What to expect when you buy a franchise

Franchising can be a great way to get into business for yourself, but if you’ve never been self-employed before then it’s important to go in with your eyes open – to take off the rose-tinted glasses and be aware of the realities of owning your own business. That’s especially the case when it comes to financial matters. Here are 10 areas where newcomers often don’t know what to expect.

1. Set-up costs – what’s included and what’s not?

Franchises come in many different types and sizes; you can buy a franchise for as little as $5,000 or more than $1,000,000. But however much you’re planning to spend, you need to know what is included and what is not before you sign the contract. When considering set-up costs, some of the common areas to investigate are:

What does the franchise fee cover? Normally, it will cover the right to use the brand and systems – but what else is included? A launch promotion and initial marketing? Manuals? Training? If training is provided, does it take place in NZ or overseas? Who pays for the travel and accommodation costs?  Do you get paid while you are training, or do you have to allow for this when planning your budget? Is there a work guarantee or an income guarantee? When do they apply and for how long?

Set-up costs will vary considerably depending on the type of franchise you have chosen: for example, home-based, mobile or premises-based? Do you have to provide a rental bond? Are there any fit-out costs? Is the fit-out on a fixed price contract or just an estimate? Is external signage included? Do you require a vehicle? What type? Must it be new or second hand? Is signwriting included or additional? What equipment or initial stock costs will be incurred? Can items be leased to preserve initial capital?

Any good franchisor will detail all the above prior to signing so that you don’t find yourself faced with unexpected costs. However, it’s important for you to know whether or not such costs are included in the figure initially quoted to you.

One question often overlooked is: have adequate provisions been made for professional costs – your lawyer’s and accountant’s advice? Who pays the franchisor’s legal costs? Are the costs of leasing negotiations allowed for?

Don’t make assumptions on any of these areas: be specific with your questions and your research. There’s a helpful list here of 250 Questions To Ask Your Franchisor.

2. Ongoing fees – how much, what for and when?

All franchise systems require their franchisees to pay ongoing fees in some way, whether as a flat fee, a percentage of turnover, a mark-up on products or services provided or some other approach. These fees are the life blood of the franchise system; they fund various services from the franchisor such as support, analysis and development, and also provide the franchisor with the return on their own investment.

Ongoing fees, sometimes called royalties, management fees or licence fees, are separate to and additional to the upfront franchise fee you paid at the beginning. As the name suggests, they are payable on a regular basis – often weekly or monthly – throughout the term of the franchise agreement.

There is no ‘standard’ rate; fees vary according to the services which they pay for. Potential franchisees should avoid choosing a franchise based on lowest fees alone, as an under-funded franchisor may struggle to deliver on support and system improvements. Remember, keeping field support staff on the road or developing new online systems is expensive. It’s better to find out what you will get for your money and whether existing franchisees feel that they get value for money for their fees (see our list of 50 Questions To Ask Franchisees).

One question we are often asked is, ‘Can I negotiate the fees downwards?’ The answer is almost certainly no; fees have been calculated to support a certain level of services and return, and should be the same for every franchisee in the network.

In addition to the normal ongoing fees, there may also be specific fees charged for other services. All of these fees need to be factored into your cash flow planning. In many cases, defaulting on paying your franchise fees will mean you are in breach of the terms of your franchise agreement and face the risk of losing your franchise.

3. Ongoing costs – what’s included?

It’s important to realise that when you buy a franchise, you are running your own business. The ongoing fees that you pay will provide some services, as detailed above, but you will be responsible for everything else: rent, rates, repairs, stock, equipment maintenance, point of sales systems, staff wages, KiwiSaver contributions, fuel, power bills, local advertising, etc, etc. All of these have to be budgeted for and included in your cash flow projections.

The good news is that although you have to pay these costs, your franchisor should be able to give you a clear guide as to how much they will be and provide systems for you to calculate and manage them. Even better, the franchise should have benchmarking systems in place that allow you to compare how you are doing in each of these areas against other franchisees in the group, so that you can see where there are areas for improvement.

4. Sales projections – how are they calculated?

Unlike costs, franchisors can’t know what sales you will achieve with 100 percent certainty – there are too many variables, including your own performance. It’s therefore important for you to ask how any sales projections were calculated to know how much reliance you can place on them in making your buying decision.

Were sales projections based on existing franchisee sales currently being achieved within the system? Is your site or territory directly comparable to others? Are the projections based on trading in New Zealand or overseas outlets? Businesses often take time to get established, so how long does it usually take to reach expected sales levels? What are the assumptions used to create the sales projections – eg, operate 6 days a week for 10 hours a day, or 5 days a week for 8 hours a day?

In another article on this site, Dean Madsen of Westpac points out that a franchise which has good benchmarking processes in place can provide valuable insights. Beyond that, consulting an accountant who has experience with, and data on, the franchise you are seeking to buy can assist in this process. Finding like-for-like comparisons from actual data can create realistic sales expectations and targets for you, so that you know from the start what you need to achieve each week and can measure your progress. Talking to other franchisees in the system can give you insights about realistic sales levels and what you need to do to cover your wages and finance your borrowings. Having realistic expectations is essential.

5. How do I pay taxes & GST?

There are two main reasons for business failure: the first is lack of capital, so choose a business you can afford in the first place. The second, however, can creep up on you – not planning for your tax obligations. That’s why you need to work through a number of key questions with your accountant before you start your business.

Do you put yourself on the payroll and pay PAYE once a month? What about KiwiSaver? Employer or employee contributions? Which payroll system should you use?

Or instead of a salary, should you take drawings? Drawings are withdrawals you take as an owner that have no tax attached at the time, although it will need to be paid later. If you do take drawings, how do you record them in your books? When does the tax on the drawings become payable? Drawings will often move you from being a PAYE tax payer to being a ‘provisional tax payer’ – and recent changes mean that you have more options as to how you pay provisional tax. It can be tempting to use the money for other things ‘in the meantime,’ so beware. The Accounting Income Method (AIM) introduced by the IRD in 2018 allows you to pay your income tax as you go and may merit consideration.

There are various GST payment cycles ranging from monthly to six-monthly filing and different methods for calculating GST. This is a common area where cash flow suffers if you don’t get it right.

For all these reasons, taking tax advice from an accountant before you start trading is critical to operating a business – the IRD doesn’t accept ignorance as an excuse.

6. What can I put through the business?

This is one of the most common questions I hear from new franchisees. Operating a business means that you can claim certain types of expenses against tax, which is not the case if you’re a wage or salary earner. What you can claim, however, will vary depending on your individual circumstances.

I often hear people saying things like, ‘My friend’s accountant said I could claim the household dog food as a security cost,’ or ‘My new designer wardrobe can be claimed as uniforms.’ Such bizarre or excessive claims are frowned upon by the IRD, which has benchmarks on all industry types. Any excessive personal expenses put through the business may trigger an IRD audit – a disruptive process for any business.

The IRD do prescribe certain types of costs that can be claimed within defined parameters. Common areas include a proportion of home office expenses such as telephone and internet costs, a proportion of rent, interest, insurances, power, etc. Good record-keeping will be essential to follow these costs.

As a rule of thumb, expenses claimed need to have a connection to deriving income: for example, filling the boat with fuel will be a deductible expense if you are a fisherman, but not if you operate a stationery store! Again, it pays to get advice from an experienced accountant on this to set realistic expectations on what you can and can’t claim.

7. When can I have a company car?

It takes time to get a business up and running profitably, so unless you need one to operate then you will need to wait. You have to make the money before you spend the money, and leaving cash in the business is critical – you’ll need to spend it on more stock, more staff, more marketing or whatever before splashing out on a new BMW. Knowing your break-even point, reaching critical mass, paying all your taxes and operating costs will all help you achieve your ultimate goal.

If you do need a vehicle, take advice on claiming motor vehicle expenses before you buy it. Being realistic on the type of vehicle is important – that Beemer may not be deemed appropriate for delivering spouting! Some vehicle types will attract Fringe Benefit Tax (FBT) while others allow your business to claim 100 percent of the operating costs without incurring FBT. Other questions include: how much of my vehicle running costs can I claim as a business expense? Do I need to keep a log book? Can I claim the GST on the purchase of my vehicle? What happens when I sell it? This is a complex area and each case needs to be evaluated on its own merits.

8. How much can I earn?

This is a million dollar question, although the answer is unlikely to be ‘a million dollars.’ The real question is, ‘How much money can I take out of the business without damaging it?’ A one-man-and-a-van franchise is likely to produce a different result from a large restaurant employing 50 staff.

Some questions you should ask yourself are: How much money do you need to live on? Are you comfortable with earning less than what you are being paid now until your business is established? Although some new businesses do offer a return from day one, most take time to be able to start paying you back. You need to find out how long this will take.

The franchisor and other franchisees should be able to give you some guidelines, but using a specialist accountant who knows the franchise is your best bet. Putting together a business plan and a cashflow budget will assist you in establishing what income you could reasonably expect to earn before you sign.

9. How much will my business be worth?

When the time comes to sell your business and move on, how much can you expect to get for it? Well, it’s just like selling your family home – what you can get for it depends on what someone is willing to pay.

As a general rule, though, a high-performing franchise business with a recognised brand will be easier to sell than an independently-owned business. A successful business with good cashflow will fetch more than a struggling one. Profitability, a track record of consistent performance, a good location and good record-keeping all contribute to how much a business is worth.

10. Do I need to pay for advice?

If you had a particular medical problem, you’d consult a specialist rather than your GP. In the same way, if you’re considering buying a franchise, consult a specialist franchise lawyer, banker and accountant. They won’t be learning on you, and they’re likely to know the franchise system and the franchisor involved. They’ll know about the specific issues, set you on the right path and, ultimately, save you time, money, headaches and even tax.

Having realistic expectations is important for your future success and your future happiness, so don’t try to save money or take short-cuts. Do proper pre-purchase evaluation and remember: good advice pays, not costs.

 

This article appeared in Franchise New Zealand magazine (Year 27 Issue 1). Read the entire article in the digital magazine or, if you live in New Zealand please send for your free print copy.