Financial aspects of launching a franchise

There are a number of financial aspects which need to be addressed by a prospective franchisor when formulating a development plan and I propose to look at three key areas. By Mark Scott, director, franchising development at NatWest.

1. How the franchisor obtains its income.

2. The pilot stage and related finance.

3. The development stage and the franchisor’s financial plan.

1. How the franchisor obtains his income

The franchisor derives its income from two principal sources – the initial franchise fee and on-going fees – and one of the most difficult problems at the planning stage is deciding at what level these fees should be pitched.

The franchisor has to gauge precisely what is a fair and reasonable financial balance between what it receives and what the franchisee retains. Such a balance is of paramount importance to achieving the ultimate objective of a partnership for profit.

The difficulty is in deciding just what is, and what is not, fair. Account has to be taken of the fact that the income to the franchisee needs to be at a level which is sufficient for it to live and pay its mortgage etc. and that the franchisor’s income is sufficient to cover its costs and make it a reasonable profit. The franchisor also needs to consider the fees in relation to other similar franchises. If they are more expensive this could put off a prospective franchisee.

In the final analysis, the franchise should be constructed to ensure that the franchisor receives an acceptable return on the capital employed, and the franchisee equally should be able to obtain a return on its investment, comparable with opportunities available elsewhere.

The fee structure which is imposed within any franchise should not be negotiable by the different franchisees. All of them must be recruited on the same basis and the franchisor must be completely open in explaining to the franchisee its exact sources of income. Failure to do so can only lead to subsequent suspicion and discontent.

Initial fees

In essence, the initial fee should take into account the cost of constructing the franchise concept, both initially and on a continuing basis. The amount should be apportioned among the number of franchisees which it is anticipated will be recruited over a start-up period of, say, 3-5 years.

Certainly, there should be no appreciable profit for the franchisor included in this initial fee, and the fee will also need to stand comparison with other franchise opportunities on the market.

In the course of time, it may be possible to increase the initial fee by modest proportions to reflect the growing strength and success of the franchise, and it would certainly be prudent to review the figure from time-to-time to ensure that it is increased in line with inflation. The franchisor, however, should remember that its prime task is to help its franchisees into business effectively, whilst keeping the investment level as modest as possible.

The franchisor must realise that it will be faced with expenses in the early stages which its income from the franchise will not cover at that time.

However, its income should grow faster than its expenses. For example, the number of staff required to cope with 15 franchisees may be the same number as that required to service as many as 35 and each franchisee will represent additional income to the franchisor. This factor should be reflected in the development plan.

On-going fees

It would be very unusual for the initial fee to be the only fee income which the franchisor will ever receive, otherwise it would have no capacity to finance the continuing relationship. On-going income is provided by the continuing franchise fee.

It is normal for the franchisor to charge a straight percentage fee on the gross sales achieved by its franchisees (known as the management services fee), but in some cases, particularly where trade marked goods are involved, the franchise agreement compels the franchisee to buy goods from the franchisor, or a nominated supplier of the franchisor.

Where there is a mark-up on goods, the franchisor is, in fact, receiving its franchise service fee by taking a larger gross profit on the goods. If a nominated supplier is used, the franchisor can obtain its income in the form of commission from the supplier.

In practice, from the financial point of view, the level of management services fee taken from the franchisee usually falls within the range of 25 – 35 per cent of the franchisee’s projected net profit figures, excluding service fees, personal drawings, tax, depreciation and finance charges. However, this is not a hard and fast rule.

With franchising we are not dealing with a precise science, nor a system with rigid guidelines. The key consideration in assessing the franchisor’s on-going income is the bottom-line figure available to the franchisee after the management services fee has been paid, or the mark-up applied to the goods purchased.

Whatever income method is adopted and, generally speaking the turnover based level is the most common, the franchisor should tell the franchisee clearly how it obtains its income. It should correctly calculate all initial and on-going fees and be able to demonstrate that it is capable of providing its franchisees with the level of support, guidance and expertise which will enable the development plans to be achieved.

Other sources of income

In theory, the franchisor does have the opportunity of deriving extra income from other sources, including the items in the start-up package which might include the lease of premises and/or equipment, and the sale of equipment.

In most cases, these items or services will be passed on at cost with the addition of modest handling charges or administrative costs which are perfectly legitimate. In those relatively exceptional cases where the franchisor is supplementing, or substituting income from other sources for traditional fee income, then it is essential that it is completely overt with its franchisees from the outset.

Fixed and minimum fees

In some instances, a franchisor may wish to impose a fixed level of management services fee. Where that fee is pitched at a set level, regardless of the turnover or the level of maturity of the business, then problems could arise.

Firstly, they may be caused by the franchisee having to struggle to meet the fixed fee in the early days when his turnover is relatively low and secondly, the franchisor will find that it is unable to benefit from the increased business as the franchise develops. In this latter case, the level of support the franchisor is able to give to the franchisee may suffer. On the other hand, with a cash business this method could be the only way of ensuring it receives what is due, as a franchisee may under declare its turnover and the franchisor will be unaware.

2. Pilot stage and related finance

New franchises principally come from two sources. Firstly, there are existing companies, which wish to expand. This may include overseas businesses that have decided to franchise in the UK. Secondly, there are individuals, partnerships or companies with an idea which, when proved, will be capable of being franchised.

The former is the more common and perhaps more likely to succeed. Either way, there are two principal stages in the franchise expansion programme – firstly, the pilot operation; and secondly, the development process. In this section we shall look at the pilot operation.

The main initial task of the franchisor is to develop a tried and tested formula which will be capable of creating a successful business for the franchisees. As I have indicated earlier, whilst the franchisor will derive some income from selling franchises, it will normally only be sufficient to repay it for setting-up the early franchisees in business.

The break-even performance and in time return on investment, will only come from successful franchisees contributing their on-going management services fee or, in the less common situation, the mark-up on goods.

To develop an idea into a franchise, it is essential, therefore, to prove that it can create a successful business and it is the responsibility of the potential franchisor to invest its own money to provide that proof to everyone’s satisfaction.

An existing company may need to open a new outlet or outlets to re-prove the system or, alternatively, designate an existing branch for this purpose.

The new company will need to start from scratch. It is essential that the pilot operation is a typical outlet as to size, market area, cost, etc. and one which can be cloned in due course when the franchise is ready to be launched.

Therefore, it is difficult to give guidance on the costs of a pilot operation as it will depend on how much expenditure is necessary to maximise the performance of the outlet to make it capable of being franchised. If the company has a sound existing business which needs little in the way of adaption, the costs can be relatively modest. Where the adaption required is greater, or much experimentation is needed, the costs will be higher, especially if a number of pilot operations have to be run.

In the case of the established business which is planning to launch into franchising, finance for the pilot operation should not create too many problems for the bank as it falls within the normal scope of business – financing a business with defined assets and a defined source of income.

In the case of a new venture, financial support is not so easy to obtain and the banks will take a more cautious attitude to both the size of the cash contribution and the security cover required.

The financial requirements of the pilot operation are often below the threshold levels of venture capitalists, but if conventional bank finance is not available, a possible alternative is to take advantage of the Government-backed Small Firms Loan Guarantee Scheme.

Whoever is providing the finance will, of course, need convincing that the product or service will be successful in the marketplace and over a long term.

What is it then that the pilot operation should set out to achieve?

Firstly, it must prove that the product or service will satisfy a continuing consumer demand. It must also demonstrate that the technology and expertise necessary to run the business can be transferred to a franchisee, who has little or no experience of the business. In financial terms, it must show that a typical outlet is capable of providing a return of the investment within a reasonable term, say 2 – 4 years, depending upon the basis of the calculation.

If such a financial performance cannot be achieved, the business opportunity will be unlikely to attract investors and will not be competitive with other such opportunities.

The franchisor from its experience with the pilot operation should be able to give a guide to would-be franchisees of the profit and loss profile of the business. Usually, Year 2 would show a possible growth pattern, based on the business becoming established in its particular locality.

3. Development stage and the franchisor’s financial plan

Having established and financed the concept and proven its viability, the next stage is the development plan leading to a possible need for franchisor funding.

From a financial point of view, the pilot operation and the on-going plan are two distinct and separate considerations. It may be necessary in some cases to have an early indication that finance will be forthcoming for the second stage, particularly if the business is totally dependent upon franchising for its progress.

Initial costs of a franchise

At this point it is worth looking at the costs which may be incurred by a franchisor in the initial stages, excluding the costs of the pilot unit/s and any additional staff required. Initial costs can generally be regarded as those costs incurred up to the point where the first franchisee is recruited.

The following illustration gives some indication of the order and nature of expenses which will be involved.

Professional fees, accountant, consultant, solicitor, agreements/ trade marks, BFA membership, etc. – £20,000

Training and operations manuals, research, compiling, printing – £15,000

Corporate identity, logos and prospectus (design/printing) – £10,000

Advertising for initial franchisees, interviewing costs, training (continuing at approximately £2,000 per franchisee per year) – £5,000

Total – £50,000

Of course, these costs vary widely depending on some key factors which include:

  1. the type of business,
  2. the degree of conversion required from the existing concept,
  3. the availability of the time, resources and skills within the company which is franchising, and
  4. the proposed approach to franchising.
  5. franchisee investment level.

It is essential, however, that time and resources allocated by the franchisor to the franchise development should be included in these costings.

The latest NatWest/BFA franchise survey found that the average investment by a new franchisor in establishing its franchise was £170,000. However, there was a range in those questioned from £25,000 to over £250,000.

Franchisor’s financial plan

Just as it is difficult to generalise on the scale of the financial costs of a franchisor, it is equally difficult to give an accurate model of a ‘typical’ franchisor’s financial development plan.

The principal features will be:

  • A large initial investment will be required which could result in a funding requirement in the region of £100,000. This could be even higher in larger-type franchises with the need for large-scale adaptation.
  • A cumulative break-even position may not be achieved until Year 4 of trading.
  • After break-even, the franchisor should be richly rewarded from the scale of its operations, and its return on capital is high.

Sources of finance

When it comes to finance for the development of a franchise, there are two principal avenues to consider.

Firstly, there is bank finance. Because the bank is being asked to finance a business idea as opposed to the actual acquisition of assets, it will need to look critically at the level of security cover and the viability of the projections which form the basis of the plan.

A company with a profitable mainstream business which is generating profits from a core business is at an advantage here and loan facilities over a period should be available, together with a measure of working capital as is necessary.

Secondly, there may be a case for looking for some element of equity finance if the proprietors are not able to raise the finance needed, or to provide a sufficient proportion of the risk capital themselves. It should be noted that such a source of finance may involve the provider taking a proportion of the equity, or an option to subscribe to the equity.

When seeking finance, the franchisor should support its financial development plan with very detailed budgets and cash flow forecasts. A bank would normally expect to see, as well as profit and loss projections, a three-year cash flow projection with the first year at least on a monthly detailed basis and Years 2 and 3 on, say, a quarterly basis.

The franchisor makes its profits from the eventual scale of its operation and it may be some time before it has sufficient franchisees of the right quality to produce these profits. Premises may be involved and finding suitable sites may be a problem. Invariably, in such cases the take-up rate by franchisees is not achieved within the expected time scale.

Often a subsidiary or separate company is formed to run the franchise and very often the company-owned outlets will be asked to pay an artificial service fee so that correct comparisons can be drawn between the trade and performance of company-owned and franchised outlets.

Summary

In summary, a franchisor should firstly be certain that it has a business which is capable of being franchised successfully. In view of the costs and time involved in establishing a franchising concept, it should take time to establish it on a proper basis and carefully prepare a business plan, ensuring that it is within the financial and managerial capabilities of the business. The pay-back will not be immediate, but when it comes the business can be extremely profitable.

If the prospective franchisor is then able to demonstrate its professionalism and the overall viability of the concept, it is likely to find the banks, particularly those with a long-term commitment to franchising, agreeably responsive to a request for financial support.