Should I fund my franchisees?

In an economic environment where many potential franchisees are struggling to raise the funds to invest in a franchise, some franchisors are wondering if they should now be offering to help fund franchisees into a business.

Offering finance to franchisees challenges conventional thinking in franchising, and should be a last resort for a franchisor (unless you are a banking or financial services franchise, where you are already in the business of lending money).

Most franchisors initially use franchising to grow their businesses because they don’t have sufficient capital themselves to grow their brand. This is known as the capital constraint theory of franchising which basically introduces franchising as a third option for raising capital after debt (ie. the franchisor borrows money to grow their business) or equity (the franchisor sells a stake in the business to fund its growth).

Debt and equity both have limitations in raising capital for franchisors, most of which are privately-owned and often fall under the definition of a small business themselves with often 20 or fewer employees in head office, and less than $10 million in revenue, according to the Australian Taxation Office (ATO) definition of smfranchisee financefinanall business.

A franchisor can only raise so much debt to fund their growth before they reach their maximum borrowing capacity, which limits their growth.

A franchisor’s capacity to grow

Equity financing also comes at the cost of selling a stake in the business to fund its growth (but not so much as to lose control), and risks changing its focus from delivering good outcomes for franchisees to delivering good outcomes for investors (and while these shouldn’t be mutually-exclusive, investor needs can often be placed ahead of franchisee needs).

Franchising can be an ideal form of capital raising as the franchisee brings their own money to the deal, and the franchisor has effective control over how that money is deployed via the franchise agreement and the operations manual.

But at a time when household debt in Australia has hit record high levels, many potential franchisees are unable to borrow enough money through traditional lenders (ie. banks) to afford a franchise, and this has a flow-on impact to franchisors which restricts their capacity to grow.

In response, franchise candidates (especially those from Generation Y) are turning to non-traditional lending sources, such as the Bank of Mum and Dad (BOMAD).

Non-commercial franchisee funding

 While the Bank of Mum and Dad can be a pretty generous financier, this source of funding is often on non-commercial terms, with no loan agreement, minimal (if any) interest payable on the loan, and a repayment timeframe that may not align with the term of the franchise. 

Worse still, BOMAD loans are rarely disclosed up front, so the franchisor might not know that their franchisee’s parents are funding a deal until they start getting contacted directly by the parents when they want to know something about the performance of their child’s business.

Many franchisors have already had the even worse experience of “inheriting” Mum and Dad as the franchisees who have stepped-in and taken over the franchise after their child has lost interest or driven it into the ground. In these cases, the franchisor has unhappy and unaligned people begrudgingly running the franchise because they need to protect their investment, rather than because they are excited about the brand and its market.

Other non-traditional lending is finding its way into franchising, and franchisors are encouraged to familiarise themselves with these new lenders and understand how they work. For example, a recently-established Australian investment fund is offering loans to franchisees of service brands without requiring real estate security, but requires that the franchisor must have a Franchise Advisory Council, and that each participating brand contribute to a fidelity guarantee fund which helps protect the lender from loss if a loan goes bad.

But before franchisors get too excited about BOMAD or other non-traditional lending solving the problem of franchisee finance, they should also be looking at the both the cost of their franchise investment to see if it can be reduced to make the franchise more affordable, as well as the profitability of the model to make it more attractive to financiers.

The cost of a franchise investment

Often the largest component of a retail franchise is the fit-out cost, which can be potentially reduced by utilizing smaller store footprints, alternative materials and equipment and better economies of scale. 

The next largest component of a retail franchise (and usually the largest component in the cost of a service franchise) is the upfront fee payable to the franchisor for the use of their brand and intellectual property, commonly known as the franchise fee. If franchisors are struggling to find franchise candidates who can afford their franchise, it may be necessary to reassess this fee to determine if it is too high. At the end of the day, a franchisor’s profits should ultimately be derived from royalties rather than selling franchises, and if a franchisor can’t sell any franchises because they are unaffordable then they will never receive any royalties either.

So before deciding to offer finance to franchisees, franchisors should consider how they are best capable of engaging with non-traditional lenders, and what (if any) extra monitoring of franchisee performance may be required to reduce risk to the lender. Franchisors should also review the profitability and total investment cost of their franchise to ensure it is affordable and can provide an appropriate return on investment for their franchisees.

How to recruit cash-strapped franchisees

If, after doing that, franchisors are still struggling to recruit franchisees, they might consider the following approaches:

• Opening and operating their own outlets for 1-2 years before selling them as going concerns (for which it will be easier for a candidate to raise finance based on the business’ proven performance and cashflows, than compared to a start-up greenfield franchise. This also has the added bonus of potentially providing a capital gain to the franchisor on the sale of a going concern;
• Lease or rent-to-own programs, which still requires the franchisor to fund the opening cost of the outlet, which is subsequently recovered from a franchisee via a higher royalty fee to cover the franchisors cost of capital. These programs have been used well by some brands, but unlike the first option above which will see the franchisor’s investment in a site returned after one or two years, this option will take potentially much longer for the franchisor to recover the cost of setting-up the outlet. Candidates under these programs may need to have worked in the brand for a minimum period of time to demonstrate commitment and loyalty to the brand and its value before they can be considered for a lease or rent-to-own option;

These two approaches will work better for franchisors of businesses which operate from a fixed location as they are more feasible to fund, establish and operate based on the franchisor’s existing resources, however might not be an option for mobile service brands where the franchisee is the entire business themselves. Having said that, mobile service franchises are generally a much lower investment cost than a fixed-location business and therefore may have less problems with franchise candidates being unable to raise finance.

The bottom line is that if franchisees are not currently able to raise finance to invest in your franchise, there are other things you can consider before funding franchisees yourself.