Are franchise income guarantees a good idea?

This article first appeared August 31, 2010.

Income guarantees have existed in mobile service franchising for more than a decade, but in recent times they have started to appear among retail franchises as well.

There are both advantages and disadvantages to the provision of income guarantees, with different approaches taken by service and retail franchises with varying degrees of success.

At their simplest, income guarantees are top-up payments made by the franchisor to a franchisee to a predetermined level, depending on the performance of a franchisee’s business.

For example, an income guarantee of $1,000 per week in a service franchise may not mean that the franchisor actually pays $1,000 to the franchisee if they generated sales of $800, but would instead pay $200 as a top-up amount so that the franchisee’s overall sales income for the week is $1,000.

This is the most common form of income guarantee in service franchising, and equates sales turnover to income as the business operator usually has low overheads and often sells only their labour.

By contrast, income guarantees in retail franchises may not be tied to sales turnover, but instead to net profit based on a formula calculated by the franchisor around highly controlled costs and margins.

Under this method, the assumption is that every $X in sales generates costs of Y% and a surplus of Z% if the business is operated in accordance with the system guidelines. If a franchisee incurs higher costs by rostering excess staff or paying them too much, then the amount they could claim under any income guarantee would be reduced by the excess costs paid above the franchisor’s formula.

The following are a summary of the advantages of income guarantees:

Enhances appeal of the franchise to potential franchisees

When considering buying a franchise, a first-time business buyer who is accustomed to the predictable regularity of a fixed wage or salary can be truly daunted by the uncertainty that comes with self-employment.

An income guarantee – for as long as it is in place – eases this concern by providing a franchise buyer with the confidence that their mortgage repayments and other living costs will generally be covered while the business grows.

Provides a point of difference between similar franchise offers

With more than 1,100 franchise brands now on offer to potential franchisees according to the 2008 Franchising Australia survey, there is a high level of competition among many similar offers to attract quality franchise candidates.

In some industries, the competing systems may appear to be basically identical but for the brand. Where investment level, fee structure, market appeal, support levels and overall income potential may appear the same, an income guarantee can provide a unique point of distinction that separates a franchise offer from “me-too” rivals.

Ensures franchisees have working capital

A key advantage of an income guarantee offered during the opening months of the franchisee’s new business is that it helps ensure that the franchisee has enough working capital to pay their bills until the business is capable of generating enough cash for itself.

This is of particular significance to low-investment service franchises where the requirement to produce business plans and cashflow forecasts may not be so well understood by potential franchisees, or so well enforced by franchisors.

On the other hand, where income guarantees are offered by retail franchises, the qualifying period may be up to a year (and usually once the cashflow of the business has stabilised) compared to a few weeks or a couple of months offered by service franchises on commencement.

Smooths the transition from employment to self-employment

The great uncertainty of self-employment and the risk of an unpredictable and infrequent income can be a major concern to those who have only ever known the security of a wage or salary throughout their working life.

Consequently an income guarantee can smooth the transition from employment to self-employment by easing a new business owner into a ways of thinking about how their income is averaged over a longer term, rather than just from one pay packet to the next.

There are however, disadvantages to income guarantees, and these are summarised as follows:

Inflates the cost of the franchise offer

Franchisors incur costs every time they grant a franchise. These costs include training, equipment, inventory, marketing, start-up support, store or vehicle fit-out, materials and so on, and may ultimately be paid to external organisations for these goods or services (eg. shopfitters, suppliers, etc). The franchise fee paid to the franchisor for the use of their intellectual property is often the only component of the franchisee’s initial investment that the franchisor retains, and it would be from this that any income guarantee is paid.

However franchisors are unlikely to forego this income, so it is likely that the franchise fee is set at a high enough amount, or increased to absorb the anticipated cost of income guarantee payments. In other words, the franchisee pays for their own income guarantee by paying a higher price for the franchise than might have been available without an income guarantee.

Encourages an employee mind-set among franchisees

Franchisees are business owners in their own right but can fail to realise how financially self-reliant they must become if they are conditioned to receiving top-up payments from the franchisor when sales are low. If head office is paying a franchisee on a regular basis, it still bears some similarity to the employer/employee relationship experienced by the franchisee in their prior experience in the workforce. In this regard, an income guarantee may encourage other employee-related attitudes and expectations, such as expectations of franchisor support to cover sick days, holidays, retention of PAYG tax, and so on.

Many such expectations are highly unrealistic, but may evolve if the franchisee develops a financial dependence on the franchisor during the guarantee period, and may lead to conflict or substantial non-compliance by the franchisee once the guarantee has ended.

Fails to take into account a franchisee’s true cashflow needs

An income guarantee, which can be viewed as a form of working capital, may not be set high enough to meet a franchisee’s needs and can lull a franchisee into a false sense of security.

Where service franchise income guarantees equate sales turnover to income, a person who received a salary of $1,000 per week in their job may not fully appreciate that sales turnover of $1,000 a week (or topped up to that amount by the franchisor) will not have the same spending power after allowing for expenses and taxes.

In this scenario, the operator could have even less cash to meet their living costs (eg. mortgage repayments, groceries, education, etc) which have probably remained at a constant level and should have planned instead to target a much higher level of turnover.

Little or no appeal to sophisticated candidates

While an income guarantee might be attractive to a person going into business for the very first time, those who have business experience and understand how to plan their cashflow are unlikely to be drawn by guarantees.

Candidates with prior business or franchise experience may disregard income guarantees as gimmicks and may even judge more harshly those franchisors who offer them.

Disclaimers limit scope of guarantee

As with most other kinds of guarantees, franchise income guarantees may come with strings attached. These conditions might include:

1. The franchisee must comply with the franchise agreement and operations manual at all times;
2. The franchisee must undertake, at their own cost, whatever marketing programs or initiatives the franchisor suggests;
3. The franchisee must offer discounts, or stock certain inventory, or demonstrate hours worked, or provide some act or consideration in return for the income guarantee.

Conclusion

There are many advantages and disadvantages to income guarantees, the nature of which may differ between mobile service and retail franchises, and which may affect the way the franchise and the franchisor is perceived by potential franchisees and others.

An income guarantee should not be offered as a substitute for an unproven or unprofitable business model, and should always be assessed carefully by both franchisors and potential franchisees.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for nearly 20 years at franchisee, franchisor and advisor level. He advises both potential  and existing franchisors and franchisees, and conducts franchise education programs throughout Australia, and publishes Franchise News & Events, a fortnightly email news bulletin on franchising issues and trends.