Financing a franchise

Recent statistics have proved viability of franchising beyond the shadow of doubt. It has tremendous potential in Canada and the United States. Canada has the resources – human, technical and financial – to make the most of the opportunities available.

Canadian Banker magazine
March-April 1989

Financing a franchise
Like other financial institutions, chartered banks are more inclined to lend to an individual who can count on the support of a franchisor. The many reasons are undoubtedly related to the strength of the franchising system. Mr. Garceau, manager, Sales –
Pierre Garceau

The retail and services sector is expanding at a rapid pace. With the continued growth of markets and influx of new products, operating methods have changed a great deal. Sales volume has been increasing steadily in recent years. And, yet, because of economic disruption, profit margins are shrinking and small family businesses are being edged out by highly complex, competitive chains operating regional or national networks.

In this context, independent establishments find it extremely difficult to stay competitive and maintain their identity. The demand for new products and services, combined with new purchasing habits, has made marketing even more complicated for these businesses. As for large companies, they have excellent growth prospects, but are having difficulty expanding because of the tremendous investments required.

Franchising, banking perceptions change
In the face of these problems, many companies have turned to franchising. Franchising is a distribution system whereby a company (the franchisor) grants an entrepreneur (the franchisee) the right to operate a business according to methods and procedures controlled by the franchisor. The franchisor offers the franchisee technical expertise, the use of its trademarks or trade names, and initial and continuing assistance with operations; in return, the franchisee agrees to compensate it on a permanent basis.

Combining the energy and ingenuity of a small private business with the power and expertise of a company that has centralized purchasing and marketing services means reciprocal advantages for franchisor and franchisee.

The concept was born in North America in the late 19th century. By the 1930s, it was the main means of distributing certain products such as cars, gasoline and soft drinks. During the period of rapid growth that characterised the 1960s and early 1970s, development of the retail and services sector opened up a much broader field of action for this traditional type of franchising.

Advantages for the franchisor
The prospective franchisor has three important reasons to consider franchising seriously. The first relates to capital. Franchising enables a franchisor to hold on to its capital, or to obtain outside capital without paying interest, and to set up an efficient distribution network in a relatively short period of time.

It also offers many advantages over borrowing money or issuing shares. Extensive borrowing leads to a heavy debt load, and shares present the disadvantage of increasing the number of owners. As well, with standard loans or the issue of securities, it can take longer to obtain funds. Securities also entail underwriting costs that reduce the amount of available capital proportionally. Franchising, however, gives the franchisor a certain latitude regarding the use of the funds.

The second advantage for the franchisor is lower distribution costs. A company that has no choice but to establish its own network of outlets will necessarily incur high marketing costs. With franchising, however, the stores (i.e. the franchisees) pay for the right to sell the franchisor’s products and services.

The third argument in favour of franchising is that it motivates the owner/manager, a factor many consider essential to its success. Because franchisees have an investment to protect, bank loans to repay and supplier commitments to honour, they are less inclined to hide from any problems that arise.

Franchisees are aware that 70 per cent of small businesses fall within five years

Advantages for the franchisee
Franchising also offers three equally substantial advantages for franchisees. The first is the security of knowing they are not alone, even if self-employed. Prospective franchisees may lack experience and have no idea how to acquire the required expertise. Most likely they are aware that 70 per cent of small businesses fail within five years. Franchising enables them to acquire a business fairly easily, to familiarlize themselves with an operating method that has already proved itself, and to market a product or service under a brand name that is recognized and accepted by the public. The advice offered by the franchisor at all levels of operations also represents an important asset for many franchisees.

The second advantage for franchisees relates to operations. The system enables them to enjoy significant economies of scale, because purchasing and advertising can be done on a national basis. Affiliation with large national company also makes it easier to compete with chains of stores.

The third advantage relates to financing, Chartered banks and other financial institutions much prefer to lend to an individual backed up by a franchisor with a solid financial base, rather than to an independent entrepreneur. Some banking programs even cover the financing of day-to-day operations and longer-term requirements, such as basic inventory, equipment, facilities, automotive equipment, land and buildings.

Franchisees generally obtain interest rates that are lower than those granted to independent entrepreneurs who are just starting out, and the terms are usually fairly flexible. Franchisees can obtain larger loans, as well as more flexible credit terms, from their franchisor. Those whose franchisor has a good reputation may be able to obtain advantageous credit conditions from other suppliers.

The outlook for franchising is excellent, as it offers substantial advantages for franchisors and franchisees alike.

Franchising market
Franchising is a highly adaptable system. Although it is used mainly in the retail and services sector, virtually no product or service absolutely cannot be franchised. It is widespread throughout the economy, having been applied to the automobile industry, weight-loss clinics, dry cleaning, retail sales of computer software and hardware, dental care, sanitary and hotel services, placement firms, instant printing and security systems.

But let’s talk numbers. The figures used until now have generally been provided by specialized organizations in the United States. On the basis of these data, the U.S. market is simply divided by 10 to obtain an approximate profile of the Canadian market.

A banker, however, cannot justify presenting sophisticated readers with extrapolated or stale data. Accordingly, I have used the most recent survey of the Association of Canadian Franchisors (“The Current Situation” prepared in 1987) in order to provide an accurate picture of franchising in Canada. Of the approximately 1,000 franchisors on the association’s list, 250 sent usable responses. This 25 per cent sampling is very representative of the Canadian market.

Survey Participants No. % Restaurant services 82 33· Restaurants (60)· Take-out counters (22) Retail sales (non food) 62 25 Business services 26 10 Automotive parts and services 25 10 Other 55 22· Home repairs and maintenance (16)· Miscellaneous business (16)· Grocery (11)· Hotel – motel (4)· Other (6)· Unspecified (2)

Franchisees obtain lower interest rates and terms are usually fairly flexible

I would like to name all the franchisors who responded, but cannot, as the confidential services of a third party were used to gather the data. A great deal of information about them is available, however. Here is the gist of it shown on the chart above:

Location of head office
More than 80 per cent of the franchisors have their head office in Canada, with approximately 36 percent in Ontario, 20 per cent in Quebec and the remainder in the other provinces.

Franchising experience
Franchising is the major trend of the 1980s. More than 50 per cent of the participants have opted for it since 1980, and 30 per cent decided on it in the 1970s. The remainder are pioneers in the field.

Growth rate
The large chains are growing just as quickly as the small networks. As the chart on the right shows, this rate is quite remarkable.

The royalties required by franchisors vary widely and are based on the services provided in this highly competitive market. Seventy per cent ask for four to seven per cent of revenues in return for their services.

Advertising costs
Advertising costs vary in much the same way. About 50 percent of the franchisors ask for two to three percent of revenues.

Franchising offers substantial advantages for franchisors and franchisees alike

Initial franchise fees
Initial franchise fees vary depending on the sector and the type of establishment, but generally range from $10,000 to $20,000. For business services and restaurants, the costs are usually from $31,000 to $50,000, whereas in the automotive and other sectors they range from $16,000 to $20,000. In retail sales, the range is from $11,000 to $100,000.

Total investment per establishment
One-third of the participants estimated their total investment at $50,000 to $100,000. Another one-third put it between $100,000 and $200,000. In the restaurant category, 40 percent of the participants made a total investment of $100,000 to $200,000, whereas in the other categories it was generally $50,000 to $100,000.

The most interesting part of the survey concerns personnel. Most of the employees work for the franchisee. Head offices have very small staffs, with one employee for every 97 at the points of sale.

*Personnel by sector**
Most of the jobs are found in the restaurant sector.

Job creation
In 1986, the participants employed 200,000 people. This number will increase by 36,000 in 1987 and by 100,000 by 1989. These figures are based on the answers provided by the 25 per cent sampling; accordingly, franchising should create 500,000 jobs by 1989. If franchisors are having recruiting problems today, imagine their difficulties a few years from now!

Prospective franchisor’s activity must generate higher than average profitability

Bank financing and franchising
When a bank evaluates a loan application for the financing of a franchise, it should use a special evaluation process, as each party must consider certain rights and obligations before contracting or granting the loan.

It is essential that the bank apply a number of standard criteria. Here is the list:

  • Does the franchisor have a solid financial base that will enable it to fulfil all its responsibilities toward future franchisees?
  • Does it offer a quality product or service meeting a market need?
  • What assistance does it give the franchisee with site selection and marketing?
  • What experience does it have in business generally and franchising specifically?
  • What are the growth and profitability rates for its business?
  • Does it have a good reputation?
  • Has it developed equitable and legally binding contracts that protect all parties?
  • Does it derive its revenues mainly from the sale of franchises (is it involved in selling franchises or in distribution?) or from royalties paid by franchisees?
  • Does it take a genuine interest in the success of its network? Is it the owner of the franchisee’s site, the guarantor of the premises or the holder of the main lease?

*Is it prepared to get involved to save a franchise that is having difficulties? Is it prepared to sign repurchase agreements or letters of comfort and letters of intent?

  • Does it assist franchisees with their marketing plans, cash flow projections and financial statements?

A bank that obtains satisfactory answers to these questions will be prepared by work with the franchisor to ensure that its network develops in a manner that is profitable and equitable.

The franchisor must consider a number of important factors, including the following:

  • Has the bank demonstrated a genuine interest in franchising? A franchisor can gain a great deal by joining forces with a bank that has extensive experience in the direct financing of franchises.
  • Can the bank provide the necessary support? More specifically, does it have full-time resource people working on franchising problems? Do they understand the specific problems of a franchisor and can they respond to them rapidly?
  • Does it have such resource people in each region of the country? This is a valuable advantage for a franchisor that wants to develop a local market or to expand geographically.
  • Does it have a large branch network in Canada? This is essential for a franchisor that intends to set up a national network.
  • Can it provide the full range of advanced banking services, including state-of-the-art data processing? It is essential to remember that the needs of a network of franchises will change as it expands.

The franchisee must take the following factors into consideration:

  • Does the franchisor have a financing program with a bank?
  • What advantages does this program offer over the bank’s usual financing methods?
  • What are the interest rates?

*Has the franchisor negotiated specific agreements with the bank, such as letters of comfort, repurchase agreements, etc.?

  • Does the bank make services other than financing available to franchisees, such as automated payroll, direct deposits, etc.?

To franchise is to repeat a success, and this is why banks like franchise loans.

Bank’s responsibilities
What must the bank do if the franchisor ceases to meet the basic requirements, if the franchisee is ready to give everything to obtain a loan, if the franchisor expands too quickly and becomes a “seller of franchisees” or if the franchisor no longer responds to the franchisees’ problems?

These are only a few of the situations that can arise. These problems sometimes occur because financial institutions are more interested in providing financing than in getting to know the franchisor and ascertaining whether its system deserves to be financed. For example, an equipment-repurchase agreement is worthless if the franchisor doesn’t have the wherewithal to buy the equipment back.

How can a bank reassure a prospective borrower when it knows that the franchisor’s financial worth is inadequate? Can the bank whitewash itself by placing all the responsibility for the evaluation on the franchisees’ shoulders? Can a banker use the reasoning that the bank finances franchisees on the basis of their credit worthiness alone and that if they have problems with their franchisors, they’re on their own?

This is an easy way for bankers to shirk their responsibilities. Competent bankers, however, will get to know a franchisor very well and will support its system before financing franchisees. They must ensure that the franchisor is well versed in franchising and the obligations it entails. Bankers cannot ignore a contractual agreement binding a franchisee to a franchisor for five, 10 or 15 years, just as they cannot ignore a situation in which the franchisor uses a third party to sell its franchises. A bank has a moral obligation toward franchisees (its future customers) and must face this obligation.

Voice of experience
When I said that virtually no product or service absolutely cannot be franchised, I was not implying that anything goes – far from it. The saying that anything can be franchised is a dangerous one. A franchise evaluation should be based on three criteria:

  • repeatability;
  • marketability;
  • profitability.

Because to franchise is to repeat a success, the potential franchisor must have mastered the activities it wants others to carry on. That it may consider itself the best at what it does is of little consequence. Rather, the calibre of its operations must be proven and the references it has built up through experience must show that, in terms of technical value and financial results, it has achieved above-average results in comparison with competing businesses.

The banker must then consider whether others can duplicate the franchisor’s success, as a number of limitations, may come into play and exclude the activity from franchising.

A banker cannot ignore a situation in which a third party is used to sell franchises

Second: the market.

The market must be able to absorb the activity and must be durable and strong. Many specialists maintain that the product or service must be new for it to be successfully franchised. But this theoretical criterion has to be applied very carefully, since many new products never reach maturity. The mystique of novelty is often deadly, especially for a product or service that is brand new. In point of fact, a commercially exploitable novelty is far more evolutionary than revolutionary; often, it entails changing the way a product is presented, packaged, marketed, used or perceived, or adapting it to a new target market.

Third: profitability.

The prospective franchisor’s activity must generate higher than average profitability for its sector of activity. Otherwise, franchising probably has to be ruled out. In North America, a return on investment of 15 percent each year – not exactly small change – is sometimes the minimum requirement.

Canadian banks are well positioned to help customers meet these challenges

Another important matter is the franchisor’s social responsibility. Although it cannot be held legally responsible for the outcome, it must realize that it should not propose a model for others unless it has objectively measured whether a franchisee can reasonably hope to succeed by repeating the model. Remember Murphy’s law: If something can go wrong, it will.

Recent statistics have proved viability of franchising beyond the shadow of doubt. It has tremendous potential in Canada and the United States. Canada has the resources – human, technical and financial – to make the most of the opportunities available.

A number of Canadian franchisors are already operating in more than one province and are thinking of expanding into the United States. Canadian banks are well positioned to help their customers meet these challenges. All the parties involved in franchising are working hard to make it an industry to be emulated.

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