How franchising works: the two sides of the story

Business-format franchising, according to the British Franchise Association (BFA), is the granting of a licence by one person (the franchisor) to another (the franchisee), which entitles the franchisee to trade under the trade mark/trade name of the franchisor and make use of an entire business package, comprising all the elements necessary to establish a previously untrained person in the business and run it with continual assistance on a predetermined basis. By Cathryn Hayes, formerly of HSBC and the BFA.

A well-established and proven business-format franchise should provide:-

  •     An established market for the franchisor’s products or services.
  •     Proven sales, marketing and operational procedures.
  •     The benefit of an established business name.
  •     Training, ongoing support and help in running the business.
  •     Where appropriate, help in finding, fitting out and furnishing premises.

In this article, I shall look at the two sides of the franchise relationship – that of the franchisor and franchisee. To be successful, both need to benefit from the relationship.

Franchising from the franchisor’s perspective
Franchising has grown steadily in the UK over the last decade and is now present in almost all business sectors, especially the fast-food and service industries. With many well-known companies operating successful franchise networks, you may be attracted to the idea yourself. It could be the ideal way to expand your business without the huge capital investment needed to set up a wholly-owned operation.

As a franchisor, you grant a licence to local operators (franchisees) to sell your products or services, trade under your name and use any of your trade marks and logos for a specific period. The franchisees have a personal stake in the business and own their outlets so you can expect them to be more motivated to maximise sales than salaried managers. However, you specify exactly how your franchisee must operate in strict compliance with your business style.

You may be involved in substantial expenditure at the outset to develop your franchise operation, but when it comes to the stage at which you are appointing your franchisees they will pay you an nitial fee that will over time help to reimburse these costs. When they are up and running, you will receive a regular income from them by charging a management service fee, or marking-up the price of goods you supply.

At first glance, it may seem too good to be true, but as well as benefits, franchising can have its drawbacks. The development of a successful franchise network requires careful planning, continuous monitoring, and advice and support from professionals, such as a franchise consultant, accountant, franchise lawyer and, of course, your bank manager.

So why are banks interested in attracting franchise business? We see lending to a franchisee as much less risky than lending to someone starting a business entirely on their own. This, however, is only true of well set-up, sound and ethical franchises, and unfortunately not every business calling itself a franchise can claim to be that.

Franchising is not the path to salvation for an ailing business and even when it is done properly by a successful business it may take some years to achieve a positive cash-flow and worthwhile profits.

This article offers a brief overview of the aspects a business needs to consider when expanding through franchising.

What is franchising?
Franchising is a “joint venture” between an independent person (the franchisee) and a business (the franchisor) which wishes to expand its activities.

The venture is governed by a contract. This gives the franchisee the right to operate using the franchisor’s trade name/trade mark, in accordance with a business-format or “blueprint”. All aspects of the franchisee’s business are strictly controlled including image, products or service, systems, and administration. This method is usually known as business-format franchising.

As a franchisor you will:-

  • Allow franchisees to use your trading names, logos, business style and format.
  • Help franchisees establish their own businesses to a pre-determined format.
  • Provide continuing support to enable franchisees to operate and develop their businesses successfully.

You can only become a successful franchisor if you yourself are already operating a successful business with a good track record, and have sufficient management and financial resources to develop and support a franchise network.

The advantages

  • You can achieve rapid business growth without large-scale capital investment because each franchise operation is self-financing.
  • You can quickly create a number of outlets to distribute your products or supply your services.
  • You need only a small central organisation with a few highly skilled staff. This keeps your overheads to a minimum, allowing you to maximise profits. It also reduces the amount of time and effort you spend on staffing and administration – leaving you free to concentrate on developing the business.
  • Franchisees invest their own money in their operations, so they are likely to be highly motivated, and keen to minimise costs and maximise sales.
  • Franchisees may have considerable local knowledge and involvement in local community life, which is likely to be advantageous to the business.
  • Franchisees are responsible for financing and maintaining their units.

The disadvantages

  • Developing a franchise network can be expensive at the outset, both in terms of management time and capital outlay.
  • Your investment cannot be recovered until franchisees are appointed and you receive initial fees and then a regular income from them.
  • You receive only a part of the profit made by the outlet, instead of all the profit if they were owned by you.
  • Some franchisees may try to reduce the amount they pay in management service fees by not disclosing all their income.
  • To protect your income and your company’s reputation you need to monitor not just the sales performance of each franchisee, but also their quality standards. It is not always easy to enforce contract terms relating to dress, decor and marketing methods.
  • Some franchisees may try to change the style and direction of your business.
  • Franchisees will gain in-depth knowledge of your business and some may subsequently try to use it to set up as competitors.
  • You must be sure that the people you select as franchisees can accept the responsibility and stress of running a business.
  • Franchisees cannot be treated like managers as they are independent business people in their own right. Communication and people management skills are, therefore, vital.

Where to start
The first step is to find out more about franchising and see how you can use the experiences of others to avoid mistakes. Contact the BFA, buy its excellent franchisor information pack, and visit a franchise exhibition and attend the free seminars. Also consider attending a franchisor seminar run by the BFA. Think about appointing a franchise consultant to help you put your franchise operation together. We recommend you use a BFA-affiliated consultant, speaking to two or more to ensure you chose the right one for your business.

The next big step is to set up one or more pilot operations – a vital ingredient in creating a franchise that will have a long-term future. The benefits of the pilot units are:-

  • They will demonstrate whether the business is viable on a stand-alone basis.
  • Enable you to identify any problems, and rectify them. Franchisees, who have parted with their hard-earned savings to buy your franchise, expect to receive a tried and tested format in which any difficulties and problems have been ironed out.
  • Enable you to put a comprehensive operations manual together. This will be one of the methods of ensuring that franchisees follow your systems and procedures.
  • They will give you a better idea of how much the setting-up costs for the business will be, what sales are required for break-even, and what level of profits franchisees may expect, and so on.

The franchise agreement
We strongly recommend you use a BFA-affiliated specialist franchise lawyer to draw up your legal contract. This important document will set out the terms under which you are selling the franchise, your obligations, and those of the franchisee. It must accurately reflect the promises you have made in your franchise prospectus and marketing material, and it should be fair, whilst at the same time ensuring that the controls that are necessary to protect both you and the franchisee are in place.

Preparing for launch
When the pilot is running successfully, you will be ready to prepare for the launch of the franchise. These are some of the things you will need to do:-

  • Prepare a prospectus to attract suitable franchisees. This should give clear, concise and accurate information about your business and promote a strong company image. It is a good idea to get your lawyer to check what you are saying to ensure you are not making unsubstantiated or unsupported claims which could lead to problems in the future.
  • Draw up a comprehensive training programme for your franchisees and, if appropriate, include practical experience for them in one or two of your outlets.
  • If necessary, establish sales areas or territories for each franchisee. Again, check with your lawyer to ensure that you are complying with competition legislation.
  • Decide how to calculate the initial franchise fee, management services fees, advertising fees, mark-ups and any other payments that the franchisees will be making.
  • You may need to prepare projected cash-flow forecasts and profit projections, based on your pilot operations, taking care not to promise that franchisees will reach specific profit figures.
  • Prepare a comprehensive operations manual, covering all aspects of the day-to-day operation of the business.
  • Consider applying to join the BFA. It has established a code of business conduct for its franchisor members that they must adhere to, and is a source of information for both prospective franchisees and franchisors.

Recruitment
The selection of suitable franchisees is absolutely vital. You must ensure you recruit people with the right skills and attitudes to join your network. The reputation of your business and the future of your franchise network could be at stake.

One of the most common mistakes a new franchisor makes is to take on franchisees in the early stages, who do not really have the skills required, or sufficient capital. When you launch your franchise, you will be keen to get things moving as quickly as possible, and to start recouping some of your initial outlay. Do not, however, be tempted to lower your standards as this will lead to problems in the longer term.

Popular recruitment methods include leads from your own website, exhibiting at franchise shows, advertising in the national and regional press, as well as on specialist websites, and in franchise magazines and trade magazines covering your particular business sector – a mix of all, or several of these. You should carefully consider what are the essential skills a franchisee in your network will require and plan your interviewing/vetting procedures to ensure that candidates have these skills.

Beware of letting a third party recruit franchisees on your behalf on a commission basis. They may not necessarily be the best judge of the right person for your network, and if they are paid for each one they sign you could find yourself recruiting in quantity rather than quality.

Franchisee finance
Depending on the start-up costs, franchisees will probably need to borrow to buy into your franchise and will have to put in some cash as well. In the early days banks will probably lend around 50 per cent of the costs, but when the network is well established with a good track record they may be able to borrow up to two-thirds of the costs.

By providing the banks with information about your franchise network, they can begin to build up a profile of your franchise. This is used to support lending managers when they are considering a request for finance from one of your franchisees, and means that the managers will have a better understanding of the business.

Franchisees will need to prepare a business plan, together with financial forecasts to support their request for finance. You will probably need to help with this, but the franchisee should understand the figures and “own” the business plan

Franchising from the franchisee’s perspective
Most of us are only too aware of the scale of the risks associated with starting a business. However, there is a way of significantly reducing the risks – franchising. This gives the franchisee the opportunity to own and run a business under an established brand with a proven business format and market. A well established franchise will provide all the essential elements for a successful business, except the most vital piece, the person who will run the business. The missing piece is you – the dedicated and motivated franchisee.

Advantages

  • You own your individual operation whilst having the benefit of a recognised brand name and the associated goods and/or services.
  • Franchising offers business systems and products/services which have been market tested and proved to work. As a result, the risk of your business failing is usually greatly reduced.
  • The franchise package you receive at the outset will normally include operations manuals, book-keeping and accounting systems, marketing guidance and administrative support. You will, therefore, not have to spend time or money developing these.
  • You should also receive practical help in setting up your operation so you are more likely to avoid any major teething problems.
  • Where appropriate, you will benefit from the bulk purchasing and negotiating capacity of the franchisor, and have an established, reliable source of supply.
  • Your business will also benefit from the franchisor’s advertising and promotional campaigns.

Disadvantages

  • You will be investing in the franchisor’s business as well as your own.
  • You sign a formal contract undertaking to run your business in strict compliance with the franchisor’s specifications. After time, you may feel restricted and want to have a more a free hand in running your own business.
  • As the success of your business grows you may want to spread your wings, but you may not be able to expand into neighbouring areas as they may already be occupied by other franchisees.
  • The brand name or image of the franchise could become less reputable for reasons associated with the franchisor or other franchisees.

So, how do you check out a franchise?
The first step is to assess the franchisor and its business. When you take up a franchise you are entering into a long-term business relationship and it is very important that you spend some time looking into the background and performance of your prospective “partner”. Beware the franchisor who attempts to deny you the time to do your research.

A good franchisor wants you to be happy and confident that you are making the right decision and will welcome your enquiries as evidence of your good sense. You should check how long the franchisor has been in business and in franchising.

Information
These enquiries should be backed up by financial information on the franchisor, including its audited accounts. Your accountant will comment on the accounts for you and a bank reference on the franchisor (provided for you by your bank) will be helpful.

Information on the performance of existing franchisees should be forthcoming and the franchisor should be willing to let you have a full list of franchisees to whom you can talk and preferably visit. A franchisor should also be prepared to admit to any franchisee failures and explain why they failed.

In the case of a new franchise, you should look carefully at the performance of the pilot operations. If there are no pilots you are entitled to ask what you are getting for the franchise fee. You should ascertain whether or not there is a market for the products/services in your chosen area and what the future market is likely to be. The franchisor may have carried out market research in your area, but you should also do your own, ensuring that you understand what the business potential is and are aware of the strength of the competition.

Support
You should then look at the strengths and weaknesses of the franchise operation. Critical to your likely success or failure is the level of support and training provided by the franchisor, both at start-up and subsequently.

Support from the franchisor can include: accountancy packages and advice, holiday cover, national and local advertising, regular communication through newsletters, new products, service and market information, and ongoing training. A number of good franchisors hold, at their expense, annual national conferences, and have franchisee associations.

There should be a comprehensive operations manual, which gives you guidance on all aspects of running your operation. An important aspect to consider is what help, if any, does the franchisor give in respect of any staff recruitment and staff training you may have to undertake.

Some franchisors will train your staff for you while others will train you to train them, and others provide little, or no help at all. Another important aspect is the legal and regulatory issues, particularly in relation to the public and employees, such as insurance, health and safety, tax, local by-laws and so on. Your franchisor should be able to help you deal with all these type of matters, and advise you on any changes that may occur from time-to-time in the laws and rules that might affect your business.

Franchise contract
The next step is to consider the legal implications of the franchise contract. This is a very important document as it sets out the rights and obligations of both yourself, as a franchisee, and your franchisor. You should receive a copy well in advance. It should be examined carefully and it is strongly recommend that you seek independent legal advice on the contract from a solicitor specialising in franchise agreements.

You should not expect a franchisor to amend the terms of the contract to suit you as franchisors generally prefer to have a standard contract for all their franchisees. However, having the contact vetted is not a waste of time as it is important that you fully understand its terms and limitations. If you do not like the contract you are, of course, free to walk away.

Financing
The next step is to examine the financial aspects of the franchise. These broadly speaking fall into two categories – the start-up costs and the projected income and profits. Looking at the start-up costs first, it is important that you identify the total amount of money required to get the business going, including any working capital you will need.

Against the costs will be set the amount of cash you can put into the venture, leaving the sum you will need to borrow. You will then have to consider what assets, if any, you or the business might have available to offer as security for the required loan.

You must be prepared to take a realistic view of what might be a practical possibility in borrowing terms. Whilst unsecured borrowing may be possible in some circumstances for a good franchise, it is, for example, no good thinking you can borrow say £90,000 towards a franchise costing £100,000, especially if you have no security.

Having established the start-up costs and borrowing requirements you will then have to look at the potential earning power of the business on a realistic basis. Does it justify the level of investment that it calls for and how long will it take you to recover the investment?

Projections
You will need to ensure that any profit and cash-flow forecasts prepared by the franchisor for your franchise are sensible (allowing for items, such as borrowing costs and drawings) and that they are based on realistic assumptions. This is also a good opportunity to look closely at matters such as how the franchisor gains its income and if there are any other fees that may be payable.

Borrowing money
It is a big step from deciding to start a franchise to actually opening your doors for business. For many, one of the biggest hurdles is approaching the bank for finance. Of course, there is a lot of work to do to before you, or your bank, part with any money. You will need to research your chosen franchise thoroughly, making sure that it is the right one for you and that you are fully aware of what is involved.

You will also need to ensure you can afford the franchise you are interested in, and that the business offers a good return on your investment. Decisions on how much you are prepared to invest, and whether you will draw on savings or financial support from your family, should all be made before going to your bank.

You will find that for an established franchise system most major banks will lend up to 70 per cent of the start-up costs, while for new franchises the figure will probably be around 50 to 60 per cent.

With this in mind you should approach your bank having considered or prepared the following:-

  • How much will you be able to borrow? Prepare a full list of your personal expenditure: mortgage, hire purchase, household bills, and so on. This will show how much money you will need to take out of the business for living expenses.
  • What security can you offer to back up your loan? You might, for example, have a life policy with some value, or have equity in your home.
  • Start preparing your business plan. This is a vital document to obtain finance from the bank. Your chosen franchisor will often help you with this. As part of your business plan, you will need to prepare cash-flow forecasts for the first couple of years. Your franchisor will help, but you need to be sure that you understand the figures, what they are based on, and how much turnover you will need to break-even.

One of the most common questions I am asked by potential franchisees is, what are the banks looking for when approached for finance for a start-up business? The following outlines HSBC’s basic approach to assessing such requests. It should provide a useful insight, and make that first meeting with the bank an easier and more fruitful experience.

Person – who are we lending the money to? We carry out a full review of your background and reliability; your training, qualifications, and track record; financial resources; and suitability to run the business. The franchisor will also have considered these qualities to ensure you are a suitable franchisee.

Amount: Apart from looking at the actual amount you would like to borrow, the purpose for which the money will be used, and its effect on your business, we also consider whether there is sufficient demand for the product/service you will be offering (the fact that you are going to be investing in a tried and tested franchise format helps here). We will also assess how the money borrowed will benefit the business, the type of finance you are looking for (overdraft, loan or a package of financial services), and how much you are personally prepared to invest in the business.

Normally, you will be expected to contribute towards the total start-up costs from your own resources, but it is important to get the balance right. Often, start-ups underestimate how much they will need to borrow to make the business successful and it is, therefore, important to put a realistic case to your bank. Your franchisor will normally help with setting out details of the start-up funds required and the preparation of cash-flow forecasts.

Repayment: It is not in our interests – or yours – to lend you money unless we think that you can repay it and we will, therefore, ask a number of questions on this subject. Will repayment come from future trading profits, after allowing for all your other financial commitments, or from the sale of an asset? Does the cash-flow forecast show that you will be able to afford to repay the loan? What assumptions have been made in the cash-flow forecast? What level of sales are needed to break-even and are they achievable? Is there a contingency plan for any setbacks?

Security: We must also assess the risk of lending to you and decide whether we require any security. This will depend on our evaluation of your business as a whole. The prime source of repayment will be the cash generated by your business and no amount of security will be acceptable if we feel that your business is not viable. If a business runs into difficulties, the earlier the bank is informed of any problems, the more likely it is that we can help. We always recommend you take independent advice from your solicitor before you provide security.

If no security is available, we may be able to consider finance under the government’s Enterprise Finance Guarantee, if your business is eligible. This is a government-backed scheme that guarantees to the bank 75 per cent of a loan, where security is not available and where that lack of security is the only bar to the bank lending the money.

As a potential franchisee, you are in a better position than a self-employed person setting-up a business from scratch. You have the backing of a proven business format, and the track-record of how similar franchisees are successfully operating their businesses to show the bank in support of your loan application.

So, there we have it – the two sides to franchising – a business in which both need to be fully committed to their responsibilities to each other and both need to succeed if the franchise is to survive and prosper.