by Westpac New Zealand
last updated 25/06/2013
Beware The Hidden Costs
by Westpac New Zealand
last updated 25/06/2013
Daniel Cloete of Westpac identifies some areas that can be overlooked when buying a franchise
Over the 20-plus years that Westpac has had a specialist franchise team, we’ve found a number of areas that can be overlooked when planning to buy a business. These can have a significant effect upon the resources needed to fund some businesses, or on the cash flow of a business once established. It’s therefore worth exploring if any of these apply to your chosen franchise when you start getting serious.
Set-up & start-up costs
The costs of getting into a franchise vary a lot depending on the type of industry you choose. Generally, service franchises tend to be less complex and require less capital. Retail stores, fast food outlets or restaurants require leases and relatively expensive fit-outs; there may be construction, remodelling, leasehold improvements and decorating costs. There will also be equipment, fixtures, stock and fit-out. Fit-out contributions from the landlord can counter some of these expenses, but you need to allow for all eventualities.
Other items that people typically neglect when determining their funding requirement include:
- The interest on the funds required during the building process – after all, it can be a long period before any money comes in.
- The rent during the same time (except where they have negotiated a rent-free period)
- The time and cost the consent process may take.
- Working capital for other pre- and post-opening expenses as well as legal fees. In most instances, retail/food outlets tend to be overstaffed during the launch phase so there are additional wages. There will also be initial marketing costs.
- Insurances and licensing costs.
- Although one can eventually claim the GST component back on a lot of expenditure, remember that this also needs to be funded in the meantime.
In some business models, the business may need 6-12 months to reach break-even. This means that the franchisee has to be able to fund the balance of the expenses for a considerable period. It’s better to know how much you will need, and have the appropriate funding strategies in place before you start, to save worries and surprises later on.
Guarantees and rental bonds
Another aspect that is regularly required these days, but tends to be ignored by potential franchisees (and their financial advisors) until the last moment, is the need for guarantees like rental, stock or other bonds. This can create huge issues with funding. Some examples are:
Rental bonds. It used to be that no bank guarantee (or nothing more than a month or two of rent in advance) was required when signing a lease. This is no longer the case, with relatively large rental bonds being required by some landlords, especially in mall locations.
Now, a rental bond (or, in some cases, security deposit or performance bond) in the form of a bank guarantee is only ever called on when the business can’t afford to pay the rent – in other words, when it’s in trouble financially. That means that, in general, the rental bond can’t be secured against the business so the franchisee may need more hard security in the form of equity in a property or even a cash deposit. This is hardly ideal if you’re trying to invest all possible funds into the set-up of the business and suddenly need to come up with another $20,000 to $150,000. Effectively, it means a franchisee needs more equity than was previously the case.
Guarantees for stock. Some systems or suppliers now require franchisees to provide a guarantee to a certain level - for example, a month’s stock, or two drops of fuel for a petrol station. In many cases, this also comes in the form of a bank guarantee. Where payments are taken by direct debit, this can create a double-funding requirement: the business or franchisee has to arrange an overdraft with the bank to cover any direct debits that come through and then also has to provide a guarantee. The effect is that instead of buying the stock on terms and getting the cash from selling it before you need to pay the supplier, you may have to secure an overdraft and provide a guarantee! That would certainly change the business model of many franchises, as well as the resources required to enable a new franchisee to come on board.
Other bonds. These include aspects such as customs bonds for importers, which are likely to affect franchisors who import directly.
You would need to calculate the additional equity requirement (and cash flow implication) of any guarantees and rental bonds required. One would expect franchisors to take this into account when providing typical set-up figures and for experienced franchise accountants and bankers to address this.
Inexperienced franchisees going into business sometimes get caught out when going into business by not keeping up-to-date with GST or even PAYE payments.
An even bigger problem for the franchisors is when franchisees start to use the IRD as a bank by not paying, or delaying paying, tax to fund lifestyle or other expenses. This almost inevitably has a bad outcome when the business gets overextended and can’t catch up; penalties are levied and the franchisee is in trouble. The franchisor may be surprised to find that a franchisee that is doing well on sales can suddenly fall over, owing the suppliers and the franchisor a lot of money and with the IRD first in the queue to get paid.
For this reason many franchisors will have their operations managers monitor tax compliance. When re-financing an existing business, the bank will also ask the accountant for proof that the normal tax cycle is up-to-date.
Selling the business
The last area that is often under-investigated by franchise buyers is, ‘What happens when the time comes to sell?’ There are a number of issues that influence what you can get for a business when you sell and I have seen various reasons make a sale fall through, including:
- Does the business need a refit or is there a re-fit requirement imminent in a mall?
- Will the franchisor approve the potential buyer?
- What term is left on the franchise agreement and/or can the buyer get an extension or a new agreement?
- Is there a transfer/training fee payable?
- If there are sign-written vehicles, in what condition are they and does the franchise agreement require them to be replaced soon?
One other area to be cautious of is under-reported sales. Some franchisees think it’s smart (albeit illegal) to under-report sales in an attempt to avoid tax and percentage-based franchise royalties. When wanting to sell however, they still want top dollar, based on ‘actual’ rather than professed sales. In the current environment, however, buyers are rightly a lot more conservative and less inclined to pay for unproven sales. Apart from the obvious dangers of taking the seller’s word for it, paying more than the figures justify will make it more difficult to obtain funding against the business.
The franchise advantage
Of course, most of the items I’ve mentioned above apply to all businesses, not just to franchises. The advantage of choosing a franchise is that, in general, experienced franchisors will be aware of – and have solutions for – many of these issues and will be able to ensure new franchisees make allowances for them from the start. By choosing a franchise which has strong management information systems, and taking good professional advice, franchisees can also help to guard themselves against the unexpected.
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.
This advertorial is taken from Franchise New Zealand magazine Volume 22 Issue 2
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