FOOD FINANCE 101
Daniel Cloete of Westpac explains how to fund a food business
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Daniel Cloete, Westpac "By buying a franchise, these funding options mean you may therefore be able to afford a much larger food business than when setting up an independent outlet."
The food sector has always offered some of the most attractive opportunities in franchising. Over the past few years, many such franchises have seen strong sales growth with solid bottom line profitability. That makes them an attractive proposition for potential franchisees. If you’re tempted to own your own food business, then, it’s worth looking at some of the factors involved when it comes to raising the necessary funding.
The profitability of a food franchise is dependent on a number of factors: sales performance, Gross Profit (GP), food cost, wages and rent. The calculation known as EBIT (Earnings Before Interest and Tax) in turn determines the ability of the business to obtain funding and reward its owners for the investment risk.
Sales are also influenced by many factors, including the drawing power of the particular brand, location, price, availability of parking, service, market trends, etc. As a result, there is considerable variation between different sectors, and between individual brands in the same sector. However, although high sales may be attractive, they don’t lead to profitability unless the business can achieve a satisfactory GP margin.
The fact that larger food franchises can collectively negotiate much better prices than individual businesses should lower a franchisee’s input cost and increase their competitiveness and profitability. However, understanding food costs and how to control them is key to success.
Many franchises have very sophisticated measurement tools and management information systems to assist with controlling food costs. These may analyse overall categories like beverages and food, or even detail specific items so that the franchisee is aware of what contribution each category or item make to their Gross Profit. This also helps franchisors and their support team keep a watchful eye on factors like wastage and shrinkage. The fact that franchisees can compare these figures or percentages with others in the same franchise system (benchmarking) is a really important advantage when it comes to fine-tuning the performance of a business.
Preparing and serving food is a relatively labour intensive activity and the profitability of the business will be negatively impacted if the business is over-staffed. Getting the wages right is very important.
This is one component that franchisees have total control over and, as a banker, I’m sorry to say that it’s an area where I often see people getting it wrong. When it comes to buying an existing business, a new owner can sometimes increase the profitability significantly by resolving over-staffing issues or by working more in the business themselves rather than employing a manager. It’s worth noting that this can have a significant impact upon the business’s ability to service debt funding.
For fast food or fast casual dining options, foot traffic may be very important to drive sales. This may be less important where the establishment is a destination with good parking, or most of the business is through delivery. All of this affects the level of rent the business needs to pay – and can afford to pay. In mall locations, high rents together with higher operating and other expenses, may push up the rent as a percentage of total turnover. This could have a direct impact on profitability and the ability of the business to weather downturns in sales.
In recent years, paying rental or purchase bonds to secure premises or supply has become more prevalent. This can tie up capital and reduce borrowing ability, or increase debt servicing levels. Experienced franchisors will allow for these factors in their business model, but it’s something new franchisees need to be wary of.
When considering buying a food franchise, then, all of the above factors need to be taken into account. It’s therefore important to work with your franchisor, accountant and banker to find out what is achievable, what is realistic, and to put together the best funding for your own specific needs. In all likelihood, this will not just be a simple loan but will involve a combination of two or more of the following options.
Term loans can be used to fund the purchase of the business or the set-up, franchise fee, fit-out and equipment. Typically three-to-five year term loans secured against the business and cashflow are used. The funding term would be limited by the term of the franchise agreement. A term loan is a good way to fund the business, getting the loan repaid within the terms of the lease or any re-fit requirements from the mall operators. By funding against the business’s cashflow it also lowers the investment required by the owner.
Equipment finance and leasing: Equipment finance is normally done using the equipment as security over a term within the useful working life of the equipment being funded. Examples include items like pizza ovens (which may last a long time), display cabinets, delivery vehicles, etc. Equipment finance funding has the advantage of lowering the equity/investment required, as funding could be up to 80-100 percent of value secured against the equipment (if new).
Not all types of equipment will be suitable for equipment finance, but some – such as computers – can be leased instead. Leasing the equipment takes it off the balance sheet and may have some tax advantages as well.
Some banks (like Westpac) offer equipment finance and there are also specialist leasing and equipment finance companies in the hospitality industry. Some equipment manufacturers may also offer funding. The franchisors in many systems have negotiated special funding packages for franchisees through their bank. It’s important to be aware though, that equipment financing rates can be higher than other forms of funding.
Secured funding is used extensively when buying a franchise, particularly where long-term finance is required. The owner’s contribution may be in the form of free equity in a property, or the total funding can be secured against property. Other forms of security or third party guarantees can also be considered. Secured lending would be the cheapest option and the part secured against property can be done over a longer term, which can lower monthly payments and ease cash flow pressures.
Short term funding may be required where the restaurant or food outlet has a highly seasonal component – for example, where there is a large outdoor area that is only busy in summer or the outlet is located in a holiday town that is only busy in season. Fixed costs like rent may require funding until the cashflow turns positive again.
Other possible sources of funding for food businesses include fit-out contributions from landlords and, in the case of bars/restaurants, set-up contributions from the breweries. These generally come with strings attached, which both the franchisor and franchisee need to be aware of.
In conclusion, the strong systems and brands developed by the better-known food franchise systems tend to lower the business risk considerably. As a result, a bank with a specialist franchise unit like Westpac is often prepared to lend against the existing or new franchised business itself, based on industry knowledge and the record of the franchise system and the other existing franchisees.
The advantages in collective purchasing, marketing and benchmarking make a franchised business easier to manage and support profitability. This means that potential franchisees need less of their own money and can secure part of the investment against the assets and future cash flow of the business.
By buying a franchise, these funding options mean you may therefore be able to afford a much larger food business than when setting up an independent outlet.
The information contained in this article is intended as a guide only and is not intended as an exhaustive list of matters to be considered. Persons entering into franchise agreements should seek their own professional legal, accounting and other advice.
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