Financial considerations when acquiring franchise

Friday December 7 2018

Both franchisors and franchisees must consider several financial angles before engaging in a franchise relationship. This article discusses the franchisee’s considerations.

The potential franchisee needs to have a thorough understanding of the type and level of funding required to obtain the rights to a franchise. This includes the start-up costs and the working capital needed to tide him/her over until the business begins to break-even.

The characteristics of financial success, which the franchisee must consider, will be determined by the following factors:

First is profitability. The margins of the business should be sufficient to not only sustain the business, but also to finance further growth if required.

If the margins are low, high volumes of sales will be required to ensure the business can generate enough profits to sustain itself in the long term.

Second is stability. The proven track record of the franchisor is an important factor when planning the financials for the franchise unit.

There must be an element of predictability to the sales volumes, monthly expenses and the inputs required to meet the daily demand of customers.

This explains the fact why it is important for a franchisor to have been in operation for a reasonable period before considering franchising.

Third is cash flow. There needs to be a good understanding of the way the working capital cycle works and which external or other factors cause pressure on the cash flow. Such pressure needs to be catered for, for instance, provision needs to be made for the seasonal nature of demand- holiday periods etc.

Fourth is debt structure. The ability to repay debt and other commitments must be taken into account. High gearing (too much debt as opposed to owner’s equity contribution) is a bad way to start. The owner needs to contribute sufficiently in order to demonstrate commitment to the venture and to ensure that the business is not over burdened by debt financing cost.

Other than in Tandem Franchising, it is an international best practice for a franchisee to deposit with the franchisor at least 50% of the franchise investment cost in unencumbered cash before borrowing to finance the balance.

Fifth is fees and other fixed payments. The fees payable to the franchisor e. g. royalties and marketing/ advertising fees must be considered to determine the income viability of the franchise.

Similarly, other payments such as tax must also be calculated to determine the monthly and ongoing profitability of the franchise.

Sixth is return on investment. The owner must weigh up the risks associated with investing in the business venture to ensure sufficient returns are realized on the investment.

In East Africa, no records exist regarding how long it takes to recoup invested capital in a franchise network (there are very few franchises) but in South Africa it is estimated that capital invested is recouped on average between twelve to eighteen months for an established franchise system.

The franchisee considerations will, to a large extent rely on guidelines provides by the franchisor in terms of sales, expenses etc. based on historical trends and experience in the industry.

While start- up costs may be quantified, projections are not a science and these assumptions must be carefully tested and evaluated by the prospective franchisee.

A business plan prepared by the franchisee for their allocated franchise territory, complete with financial projections, break-even, ratio and sensitivity analyses is a good starting point by the franchisee when compared to what the franchisor suggests.

A middle ground, once reached, gives a fair picture of the financial outlook.

The writer is a Franchise Consultant helping indigenous East African brands to franchise, multinational franchise brands to settle in East Africa and governments to create a franchise-friendly business environment.

E-mail: info@worldaheadafrica.com or

franchising@eabc-online.com

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