possibly employees.
- It can be a point of reference, once you are trading, for monitoring your progress against the goals or targets you have set.
As a starting point, for new and small businesses, a plan should include the following:
- The business - include the entity name, trading name, legal structure of ownership, ABN, trading location, franchise information, shareholders, and a summary of what the business does.
- The market - discuss your target market, what products you offer, a little about the industry you will operate in and your competitors. Prepare a SWOT (strengths, weaknesses, opportunities and threats) analysis, market demographics and trends.
- Marketing strategies – discuss what advertising and marketing strategies you will undertake to ensure you reach your projected revenue targets. Some franchisors offer assistance with Local Area Marketing plans which may be a good place to start.
- The management team - outline your experience as the owner as well as your key personnel that will be employed in the business. Include prior business experience, education and training that may assist the business, as well as any awards or recognition.
- Financial information - this should include financial projections for the business as well as current financial statements in the case of an existing business. For a new business, you should also include a summary of the total cost to set up the business and clearly show how the total purchase is going to be funded.
- Goals - you may have particular goals relevant to your business and these can be a great way to engage your staff in the business plan. You may have broad business goals like aiming to be a multi-site franchisee and opening more locations. You could also outline your exit strategy here too.
Including your exit strategy in your business plan may seem strange, but I doubt very much you plan to work in your business for the rest of your life. At some point you are going to want to sell and hopefully realise the growth in value of the business you have started. In franchising it’s also not uncommon for some franchisees to adopt a strategy focused on opening new locations, growing them and selling. Documenting some ideas about your future plans to exit the business will ensure you plan for this event.
Keep in mind when preparing your business plan to be concise. Quality over quantity is what you want in a business plan. Lenders, investors and other stakeholders don’t want to read long business plans. Be realistic with goals and projections. Get the numbers right; if you are unsure where to start with your financial projections, you can try and seek some guidance from your franchisor, speak to other franchisees, search for industry benchmarks, or seek professional advice.
Asset & Liability Statements
Be honest about your financial position. Bank account balances can be verified, assets can be valued, liabilities can be seen by lenders through credit reporting agencies. The asset and liability statement should be used to compile a list of what you ‘OWN’ and what you ‘OWE’. Obvious assets may include property, vehicles, furniture and cash, but don’t forget about superannuation and shares. Your liabilities will include loan balances on properties, personal loans, vehicle lease and credit cards.
Make them realistic and make sure you include the repayments of the finance you are applying for so the lender can see how the business can service the debt. This is what I was referring to earlier about how to determine what a safe and responsible level of debt might be that your business can employ. The projections are a great place to start to determine this. Don’t forget, if numbers aren’t your strong point then seek assistance from an advisor or accountant. Stress test your projections. What if revenue was 30 per cent lower, what if wages were 5 per cent higher, is the business still profitable and can it still afford the finance repayments.
How do lenders assess applications?
When assessing the supporting information provided with a finance application, lenders typically do this whilst being guided by a set of credit principles known as ‘The 5 Cs of Credit’.
The 5 Cs of Credit are:
- Character: this is all about you, the borrower, your reputation, and your willingness to repay the debt. Not only will lenders use traditional methods like credit reporting agencies but increasingly online searches can be a source of information in this respect as well.
- Capacity: to differentiate from character, this principle is about your ability to repay. This may cover income, expenses, and other debt obligations.
- Capital: your overall financial position. This means your net asset position and how liquid those assets might be. That is, if things started getting difficult can those assets be turned to cash to either continue servicing your obligations or pay out your obligations.
- Collateral: this refers to the security that you may be able to put up to secure your finance. Most commonly this can be your home or property, although this is more typical of a bank loan. Many specialist equipment funders won’t take security over personal assets and instead use the assets being financed as security for the debt. It is also important to consider the implications of providing Director’s Guarantees and Personal Guarantees as a commonly requested form of security as well.
- Conditions: this relates to all of the terms upon which the finance may be offered to you and may include the interest rate, fees, and length of the contract.
When preparing your business plan and providing other supporting information, keep these principles in mind.
Depending on the franchise system you are buying into, you may find that a relationship exists with one or more financiers. This relationship is commonly referred to as Franchise Accreditation. If your franchise system is accredited with a lender, then this should make the process of seeking funding easier and less stressful. You will typically have access to franchise lending specialists and you should enjoy a more seamless approval process.
All the major banks have accreditations with various franchise systems and some smaller specialist lenders like Cashflow It does also. Your franchisor would be able to provide you with this information.
Cost of Debt
Do you know how to work out your cost of debt? No, I am not referring to the actual equation you learn in Finance 101 involving the risk premium, the risk-free rate and tax. Let’s look at something much more simple. You should have an idea of what it is costing you to borrow funds for your business. If you are unsure about how interest rates work, then the easiest way to compare loan products is to compare what is paid back over the life of the loan.
Simply add up all of the repayments due over the term of the loan, add any application fees, payout amounts at the end of the term and any other fees or charges. Then deduct your original loan amount, this will give you the amount you have paid the lender for the privilege of using their money over the term of the contract. To express this as an annual cost, then just divide it by the loan term. If you are going to compare lenders, then make sure you compare like for like products over the same term.
Beware of Finance Traps
Getting stuck in a finance contract that you didn’t fully understand can be a very costly mistake. The only advice I have for you is to make sure you read your contract in full before you sign it. It’s simple advice, but very few people read their contract terms and conditions. If you don’t understand what the terms and conditions mean, then ask your lender to explain them or seek legal advice.
Here are a few common traps to be aware of:
- Repayment Free Periods - being offered a 1, 2, 3 or even 6-month repayment free period may look great on the surface, but they are rarely free. The cost of the lender forgoing any income from your loan for that period is costed into your total contract. Refer back to my comments on Cost of Debt and work it out for yourself. Typically, the longer the repayment free period, the higher the real cost of the contract will be.
- Contracts Without a Fixed Term - you might see your contract say ‘Minimum Term’ or it may actually state a term but when you refer to the terms and conditions, you will see that your obligations continue after the term. These aren’t necessarily a trap, but you need to be aware of it. In the case of a rental or operating lease, the reason it is structured this way is for the tax benefits you get from this type of finance. The contract will be written in accordance with tax legislation.
- Paying Out Your Contract Early - if you decide that you want to pay out your contract earlier than its full term then make sure you know how the payout is calculated. There are numerous ways that finance companies can calculate payouts, some of them fair and some of them not so fair. Any reputable lender should be able to provide you with an Amortisation Schedule for your loan and this document should also include the payout amount due each month throughout the term of your contract.
Make sure you also check if there are any other early payment fees or penalties. Hopefully now you have some more tools to help you secure the funding required in your franchise business. Good luck.
This editorial appears in the 11th issue of Business Franchise Guide.