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MAKING FRANCHISES AFFORDABLE

by Simon Lord,
last updated 23/07/2009

Franchisors are looking for creative solutions to help solve an old dilemma - what do you do when your potential franchisee has all the right qualities but not enough money? We investigate alternative funding strategies

 

As franchising enters its second half-century, competition for potential franchisees is hotting up. In New Zealand, there are more franchise systems to choose from than ever. In most cases, big redundancy payments are a thing of the past. And many of the age group most likely to buy businesses (the 35-50 age range) have either already done so or have settled back into corporate life.

Franchisors have therefore been forced to look at other options and, not surprisingly, many have started to look for younger franchisees. Such people have energy, vigour and enthusiasm, and are less likely to be set in their ways. Unfortunately, they are also less likely to have the sort of money behind them which is necessary to buy a franchise.

This has always been a dilemma. Now, however, many franchises are coming up with creative solutions to the problem. We asked them to share some ideas with us.

Joint Ventures

Chris Ring is the founder and managing director of Pit Stop, the under-car servicing specialist, which has both company-owned and franchised outlets.

'Like every company, we have some outlets which perform better than others,' Chris says. 'Over the past eighteen months, we have turned three company-owned outlets from making a loss into profitable businesses by using a form of joint venture scheme with new franchisees.'

The Pit Stop joint venture scheme works in one of two ways. 1. 'Say the prospective franchisee has enough to put in 25% of the cost of the franchise,' explains Chris. 'We will effectively bankroll the rest, and they can gradually build up their share to 49%. At that point, they are receiving 49% of the profits, and can save them up until they have enough to buy the remaining 51% from us, at which point the whole business – and all the profits – are theirs.

'The second option applies where we are convinced that they are the right person but they have no money at all. Let's say the business is worth $100,000. The prospective franchisee does not put in any money initially, but receives a base retainer and a percentage of all the profits. Their profits are held in trust until such time as they reach 20% of the company's value – in this case, $20,000. At this point, the savings are converted into shares and they have 20% equity in the business. From this point on they receive 20% of the profits in cash, which they can then save towards buying further shares as in the first option.'

Under the second option, if the prospective franchisee leaves before they have acquired equity, they do not receive the funds held in trust. 'It's a commitment thing,' says Chris. 'We're looking for people to make the business fly. A lot of people can do it for 3-6 months, but we want the people with long-term goals and genuine customer focus. It usually takes 18-24 months to build up that first 20% under this scheme, which is long enough to deter the fly-by-nights.'

Dramatic Growth

Philip Horrocks uses a variety of schemes to help new people into his Have A Snack! franchise, and is about to expand them into the new PlanetBurger enterprise.

Philip puts the franchisor's dilemma in a nutshell. 'We realised some time ago that in a high proportion of cases, the people who have the right skills to manage and grow our businesses are not necessarily the people who have the capital. In fact, the people with capital can be risk-averse. The job environment is often the complete reverse of the business environment. The person who patiently accumulates capital or who receives a redundancy package often doesn't have the entrepreneurial flair to take a business opportunity and run with it.'

Have A Snack! has been running alternative funding schemes for four years. 'They have enabled us to grow at a faster rate, and to select franchisees from a wider range of people. Up until now, we have treated each one as a pilot case, but over the next three years we can grow our business dramatically,' says Philip.

Philip firmly believes that large upfront franchise fees will soon become a thing of the past. 'They are a deterrent to attracting the right sort of people into the business, and they are not a revenue generator which is what a franchise needs in the long term. A third of the upfront fee goes in tax anyway.

'In order to provide the level of management you need to make franchisees successful, you need higher ongoing fees. A lot of franchises fold after 3-5 years because the capital they received from initial fees has evaporated and they find they have insufficient ongoing revenue to fund the level of services needed.

'I hear the all-up fee structure of McDonald's amounts to some 24% of gross sales. That keeps the company healthy and provides the level of management which helps make the franchisees successful.'

In addition to a similar system to that developed by Pit Stop, the Have A Snack! options include:

1. Territory leasing, where each franchise territory is leased out rather than sold. There is no upfront franchise fee with this system: instead, the franchisee pays a percentage of their sales as a lease fee on top of the royalty payments. A variation of this enables franchisees to lease a total package from the company, including vehicles, stock, and all the other items.

2. Financing. 'If a franchisee is able to raise, say, 40% of the necessary amount, we may lend them the remaining 60% on a preferential funding arrangement,' Philip says. 'Some of this may be structured as deferred franchise fees into the future in return for an agreed share on the sale of the business.'

3. Regional Franchise Directors, who fulfil some of the roles of an area master franchisee for Have A Snack! They pay no upfront fee for their territory, but are expected to fund the franchisee advertising, recruitment and management in their territory initially from their own funds but ultimately from the percentage of ongoing royalties which they receive. 'It is a capital-free risk,' says Philip, 'which allows us to recruit the best people for the job. They then reap the rewards from making the franchisees in their territory as successful as possible.'

4. Regional Development Agents are a new option for the PlanetBurger franchise. Again, they pay no upfront fee for their territory but are required to fund a pilot store locally. This establishes the brand locally and provides them with the ongoing revenue to fund franchisee advertising, recruitment and management in their territory. Ultimately, they can retain the pilot store or sell it, while still deriving ongoing income from the franchisees they manage in their territory.

'By doing away with that upfront fee, it means age is no longer a barrier,' says Philip Horrocks. 'You can afford to recruit people based purely on their attitude and their aptitude – which are the most important determinants of franchise success anyway.'

Showing Confidence

Robert Fowler is also a fan of alternative funding strategies. 'All too often, potential franchisees in the right age bracket to have the enthusiasm and energy have not had time to build up enough assets to buy a franchise. If that's the case, it's sometimes in the interests of both parties to find a way to help.'

Robert, managing director of the Bedpost franchise, has used a joint venture approach once and is 'about to do it again. The first time, the couple certainly did OK – they repaid a substantial debt after one year.'

Bedpost took no shareholding in the new franchisee's business. 'We did it as a straight loan, taking a security caveat over their home and a recognised interest in the business. We were able to loan money at a cheaper rate than the bank, but to get a higher rate than the bank would have given us. It was a win/win.'

He feels that showing such confidence in your own franchise – and in your selection procedures - is no bad thing. 'Some banks will actually lend up to 50% against the value of certain franchises because they recognise that the franchise system itself has a value. Why shouldn't you, as the franchisor, do the same and put money back into your own business? You're using your capital to grow, exactly as you would if it were a managed outlet, but you're getting the benefit of having a committed franchisee.'

Business Leasing

Perhaps the most formalised and best-established of the alternative funding strategies is the Business Lease scheme operated by the Bakers Delight chain of hot bread shops. The scheme originated in Australia, and was brought to New Zealand as part of the company's strategy for growth when it entered the market here in 1995.

'It was designed to give people – and especially younger people – the opportunity to get into Bakers Delight,' says Karen Turketo, the company's NZ Regional Manager.

'We take the head lease on the property and put up the money to build the store, which is around $300,000. The franchisee then leases not just the property but the entire business from us. They have to put up $10,000 security and $10,000 for working capital, which is enough to represent a genuine commitment to making it work.

'They then pay us normal royalties and a lease cost on top, which is usually 50% of the profits. They keep the other half and save it until they are able to put down a large enough deposit to raise bank finance on the rest. We don't want to continue bankrolling them after that point because it ties up our capital – once the franchisees are able to be independent, we prefer to extract our money and use it to build another shop.'

'The ideal is to have the people in a position to buy the franchise after a year, but sometimes the lease can last longer,' says Karen.

With the potential buyers managing the store – and the refore responsible for its profitability – how does Bakers Delight set the price? 'First, we give them strict performance criteria based on the average Bakers Delight. If they fall below that level, we work with them to improve things. Ultimately, we would terminate the lease if they weren't performing, but we've never had to do that because we've always selected the right people. Secondly, we agree right at the start what the purchase price will be if they want to buy the business after six months, or ten, or twelve.'

'In a way, we set out a career path for people – they can see where they can go if they choose. Tristan Corbett (see page 51) is a good example - he started as an unskilled employee, went through all our training courses, managed a store for a franchisee and is now leasing his own business. Eventually, he will have the opportunity to buy his own franchise. Not bad for a young man who came to us with nothing but ambition.'

Karen says that the business lease scheme enables Bakers Delight to take up good sites and good people quickly, and to achieve critical mass faster. 'Most of our Auckland stores were initially set up this way, and the majority of those people now own their own stores. Now we're moving out to the rest of New Zealand, it's a system which gives us great flexibility.'

And the system is so well accepted that in Australia some Bakers Delight franchisees are leasing out their own stores. 'If a qualifying franchisee wants to take a year out, he can lease it to someone for that period – who again gets a share of the profits,' says Karen.

 

Bakers Delight is also trialling a tripartite funding arrangement in a few cases where the company, the franchisee and a bank all provide part of the funding. 'The franchisee pays off part of the bank loan first, then re-finances with the bank so they don't need us any more. Basically, we know the value of our system and are prepared to lend against it.'

The Enterprise Allowance Scheme

Another – external - form of alternative funding for franchisees is available from Work & Income New Zealand through the Enterprise Allowance Scheme. This is available to all those receiving a community wage who have been enrolled for 26 weeks or more and who have been unable to find work.

'We will provide recipients with funding of $200 per week for the first six months and $150 per week for the next six months,' explains Lyndon Hay of W&INZ in Auckland. 'A portion of that can be capitalised up to a maximum of $5000 for such items as machinery and equipment.

'To be eligible for the allowance, applicants need to provide us with a good sound business plan, which we will help them develop. The scheme does cover franchisees; however, because of the initial cost involved in buying a franchise very few people end up in franchises.'

Justin Worsley of Green Acres Home Cleaning in Auckland has had several franchisees come through the Enterprise Allowance Scheme.

'Some of them have done very well indeed,' he says, 'although a few have come and gone. They were able to buy a franchise, spend a year building it up, then sell it on for $16-20,000. We have had immigrant doctors and dentists who wanted to earn while they re-qualified locally, and others who just wanted to put their heads down and work – some really nice people.'

Selection & Commitment

One thing stressed by all of the franchisors interviewed was the importance of selecting the right people for any sort of alternative funding venture. 'You have to get the right person with the right attitude first,' says Pit Stop's Chris Ring. 'For us, they have to be motivated by customer service, and they have to be able to bite the bullet and say "Right, this is my chance. If I put in the hard graft and save the money for the next two years, I'll get the payback every year for the next twenty." Finding those people comes down to gut feel.'

It is often observed that the payment of an up-front fee means the franchisee is totally committed to the success of their business. Do these easy-entry schemes dilute that commitment?

'In some ways they can be more committed than the guy who walks in with $100,000. They start with next to nothing and they want the system because they've seen what the system has given other people,' says Chris.

Karen Turketo agrees, but notes that time and time again when the franchisee buys the store and they're getting 100% of the profits, the sales grow.

'Potentially they could be less committed,' agrees Philip Horrocks, 'But if you are selecting younger people you have to remember that what might seem like a small investment by normal standards might be huge in their terms – it's every cent they've ever saved. The important thing is to help them manage their earnings, as Pit Stop does with its trust funds, so that they can increase their share of the business as quickly as possible.'

Money

All the franchisors agreed that they would not make the internally-funded schemes available to people who actually had the money to buy the franchise outright. 'If someone has the money, I won't talk about joint ventures with them,' says Chris. 'A joint venture partner has to work just as hard as a 100% franchisee, but they don't get 100% of the profits – what's the point?' Karen Turketo agrees. 'It is a slower way of buying a franchise, so it's more expensive. On the other hand, if it's the only way you're going to get your own business, you're going to grab the chance with both hands.'

'I remember that horrible feeling of having ambition but no money,' recalls Chris Ring. 'The hardest part of getting into your own business is taking that first step. By re-investing in my own business, I can help people do that. I can also select the person I want to be a franchisee, rather than being limited to those who have the money to buy a franchise.

'A franchise is a long-term partnership anyway, so I have no problem with being more closely involved for the first couple of years. It's eighteen months since we first did it, and that franchisee has nearly trebled sales and turned a bad loss into a nice profit in that outlet. That speaks for itself,' says Chris. 'I think it's a technique we will use increasingly.' 

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