Alternative finance options for franchising

The limitations of traditional bank lending to potential franchisees is restricting the growth of franchise networks and is a source of frustration to franchisors, according to a recent meeting of franchise leaders.

More than 60 franchisor chief executives and senior executives gathered for the Franchise Management Forum, a conference and think-tank event jointly organised by the Franchise Advisory Centre and Griffith University’s Asia Pacific Centre for Franchising Excellence to explore key issues affecting the franchise sector.

Based on consistent findings from the Franchising Australia survey over several years that access to finance by potential franchisees was causing a barrier to growth for the sector, an interactive exchange session at the forum explored the topic of alternative finance options for franchising.

While some of this discussion still gravitated towards traditional lending, albeit via franchise accreditation programs with the major banks, spirited discussion was also held on vendor and family financing, plus the need to review investment levels to reduce the overall cost of joining the franchise.

Bank franchise accreditation programs

It was acknowledged that the Big Four banks in Australia all offer a franchise accreditation program of some kind which recognises the strength of a franchise brand and business model to generate strong cashflows for a new outlet.

In some cases, banks will offer accredited systems cashflow lending worth up to 70% of the value of the initial loan, with the franchisee required to provide either cash or real estate equity for the remaining 30%.

However, while such programs are common in the Big Four banks, and are now also appearing in several second-tier Australian banks, accreditation is not for everyone.

With a few exceptions, the sorts of franchise business models which qualify for bank accreditation are businesses which transact in cash, carry no debtors, and require an initial investment of greater than $250,000 or more.

This investment threshold alone excludes potentially half of Australia’s 1180 franchise systems from consideration for bank accreditation, as service franchises (particularly mobile service business) rarely require investments at this level.

Other types of businesses may be subject to preferential lending criteria depending on the industry in which they operate, instead of franchise accreditation. Examples include pharmacies and childcare centres, which are often recogised by banks as businesses with predictable cashflows in highly regulated markets, irrespective of whether or not they are franchised.

Leaders of mature franchise networks recommended that franchisors should seek accreditation with all major banks, rather than relying on just one, but warned that the process of gaining accreditation required a significant investment of time and organisational resources, plus full transparency of the business at franchisor and franchisee level.

Once obtained, accreditation does not mean that every qualifying franchisee will be funded as banks may apply internal limits to how much they will lend to any one brand, or any particular industry. Additionally, accreditation is reviewed on a regular basis by the banks, and may be withdrawn.

Vendor financing

A number of franchise systems indicated that they are currently offering vendor financing (for new outlets only), while others indicated that they are strongly considering this as an option in future.

Franchisors who offer vendor financing expose themselves to the risk that the franchisee won’t or can’t pay, and that the franchisor may need to take over and operate the outlet. This means that franchisors with the internal resources to manage company-owned outlets are more capable of offering vendor financing.

Repayments under vendor finance arrangements are made in one of two ways. Either the franchisee pays a premium in addition to their ongoing royalty payments until the business is paid off, or the franchisee earns their equity by delivering profits in excess of a pre-agreed level of performance, with the surplus profits “buying’ the franchisee’s stake in the business.

Either method can be applied to ‘greenfield’ (i.e. new) outlets, or existing operations, although the risks to the franchisor (and franchisee) may be less in an existing outlet compared to a greenfield site, depending on the circumstances.

The problem with vendor financing is that franchisors may not have enough capital themselves to offer this option to all suitable candidates who cannot otherwise qualify for bank finance, and therefore still risks limiting the growth of a network.

Family financing

Many franchisors reported that they had granted franchises to candidates who had borrowed some or all of the money from their family or friends. This is generally known as family financing, and comes with a number of risks and challenges.

A number of franchisors who had accepted family-financed franchisees later regretted doing so, as they found that the franchisee was not fully committed to the business (and in some cases would even abandon it without fear of the financial consequences attached to bank finance), or that the family members who had lent the money would seek excessive control over the operation of the franchise, often in conflict with the policies and procedures set out by the franchisor.

In some cases, franchisee abandonment of family-financed businesses led to the parents taking over the business in order to protect their investment, but with the result that people who may not otherwise meet the franchisee selection criteria effectively became franchisees by a reverse acquisition process.

Some franchisors expressed the sentiment that “parental cash was better than parental real estate equity”, indicating that guarantees provided by parents for bank loans could often be given too freely without due consideration of the performance needs of the franchisee’s busines, and the exposure risk for the parents’ home if their franchisee son or daughter failed to operate their business at the required level of performance.

Other franchisors indicated that a family-financed franchisee candidate would need to provide a copy of the loan agreement between the family members as a further condition of granting the franchise, and must still contribute a minimum proportion of the initial investment from their own funds.

All franchisors agreed that the performance of vendor or family-financed franchisees needed to be closely monitored at all times, and early intervention applied if the business fell below the expected level of performance, but then agreed that such monitoring and intervention should be the same for any franchisee no matter how they are financed.

Reducing the cost of joining the franchise

Many franchisors also commented that they have reviewed, or soon will be reviewing the setup costs of new outlets to reduce the overall investment required.

Much of the set-up cost in fixed-location businesses is in fitout and equipment, with franchisors actively seeking cheaper but equally effective fitout and equipment inputs. Some franchisors indicated they have reduced the physical size of their locations, meaning a reduction in ongoing costs such as rent, but also reducing the initial set-up costs as well.

Other franchisors have worked more collaboratively with suppliers, particularly landlords to bring down set-up costs, and in rare cases have been able to obtain landlord contributions that have covered the entire cost of a store fitout.

Additionally, franchisors are looking at their own upfront franchise and training fees to increase overall affordability of their outlets.

The future

While this article has explored some responses to franchise financing issues, it is by no means an exhaustive treatment of the subject, and has not included discussion of all possible financing models.

It also does not take into consideration the likelihood that an increasing proportion of franchise finance in future will be obtained outside of traditional lending models as a newer generation of franchisees emerge who may have little or no real estate equity to offer conventional lenders as security for their franchise investments.

However, this article does recognise the growing realisation in the franchise sector that traditional lending will be unable to meet the needs of the sector in future, and that alternative financing models will be necessary for its future growth.

Jason Gehrke is the director of the Franchise Advisory Centre and has been involved in franchising for 20 years at franchisee, franchisor and advisor level.